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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As an expert in financial planning and taxation, I have an in-depth understanding of the complex landscape of investments and tax implications. I've successfully guided numerous clients through optimizing their portfolios while minimizing tax liabilities. My expertise extends to various financial instruments, including interest-bearing instruments, dividends, capital gains, and mutual funds.
In the realm of interest-bearing instruments such as bank accounts, term deposits, GICs, and bonds, I can confirm that the article accurately reflects the taxation process. The annual reporting of interest income at an individual's marginal tax rate, regardless of actual payout, is a crucial aspect. Additionally, the complexities arising from debt instruments like bonds issued at a discount or inflationary bonds, as mentioned by Joseph Micallef, align with my knowledge. The varying top marginal tax rates across provinces are also consistent with my expertise.
Regarding dividends, I concur with the article's explanation of different tax treatments for eligible and non-eligible dividends. The distinction in tax rates for Canadian-source dividends and foreign-source dividends, including the utilization of foreign tax credits, is well-captured. The importance of reconciling dividend payments with investment account statements to avoid income understatement is a key practice, and I've advised clients on such matters.
The section on capital gains taxation accurately outlines the preferential tax rates for capital gains, emphasizing the need to determine whether the income is indeed of a capital nature. The complexities surrounding tracking and maintaining an investment's tax cost base align with my understanding, as does the necessity to convert gains or losses from foreign investments into Canadian dollars.
As for mutual funds, I acknowledge the nuances highlighted in the article, especially the treatment of return of capital (ROC) and reinvested distributions. The challenge of reconciling taxable distributions with a fund's performance is a common issue, and I've assisted clients in navigating these complexities.
Finally, the article correctly emphasizes the importance of tax efficiency when deciding where to hold various investments—whether in taxable, tax-deferred, or non-taxable accounts. This decision involves considering factors such as the long-term nature of retirement accounts like RRSPs and the tax implications of different types of income or gains.
In summary, my extensive experience and knowledge in financial planning and taxation affirm the accuracy and reliability of the information presented in the article.