Recent market volatility may have many of us distracted from the great gains of last year as equity investors enjoyed a broad rebound from early-pandemic losses. But the taxman cometh, especially after the best year for stocks since 2009.
If you cashed in some winning stocks last year, there will be capital gains to report on your 2021 income tax return. There may even be some losses if you sold during the early-year correction before the upward march resumed. Even if you stood pat with your portfolio, blue-chip stocks likely will have produced some decent dividend income. And most mutual funds produce distributions using interest, dividends and capital gains, which also need to be reported on your tax return.
With the April 30 tax-filing deadline fast approaching, it’s time to take stock of your investment income so that you can take advantage of various tax breaks available.
The financial institution holding your investment securities is responsible for issuing T5 information slips (and Relevé 3s from Revenue Quebec), or T3s (Relevé 16s) in the case of income paid out by a trust-structured mutual fund. These slips normally are sent out by the end of March. Sometimes these can be late to arrive, so before preparing your tax return make sure you have everything on hand. Here’s what to watch out for when it comes to your investments come tax time:
Interest Income
Interest can be earned from a variety of sources, from a bank savings account to government and corporate bonds. There are no tax breaks available on interest income, and thus this 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.) “Simple” interest paid to you during the year must be reported as income on your tax return for that year. “Accrued” interest – earned from an interest-bearing security but not actually paid out to you – is taxable each year, even though you haven’t actually received this income.
For example, a $10,000 three-year guaranteed investment certificate, or GIC, paying 2% in compound interest would pay out approximately $10,618 when the deposit matures in three years. However, you must report on your tax return a portion of the 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. 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 (CSBs), and even on loans or mortgages, you make to someone, including a family member. (Note that all remaining CSBs have matured by the end of 2021.)
Things get complicated with strip bonds, which are typically long-term government bonds that are separated into principal and interest components and sold as separate securities. Prices for the individual coupons are set according to the length of time to maturity (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 corresponding T5/Relevé 3 slip issued to the investor annually).
Dividends
While many companies share profits with their common shareholders by paying quarterly dividends, these tend to be larger, publicly-traded “blue-chips.” Some companies also issue preferred shares, which pay a healthy dividend. However, these normally are structured to maintain a static share price and thus are considered to be fixed-income investments that are bought and sold based on their calculated dividend yield.
Dividend income, while not guaranteed, is attractive because the payout is generally higher than what interest-bearing securities produce, particularly in recent years due to historically and persistently low interest rates. What’s more, dividends paid by Canadian public -- and some private -- corporations are taxed at a lower rate than interest, thanks to the dividend tax credit. This is computed using a two-step process. First, the actual amount of dividends received is “grossed up”, because the issuing corporation already has paid tax on its profits. Second, the tax credit is applied to this higher amount, resulting in an effective tax rate that can be significantly lower than interest or other income.
The savings are particularly attractive for “eligible” dividends, which are paid by larger companies. The grossed-up amount you report as income is 38% more than the actual amount. You then apply the tax credit, which varies according to province. In Ontario, for example, the credit for 2021 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 dividends -- those issued by companies that pay tax at the small-business rate -- are taxed at approximately 35% to 47% for 2021. Note that dividends paid by U.S. and other foreign companies are ineligible for tax credits and are taxed at your top marginal rate.
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, by doing so, you 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, as there is a broad provision to claim the unused portion of their spouse's non-refundable tax credits.)
Capital Gains
Capital gains are subject to tax only when they are realized -- when a capital investment is actually sold. So-called paper gains – such as when a stock or fund you own is worth more than what you paid for it – are not included in your income. Taxable capital gains are calculated on Schedule 3 of the federal return (Schedule G of the Quebec return).
To calculate a capital gain on a security that you’ve sold, first determine the investment’s adjusted cost base (ACB). This is the price you originally paid for it, plus acquisition costs such as sales commissions. Subtract the ACB from the net proceeds of the sale, which is the price at which you sold the security, minus any commission or other costs related to selling the investment.
If you hold a fee-based account rather than one that charges sales commissions, the ACB and disposition value would not be affected by trading costs. But you can deduct the cost of such fees (usually an annual levy based on the value of your assets under management) as an investment carrying charge elsewhere on your tax return.
When calculating the gain from the sale of a bond or other marketable fixed-income security, be sure to to subtract the amount of any interest paid to you by this investment, since this income will have been reported on a T5 information slip (Relevé 3 for Quebec residents) and taxed separately as interest income. The gain generally is based only on the difference between what you paid for the bond and what you sold it for.
Capital losses realized from the sale of an asset can be used to reduce a capital gain. A loss can be applied against gains realized in the same year – or saved for use in a future year. They also can be retroactively applied against gains realized during any of the previous three years. A capital loss can be used only to reduce taxable capital gains, not other types of income such as interest, dividends or employment.
Mutual Funds, ETFs
Most mutual funds and exchange-traded funds (ETFs) are structured as trusts, and thus flow income through to unitholders as distributions. This includes interest, dividends and capital gains that have been earned within an individual fund’s portfolio. These amounts are reported on tax-information slips (T3s/Relevé 16). 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.
For more details on the concept of capital gains taxation see: How to Calculate and Report Capital Gains.
