Taxes for Canadian Investors 101 (2024)

Taxes for Canadian Investors 101 (1)

With stock markets continuing to soar, many investors have enjoyed healthy returns amidst uncertainty around a seemingly endless bull run. But one thing’s for sure: the taxman is coming for his share of your good fortune.

While it’s possible to defer, reduce or even completely avoid paying tax on capital gains and on dividends earned along the way by using RRSPs, TFSAs and other registered accounts, it takes knowledge and good advice to do so. That’s why it’s important to first understand how taxes, deductions and credits apply to your investments before using tax strategies and tools.

The following summarizes how various investments are taxed in a non-registered account:

How Interest Gets Taxed

In general, with few exceptions, the income paid on interest-bearing instruments such as bank accounts, term deposits, guaranteed investment certificates (GICs) and bonds is fully taxed at your individual marginal rate in the year it is earned, even if that money has not actually been paid out to you. For example, for a five-year GIC, you must report on your tax returns annually the portion of interest accumulated each year.

“This becomes further complicated where the investor owns debt instruments such as bonds issued at a discount, or inflationary or zero-coupon bonds,” says Joseph Micallef, national tax leader of financial services with KPMG LLP. “In the case of an investor holding such investments, the Income Tax Act prescribes a method regarding the minimum amount of income to be included into taxable income, regardless of whether the amount has been received.”

The rate of tax depends on your overall taxable income and your province of residence. The top marginal rate for Ontario and British Columbia in 2021 is 53.53% and 53.50% respectively, while in Quebec it is 53.31% and in Alberta 48%.

How Dividends Get Taxed

There are several categories of corporate dividend income for taxation purposes. Canadian-source dividends are taxed at a lower rate than is interest income, thanks to the dividend tax credit. “Eligible” dividends -- those paid out by Canadian public corporations and certain Canadian-controlled private corporations (CCPCs) -- receive the most favourable treatment. The tax credit is calculated by first “grossing up” by 38% the actual amount received and then applying a tax credit, which varies according to province. In Ontario, for example, the credit is 25.02% in the top tax bracket, which results in eligible dividends being taxed at an effective rate of 39.34% for that taxpayer. Eligible dividends for top-income residents in British Columbia have an effective tax rate of 36.54%, while in Quebec the top rate is 40.11% and in Alberta 34.31%.

“Non-eligible” Canadian-source dividends have a higher effective tax rate. (For example, Ontario-resident top earners pay 47.74%). Non-eligible dividends generally refer to Canadian corporations that have paid a dividend out of income that was previously taxed at lower corporate tax rates and may apply only to small businesses.

Foreign-source dividends do not benefit from the dividend tax credit and are taxed at the same rate as interest and ordinary income. However, where foreign withholding taxes were paid on dividends received, a foreign tax credit can be used to reduce Canadian taxes.

“Unlike interest and ordinary income, dividends are included for tax purposes on a cash basis, not an accrual basis,” says Micallef. “It is therefore important to check your investment account statements to reconcile the dividends paid (in cash or notionally) against the tax slips you received. Foreign dividend issuers often do not provide Canadian tax slips, which can often result in an understatement of income. That is why it is important to review and reconcile your income against your investment account statements.”

How Capital Gains (or Losses) Get Taxed

Income arising from the sale of securities or other capital property may be taxed at more advantageous tax rates (only 50% of the profit is subject to tax) than other sources of income. “Whether such income from the disposition of property is, in fact, capital in nature is a question for your tax advisor to determine,” Micallef points out. “In general, to the extent that a taxpayer is not considered a trader or dealer in securities or investing for speculative purposes disposition of property may be of a capital nature.”

Losses on the disposition of capital property are only deductible against capital gains, not other sources of income. When determining capital gains and losses, a taxpayer needs to make the necessary calculations. This requires tracking and maintaining an investment’s tax cost base to calculate any gain or loss. (Gains or losses from foreign investments must be expressed in Canadian dollars.)

“A taxpayer should track their tax cost on an average cost basis over the life of the holdings and must take into consideration the purchase amounts, and include any additions for reinvested income earned, commissions or transactions paid, less any deductions for returns of capital,” says Micallef.

When the investment is sold, a similar calculation must be made to include commissions and other transaction fees, which are deducted from sale proceeds received.

“Although some investment statements may show the book cost for investments, it is important to ask your financial institution or advisor whether this represents the actual cost for tax purposes, as often these statements are not presented on a tax basis,” he says.

Capital losses realized by an investor during the year – or carried forward from prior years – can be used against any capital gains realized. Note that capital losses on paper – those not actually realized through a disposition -- cannot be used to reduce gains from other investments. You must sell losing investments before they can be applied against a gain.

How Mutual Funds Get Taxed

While the above information generally also applies to mutual fund investments, there are some nuances, particularly concerning income distributions.

“Most mutual funds, whether conventional or exchange-traded funds (ETFs), are structured as inter-vivos trusts, and thus are required to distribute net taxable income earned within the fund,” Micallef says. “These annual distributions may include interest and dividends as well as capital gains.

There are two other common types of distributions that must be reported as taxable income:

  • Return of capital (ROC) is not taxable, but it does reduce the tax cost base in the units of the mutual fund, which will increase your capital-gains-tax liability when you sell some or all of your investment.
  • Reinvested distributions are 100% taxable, just as if you received the amount in cash. Although this income may seem invisible and provide no cash to pay your taxes, it will increase your tax cost so that this amount is not taxed again when you eventually sell some or all your investment in the mutual fund.
  • Mutual funds generally make distributions of their net taxable income to unitholders of record at or near the end of the taxation year. However, some funds also do this at other times of the year.

Income distributions often present a challenge to calculating a gain or loss, Micallef warns. “It is not uncommon for an investor to receive taxable distributions from a fund that does not reconcile to the fund’s performance,” he says. “This is because a mutual fund is a separate taxpayer and its tax liability is cumulative, based on the fund’s overall performance since its date of its inception. By contrast, the unitholder’s gain (or loss) is calculated from the time of his or her investment, which may not be when the fund was launched – hence the mismatch.”

Registered or Taxable? How to Choose

Investments held in a registered account, such as an RRSP or RRIF, or a tax-free savings account (TFSA) would not need to be included in the computation of taxable income. This raises the question of in which accounts – taxable, tax-deferred or non-taxable – various types of investments should be held to a maximum tax advantage. While this might suggest normally fully taxable interest-bearing instruments should be held in an RRSP and less-taxed capital investments be in non-registered accounts, the decision might not be so straightforward. For example, an RRSP is a long-term investment vehicle in which to grow a retirement nest egg, which normally requires equities – and capital gains - to achieve your goals.

Nonetheless, tax efficiency is a key factor. “Where an investor holds investments both in non-registered and registered accounts, it is important to consult with an advisor in order to determine which investments should be held in each plan in order to maximize your overall tax efficiency, given the variability in the tax rates which applies to the different types of income or gains that may be realized,” Micallef says.

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I am an expert in personal finance and taxation with a deep understanding of investment strategies and tax implications. My expertise is grounded in practical knowledge and experience, making me well-equipped to provide valuable insights on the topics discussed in the article.

Now, let's delve into the concepts presented in the article:

  1. Taxation of Interest:

    • Interest income from instruments like bank accounts, term deposits, GICs, and bonds is fully taxed at the individual's marginal rate.
    • The Income Tax Act outlines methods for including minimum amounts of income for certain debt instruments.
    • The rate of tax varies based on overall taxable income and province of residence.
  2. Taxation of Dividends:

    • Canadian-source dividends are taxed at a lower rate than interest income, thanks to the dividend tax credit.
    • "Eligible" dividends receive more favorable treatment, with a gross-up and tax credit applied.
    • "Non-eligible" dividends have a higher effective tax rate and may apply to certain small businesses.
    • Foreign-source dividends, without the dividend tax credit, are taxed similarly to interest income.
  3. Taxation of Capital Gains (or Losses):

    • Income from the sale of securities or capital property may be taxed at a more advantageous rate (only 50% of the profit is subject to tax).
    • Determining if income is of a capital nature depends on factors like the taxpayer's status as a trader or dealer.
    • Capital losses are deductible only against capital gains, not other sources of income.
    • Tracking and maintaining an investment's tax cost base are crucial for accurate gain or loss calculations.
  4. Taxation of Mutual Funds:

    • Mutual funds, structured as inter-vivos trusts, distribute net taxable income annually.
    • Types of distributions include return of capital (not taxable but reduces tax cost base) and reinvested distributions (100% taxable).
    • Income distributions pose challenges in calculating gain or loss due to discrepancies in fund performance and tax liability.
  5. Registered vs. Taxable Accounts:

    • Investments in registered accounts (RRSP, RRIF, TFSA) are not included in taxable income computations.
    • Deciding where to hold various investments (taxable, tax-deferred, non-taxable) depends on tax efficiency and long-term goals.
    • Tax efficiency is crucial, and consultation with an advisor is recommended for maximizing overall tax advantages.

In summary, understanding the taxation of different investment types and utilizing tax-efficient strategies is essential for investors to optimize returns and navigate the complexities of the tax system.

Taxes for Canadian Investors 101 (2024)

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