Taxes on investment income in Canada
There are four kinds of investment when dealing with income tax in Canada; the interest and other investments income, the eligible dividend, the non-eligible dividend, and the capital gain. These four types of income are included in the same provincial and federal tax brackets as the employment one, but most at a modified amount and rate. Also, it is the marginal rate applied on the investment income, so their calculations start after the last income received, but they can still reach superior brackets depending on the amount. Each type of investment income is treated differently, which we will see in this article.
Interest and other similar investment income
Interest income is taken from investment in Canada Saving Bonds, Guaranteed Investment Certificate (GIC), Treasury-bills (T-bills), Strip Bonds, foreign dividend and other similar kind of investments.
No favorable treatment is applied, unless the investment is made under the Registered Retirement Saving Plan (RRSP) or Tax-Free Savings Account (TFSA), which is in part exempt from taxes. Interest and other investment income are taxed like extra salary revenue; the rates and brackets used are the same as the employment income.
Dividends from Canadian businesses
Dividends are investment income that takes its origin from a company's share. As a shareholder, you own part of the business, and at times, you have the privilege of receiving a portion of the profits. The tax rates on dividends are lower than on employment income, because dividends are a distribution of the business' profits after tax; the government has already collected taxes on the company's earning. Therefore, governments will avoid taxing the same income twice, but will still get the remaining portion since, in general, individuals are higher taxed than corporations.
The calculation's principle is to take the dividend that would have been distributed before taxes, deduct from the personal tax the part applicable to the corporation, and then tax the difference related to the individual. To do so, the dividend is increased by a gross-up rate to hypothetically reflect a dividend distributed before corporate tax. After that, the grossed-up dividend is introduced in the personal tax bracket, but the rate of the respective bracket is decreased by the dividend tax credit (DTC). The DTC is an equivalent rate to the federal and provincial corporate tax rate. An example is illustrated further to help understand, but first we need to go over the different rates associated with the two types of dividend.
From the fiscal point of view, there are two types of dividend issued by Canadian businesses, both differently taxed: the eligible and non-eligible Canadian dividends. The eligible dividends are favourably taxed, as opposed to the non-eligible dividend, which involves lower gross-up rate and DTC. The eligible dividend is coming from businesses subject to the general corporate tax rate, and the non-eligible dividend are issued by business benefiting from the small business deduction. Since the businesses eligible to the small business deduction are paying at a lower tax rate, the gross-up rate and DTC are decreased, and therefore the personal tax goes up.
In 2015 and 2016, the gross-up rate, which is applicable everywhere in Canada, is 38% for eligible dividends and for non-eligible dividends, 18% in 2015 and 17% in 2016. The Federal enhanced DTC for the eligible dividends is 15.02% and the small business DTC for non-eligible dividend is 11.017% in 2015 and 2016. At a provincial level, every province registers a different corporate tax rate, so each one of them has their own DTC rates. The DTC rates are not progressive, they stay fix and are decreasing the grossed-up dividend tax rate of every brackets.
If we take an eligible dividend of $100.00 for example, the income included in the tax bracket after applying the gross-up rate of 38% will be $100.00 * (1 + 38%) = $138.00, which is the taxable amount the combined federal and provincial rate will be applied on. So if we take an individual tax rate of, let's say, 40%, the payable tax would be 40% * $138.00 = $55.20, but the federal DTC of 15.02% and 14.98% from the provincial (hypothetical provincial DTC to round up the calculation) will reduce the tax rate by 15.02% + 14.98% = 30%, which would be a deduction of $138.00 * 30% = $41.40. The tax payable on the $100.00 dividend will then be $55.20 - $41.40 = $13.80, which ends up being 13.8% instead of 40%.
In this example, we notice that it is the grossed-up dividend that is included in the tax brackets, which means the tax calculation is done on a higher amount than the one you actually received. Consequently, the grossed-up dividend will reach a superior tax bracket more rapidly, which is not playing in the investors' favour. In the case the employment income is very low, it is possible for the dividend to have a negative tax rate, because the first bracket rates are rather low and the DTC are fixed. The negative amount is not a reimbursement, it just decreases the payable taxes.
The factors and rates used on the dividends is an estimation made by the governments to ease up the tax report. The gross-up factor in which we increase the dividend in order to get a before-tax dividend and the DTC doesn't reflect an exact transfer from corporate to personal income tax, but is very close. The government tries to establish an equation that will bring them approximately the same amount of corporate taxes no matter how a business redistributes its profit. Moreover, the rates and factors can be readjusted when the corporate tax rates fluctuate; if it decreases, the DTC rate will decrease as well, a scenario that won't benefit the investor.
A capital gain is the sale of a financial title or real estate propriety that did appreciate from its initial purchase price. It is a capital gain if the asset appreciated, and capital loss if depreciated. Selling and cashing a share or real estate at a higher price than its original purchase value (net of transaction costs to be more precise) is in fact another form of investment income, and in the fiscal world, it is treated differently from the other investments.
Its tax calculation is simple; only half of the capital gain income is taxable, and in the case of real estate, taxation only applies if it's not the owner main's residence. In this situation, we tend to apply half of the marginal rate on the entire capital gain, which is not totally exact. Income taxation in Canada is applied on several income brackets at a progressive rate; the rate increases for every additional revenue bracket, and not just one rate on the total income. Therefore, if only half of the capital gain is taken into consideration, you need to accumulate a bigger amount in order to reach superior rates and brackets, obviously more than the total capital gain if it's calculated at half the marginal rate. This aspect is playing in the investors' favour.
Another fiscal advantage from capital gain is that it is only taxable when the asset has been sold and the amount cashed, so basically the gain of the transaction must be realized. While the tax on interest and dividend income is paid annually, you can retain a stock, bond or real estate that appreciate indefinitely without paying income tax. It is only collected when the capital gain has been realized, so the longer you wait before selling, the lower will be the effective tax rate.
Differentiating interests, dividends and capital gains in your portfolio
The different tax rules applicable on the investment income should influence the choices you make when investing your savings. For instance, to get the same result after taxes, dividend and capital gain require a lower return than interest income since they are not as severely taxed. In addition, the risk and term duration aspects add to the type of investment you aim to get in your portfolio. It is important to understand the impact of investment income taxation in order to make enlightened choices.