Canadian Tax System: Income, Rates, Deductions

Canadian Tax System

• The areas of the Canadian Tax System that are covered are:
  • Total Income vs Taxable income
  • Marginal Tax Rates
  • Average Tax Rates
  • Tax Deductions Vs Tax Credits
  • Tax Status for Registered Accounts

Total Income vs Taxable Income

• Total income is the sum of all income from various sources.
• Taxable income is calculated by making allowable deductions from the total income
• Taxable Income = Total Income - Tax Deductions
• A tax deduction reduces the amount of income on which an individual pays tax.

Marginal Tax Rates

• The marginal tax rate represents the amount of tax an individual pays on his or her next dollar of income.

Average Tax Rates

• Taxpayers must pay both federal and provincial income taxes.
• The provincial marginal rate tables are similar to that of the federal government, except for Alberta which has a flat tax of 10%.
• The average tax rate is the combined federal and provincial tax rates.

Tax Deductions vs. Tax Credits

• Refundable tax credits are paid directly to an individual if they are not required to reduce taxes payable, such as the GST tax credit.
• Non-refundable tax credits can only be used to reduce the tax payable, and may be transferred or carried forward.

Tax Status for Registered Accounts

• TFSA:
  • Contributions are not tax deductible;
  • Earnings are not taxable every year;
  • Withdrawals are tax-free.
• RESP:
  • Contributions are not tax deductible;
  • Earnings are not taxable every year;
  • Subscriber contributions only are tax-free.
• RRSP:
  • Contributions are tax deductible;
  • Earnings are not taxable every year;
  • Withdrawals are not tax-free.
• RRIF:
  • Contributions are not tax deductible;
  • Earnings are not taxable every year;
  • Withdrawals are not tax-free.
• RDSP:
  • Contributions are not tax deductible;
  • Earnings are not taxable every year;
  • Contributor contributions only are tax-free.

Taxation of Investment Income

• The types of income are:
  • Interest Income
  • Dividend Income
  • Foreign Income
  • Capital Gains and losses

Interest Income

• Interest Income is earned on cash deposited in a checking or savings account, or from T-Bills, Canada Savings Bonds, term deposits, or GICs.
• It is fully taxed at the investor's top marginal tax rate, due in the year in which it is earned.

Dividend Income

• Dividend income is investment income paid out of the after-tax net income of a corporation to its shareholders.
• Tax payable is due in the year in which it is earned.
• Foreign dividends are fully taxable at your top marginal tax rate.
• Canadian dividends are taxed at lower rates.

Foreign Income

• Foreign income is often subject to withholding tax in the country in which the income originates.
• The full amount of foreign earnings must be reported on a Canadian tax return.

Capital Gains and Losses

• Investors must pay taxes on 50% of all capital gains, and may use 50% of capital losses to offset capital gains and reduce the tax payable.
• Net capital losses can also be carried back up to three years to reduce previous capital gains, or carried forward indefinitely to reduce future capital gains.

Dividend Gross-Up and Tax Credit

• Dividends paid by Canadian corporations are taxed at a lower rate than foreign dividends.
• The dividend gross-up and tax credit is intended to minimize the double taxation of dividends paid by Canadian corporations.
• There are two types of dividends:
  • Eligible dividends are paid by large, public Canadian corporations
  • Non-eligible dividends are paid by Canadian-controlled private corporations
• Although both types of dividend receive the gross-up and tax credit, the reduction is greater for eligible dividends than for non-eligible dividends

Calculating Dividend Gross-Up and Tax Credit

• Calculate the grossed-up taxable dividend: Grossed-up taxable dividend = Dividends x Gross-up percentage.
• Calculate the tax payable: Tax payable = Marginal tax rate x Grossed-up taxable dividend.
• Calculate the federal tax payable: Fed tax payable = (Grossed-up taxable dividend x Dividend tax credit) - Tax payable.

Taxation of Mutual Funds

Income Distribution and Redemption

• Mutual fund trusts do not pay taxes directly, and flow through all taxable income to investors.
• Income earned at the trust level is taxable at the highest marginal rate.
• There are two ways in which mutual funds generate taxable income:
  • Distribution: Income earned by a mutual fund and flowed through to unitholders.
  • Redemption: Proceeds from a unitholder's sale of mutual fund units.

Capital Losses and Mutual Funds

• Capital losses are not distributed by mutual fund trusts, and offsets capital gains within the mutual fund.
• The distribution of a capital gain to unitholders is called a net capital gain, and is taxable for the investor.
• If capital losses are greater than capital gains, the net losses can be carried forward indefinitely to offset future capital gains.

Tax Treatment for Mutual Fund Corporations

• Mutual fund corporations must file a tax return and pay tax on investment income.
• They then make additional filings with the CRA to retrieve taxes paid and flow through income to unitholders.
• Only Canadian dividends and capital gains can be flowed through to mutual fund corporation unitholders.
• There is no refund or tax paid for interest or foreign income earned within the mutual fund corporation, and these can only be distributed in the form of a taxable Canadian dividend after tax.

Switches and Deemed Disposition

• In a mutual fund trust, switching from one fund to another triggers a deemed disposition for tax purposes, which is treated as a redemption triggering a taxable capital gain or allowable capital loss.
• In a mutual fund corporation, it is possible to switch from one class of shares to another without immediately triggering a taxable capital gain.

Capital Yield Funds

• Capital yield mutual funds provide the tax benefit of converting interest income into capital gains, so that investors pay less tax on the income distribution.
• The income transformation is called character conversion, and is done using derivatives.

Return of Capital

• When a fund makes distributions to unitholders that are greater than the amount of income and capital gains earned by the fund in that year, the excess distribution is considered a return of capital to investors, also called a capital dividend.
• Return of capital is not taxed when investors receive it, but is used to reduce the cost of the units.
• When investors redeem the units of the mutual fund, their capital gains will be greater, or their capital losses smaller, than they would have been without the capital dividend.

Year-End Tax Trap

• Individuals who purchase a mutual fund just prior to the ex-dividend date will have a tax liability for the year even though the total value of their holdings is the same as before the distribution.
• To avoid the year-end tax trap, investors can avoid purchasing units of mutual funds near the end of the year if those funds will be paying capital gains dividends.