For many investors, 2017 was a pretty good year, with most global stock markets posting strong double-digit returns. Even if you kept your investments at home, the Canadian stock market was up a healthy 9%.
The downside is that the tax man came along for the ride, and with the April 30 tax-filing deadline fast approaching, it's time to share some of your good fortune with the government. But by ensuring you make the most of favourable tax rules for various types of investment income, and claiming all available deductions and credits, you can minimize the tax man's take.
The financial institution holding your various deposits or securities is responsible for issuing the investor a T5 information slip (and Relevé 3 from Revenue Quebec), or a T3 (Relevé 16) in the case of income paid out by a mutual fund or other form of a legal trust. These slips normally are sent out by the end of March. Sometimes these slips can be late in coming, so, before preparing your tax return, make sure you have everything on hand.
Interest income
The most basic form of investment income is interest, whether it comes from a bank savings account or a bond coupon. Unfortunately, "basic" extends to the tax side. There are no tax breaks available; interest income is taxed at your top marginal rate. (A marginal rate refers to the various tranches of your income and the tax rate that applies to each, known as tax brackets.)
However, there can be some intricacies regarding how and when interest income is reported. Overall, any interest paid to you during the year must be reported as income on your tax return for that year. This is known as simple interest. But you may also receive accrued interest, applied to an interest-bearing security but not actually paid out to you. In the most common case, this applies to anyone who has a multi-year guaranteed investment certificate.
For example, a $1,000 five-year GIC paying 3% in compound interest would pay out $1,160 when the deposit matures in five years. However, you must report on your tax return a portion of interest that accrues within that investment each year, based on a T5/Relevé 3 information slip provided to you by the financial institution holding that certificate. (Note that information slips are issued only for interest amounts of $50 or more; however, you must still report all interest received or accrued.) Accrued interest also is earned within strip bonds, compound-interest Canada Savings Bonds, and even on loans or mortgages you make to someone, including a family member.
Strip bonds and the coupons that have been clipped from them deserve special mention. Typically, to create these securities, a long-term government bond is separated into its principal and interest components and sold as separate securities. Prices for the individual coupons are set according to the length of time until they are redeemed (when interest is paid on the coupon's date). The difference between the price paid and the amount received at maturity is considered for tax purposes to be interest, with tax payable as it accrues each year along the way (and a T5/Relevé 3 slip issued to the investor each year).
Dividends
Most investors buy stocks primarily for capital appreciation. But many also hold them to provide periodic income through dividends. Blue chip-companies are common sources of common-share dividends, which is a distribution of profit to shareholders usually made at the end of each calendar quarter. Some companies also issue preferred shares, which pay a healthy dividend -- but normally are structured to maintain a fixed share price and, as such, are commonly considered to be fixed-income investments.
Dividend income is not guaranteed. However, it is attractive because, particularly in recent years, the payout is often higher than what interest-bearing securities produce. Perhaps more importantly, dividend income is taxed at a lower rate than interest, thanks to the dividend tax credit. This applies to both common and preferred shares. For "eligible" dividends issued by Canadian public -- and some private -- corporations, the tax savings over interest and employment income can be quite significant.
Because the issuing corporation already has paid tax on its profits -- on which its dividends are based -- the calculation of the dividend tax credit is somewhat complex. Here's how it is computed on your income-tax return:
- The eligible dividend income you report as income is a "grossed-up" amount -- 38% more than the actual amount.
- You then claim the dividend tax credit, which results in your actual dividends being taxed at combined federal-provincial rates ranging from about 25% to 42%, depending on your province of residence. ("Non-eligible" Canadian dividends -- those issued by companies that pay tax at the small-business rate -- are taxed at approximately 35% to 47%.)
- Dividends paid by U.S. and other foreign companies are ineligible for tax credits and are taxed at your top marginal rate.
If you receive dividends in the form of newly issued shares of the company, you are taxed in the same way, even though you have not actually received any cash payments. Private corporations sometimes pay capital dividends, which represent the untaxed, one-half portion of capital gains realized by the corporation. You, the investor, are not taxed on this income.
Since the dividend tax credit is a non-refundable credit, you may transfer dividends to your spouse (or vice versa) if you or he/she has no income to be offset by it. Note that doing so can reduce the amount of the spousal tax credit for the higher-income spouse. Conversely, you can elect to report your spouse's dividend income on your tax return, thus preserving the spousal tax credit. (Quebec taxpayers do not make this election on their provincial tax return, since there is a broad provision to claim the unused portion of their spouse's non-refundable tax credits.)
Capital gains
For high-income individuals, capital gains, or profits, from the sale of stocks, bonds or other capital securities, such as real estate other than your principal residence, are taxed even less than dividends. (Among the larger provinces, the taxable-income level at which capitals gains become taxed less than dividends ranges from about $86,000 in Quebec to $142,000 in Alberta.) Only one-half of gains is taxable.
For high-income taxpayers, this results in capital gains being taxed at a combined rate of less than 24% to 27%, depending on the province. The favourable tax treatment is based on the fact that only half of gains are taxable, enhanced by the ability to reduce capital gains by the amount of any capital losses.
Mutual-fund income
Most mutual funds and exchange-traded funds are structured as trusts, flowing income through to their investors. This includes interest, dividends and capital gains that have been earned within an individual fund's portfolio, and flowed through to unitholders as distributions. These amounts are reported on tax-information slips (T3s/Relevé 16 for mutual-fund trusts and T5s/Relevé 3 for corporate-class funds). This income should not be confused with any capital gains or losses that you realize when you sell your fund units, which must be reported separately on your tax return.
