Kevin Greenard: What ends up in your pocket after tax

Not all investment income is treated the same for income tax purposes, and the difference in taxation between the types can be quite substantial. What is really important is how much ends up in your pocket after tax.

Investment income is generated from taxable capital gains, Canadian dividends, interest income, and foreign investment income. When I worked directly in public practice as a Chartered Professional Accountant, we had the ability to see the investment returns of all tax clients. One thing for sure is that the returns would vary considerably based on how the client’s savings were invested, i.e. what types of investments and in which account they were invested in.

In this article, we will discuss the tax differences between the four types of investment income.

Taxation of capital gains

Capital gains currently have the most favourable tax treatment out of all the various investment income types. This is thanks to the 50 per cent inclusion rate. The inclusion rate is the amount of the gain that is subject to income tax; therefore, a 50 per cent inclusion rate means that only half of the capital gain is taxable. In the history of capital gains tax, the inclusion rate has not always been this favourable.

On June 18, 1987, the Minister of Finance announced the inclusion rate was changing from 50 per cent to 66.7 per cent effective January 1, 1988. In the same announcement, they also stated the inclusion rate was increasing a second time to 75 per cent, effective January 1, 1990. Ten years later in 2000, it was reduced back to 66.7 per cent, and again later that year back to 50 per cent where it has remained for the last 22 years.

To illustrate how capital gains are taxed, we will take Betty, who is in the top marginal tax bracket of 53.5 per cent. Betty purchased 500 shares of ABC Inc. for $50 a share in her non-registered account a few years ago. The total purchase price was $25,000 (500 x $50). The share price of ABC Inc. has appreciated nicely over the last few years to $125 per share. Betty’s total position in ABC Inc. is now $62,500 and we would like to conduct a switch trade for Betty where we sell her 500 shares of ABC Inc. and use the proceeds to buy a different holding.

As Betty is in the top marginal tax bracket, she wants to understand the tax consequences for this trade, so we walk through how it’s calculated.

First, to calculate her total capital gain, we take the sale price (also referred to as proceeds), less the purchase price (also referred to as the adjusted cost base) which is $37,500 ($62,500 - $25,000).

Next, we calculate the taxable capital gain by applying the 50 per cent inclusion rate, which is $18,750 ($37,500 x 50 per cent).

Then we can take Betty’s marginal tax rate of 53.5 per cent and apply it to the taxable capital gain of $18,750. This equals tax payable of $10,031.25 ($18,750 x 53.5 per cent). This brings her net gain, after-tax to $27,468.75 ($37,500 - $10,031.25).

Capital gains also have a great characteristic called tax deferral. Unlike dividends and interest income, which we will discuss below, there is no tax paid on capital gains until the security is sold. Investors can continue to hold stocks that have had great growth and pay no tax until which time they choose to sell.

This can be particularly helpful for individual tax planning — by waiting to sell securities with substantial capital gains until future lower-income years, investors can realize significant tax savings. It is also important to note that capital gains apply to both Canadian and foreign investments.

Taxation of Canadian dividends

The second most tax-favourable form of investment income is Canadian dividends. There are two types of dividends — eligible dividends and non-eligible dividends. All publicly traded Canadian companies that pay a dividend will be paying an eligible dividend, which means that the dividend is eligible for a larger gross-up and dividend tax credit. The higher gross-up and higher dividend tax credit effectively results in lower tax rates than those payable on non-eligible dividends. Non-eligible dividends receive a smaller gross-up and dividend tax credit and are from Canadian Controlled Private Corporations (CCPCs).

For the purposes of this article, we will discuss how eligible dividends are taxed as they are more relevant to the scope of this article. The reason for the dividend tax credit is because companies pay dividends out of their after-tax profits. As there has already been one layer of taxation at the corporate level, individuals receive a reduced level of taxation in their hands.

To illustrate, we will say that instead of a realized capital gain of $37,500, Betty earned dividend income of $37,500 and wants to know how it will be taxed.

First, the dividend gross-up must be applied. For eligible dividends, this is 138 per cent. The amount of dividends Betty will include in her tax return is $51,750 ($37,500 x 1.38). Betty will have to pay tax on $51,750, but then will receive a corresponding tax credit. If not for the dividend tax credit, Betty would otherwise pay $27,686.25 ($51,750 x 53.5 per cent) in taxes.

The dividend tax credit for eligible dividends in British Columbia is 27.0198 per cent (15.0198 per cent federal and 12 per cent provincial) of the grossed-up amount, or $13,982.75 ($51,750 x 27.0198 per cent). The net tax payable after the dividend tax credit is $13,703.50 ($27,686.25 - $13,982.75). This brings her net after-tax dividend income to $23,796.50 ($37,500 - $13,703.50).

Taxation of Canadian interest income

Interest income is the worst form of investment income from a tax perspective. The reason why it’s the worst form of income is it’s fully taxable, there’s no tax deferral, and it’s not eligible for any tax credits. One hundred per cent of all interest income earned is taxed dollar for dollar at your marginal tax bracket. This is because interest paid to individuals is considered an expense to the company paying it and directly reduces the amount of tax they owe.

Since interest income has not yet had any taxes paid on it, the full tax liability is borne by the investor receiving it. Examples of investments that pay interest income are Guaranteed Investment Certificates (GICs), term deposits, and bonds.

Had Betty earned $37,500 of interest income, she would have paid income tax of $20,062.50 ($37,500 x 53.5 per cent). This would leave her with only $17,437.50 after-tax ($37,500 - $20,062.50).

Taxation of foreign investment income

There are two types of foreign investment income: dividends and interest income. Neither have favourable tax consequences and there are no tax breaks. Similar to the tax treatment of Canadian interest income, the full amount is taxable at the investor’s marginal tax bracket. Depending on the country of the investment, and the tax treaty with that country, the foreign government will typically withhold a certain amount of tax directly at the source.

As an example, U.S. dividend income is withheld at 15 per cent and there is no income tax withheld on almost all interest income, according to Canada’s tax treaty with the United States.

If Betty earned $37,500 of U.S. dividend income, the U.S. would withhold taxes of 15 per cent at source, or $5,625 ($37,500 x 15 per cent). When Betty files her tax return, she will get credit for the amount of taxes she’s already paid to the U.S. and will have to pay the remaining portion of $14,437.50 ($37,500 x 53.5 per cent less $5,625) to the Canadian government. Her total taxes owing would equal $20,062.50 ($37,500 x 53.5 per cent).

After-tax, Betty would have $17,437.50 ($37,500 - $20,062.50).

Side-by-side comparison

*Combined tax includes mandatory U.S. withholding taxes plus Canadian taxes payable

Using a side-by-side comparison of the four different types of investment income shows just how substantial the difference is between what ends up in your pocket and what goes to the Canada Revenue Agency based on the type of investment income alone.

Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email [email protected], or visit greenardgroup.com.