Tax planning is an important element of investment strategy and can impact your portfolio growth.
Broadly speaking, a gain from selling a stock or other capital investment is taxed at a more favourable rate than interest income. Most dividend income also has a smaller tax hit. As with other types of income, how much tax you pay depends on your income level and province of residence.
The following is a summary of how to make the most of your investing success - and in some cases mitigate any losses - when preparing your 2018 income tax return. For the calculations in this article, we’ll refer to residents with a taxable income of $100,000.
Interest income
The interest you receive from everything from a bank savings account to a guaranteed income certificate to a bond coupon (representing a periodic payment) is taxed at your top marginal tax rate. For a residents of Ontario, interest is taxable at a combined/federal/provincial rate of 43.4% for 2018. In B.C. and Quebec, the rates are 38.3% and 45.7%, respectively.
Dividend income from Canadian corporations
An Ontario investor for example, pays tax on dividend income at a rate of only 25.4%, while in B.C. it’s 18.3% and Quebec 29.4% (these rates apply to the actual amount of dividends received, not the grossed-up amount discussed below).
The amount of tax payable on dividend income is calculated using an unusual calculation that requires "grossing up" the actual amount received by 45%, to reflect the amount of pre-tax income the corporation earned during the year. Then an offsetting 19% tax credit is calculated on the grossed-up amount. The result is claimed as a tax credit on your income-tax return. Note that these dividend tax rates apply only to "eligible" dividends received by individual investors from Canadian public corporations and certain Canadian-controlled private corporations (CCPCs).
Small-business dividends
Dividends received from CCPCs that pay income tax at small-business rates, which are more favourable than those paid by large corporations, are taxed at a higher rate. A different gross-up formula is used. The rates payable by a taxpayer on these “non-eligible” dividends are 34.9% in Ontario, 30.4% in B.C. and 36% in Quebec.
Dividends from foreign companies are taxed at the taxpayer’s top marginal rate, as are the entire amounts received from registered retirement accounts (original capital as well as all income earned on the investment, including capital gains). These accounts include:
• RRIF (registered retirement income fund)
• RRSP (registered retirement savings plan)
• DPSP (deferred profit savings plan)
• Locked-in RRSP
• LIRA (life income retirement account)
• LIF (life income fund)
• Registered annuity
Capital gains and losses
Here’s where things potentially can get pretty complex. Many investors realize capital gains and/or losses on investments over the course of a year, and these must be reported on your income-tax return for the year in question. Note that we are talking about capital investments such as stocks, bonds or real estate that you actually sell, as opposed to on-paper increases or decreases of an investment's value that have not been realized.
Tax must be paid on any profits realized from the sale of a capital investment. For someone in Ontario the rate is 21.7%, B.C. 19.2% and Quebec 22.9%.
The tax break is created because only one-half of capital gains is taxable. The amount of the gain is determined by subtracting the proceeds of the sale (net of the broker's sales commission or other disposition costs) from its adjusted cost base (ACB). The ACB consists of what you originally paid for it, plus the broker's sales commission or other acquisition costs.
Unfortunately, these amounts are not normally computed by the institution through which you hold these investments. While your financial advisor may assist you in determining an ACB, it is basically your responsibility to calculate and report the correct amount using Schedule 3 of your federal tax return (Schedule G for Quebec purposes).
The mathematics are simple enough: subtract your sale price from the purchase price (including commissions or other fees paid in regard to both the buy and sell transactions) and the difference is the capital gain (or loss). But frequently a position in a stock or mutual fund is built through a number of transactions over time, muddying the calculation waters. Further complicating things would be any reinvested dividends, which represent additional share purchases.
Once you have tallied up the various amounts of share purchases, reinvested dividends and related transaction fees, divide the total by the number of shares of the stock you own. The result is your ACB.
For example, say several years ago you initially purchased 1,000 shares of a company at $10 each, on which you paid a $35 commission. Your cost was $10,035. The price eventually fell slightly to $8, but you continued to have longer-term faith in the stock and you decided to added 1,500 more shares of that company at that discounted price, with another $35 commission, for a cost of $12,035. Your total ACB per share became $8.83 ($10,035 + $12,035 = $22,070/2,500 = $8.83). Over several years, the shares rebounded strongly, reaching $20 late last year, and you decided to take a profit on some of your position by selling 800 shares at that price, on which a $35 commission was payable. Your total proceeds were $15,965 ($16,000 less the commission).
Based on an ACB of $7,064 ($8.96 X 800), the capital gain was $8,901 ($15,965 – $7,064). Given that one-half of capital gains are taxable, the tax on this income would be $1,923 for an Ontario taxpayer.
Note that while capital-gains taxation rules also apply to mutual funds, there are some important differences when calculating the amount of the taxable gain. Moreover, there are different issues to consider regarding the sale of small-business shares, including access to a significant tax exemption.
Capital losses resulting from the sale of an investment may be used to offset the amount of capital gains in a particular year. If you did not realize any capital gains last year but did sell an investment at a loss, you can use it to reduce any capital gains during any of the previous three years, or save it indefinitely for use in a future year.
Investment carrying charges
While brokerage fees are included in the calculation of a capital gain, there are other expenses related to owning an investment that can be deducted on an ongoing basis. Such expenses include interest paid on investment loans, fees paid on a safety-deposit box to store investment certificates, and investment management or counselling fees paid during the year.
Note that investment-loan interest is deductible only if you can prove there is a reasonable expectation of profit. This usually is not an issue when you borrow to buy stocks, but if you are doing so to invest in preferred shares, generally you can claim loan-interest costs only up to the amount of the grossed-up dividend rate. For loans taken out to purchase interest-bearing investments, the interest on these loans will be deductible only if the rate paid on the investment is higher than the rate paid on the loan. Interest charged on RRSP loans and administration fees paid for RRSPs and registered retirement income funds (RRIFs) are not deductible.
