When working with your clients to create financial plans and make investment recommendations, it is essential that you are aware of the Canadian tax system so as to better understand the impact of taxation on your clients’ income and investments.
Most adult Canadians pay taxes, in one form or another. Taxes are paid at all three levels of government: federal, provincial, and municipal. The federal tax system is administered by the Canada Revenue Agency (CRA). In addition to collecting taxes on behalf of the federal government, the CRA also collects taxes on behalf of all provinces except Quebec. Municipal taxes are collected at the local level.
In general, taxes are paid on worldwide personal income and corporate income, payroll, consumer purchases, and wealth. Payroll taxes are paid to support: 1) federal spending on employment insurance and the Canada Pension Plan benefit programs, and 2) provincial spending on worker’s compensation benefits for injured workers. Consumer purchases are subject to sales taxes and excise taxes. A federal sales tax, the Goods and Services Tax (GST), is payable in all provinces. A provincial or harmonized sales tax on consumer purchases is payable in all provinces except Alberta. Consumer goods such as cigarettes, alcohol, and gasoline are subject to federal and provincial excise taxes. Wealth taxes are payable on estates and property. Estate taxes refer to the taxes payable on an individual’s property after they have died; whereas property taxes are the major source of revenue for municipal governments.
Where Does it All Go?
|Since the CRA collects taxes on behalf of all provinces (except Quebec), one of its major functions is to make transfer payments to the provinces and the Canadians who live there. In fact, the majority of taxes collected by the CRA are returned to Canadian taxpayers, provincial governments, and other organizations through various programs. The majority of the remaining tax dollars are used to pay for the operating costs of federal government departments, agencies, Crown corporations, and other federal bodies. Finally, a significant portion of tax dollars is used to pay the interest charges on Federal government debt. The diagram below highlights how many cents of each dollar go towards various program areas:|
How is Tax Paid?
Income and tax are calculated on a yearly basis. Individuals are required to use the calendar year while corporations can select any calendar month as their fiscal year so long as the time period is consistent year over year and does not extend beyond 53 weeks.
As an advisor, it is important to ensure that your clients are aware of the importance of tax planning and that it is part of their overall financial strategy. Understanding what acceptable tax approaches are is very important.
Tax Planning, Tax Avoidance and Tax Evasion 1/2
As an advisor, it is important to ensure that your clients are aware of the importance of tax planning as part of their overall financial strategy including acceptable tax approaches.
Effective tax planning is the use of tax reduction arrangements that are consistent with the intent and spirit of the law. The terms “tax evasion” and “tax avoidance” are often used interchangeably, but they are very different concepts. Tax avoidance means the use of legal methods of reducing your taxable income or tax owed. While within the letter of the law, these actions contravene the object and spirit of the law. Tax evasion means the use of illegal methods to conceal income or information from tax authorities. Here is a list of activities considered to be tax evasion:
- underreporting income
- falsifying income records
- purposely underpaying taxes
- claiming illegitimate or fake business expenses
- claiming illegitimate dependents on a tax return
One of the most common tax evasion schemes involves scenarios where individuals conduct their business with cash purchases only and do not report the income.
Tax Planning, Tax Avoidance and Tax Evasion 2/2
As a dealing representative, it is important to be aware of legal tax avoidance approaches. Here are some examples:
- capitalizing on tax-advantaged retirement accounts
- full utilization of allowable deductions such as medical expenses and charitable donations;
- conversion of non-deductible expenses into tax-deductible expenditures;
- postponing the receipt of income;
- splitting income with other family members, when handled properly; and
- selecting investments that provide a better after-tax rate of return.
To calculate tax payable, follow these general steps.
- Step 1: calculate total income by adding together sources of income
- Step 2: subtract permissible deductions (e.g. RRSP contributions)
- Step 3: calculate taxable income
- Step 4: calculate the tax payable before tax credits by applying federal and provincial tax rates
- Step 5: subtract applicable tax credits (e.g. charitable donation)
- Step 6: calculate the total tax payable
Total versus Taxable Income
|A person’s total income represents the sum of all income from various sources. Some of the major sources of income include employment income, commissions, some government benefits, pension income, various types of investment income, business income, rental income, and taxable benefits received from their employer.An individual’s total income is not entirely subject to income taxes. In calculating taxable income, a person is allowed to make certain tax deductions from their total income. Some of the major tax deductions include pension plan contributions, RRSP contributions, union dues, child care expenses, support payments, carrying charges, and moving expenses.In general, taxable income is calculated as follows:|
|Taxable Income = Total Income – Tax Deductions|
|A tax deduction reduces the amount of income on which someone pays taxes. From the formula above, you can see that a $1 tax deduction reduces a person’s taxable income by $1. In general, to see how much tax your clients save from a tax deduction, you need to have an understanding of marginal tax rates.|
Marginal Tax Rate
|The marginal tax rate represents the amount of tax an individual pays on his or her next dollar of income. Marginal tax rates are usually presented in a table format. For example, the current marginal tax rates for federal income taxes are as follows:|
Average Tax Rate
|The average tax rate represents how much tax is payable as a percentage of income.|
|average tax rate = (tax payable ÷ taxable income) x 100|
|In addition to federal income taxes, a taxpayer must also pay provincial taxes. In general, the table of marginal tax rates in every province is similar to that of the federal government. That is, as a taxpayer’s income increases, the amount of income tax they pay on the next dollar of income will progressively increase. This is referred to as a progressive income tax system.|
Non-Resident Tax Rates
Canada’s tax system has different methods to tax non-residents and is applied to taxpayers if the following situation applies:
- the individual did not have significant residential ties in Canada and lived outside Canada throughout the year, except if they were a deemed resident of Canada. For example, they could be a deemed resident of Canada if they were an employee of the Government of Canada posted abroad.
- the individual did not have significant residential ties in Canada and stayed in Canada for less than 183 days in the year. Any day or part of a day spent in Canada counts as a day. If they lived in the United States and commuted to work in Canada, they cannot include commuting days in the calculation.
- the individual was deemed not to be resident in Canada under the Income Tax Act because of the provisions of a tax treaty Canada has with another country.
Tax Deductions versus Tax Credits 1/2
Recall that a tax deduction reduces the amount of income on which an individual pays tax. On the other hand, a tax credit reduces the amount of tax payable. Tax credits are applied after all tax deductions have been made and tax payable has been calculated using the combined federal and provincial marginal tax rates. Tax credits can be used to reduce the federal tax payable and the provincial tax payable.
Tax Deductions versus Tax Credits 2/2
You can use this formula for calculating the average tax rate to see how tax deductions and tax credits can be used to reduce taxes.
|average tax rate = (tax payable ÷ taxable income) x 100|
Types of Tax Credits
There are two types of tax credits:
Refundable credits are tax credits that are paid directly to individuals if they are not needed to reduce their tax payable. For example, if Terence has $200 in taxes owing and a refundable tax credit of $500, he will receive a $300 refund from the CRA, calculated as $500 – $200. The most common refundable tax credit is the GST tax credit.
Non-refundable credits are tax credits that can only be used to reduce the tax payable. Once an individual has no tax payable, certain non-refundable tax credits may be transferred or carried forward to future tax years. The table below lists those non-refundable tax credits that may be transferred to other individuals, usually a spouse or blood relative, or carried forward by the individual.
Other Non-Refundable Tax Credits
Some other common federal and provincial non-refundable tax credits include:
- Basic personal amount
- Spouse or common-law partner amount
- Amount for an eligible dependant
- CPP contributions
- Employment insurance premiums
- Canada employment amount
- Public transit amount
- Children’s fitness amount
- Interest paid on your student loans
Tax Credit Calculation
Recall that tax credits are applied after all tax deductions have been made and tax payable has been calculated. In order to determine the amount by which tax credits reduce tax payable, a person must add up their tax credits and multiply the amount by the lowest marginal tax rate.
The tax credit calculation is performed separately for federal tax payable and provincial tax payable. As a result, individuals multiply their total federal tax credits by 15% and their total provincial tax credits by the lowest marginal tax rate in their respective provinces.
Taxation of Registered and Non-registered Accounts
Recall that registered accounts are savings plans that are defined in the federal Income Tax Act, registered with the Canada Revenue Agency (CRA), and administered by various financial institutions. These types of plans are granted special tax status wherein contributions may be tax deductible and taxes payable on any investment earnings may be deferred. There are also a number of limitations and restrictions on these plans including how withdrawals are treated for tax purposes. The main types of registered accounts are:
- tax-free savings account (TFSA)
- registered education savings plan (RESP)
- registered retirement savings plan (RRSP)
- registered retirement income fund (RRIF)
- registered disability savings plan (RDSP)
Table: Tax Implications
Types of Income
Depending on the types of investments held within a registered or non-registered account, the types of income that may be earned include the following:
- interest income
- Canadian dividend income
- other income, such as income from foreign property
- capital gains or losses
Interest income refers to investment income that is earned on: 1) cash that is deposited in a chequing or savings account, and 2) various types of debt securities, such as treasury bills (T-Bills), Canada Savings Bonds, term deposits, and guaranteed investment certificates (GICs). Interest income is fully taxed at the investor’s top marginal tax rate. In addition, the tax payable on interest income is due in the year in which it is earned.
|Dividend income refers to investment income that is paid out of the after-tax net income of a corporation to its shareholders. Like interest income, the tax payable on dividend income is due in the year in which the dividend is received.The tax treatment of dividends will depend on the answers to the following questions:Is the dividend from a Canadian corporation or a foreign corporation?If the dividend is from a Canadian corporation, is the corporation a large public Canadian corporation or a Canadian–controlled private corporation (CCPC)?A dividend paid by a foreign corporation is referred to as a foreign dividend and is fully taxable at the individual’s top marginal tax rate. A dividend paid by a large public Canadian corporation is referred to as an eligible dividend. A dividend paid by a Canadian-controlled private corporation is referred to as a non-eligible dividend. Eligible and non-eligible dividends are taxed at a lower rate than foreign dividends. The mechanism for this reduced tax payable is referred to as the dividend gross-up and tax credit.|
Some other types of income include:
- interest and dividend income from foreign sources
- rental income
- partnership income
- spousal support payments
- business income
- farming income
- fishing income
All of the above types of income are fully taxable.
Foreign Investment Income
|Foreign investment income is often subject to withholding tax levied by the country in which the income originates. However, the full amount of these earnings must be reported on a Canadian tax return.For example, the U.S.-Canada Tax Treaty, Articles X and XI, stipulates a 10% withholding tax on U.S. interest income, while the rate is 15% for U.S dividend income. Hence, $250 of interest income from the U.S. would be subject to $25 of withholding tax, leaving $225 in the hands of the Canadian recipient. However, the full $250 must be included in income for tax purposes.Each unitholder is entitled to claim a foreign tax credit or deduction for taxes paid to a foreign government by a mutual fund. In our example, the taxpayer would claim a foreign credit of $25.For Canadian residents, the capital gains tax treatment is the same for foreign and domestic property. Although withholding tax is not applied to capital gains, you may be required to pay tax to the country where your investments are domiciled.|
Capital Gains and Losses
|A capital asset is any asset that is purchased and maintained for the purpose of generating income. Some examples of capital assets include equipment, buildings, and rental property. A capital gain results when capital assets are sold for more than their cost. Conversely, a capital loss results when capital assets are sold for less than their cost. If capital assets have not been sold, then a capital gain or loss has not been realized; this is referred to as an unrealized capital gain or loss.|
|Capital Gain: market price > cost|
|Capital Loss: market price < cost|
Taxation of Capital Gains and Losses
|In Canada, only 50% of a capital gain is taxable. This amount is referred to as taxable capital gain. Similarly, only 50% of a capital loss is allowable. This amount is referred to as an allowable capital loss.Allowable capital losses may be used by a taxpayer to reduce their taxable capital gains. This will, in effect, reduce the amount of tax that they have to pay.Investors can apply allowable capital losses only against taxable capital gains, not against other sources of income. To the extent that the allowable capital losses in a given year exceed the taxable capital gains for the year, a net capital loss will arise. In other words, in a given tax year, allowable capital losses can only reduce taxable capital gains to $0.However, net capital losses are not lost but can be carried back three years to reduce previous taxable capital gains or carried forward indefinitely to reduce future taxable capital gains.As a dealing representative, understanding how taxation of capital gains and losses on your client’s mutual fund portfolio is essential. Adjusting a client’s Non-Registered portfolio results in deemed dispositions which have taxable consequences. You need to understand and advise your clients accordingly to avoid any unintended consequences (like creating unnecessary increases in your client’s taxable income). However, there are also tax efficiencies that can be created by re-balancing a client portfolio to take advantage of unrealized gains or losses within the funds. Keep in mind that this only applies to Non-Registered accounts, as Registered accounts (RRSPs and TFSAs) are already tax-advantaged and you cannot benefit from further tax reductions. See the example below.|
Income Distribution and Redemption of Mutual Funds
Mutual fund trusts don’t pay tax directly. They are known as “flow-through” entities that distribute all of their taxable income to investors. It is important for mutual funds to “flow-through” all their taxable income since income earned at the trust level and not distributed to unitholders is subject to taxation at the highest marginal rate.
For mutual fund investors, there are two ways in which mutual funds generate taxable income:
Distribution occurs when interest income, dividends, and net capital gains earned on the investments within a mutual fund are “flowed through” to the mutual fund investor.
Capital Losses and Mutual Funds
|Capital losses are not distributed by mutual funds. Instead, capital losses are used to offset realized capital gains within the mutual fund. As a result, the distribution of a capital gain to unitholders is referred to as a net capital gain. An investor’s portion of a distributed net capital gain is taxable.If a mutual fund has a greater amount of capital losses than capital gains, the remaining net capital losses may be carried back three years or carried forward indefinitely. Since mutual funds distribute all their income, dividends, and net capital gains every year, capital losses of a mutual fund are never carried back.|
Reporting of Mutual Fund Trust Income
|The income generated from a mutual fund trust is reported on a T3 Slip – Statement of Trust Income Allocations and Designations. These slips are mailed to unitholders on or before March 31, informing them of the amounts of each type of income received. Investors living in Canada must then report the income on their annual income tax returns.For tax purposes, interest income is classified as other income, which is reported in Box 26 of the T3 slip. Depending on whether the dividend is eligible or non-eligible dividends, the dividend gross-up, and the dividend tax credit are reported in the following boxes:|
Mutual Fund Corporations
|Unlike a mutual fund trust, a mutual fund corporation must file a tax return and pay tax on its investment income. It then makes additional filings with the tax authorities to retrieve the tax paid which enables it to ultimately flow-through income to unitholders. Only Canadian dividends and capital gains can be flowed through to mutual fund corporation unitholders.There is no refund of tax paid for interest and foreign income earned within the mutual fund corporation. These can only be distributed to unitholders after tax in the form of a taxable Canadian dividend.The income generated from a mutual fund corporation is reported on a T5 Slip – Statement of Investment Income.|
Corporate Class Mutual Funds
|Most Canadian mutual funds are structured as trusts, but some are structured as corporations. There are two benefits to corporate class mutual funds. The first is potentially lower taxable distributions resulting in tax deferral. This is beneficial when investing in a non-registered personal or corporate account. The second is only capital gains and Canadian dividends flow through the mutual fund corporation, reducing the amount of interest income earned in a comparable trust version of a similar mutual fund. This can make your client’s after-tax income higher.|
Return of Capital (Capital Dividend)
|Occasionally, a fund may make distributions to unitholders that are greater than the amount of income and capital gains earned by the fund in that year.When this happens, the excess distribution is considered a return of capital to investors. In effect, some of the money invested in a fund is being paid back to investors. This amount is not taxed when they receive it. Instead, this amount will reduce the cost of the units. When investors eventually redeem the units, their capital gains will be greater (or their capital losses smaller) than they otherwise would have been without the capital dividend.A capital dividend will be reflected on a monthly or quarterly statement, but will not be recorded on the T3 slip issued by the fund.|
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