Canadian Taxation PDF

SECTION 8 WORKING WITH THE CLIENT 24 Canadian Taxation 25 Fee-Based Accounts 26 Working with the Retail Client 27 Working with the Institutional Client © CANADIAN SECURITIES INSTITUTE ...

SECTION 8 WORKING WITH THE CLIENT 24 Canadian Taxation 25 Fee-Based Accounts 26 Working with the Retail Client 27 Working with the Institutional Client © CANADIAN SECURITIES INSTITUTE  Canadian Taxation 24 CHAPTER OVERVIEW In this chapter, you will learn the basics of taxation, including the tax features of pension income, tax deferral plans, and tax-free savings plans in Canada. We explain how the different types of income are taxed and identify the expenses related to investment income that might be tax deductible. We also explain the two main types of pension plans and the different types of tax deferral and tax-free registered plans. Finally, you will learn some basic tax planning strategies. LEARNING OBJECTIVES CONTENT AREAS 1 | Differentiate between the tax treatment of The Canadian Taxation System interest income, dividends, and capital gains or losses. 2 | Calculate investment gains and losses. Capital Gains and Losses 3 | Describe the different tax deferral and tax-free Tax Deferral and Tax-Free Plans plans and their uses. 4 | Identify basic tax planning strategies and Tax Planning Strategies strategies for minimizing tax liability. © CANADIAN SECURITIES INSTITUTE 24 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. annuity past service pension adjustment attribution rules pension adjustment Canada Education Savings Grant pooled registered pension plan carrying charges registered education savings plan contribution in kind registered pension plan deemed disposition registered retirement income fund deferred annuity registered retirement savings plan defined benefit plans self-directed registered retirement savings plan defined contribution plan spousal registered retirement savings plan fiscal year superficial losses income splitting tax-free savings account marginal tax rate withholding tax money purchase plans © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 3 INTRODUCTION Taxes are a reality of life for most Canadians. All investment income in the year is taxable unless held in a tax-free or tax-deferred account. To complicate the matter, interest income, dividends, and capital gains are each taxed differently. Also, the continually changing legislation announced each year in the federal budget affects the taxation rate of investment income. In the role of an investment advisor, you do not need to become a tax expert. Most advisors rely on the professional input of accountants and tax experts when the need to make a decision on a specific tax matter arises. However, in that capacity you must have a working knowledge of the taxation of investment income. Failure to optimize the after-tax returns of your clients’ investments can result in them paying more than necessary and earning a lower return on their investments. We provide this chapter to help you understand the basic principles of taxation and some of the key strategies and opportunities used to maximize after-tax revenues. THE CANADIAN TAXATION SYSTEM 1 | Differentiate between the tax treatment of interest income, dividends, and capital gains or losses. The Canadian federal government imposes taxes on income by federal statute under the Income Tax Act. All Canadian provinces have separate statutes that impose a provincial income tax on their residents and on non- residents who conduct business or have a permanent establishment in that province. The federal government collects provincial income taxes for all provinces except the following two: Quebec, which administers its own income tax on both individuals and corporations Alberta, which administers its own income tax on corporations Canada imposes an income tax on foreign income earned by its residents and on certain types of Canadian-source income on non-residents. Companies incorporated in Canada under federal or provincial law are usually considered to reside in Canada. Also, foreign companies with management and control in Canada are considered resident in Canada and are therefore subject to Canadian taxes. CALCULATING INCOME TAX All taxpayers must calculate their income and tax on a yearly basis. Individuals use the calendar year. Corporations may choose any fiscal year, as long as the chosen period is consistent year over year. No corporate taxation year may be longer than 53 weeks. Income tax calculation is a five-step process, as follows: 1. Calculate all sources of income 2. Make allowable deductions to arrive at taxable income 3. Calculate the gross or basic tax payable on taxable income 4. Claim allowable tax credits on tax payable, if any 5. Calculate the net tax payable The various deductions, exemptions, and tax credits that may be allowable in calculating taxable income depend on the type of income earned. © CANADIAN SECURITIES INSTITUTE 24 4 CANADIAN SECURITIES COURSE      VOLUME 2 TYPES OF INCOME There are four general types of income, each treated differently under Canadian tax laws. Employment income Employment income includes wages, salary, and benefits, alone or combined. It is taxed on a gross receipt basis, which means that taxpayers cannot deduct all costs incurred in earning this type of income for tax purposes. However, they are allowed to deduct a few employment-related expenses such as pension contributions, union dues, and childcare expenses. Business income Business income is any income earned from producing and selling goods or rendering services. Self-employment income falls under this category. Business income is taxed on a net-income basis, which means that, unlike employees, business owners are allowed to deduct all costs incurred in earning the income. Those costs include business-related expenses such as rent or mortgage, employee payroll, and the cost of supplies and equipment. (Note: Taxation of this type of income is not covered in this course.) Income from Income from property includes interest income, dividends, and royalties. This income securities and other derives from assets purchased solely for investment purposes, such as stocks, bonds, and assets purchased for mutual funds. (Note: Income from rental properties is included in this category, but it is investment not covered in this course.) Capital gains and A capital gain or capital loss occurs when a taxpayer sells property. Any increase in value losses over the purchase price is a capital gain; any decrease is a capital loss. A capital gain is taxed only after the property is sold, in the year it is sold. Tax is not paid year by year as the property gains value. A capital gain is typically calculated as the sale price, minus any selling expenses (such as the commission on the sale of stocks), minus the adjusted cost base (which is generally composed of the purchase price plus commission expense at the time of purchase). TAXATION OF INCOME Basic tax rates are applied to taxable income. Rates of federal tax applicable to individuals in 2024 (excluding tax credits) are shown in Table 24.1. Table 24.1 | Federal Income Tax Rates for 2024 (for Information Only) Tax Rate Taxable Income Bracket 15% On the portion of taxable income that is $55,867 or less 20.5% On the portion of taxable income over $55,867 and up to $111,733 26% On the portion over $111,733 and up to $173,205 29% On the portion of taxable income over $173,205 and up to $246,752 33% On the portion of taxable income over $246,752 Source: Adapted from Canada Revenue Agency Note: The Canada Revenue Agency website (www.canada.ca/en/revenue-agency) should be consulted for current tax related information. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 5 Currently, all provinces levy their own tax on taxable income. Provincial amounts are calculated in essentially the same way as federal tax. Adding the provincial rate to the federal rate gives the taxpayer’s combined marginal tax rate, which is the rate at which tax must be paid on each additional dollar of income earned. EXAMPLE Margaret’s employment income during 2024 was $180,000. She has no other source of income and is a Canadian resident. Her federal tax (before credits are applied, and based on the rates in Table 24.1) is $37,785.85, as shown in Table 24.2. Table 24.2 | Margaret’s Income Tax Calculations Tax Rate Taxable Income Tax Payable 15.0% On the first $55,867 $8,380.05 20.5% On the next $55,866 $11,452.53 26.0% On the next $61,472 $15,982.72 29.0% On the next $6,795 $1,970.55 Total $180,000 $37,785.85 If Margaret were to earn an additional dollar, increasing her taxable income from $180,000 to $180,001, she would pay 29% federal tax on that dollar. In other words, her federal marginal tax rate is 29%. TAXATION OF INCOME FROM PROPERTY Except with property consisting of investments held in a registered plan (a plan registered with the government and designed primarily to defer taxation – discussed later in this chapter), income from property is taxable in the year it is earned. The tax must be paid on an annual accrual basis, regardless of whether it is actually received as cash in that year. DID YOU KNOW? Income from property held outside a registered plan is taxed on an accrual basis. In other words, it must be reported for tax purposes when it is earned, not when it is received. For example, the income of products like zero-coupon bonds are received only at maturity or at sale, but the tax on such investments is charged annually. In the role of an investment advisor, you must be cautious about taxes due on amounts not yet received. INTEREST INCOME Interest income is defined as the compensation received by lenders for the use of the funds they lend. This type of income is fully taxable at the investor’s marginal tax rate, either when it is received or as it accrues. Accrued interest is included in taxable income every year. It can be deferred for no more than one year. DIVIDENDS FROM TAXABLE CANADIAN CORPORATIONS Note: Two types of dividend tax credits are available on Canadian corporate shares: one for privately-held and one for publicly-traded corporations. In this chapter, we focus on tax credits available on publicly-traded corporate shares. A dividend tax credit is available on publicly-traded dividend-paying shares of taxable Canadian companies. This credit makes the purchase of these shares relatively attractive, compared to interest-paying securities. © CANADIAN SECURITIES INSTITUTE 24 6 CANADIAN SECURITIES COURSE      VOLUME 2 The dividend tax credit reflects the fact that corporations pay dividends from after-tax income—that is, from their net profits. The amount included in a taxpayer’s income is therefore “grossed up” to equal approximately what the corporation would have earned before tax. The taxpayer then receives a tax credit that offsets the amount of tax the corporation paid. Eligible Canadian dividends are grossed up by 38% in 2024 to arrive at the taxable amount of the dividend. The taxpayer receives a federal dividend tax credit on this amount (15.02% of the taxable amount of dividend in 2024). Dividend tax credits are also available at varying provincial levels. The amount of tax owing is calculated based on the taxpayer’s marginal tax rate. The lower the marginal tax rate, the lower the tax payable on eligible Canadian dividends. EXAMPLE Sandra receives a $1,000 eligible dividend from a Canadian corporation. She reports $1,380 in net income for tax purposes, calculated as follows: (A) Eligible Canadian dividends $1,000 (B) Gross-up total amount (%) 138% (C) Taxable amount of the dividend (A × B) $1,380 Sandra declares a net dividend income of $1,380 on her tax return (38% higher than the $1,000 dividend she received). She then claims a federal dividend tax credit in the amount of 15.02% of the taxable amount of the dividend (C). The tax credit amount is $207.28, calculated as follows: (C) Taxable amount of the dividend (A × B) $1,380 (D) Dividend tax credit (%) 15.02% (E) Dividend tax credit ($) (C × D) $207.28 The real amount of tax payable depends on Sandra’s marginal tax rate, as shown in Table 24.3. Table 24.3 | Sandra’s Marginal Tax Rate (C) Taxable amount of the dividend (A × B) $1,380 $1,380 $1,380 $1,380 $1,380 (F) Federal Marginal Tax Rate 15% 20.50% 26% 29% 33% (G) Tax Payable on the Taxable amount of the dividend (C × F) $207.00 $282.90 $358.80 $400.20 $455.40 Minus (E) Dividend tax credit $207.28 $207.28 $207.28 $207.28 $207.28 Net Tax Payable on dividend (G − E) $0 $75.62 $151.52 $192.92 $248.12 The dividend gross-up and federal tax credit are shown on the T5 tax form sent annually to shareholders. Who issues and sends the T5 form depends on how the shares are held. Registered shareholders receive the T5 form from the dividend-paying corporation itself; investment dealers holding shares in street name issue the T5 form to the beneficial owners. Quite often, the investment dealer combines all dividends paid to the investor during the year and issues a single T5 form for all of them. Stock dividends and dividends that are reinvested in shares are treated in the same manner as cash dividends. DID YOU KNOW? A T5 tax form is a document identifying the investment income that Canadian residents must report on their income tax returns. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 7 DIVIDENDS FROM FOREIGN CORPORATIONS Foreign dividends are generally taxed as regular income, in much the same way as interest income. Individuals who receive dividends from non-Canadian sources usually receive a net amount from these sources; non-resident withholding taxes are applied by the foreign dividend source. Such investors may be able to use foreign tax credits to offset the Canadian income tax otherwise payable. The allowable credit is essentially the lesser of the foreign tax paid or the Canadian tax payable on the foreign income, subject to certain adjustments. Details on what foreign tax is allowed as a deduction are available from the Canada Revenue Agency (CRA). CAPITAL GAINS AND LOSSES A capital gain arises when a property is sold (or deemed to be sold) for more than its cost. A capital loss arises when a property is sold for less than its cost. Capital gains earned are taxable and must be reported when they are realized. However, capital gains benefit from favourable tax treatment in Canada because only 50% of the capital gain is taxable. Capital losses can be used to reduce any capital gains that have been earned. They cannot generally be used to reduce any other type of income. Capital gain taxation is discussed in detail later in this chapter. MINIMIZING TAXABLE INVESTMENT INCOME Dividends from taxable Canadian corporations and capital gains are subject to lower tax rates than interest income. Accordingly, a shift from interest-bearing investments to dividend-paying Canadian stocks may reduce taxes and improve after-tax yield. Investors’ tax consequences can vary considerably, depending on their type of income and marginal tax rate. Tables 24.4 and 24.5 illustrate the difference in tax owed on $1,000 of interest income, $1,000 of eligible Canadian dividend income, and $1,000 of capital gains. The difference between the tax owed on these same amounts can be substantial, depending on the person’s marginal tax rate. Table 24.4 | Comparison of Tax Consequences of Investment Income in a 29% Marginal Tax Bracket Eligible Canadian Interest Income Dividend Income Capital Gains Income Income Received $1,000.00 $1,000.00 $1,000.00 Taxable Income $1,000.00 $1,380.00 $500.00 (Grossed up by 38%) (50% of $1,000) Federal Tax (29%) $290.00 $400.20 $145.00 Less: Dividend Tax Credit (15.02%) – $207.28 – Federal Tax Owed $290.00 $192.92 $145.00 Table 24.5 | Comparison of Tax Consequences of Investment Income in a 15% Marginal Tax Bracket Eligible Canadian Interest Income Dividend Income Capital Gains Income Income Received $1,000.00 $1,000.00 $1,000.00 Taxable Income $1,000.00 $1,380.00 $500.00 (Grossed up 38%) (50% of $1,000) Federal Tax (15%) $150.00 $207 $75.00 Less: Dividend Tax Credit (15.02%) – $207.28 – Federal Tax Owed $150.00 $0.00 $75.00 © CANADIAN SECURITIES INSTITUTE 24 8 CANADIAN SECURITIES COURSE      VOLUME 2 TAX-DEDUCTIBLE ITEMS RELATED TO INVESTMENT INCOME Tax rules permit individuals to deduct certain expenses used for the purpose of earning income from property. These deductible expenses are called carrying charges for tax purposes. The following carrying charge deductions are considered acceptable: Interest paid on funds borrowed to earn such investment income as interest and dividends Fees paid for certain investment advice Fees paid for management, administration, or safe custody of investments Accounting fees paid for the recording of investment income DIVE DEEPER Additional carrying charges than those listed above may apply in specific situations; however, they are not covered in this course. For detailed information on carrying charges, visit the CRA website. The following charges cannot be deducted from investment income: Interest paid on funds borrowed to buy investments that can only generate capital gains Brokerage fees or commissions paid to buy or sell securities Interest paid on funds borrowed to contribute to a registered retirement savings plan (RRSP), a registered education savings plan (RESP), a registered disability savings plan, or a tax-free savings account (TFSA) Administration, counselling, or trustee fees for a regular or self-directed registered retirement savings plan, or for a registered retirement income fund (RRIF) Fees paid for advice such as financial planning Safety deposit box charges CAPITAL GAINS AND LOSSES 2 | Calculate investment gains and losses. As mentioned earlier, a capital gain occurs when capital property, such as shares or bonds, is sold for more than its original cost. In simple terms, a capital gain is the difference between the property’s selling price and the price at which it was bought (the cost price). For tax purposes, however, calculating a capital gain is not so simple. Costs other than the cost price are often involved in the purchase and sale of property, such as commissions paid on purchases and sales of stocks and debt securities. In addition, the past value of certain properties on which capital gains are calculated (such as real estate held for many years) is difficult to determine. And finally, additional securities are often bought at different prices and at different times over the investment’s holding period. DID YOU KNOW? CRA uses the technical term disposition to mean the sale of an asset such as a security or capital property. Therefore, we use the terms disposition and sale interchangeably in this chapter. Generally, CRA treats the proceeds of a sale of securities (either equities or fixed-income securities) as a capital gain. However, an exception may occur if the investor’s intentions are determined to be more speculative as indicated © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 9 by the trading action. In such cases, CRA may argue that the investor is speculating and that gains realized are fully taxable as ordinary income (and losses fully deductible). CRA reviews the following factors in assessing whether trading is, by their definition, speculative: Short periods of ownership A history of extensive buying and selling or quick turnover of securities Special knowledge of, or experience in, securities markets Substantial investment of time spent studying the market and investigating potential purchases Financing share purchases primarily on margin or some other form of debt The nature of the shares (e.g., whether they are a speculative, non-dividend type) None of these factors alone may be sufficient for CRA to characterize the taxpayer’s trading activities as business activities. However, a number of factors in combination may be enough to do so. In every instance, the particular circumstances of the sale must be evaluated before a determination can be made. DID YOU KNOW? CRA interprets a dealer or trader in securities to be a taxpayer who participates in the promotion or underwriting of a particular issue of shares or who, to the public, is a dealer in shares. In general, an employee of a corporation engaged in these activities is not a dealer. If, however, as a result of employment, an employee engages in insider trading to realize a quick gain, the taxpayer will be considered to be a trader of those particular shares. DISPOSITION OF SHARES To determine a capital gain or loss, the general rule is to subtract the cost of the investment from the proceeds of the sale. The proceeds of the sale simply refers to the selling price multiplied by the quantity (shares, units or face value) of the investment sold. It is more difficult to figure out the cost of the investment to calculate the capital gain. This amount, called adjusted cost base, establishes the cost of the investment for tax purposes. The adjusted cost base of shares sold is generally composed of the total cost of purchase plus commission expense. EXAMPLE Hilde buys 100 ABC common shares at $6 per share and pays a $17 commission on the purchase. Two years later, she sells the 100 shares at $10 per share, with a sales commission of $25. In the year of sale, the client’s taxable capital gain is calculated as follows: Gross proceeds from sale (100 × $10) = $1,000 Less: Adjusted cost base, which is the share cost (100 × $6 = $600) + commission of $17 = $617 = $1,000 − $617 = $383 Less: Commission on sale of $25 Capital Gain = $358 Taxable capital gain = 50% × $358 = $179 ADJUSTED COST BASE OF ADDITIONAL SHARES Investors might own a number of the same class of shares that were bought at different times and different prices. When an investor owns identical shares in a company that were bought at varying prices, the average cost method is © CANADIAN SECURITIES INSTITUTE 24 10 CANADIAN SECURITIES COURSE      VOLUME 2 used to calculate the adjusted cost base per share. You can calculate the average cost per share by adding together the cost base of all such stock and dividing by the number of shares held. EXAMPLE Hugo bought 200 ABC common shares at $6 per share in January of last year, and 100 ABC common shares at $9 in June of this year. When Hugo sells any of these ABC common shares, the cost base used is the average cost of $7.15 per share, calculated as follows: 200 × $6 (including a $25 commission) = $1,225.00 100 × $9 (including a $20 commission) = $920.00 Total cost = $2,145.00 $2,145 ÷ 300 = $7.15 per share ADJUSTED COST BASE OF CONVERTIBLE SECURITIES When an investor exercises the conversion right attached to a security, the conversion is deemed not to be a disposition of property. Therefore, no capital gain or loss arises at the time of the conversion. Instead, the adjusted cost base of the new shares acquired is deemed to be that of the original convertible securities. EXAMPLE A client buys 100 ABC preferred shares at a total cost of $6,000. Each preferred share is convertible into five ABC common shares. These securities are later converted into common shares, so the client now holds 500 ABC common shares. For tax purposes, the adjusted cost base of each ABC common share is $12, calculated as follows: Adjusted cost base of each preferred share (original cost + commission) = $60 Number of common shares acquired through conversion of one preferred share = 5 shares Adjusted cost base of one common share ($60 ÷ 5) = $12 per share ADJUSTED COST BASE OF SHARES WITH STOCK DIVIDENDS OR REINVESTMENT PLANS Investors who receive stock dividends or who subscribe to dividend reinvestment plans must declare the dividends as income in the year they are paid. Investors should keep a record of stock dividends and reinvestments because they increase the adjusted cost base of the investment. When the stock is later sold, the higher adjusted cost base will prevent double taxation on the dividends that were previously taxed when originally paid to the investor. EXAMPLE Moira purchased 100 shares of ABC Inc. when the shares were trading at $40. Her initial cost base was $4,000. When the shares increased in value to $50 per share, Moira received a dividend payment of $100. The dividend was automatically reinvested to purchase two additional shares at $50 per share. Moira adjusted her cost base to $4,100 (her initial $4,000 investment plus her $100 dividend reinvestment). A year later, the value of the shares increased to $55 per share, and Moira decided to sell. At the time of sale, the value of her investment was $5,610 (102 shares × $55). When she subtracted her adjusted cost base of $4,100, she was left with a capital gain of $1,510. If Moira had not adjusted the cost base and assumed that her total cost was still $4,000, her capital gain would have been $1,610. She would have paid tax twice on the $100 dividend. This scenario demonstrates the importance of adjusting the cost base when necessary through the life of the investment. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 11 ADJUSTED COST BASE OF SHARES WITH WARRANTS OR RIGHTS Investors acquire warrants and rights in one of three ways: Through direct purchase in the market By owning shares on which a rights offering is made By purchasing a unit of securities (such as a bond with warrants attached) The method by which warrants and rights are acquired is important because there is a different tax treatment for the shares acquired when the warrants or rights are exercised. Four different approaches are described below. Direct purchase of warrants and rights Exercising warrants and rights is deemed not to be a disposition of property. Therefore, no capital gain or loss arises at the time of exercise. Instead, the adjusted cost base of both types of securities, once exercised, will be based on the total outlay of funds divided by the number of common shares owned. Rights received from direct share When receiving rights from direct ownership and then exercising those ownership rights, the investor must calculate a new cost base for all the common shares owned, including the original shares purchased as well as the new shares purchased when exercising the rights. Unexercised warrants or rights Warrants and rights are not always exercised. Instead, the investor may sell them in the open market or allow them to expire. If the warrants and rights were directly purchased, the capital loss would equal the purchase cost plus commission. If the warrants and rights were acquired at zero cost, neither a capital gain nor loss would apply. Warrants and rights received at zero Their cost is considered to be zero, and all the profits realized are taxed cost and then sold in the open market as capital gains. DISPOSITION OF FIXED-INCOME SECURITIES The sale or redemption of a fixed-income security by investors (but not by traders) often produces a capital gain or capital loss. For tax purposes, fixed-income securities include bonds, debentures, bills, notes, mortgages, hypothecs, and similar obligations. DID YOU KNOW? Some fixed-income securities do not result in capital gains when disposed of by an investor. For example, savings bonds typically do not have a secondary market; therefore, they do not fluctuate in price and cannot generate a capital gain. ACCRUED INTEREST Capital gains and losses on fixed-income securities are determined in the usual manner—by subtracting purchase costs from the proceeds of the sale. (Purchase costs consist of the adjusted cost base plus expenses of the sale). In addition, a security may have accrued interest owing at the time of disposition. Accrued interest is not included in the capital gains calculation because interest at the date of sale is income to the vendor. Purchasers may therefore deduct that amount from interest they subsequently receive when they report income on their tax return. © CANADIAN SECURITIES INSTITUTE 24 12 CANADIAN SECURITIES COURSE      VOLUME 2 Investors selling bonds are entitled to receive the interest up to the settlement date. However, suppose that a situation arises where the date of sale is five months after the last regular interest payment and the next payment is due in one month. In such a case, the buyer must pay the seller interest due from the last payment of regular interest up to the settlement date. EXAMPLE Jared buys $10,000 principal amount of a 5% semi-annual bond at par. He must pay accrued interest of $200 at the time of purchase to the seller, which is calculated as follows: $10,000 principal amount of 5% bonds at par = $10,000 Plus: Accrued interest = $200 Total cost = $10,200 The seller of the bond includes, as investment income for the year of sale, $200 accrued interest that was received from the sale and any other interest received as the bond owner during the year. On the same return, the proceeds of disposition of $10,000 are used to calculate a capital gain or loss. The buyer includes, as investment income for the year of purchase, net interest income of $300 from the bond ($500 interest for the year less $200 accrued interest paid to the seller). When the buyer later sells the bond, the adjusted cost base is $10,000, rather than $10,200. CAPITAL LOSSES A capital loss occurs when a security is sold for less than its cost. Capital losses are calculated in the same manner as capital gains and can be deducted from capital gains, in most circumstances. EXAMPLE Stanley sold shares in his bank stocks for a $5,250 capital gain. That same year, unfortunately, Stanley’s computer tech stocks dropped in value and he sold the shares for a capital loss of $3,000. Normally, Stanley would pay tax on $2,625 of his capital gain ($5,250 gain × 50%) but is permitted to deduct $1,500 of the allowable capital loss ($3,000 loss × 50%) from that amount. Because of the deduction, Stanley will pay tax on only $1,125 ($2,625 taxable capital gain − $1,500 allowable capital loss). Allowable capital losses that cannot be used in the tax year can be carried back and applied against taxable capital gains in any of the previous three years in most cases or can be carried forward indefinitely. It is also important to note that allowable capital losses can only be used to offset taxable capital gains. Typically, allowable capital losses cannot be used against other income. Two additional factors involved in capital losses are important considerations: worthless securities and superficial losses. WORTHLESS SECURITIES When a security becomes worthless, the security holder must fill out a CRA form electing to declare the security worthless, so that a capital loss can be realized for tax purposes. Of course, the tax rule does not apply to instruments that have an expiry date, such as warrants, rights, or options. Investors can claim capital losses for such securities after they have expired without signing a declaration. One exception to this rule occurs when a security becomes worthless due to the underlying company’s bankruptcy (or insolvency, under certain conditions). In this situation, the Income Tax Act deems the taxpayer to have disposed of the security for nil proceeds and reacquired it at a cost of nil. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 13 SUPERFICIAL LOSSES A superficial loss occurs when securities sold at a loss are repurchased within 30 calendar days before or after the sale and are still owned at the end of 30 calendar days after the original sale. Superficial losses are not tax deductible as a capital loss. The tax advantage may not be totally lost; in most cases, it is simply deferred. The superficial loss rules are intended to make it more difficult for taxpayers to sell and repurchase assets solely for the purpose of creating deductible capital losses without any meaningful change in ownership. EXAMPLE Pierre buys 100 XYZ shares at $30 per share in mid-April and sells the shares at $25 per share on May 1. He incurs a $500 capital loss (calculated as $3,000 − $2,500). Normally, an allowable capital loss of $250 (calculated as 50% of $500) would be deductible against taxable capital gains. However, the superficial loss rule applies in either of the following two scenarios: On May 15, Pierre reacquires 100 XYZ shares at a price close to the $25 per share sale price and holds the shares until July. Because the transaction took place within 30 days after the disposition on May 1, and the shares are held 30 days after the original disposition, the loss is considered a superficial loss. In other words, it is not a capital loss that can be deducted against taxable capital gains. On April 29, Pierre acquires an additional 100 shares of XYZ near the initial $30 per share purchase price. The shares then fall in price and he sells 100 XYZ shares on May 1 at $25 per share. He still holds 100 shares until July. Because the same shares were acquired less than 30 days before the May 1 disposition and owned for at least 30 days after the original disposition, this loss is also considered a superficial loss. Tax rules for superficial losses apply not only to trades made by the investor, but also to the following people affiliated with the investor: The investor’s spouse or common-law partner Corporations controlled by the investor or spouse A trust in which the investor is a majority interest beneficiary Superficial losses are non-deductible for tax purposes. In most cases, however, the taxpayer eventually receives the tax benefit of a superficial loss when the investment is sold. The amount of the loss is added to the cost of the repurchased shares, thereby reducing the ultimate capital gain for tax purposes. EXAMPLE Using the previous example, suppose Pierre’s $500 capital loss had been a superficial loss, and the shares were reacquired at $25 per share before May 31. The loss of $5 per share would be added to the cost of the 100 XYZ shares owned on May 31. In this way, the potential future amount of the capital gain is reduced. If 100 XYZ shares are later sold at $40 per share, the capital gain is calculated as follows: Proceeds from disposition (100 × $40) = $4,000.00 Less: Cost of repurchasing shares (100 × $25) = $2,500.00 Commission on purchase = $45.00 Superficial loss (100 × $5) = $500.00 Subtotal = $955.00 Less: Commission on sale = $60.00 Capital gain = $895.00 Taxable capital gain (50% of $895) = $447.50 © CANADIAN SECURITIES INSTITUTE 24 14 CANADIAN SECURITIES COURSE      VOLUME 2 Rules regarding superficial losses do not apply to losses that result from the following circumstances: The investor emigrates from Canada. The investor dies. An option expires. A deemed disposition of securities by a trust occurs (a deemed disposition is a disposition that is considered to have occurred even though an actual sale did not take place). The securities are sold to a controlled corporation. TAX LOSS SELLING A decision to hold or sell a security should be based on your client’s expectations for that security. In some circumstances, however, you might also consider tax consequences. For example, your client may own shares whose market price has declined, with no potential for appreciation in the immediate future. By selling the shares, your client can create a capital loss that can be used to reduce capital gains from other securities. Your client can then re-invest the proceeds from the sale in more attractive securities. When a tax loss sale looks advantageous, without breaching investment principles, you should consider the following factors: If your client plans a subsequent repurchase, the sale and repurchase must be carefully timed to avoid a superficial loss. For tax purposes, the settlement date (usually one business day after the transaction date) is the date on which transfer of ownership takes place. This is an important tax rule to remember when selling securities near the end of a calendar year. For example, an investor who sells a stock on the last business day of December does not incur a capital loss for the taxation year in which the sale occurred. The loss would apply to the next taxation year, because the settlement date would be in early January. CALCULATING INVESTMENT GAINS AND LOSSES Can you determine the taxable portion of a capital gain or loss? Can you apply the capital gain tax calculations in various client scenarios? Complete the online learning activity to assess your knowledge. TAX DEFERRAL AND TAX-FREE PLANS 3 | Describe the different tax deferral and tax-free plans and their uses. A tax deferral plan allows taxpayers to delay paying tax on income until some point in the future, typically at retirement. At that point, their income, and therefore their marginal tax rates, are usually lower than they were before retirement when contributions were made. The federal government’s main purpose in offering tax deferral plans is to encourage Canadians to save for retirement, although some plans are designed for other purposes. Tax deferral plans typically impose penalties if funds are withdrawn before a certain date. A tax-free plan, on the other hand, allows income from property to be fully exempted from tax. Funds from such accounts can be withdrawn at any time, for any purpose, without penalty. In this section, we discuss the most commonly used tax deferral and tax-free plans available to Canadian taxpayers. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 15 REGISTERED PENSION PLANS A registered pension plan is a trust registered with CRA or the appropriate provincial agency. These plans are established by companies to provide pension benefits for their employees when they retire. Both the employer and the employee contributions to the plan are tax deductible. Tax-assisted retirement savings plans use a uniform contribution level of 18% of earned income as the amount that can be contributed toward retirement, to a maximum dollar amount per year, depending on the type of plan. The rule applies regardless of the timing of the contributions and regardless of whether the contributor is the employee or employer. Individual taxpayers must determine the value of the contributions made to their registered pension plans or of the benefit accruing to them. This amount is called the pension adjustment (PA). The PA reduces the amount the taxpayer can contribute to an RRSP. An annual contribution limit is imposed on the combined plans and must not be exceeded. Employers or administrators of pension plans report a plan member’s PA on the employee’s T4 tax form. Employers may upgrade employee pension plans within certain limits by making changes to existing plans or by introducing new plans. The employer can thus make additional contributions to the plan. This additional amount is called the past service pension adjustment (PSPA). It is calculated as the difference between the old plan’s PA and the new plan’s adjustment. The PSPA also reduces the amount an employee can contribute to an RRSP. Investors do not have to contribute the maximum contribution allowed on all plans combined in any given year. Any amount not contributed is recognized as RRSP carry-forward room. Carry-forward provisions allow people to make up deficient contributions in future years. In general terms, there are two types of registered pension plans: money purchase plans (MPP) and defined benefit plans (DBP). Money purchase plans In an MPP, also known as a defined contribution plan, the contributions are set at a fixed amount. The benefit amount at retirement depends on how the contributions are invested over the plan’s life. With an MPP, the combined employer or employee contributions cannot exceed the lesser of the following two amounts: 18% of the employee’s current year compensation The MPP contribution limit (which is indexed annually to inflation) Defined benefit plan In a DBP, the benefit amount is predetermined based on a formula that considers years of service, income level, and other variables. The contributions are set at a level necessary to fund the pre-set plan benefits. With a DBP, the combined employer and employee contributions are deductible up to the amount recommended by a qualified actuary, so that the plan is adequately funded. The current DBP limits are designed to provide employees with a maximum pension of 2% of pre-retirement earnings per year of service. The current limit is indexed to inflation. The actual benefits an employee receives depends on the terms of the pension plan. In addition, employees’ current service contributions are restricted to the lesser of the following two amounts: 9% of the employee’s compensation for the year $1,000 plus 70% of their PA for the year © CANADIAN SECURITIES INSTITUTE 24 16 CANADIAN SECURITIES COURSE      VOLUME 2 REGISTERED RETIREMENT SAVINGS PLANS An RRSP allows people to defer tax payment on a portion of their income and put it toward their retirement savings. Annual contributions to the plan are tax deductible up to allowable limits, and income earned in the plan accumulates tax-free as long as it remains there. Any withdrawal from an RRSP is treated as regular income, and thus taxed, in the year the withdrawal is made. Essentially, there are two types of RRSPs: single vendor plans and self-directed plans. Single vendor plans The holder of a single vendor plan invests in one or more guaranteed investment certificates (GIC), segregated pooled funds, or mutual funds. The investments are held in trust under the plan by a particular issuer, bank, insurance company, credit union, or trust company. The holders do not make day-to-day investment decisions. They may pay a trustee fee for this type of plan in addition to any costs incurred for purchasing the investments themselves. Self-directed plans Holders of self-directed plans invest funds or contribute certain acceptable assets, such as securities, directly into the plan. The plans are usually administered for a fee by a Canadian financial services company, but the holders make many of the investment decisions. Although there are rules with respect to allowable content, a full range of securities may be held in these plans. QUALIFIED AND NON-QUALIFIED RRSP INVESTMENTS The following investment products are among the more popular in a long list of qualified RRSP investments: Money on deposit in a bank or similar institution GICs Government-guaranteed bonds Shares and debt obligations of Canadian public companies Shares of foreign public corporations listed on a prescribed stock exchange Foreign government bonds with investment grade ratings However, certain investments do not qualify for investment in an RRSP, including the following non-qualified items: Shares and debt obligations of private corporations (unless certain prescribed conditions are met) Real estate (other than real estate investment trust units, which are qualified investments) Commodity and financial futures contracts Property such as artwork, jewellery, rare manuscripts, and stamps DIVE DEEPER For more information on qualified and non-qualified RRSP investments, visit the CRA website. CONTRIBUTIONS TO AN RRSP There is no limit to the number of RRSPs an individual may own. However, the amount that may be contributed to the RRSPs as a whole, on a per-year basis, is restricted. The maximum annual tax-deductible contributions allowable is the lesser of the following two amounts: © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 17 18% of the previous year’s earned income The RRSP dollar limit for the year However, from the lesser of these two amounts, the following additional calculations are required: Deduct the previous year’s PA and the current year’s PSPA. Add the taxpayer’s unused RRSP contribution room at the end of the immediately preceding taxation year. The RRSP limit is indexed to inflation each year. For the 2024 taxation year, the RRSP contribution limit is $31,560. The contributions must be made in the taxation year or within 60 days after the end of that year, to be deductible in that year. Individuals can carry forward unused contribution limits indefinitely. EXAMPLE In 2023, Mario earned $70,000 in income and had a PA of $5,400 reported on his 2023 T4 tax form. He had no PSPA, no unused RRSP contribution room, and no previous RRSP over-contributions. His maximum tax- deductible contribution to an RRSP for the 2024 tax year is calculated as follows: The lesser of $12,600 (calculated as 18% of $70,000) and $31,560 (the 2024 RRSP contribution limit) is $12,600. From that amount, we subtract the 2023 PA of $5,400 to get $7,200 (calculated as $12,600 – $5,400 = $7,200). Therefore, Mario can contribute up to $7,200 for the 2024 taxation year. EARNED INCOME ELIGIBLE FOR RRSP CONTRIBUTIONS Earned income for the purpose of RRSP contributions may be simply defined as the total of the following amounts: Total employment income (less any union or professional dues) Net rental income and net income from self-employment Royalties (from a published work or invention) and research grants Some alimony or maintenance payments ordered by a court Disability payments from the Canada Pension Plan or Quebec Pension Plan Supplementary employment insurance benefits, such as top-up payments made by the employer to an employee who is on parental leave DID YOU KNOW? For the purpose of an RRSP, Employment Insurance benefits paid by Employment and Social Development Canada are not included in earned income. OVER-CONTRIBUTIONS Plan holders whose contributions to RRSPs exceed the amount permitted by legislation may be subject to a penalty tax. Over-contributions of up to $2,000 may be made without penalty. A penalty tax of 1% per month is imposed on any portion of over-contribution that exceeds $2,000. © CANADIAN SECURITIES INSTITUTE 24 18 CANADIAN SECURITIES COURSE      VOLUME 2 CONTRIBUTION IN KIND A contribution in kind is made when a plan holder contributes securities they already own to an RRSP. According to CRA, a contribution of this type is considered to be a deemed disposition at the time the contribution is made. Consequently, the capital gain or loss on the day of the deemed disposition must be calculated. To this end, the plan holder must use the fair market value of the securities at the time of contribution as the proceeds from disposition. (The fair market value is the price at which the property would sell on the open market.) Any resulting capital gain is included in income tax for the year of contribution. A capital loss cannot be used in this situation and is deemed to be nil for tax purposes. EXAMPLE Two years ago, Shen bought 100 shares of Grow Stock Inc. at a price of $10 per share, for a total value of $1,000. The shares eventually increased in value to $20 per share. Shen has now decided to contribute the shares to his self-directed RRSP. The fair market value of the shares is now $20 per share. The contribution to the RRSP, which now holds the shares, is the fair market value of the shares—that is, $2,000. The shares had an accrued capital gain of $1,000 (calculated as $2,000 fair market value − $1,000 original cost = $1,000 gain). Shen must now report this capital gain in his taxes for the year, even though he still owns the shares. WITHDRAWALS FROM AN RRSP An RRSP is a trust account designed to benefit the owner at retirement. Withdrawals from an RRSP are therefore subject to a graduated withholding tax. Withholding tax refers to an amount of income tax that the financial institution is required to deduct by law from a payment made to the owner. Withholding tax amounts and rates for Quebec and the rest of Canada are shown in Table 24.6. Table 24.6 | Withholding Tax Amounts and Rates All Provinces (Except Quebec) Quebec Amount Withdrawn Federal Tax Combined (Federal and Quebec Amounts) Up to $5,000 10% 20% $5,001 to $15,000 20% 25% More than $15,000 30% 30% Holders must include in their income tax the amount withdrawn in the year of withdrawal. More tax may be payable at year-end, depending on the income level of the taxpayer. Note that funds cannot be withdrawn from an RRSP to be used as collateral for a loan. DIVE DEEPER The RRSP plan holder may borrow from the plan without penalty through the Home Buyers’ Plan and Lifelong Learning Plan. To avoid a penalty, the borrower must meet specific repayment conditions. For more information about these programs, visit the CRA website. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 19 SPOUSAL RRSPS A taxpayer may claim a deduction by contributing to a spousal registered retirement savings plan, which is an RRSP registered in the name of a spouse or common-law spouse. The plan holder may contribute to the spouse’s plan only to the extent that contribution room is available in his or her own plan. EXAMPLE Sofia and Nigel are married and contribute to separate RRSPs. Sofia has a maximum contribution limit of $11,500 this year. She can contribute this entire amount either to her own RRSP or to a spousal RRSP for Nigel, or she can split the amount and contribute any percentage to both RRSPs. However, she cannot exceed her contribution limit. For example, if Sofia contributes $10,000 to her own RRSP and $1,500 to Nigel’s spousal RRSP, her $1,500 contribution will not affect Nigel’s contribution limit, because his own RRSP is separate. In other words, Nigel has two plans: one for personal contributions and another (the spousal plan) for contributions made by Sofia on his behalf. WITHDRAWALS FROM SPOUSAL REGISTERED RETIREMENT SAVINGS PLANS Withdrawal from a spousal plan can be considered taxable income to the spouse or to the contributor, depending on when the withdrawal is made. If the contribution was made in the year funds were withdrawn, or within the two calendar years prior to the year of withdrawal, the withdrawal is considered taxable income to the contributor. If the withdrawal is made three years or more after the contribution was made, the withdrawal is considered taxable income in the hands of the spouse. Any interest earned on contributions, no matter when they were made, is taxed in the hands of the spouse. EXAMPLE In each of six consecutive years, Davide contributes $1,000 to his wife Elena’s spousal RRSP, which he claims as tax deductions. In the seventh year, he makes no contributions, and Elena deregisters the spousal RRSP when its total value is $6,800. In the current taxation year, Davide reports $2,000 as taxable income withdrawn from Elena’s spousal RRSP. This amount is the sum of his contributions over the past three years. In the same year, Elena reports $4,800 as taxable income withdrawn from the same source. This amount is the sum of Davide’s contributions over the first four years ($4,000), plus all earnings ($800) that accumulated in the spousal plan. Table 24.7 outlines the plan’s contributions and taxable income. Table 24.7 | Contributions and Taxable Income for Elena’s Spousal RRSP Contribution Made by Davide Income Taxable in the Hands to the Spousal RRSP of Elena or Davide 6 years ago $1,000 Elena 5 years ago $1,000 Elena 4 years ago $1,000 Elena 3 years ago $1,000 Elena 2 years ago $1,000 Davide 1 year ago $1,000 Davide This year $0 Nil Withdrawal $6,800 © CANADIAN SECURITIES INSTITUTE 24 20 CANADIAN SECURITIES COURSE      VOLUME 2 OTHER TYPES OF REGISTERED RETIREMENT SAVINGS PLAN CONTRIBUTIONS Some pension income can be transferred directly to RRSPs. The following transfers can be contributed without affecting the regular tax-deductible contribution limits: Lump-sum transfers from registered pension plans and other RRSPs, if transferred directly to the holder’s RRSP, are not included in income and no deduction arises. Allowances upon retirement for each year of service (commonly known as retiring allowances) are transferable under very specific guidelines. TERMINATION OF A REGISTERED RETIREMENT SAVINGS PLAN An RRSP holder may make withdrawals or deregister the plan at any time. However, deregistration is mandatory during the calendar year when the plan holder reaches age 71. In that year, the plan holder has the following options, alone or in combination: Withdraw the proceeds as a lump-sum payment, which is fully taxable in the year of receipt. Use the proceeds to purchase a life annuity. Use the proceeds to purchase a fixed-term annuity, which provides benefits to a specified age. Transfer the proceeds to an RRIF, which provides an annual income. If the plan holder dies before the RRSP is deregistered, the beneficiary of the plan may transfer the proceeds, free of tax, into his or her own RRSP. The beneficiary can be a surviving spouse or common-law partner. Under certain conditions, the beneficiary can be a financially dependent child or grandchild. If there is no beneficiary, or if the beneficiary does not transfer the proceeds into an RRSP, the proceeds are taxed as the deceased’s income in the year of death. ADVANTAGES OF REGISTERED RETIREMENT SAVINGS PLANS An RRSP can provide the following advantages: The tax-deductible contributions can reduce taxable income during high-earning years. Certain types of lump-sum income can be transferred into an RRSP, and thus sheltered from tax. Savings for future retirement can earn compound interest on a tax-free basis until they are withdrawn. Income taxes can be deferred until later years, when the holder is presumably in a lower tax bracket. Spouses can split their retirement income for the following two purposes: Lower taxation of the combined income The opportunity to claim two $2,000 pension tax credits DISADVANTAGES OF REGISTERED RETIREMENT SAVINGS PLANS An RRSP can also have some disadvantages, as follows: The plan holder pays income tax (not capital gains tax) on the entire amount of a withdrawal, not just on the earnings from the amount invested. The plan holder cannot take advantage of the dividend tax credit on eligible shares that are part of an RRSP. If the plan holder dies, all payments out of the RRSP to the plan holder’s estate are subject to tax as income of the deceased (unless they have been transferred to the beneficiary’s RRSP). The assets of an RRSP cannot be used as collateral for a loan. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 21 REGISTERED RETIREMENT INCOME FUNDS An RRIF is a tax deferral vehicle available to RRSP holders who wish to continue to shelter the assets in their plans from tax. When the plan holder transfers the RRSP capital plus accumulated earnings into an RRIF, certain rules apply. In the year after the RRIF is acquired, and in each following year, the plan holder must withdraw a fraction of the total assets in the RRIF. The plan holder pays income tax on this so-called minimum annual amount. The amount is determined by factors prescribed by CRA that are designed to provide benefits to the holder until death. The term of the RRIF may be based on the age of the holder’s spouse (if younger), rather the plan holder’s own age. In such cases, the term is extended, and the amount of the required withdrawal is reduced. Before the RRIF holder reaches age 71, the annual minimum amount that must be withdrawn is a percentage based on the person’s age. The percentage is calculated as follows: 1 ÷ (90 − age). At age 71, plans use a percentage prescribed by CRA. The RRIF withdrawal factor at age 71 is 5.28% and increases until age 95, when it is set at 20%. EXAMPLE Walter transferred his RRSP to an RRIF last year. This year, Walter is 65 and his RRIF has a value of $200,000. Based on the formula for plan holders who are younger than age 71, Walter must withdraw a minimum amount of $8,000 this year from his plan, calculated as 1 ÷ (90 − 65) = 0.04, or 4%. RRIF owners must adhere to the annual minimum withdrawal amount, but there is no mandatory maximum amount. As with an RRSP, taxpayers can own more than one RRIF. Also like an RRSP, an RRIF may be self-directed by the holder through instructions to the financial institution holding the plan, or it may be managed. A wide variety of investment vehicles within the Canadian content framework qualify for self-directed plans. They include stocks, bonds, investment certificates, mutual funds, and mortgages. DEFERRED ANNUITIES An annuity is an investment contract through which the holder deposits money to be invested in an interest-bearing vehicle. The annuity returns not only interest but also a portion of the capital originally invested. With immediate annuities, payments to the holder start immediately. With a deferred annuity, payments start at a date specified by the investor in the contract. Both types of annuities can be paid for in full at the beginning of the contract. The deferred annuity can also be paid for in monthly instalments, until the date the annuity begins payment. Contributions to a deferred annuity, unlike those to an RRSP, are not tax deductible; therefore, they do not reduce the current taxable income. The annuitant is taxed only on the interest element of the annuity payments, not on the capital portion, because the annuity is purchased with after-tax income. This contrasts with annuities bought with money from RRSPs. In this case, the full annuity payment is taxable because the principal cost of the annuity was not taxed when first deposited to the RRSP. However, some deferred annuities may be registered as RRSPs. Investments in such annuities, within RRSP contribution limits, are deductible from income for tax purposes in the year deposited. The proceeds are fully taxable. Because the interest earned during the accumulation phase is taxable on an annual basis outside a registered plan, deferred annuities are usually purchased with registered funds. Should the annuitant die, benefits can be transferred to the annuitant’s spouse. Otherwise, the value of any remaining benefits must be included in the deceased’s income in the year of death. Under certain conditions, the remaining benefits may be taxed in the hands of a financially dependent child or grandchild, if named as beneficiary. The child or grandchild may be entitled to transfer the benefits received to an eligible annuity, an RRSP, or an RRIF. Deferred annuities are available only through life insurance companies. © CANADIAN SECURITIES INSTITUTE 24 22 CANADIAN SECURITIES COURSE      VOLUME 2 TAX-FREE SAVINGS ACCOUNTS A TFSA is a savings vehicle that came into existence in 2009. Income earned within a TFSA is not taxed in any way throughout the account holder’s lifetime. There are no restrictions on the timing or amount of withdrawals from a TFSA, and the money withdrawn can be used for any purpose. However, there is a dollar limit on the amount that can be contributed to a TFSA in any one year. BASIC TFSA RULES Any resident of Canada who is at least 18 years old, whether employed or not, can open a TFSA. Contributions can come from any source: a tax refund, a bequest, savings, a gift, or earnings from employment or a business. TAXATION OF A TFSA The money contributed to a TFSA is not tax deductible. No tax is applied on investment income in the year it is earned, nor is it owed on any funds when they are withdrawn. Income earned in a TFSA can be interest, dividends, or capital gains. QUALIFIED TFSA INVESTMENTS A wide variety of products are considered qualified investments for a TFSA. They include GICs, savings accounts, stocks, bonds, or mutual funds. TFSA CONTRIBUTIONS Yearly contribution room in a TFSA consists of the dollar limit for that year, plus any unused contribution room from previous years. Unused contribution room includes room freed up by withdrawals made in any but the current year. Based on information provided by the TFSA issuer, CRA determines the annual contribution room for each eligible taxpayer. That amount appears on the taxpayer’s online CRA profile. Any contribution amount over the limit is taxed at the rate of 1% of the excess contribution every month. Table 24.8 shows the TFSA annual contribution limit since its inception. Table 24.8 | Tax-Free Savings Account Annual Contribution Limit 2009–2024 TFSA Annual Contribution limit 2009 to 2012 $5,000 2013 and 2014 $5,500 2015 $10,000 2016 through 2018 $5,500 2019 through 2022 $6,000 2023 $6,500 2024 $7,000 Total $95,000 © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 23 EXAMPLE Any Canadian who was 18 years old or older in 2009, who has never contributed to a TFSA, had contribution room of $95,000 in 2024. The same is true of a person the same age who had withdrawn the entire contribution in 2023 or earlier. However, those who turned 18 more recently have less contribution room. For example, a person who turned 18 in 2019 has total contribution room of $37,500 in 2024 (calculated as $6,000 + $6,000 + $6,000 + $6,000 + $6,500 + $7,000). TAX-FREE SAVINGS ACCOUNT WITHDRAWALS Withdrawals can be made from a TFSA at any time. There is no limit to how much may be withdrawn, and there is no penalty or tax on withdrawals. Withdrawal amounts can be re-contributed, but there is no obligation to do so. The funds can be replaced in the same calendar year of the withdrawal up to the amount of unused TFSA contribution room available. If there is no room available, they can be replaced in the next calendar year without affecting that year’s contribution limit. EXAMPLE Emma has unused contribution room of $14,000 in her TFSA, and her husband Liam has no contribution room left. In January, they each withdraw $10,000 from their respective TFSAs for a down payment on their new house. Later that year, they both want to put their $10,000 back into their TFSAs. Emma has room to re-contribute the full amount because she had $14,000 in contribution room, prior to her withdrawal. However, Liam is not allowed to re-contribute this year. He had no contribution room left when he withdrew his $10,000. He must now wait until next year, when contribution room becomes available. It will then consist of the sum of the yearly maximum ($7,000 in 2024) plus any amount withdrawn the year before ($10,000 in this case). Because the rules allow funds to be withdrawn and re-contributed without penalty, a TFSA is a useful savings vehicle for a variety of expenditures at different life stages. They are suitable for tuition fees, repayment of student loans, a wedding, a holiday, a new car, or a down payment for a house. They can also be used as an emergency fund or simply to increase the value of one’s estate. THE TAX-FREE FIRST HOME SAVINGS ACCOUNT A First Home Savings Account (FHSA) came into effect in April 2023 for first-time home buyers. This account type combines some features of an RRSP with those of a TFSA. Like an RRSP, a qualifying contribution made to an FHSA is eligible for an income tax deduction (up to specified limits). And like a TFSA, income earned within the account is not taxed. Withdrawals from the account used to buy a first home are also tax-free. To qualify, a contributor must be a resident of Canada, age 18 or over, who is purchasing a qualifying home in Canada. In the year the FHSA is opened (or in the previous four calendar years), the contributor must not reside (or have resided) in a home they or their spouse own (or owned). Qualified individuals can contribute $8,000 a year to an FHSA up to a maximum of $40,000. Like an RRSP, the contributions are income tax deductible. Like a TFSA, income earned within the account is not taxed, nor are withdrawals from the account that are used to buy a first home. The maximum amount of unused FHSA participation room that can be carried forward to a subsequent year is $8,000. © CANADIAN SECURITIES INSTITUTE 24 24 CANADIAN SECURITIES COURSE      VOLUME 2 REGISTERED EDUCATION SAVINGS PLANS An RESP is a tax-deferred savings plan intended to help pay for the post-secondary education of a beneficiary. The contributions to the plan are not tax deductible, but tax-deferred income accumulates within the plan. Upon withdrawal, the portion of the payments that were not original capital are taxable in the hands of the beneficiary (or beneficiaries), provided that they are enrolled in a qualifying or specified educational program. The assumption is that, at the time of withdrawal, the beneficiary will be in a lower tax bracket than the contributor, and so withdrawals will be taxed at a lower rate. The lifetime maximum contribution allowed in an RESP is $50,000 per beneficiary. Any of this amount can be contributed in a single calendar year for each beneficiary. Contributions can be made for up to 31 years, but the plan must be collapsed within 35 years of its starting date. There are two types of RESPs: pooled (or group) plans and self-directed plans. Pooled RESPs As their name suggests, pooled plans allow various subscribers to make contributions for their beneficiaries. The pooled funds are managed, usually conservatively, by the plan administrators. Annual contributions are generally pre-set. The administrator determines the amount paid out to beneficiaries. Self-directed RESPs Self-directed plans are administered by various institutions including banks, mutual fund companies, and investment brokers. Contributions tend to be more flexible, and contributors can participate in both the investment and distribution decisions. More than one beneficiary can be named in any particular plan, in which case they are called family plans. These RESPs are often used by families with more than one child. If one of the named beneficiaries does not pursue post- secondary education, all of the income can be directed to the beneficiaries who do attend. The contributor (but not the beneficiary) can withdraw the income from an RESP in any of the following two circumstances: The plan has been in existence more than 10 years and none of the named beneficiaries has started qualified post-secondary programs by age 21, or All of the named beneficiaries have died. If the beneficiaries do not attend qualifying programs, the government grant must be repaid (without interest). Contributors are allowed to transfer a maximum of $50,000 of RESP income to their RRSPs (providing that there is sufficient contribution room and the RESP has been in existence for at least 10 years). No taxes are charged on contributions when they are withdrawn by the contributor. However, revenues earned on the contributions that are not transferred to an RRSP are taxed at the contributor’s regular income tax level, plus an additional penalty tax of 20%. If the contributor (as opposed to the beneficiary) starts to withdraw income from the RESP, the plan must be terminated by the end of February of the following year. CANADA EDUCATION SAVINGS GRANTS A Canada Education Savings Grant (CESG) provides further incentive to invest in RESPs. Under this program, the federal government makes a matching grant of 20% of the first $2,500 contributed each year to the RESP of a child under 18. Depending on family income, an additional CESG is available over and above the basic CESG amount. This grant is worth between $500 and $600 per year, depending on family income. It is forwarded directly to the RESP firm and does not count toward the contributor’s lifetime contribution limit. The lifetime grant amount a beneficiary can receive is $7,200. However, The CESG must be repaid if the child does not attend a qualifying post- secondary institution. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 25 Table 24.9 shows the contribution and matching grant amounts of the CESG program. Table 24.9 | Canada Education Savings Grant Contributions Contribution Basic CESG Total CESG % $ All families $2,500 20% $500 $500 On the first: Additional CESG Total CESG Families earning*: % $ Up to $55,867 $500 20% $100 $600 More than $55,867 and up to $111,733 $500 10% $50 $550 * Note: These figures apply for the calendar year 2024. Source: Adapted from the Canada Revenue Agency EXAMPLE A family earning under $55,867 that contributes $2,500 per beneficiary in a year will receive a CESG of $600 a year per beneficiary. This amount represents 20% of the $2,500 contribution from the basic CESG and an additional 20% on the first $500 invested in the program (calculated as $2,500 × 20% + $500 × 20%). POOLED REGISTERED PENSION PLANS A pooled registered pension plan (PRPP) is a type of retirement savings plan offered by the federal government. The plan is designed to address the gap in employer pension plan coverage by providing Canadians with an accessible, large-scale, low-cost pension plan. PRPPs hold assets pooled together from multiple participating employers. They allow workers to take advantage of lower investment management costs that result from membership in a large pooled pension plan. PRPPs are administered by eligible financial institutions such as banks and insurance companies. This design reduces the risk and cost that employers would normally bear when offering a retirement plan for employees. Participation in a PRPP is open to the following people: Those employed or self-employed in the Northwest Territories, Nunavut, or Yukon Those who work in a federally regulated business or industry for an employer who chooses to participate in a PRPP Those who live in a province that has the required provincial standards legislation in place A PRPP can be designed to permit members to make their own investment decisions, or to select from investment options provided by the plan administrator. Options include varying levels of risk and reward based on investor profiles. Much like an RRSP, contributions to a PRPP are limited to available contribution room based on earned income, and contributions are tax deductible. JOHN AND BETTY’S RRSP DECISIONS Can you help John and Betty with their understanding of registered investments? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 24 26 CANADIAN SECURITIES COURSE      VOLUME 2 TAX DEFERRAL PLANS Can you describe the various tax deferral plans and the advantages of using such plans? Complete the online learning activity to assess your knowledge. TAX PLANNING STRATEGIES 4 | Identify basic tax planning strategies and strategies for minimizing tax liability. Proper tax planning should be a part of every investor’s overall financial strategy. The minimization of tax, however, must not become the sole objective, nor can it be allowed to overwhelm the other elements of proper financial management. The important factor is after-tax income or return. Choosing an investment based solely on a low tax status is not normally the best approach. Given the choice of two investments, the one that is more heavily taxed might still provide a higher after-tax rate of return than the other. Also, the time and effort you spend on tax planning must not outweigh the rewards you reap. Tax planning is an ongoing process with many matters being addressed throughout the year. The best tax advantages are usually gained by planning early and often and allowing reasonable time for the plan to produce the desired results. Of course, tax evasion is against the law. However, taxes can be minimized by one or more of the following legitimate means: Make full use of allowable deductions. Convert non-deductible expenses into tax-deductible expenditures. Postpone the receipt of income. Split income with other family members (under certain conditions). Select investments that provide a better after-tax rate of return. Various general strategies to reduce taxes are discussed below. However, you should not consider these strategies as specific recommendations. Taxes play a significant role in your clients’ overall financial plans and can greatly affect the choice of investments. You should therefore make sure to remain up to date with the ever-changing rules and interpretations. SPLITTING INCOME Income splitting is a tax savings strategy that involves transferring income in a higher tax bracket to a spouse, child, or parent in a lower tax bracket. Doing so allows the same income to be taxed at a lower rate. However, changes to tax laws have made it more difficult to split income in this manner. Spousal RRSPs are an effective and legitimate vehicle within which to split income. Other vehicles include family trusts, partnerships, small business corporations, and investment holding companies. Because there are many technicalities involved in establishing these structures, professional advice should be sought. Income splitting techniques are covered in more advanced courses offered by the Canadian Securities Institute, such as the Wealth Management Essentials course. TRANSFERRING INCOME Transferring income to family members can trigger what is called attribution rules. If property or income-producing assets are transferred from the taxpayer to other family members, the tax consequences may be passed back to the taxpayer. One exception to these rules occurs in the event of a marriage breakdown. If the married couple is living apart, the attribution rules relating to income and capital gains do not apply. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 27 Both income and capital gains from property transferred from one spouse to another are attributed to the transferor unless the transfer is made for fair market value. If the transfer is made by way of a loan, the loan must bear interest. The rate of interest cannot be less than the prescribed rates published by CRA. In addition, the interest must actually be paid within 30 days after the particular year to which it relates. PAYING EXPENSES When both spouses have earnings, non-deductible expenses are not always paid in a tax effective manner. Instead of using funds for investment purposes, the higher-income spouse should first pay all family expenses, while the lower-income spouse should invest as much income as practical. This practice allows the lower-income spouse to maintain a larger investment portfolio for earning income. Presumably, this income will also be taxed at a lower rate than if it were earned by the other spouse. MAKING LOANS The attribution rules do not apply on money that is loaned when interest is charged at a rate prescribed by CRA and paid within 30 days after the year-end. When an investment can be expected to generate earnings in excess of the prescribed rate, it is often worthwhile for the higher-income family member to loan funds to a lower-income family member. The person with the lower income then uses the loan to purchase the investment. Therefore, the excess of the investment earnings, over the interest charged, is effectively transferred to the person in the lower tax bracket. Of course, the interest charged must be added to the income of the higher-income family member. DISCHARGING DEBTS The attribution rules do not apply if a taxpayer directly discharges the debt of his or her spouse, or a designated minor or other non-arm’s length individual. As a tax-saving strategy, the person with the lower income can thus borrow money from a third party, which the person with the higher income repays. DID YOU KNOW? A non-arm’s length transaction is a transaction between two parties who are related to each other. In an arm’s length transaction, the two parties are not related. EXAMPLE Jonah, a house painter, borrows $20,000 to purchase a truck. His wife Wilma, a university professor, assumes the debt and pays it off from her income. Jonah, who no longer has to make the loan payments, can use this freed-up income to invest. And, because his income is lower, his investment income will be taxed at a lower rate than Wilma’s would be. CANADA AND QUEBEC PENSION PLAN SHARING The Canada Pension Plan and the Quebec Pension Plan legislations permit spouses to share their pension benefits. If both parties agree, the portion of the retirement pension being received can be split according to the length of time the couple lived together, and the amount they contributed during that time. If both parties are eligible for a pension and want to share benefits, then both pensions must be shared. GIFTING A taxpayer may choose to transfer investments to adult children or parents by way of a gift. Such a gift results in a deemed disposition at fair market value by the person who made the gift. Before making or recommending a gift of investments, it is important to consider the effect of any resulting capital gains or losses in the year the gift is made. © CANADIAN SECURITIES INSTITUTE 24 28 CANADIAN SECURITIES COURSE      VOLUME 2 CASE SCENARIO Can you answer Eisha’s RRSP questions? Complete the online learning activity to assess your knowledge. CASE SCENARIO Marcus is struggling with how investment income is taxed, and he turns to you for help. Can you guide Marcus through the various calculations? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 24      CANADIAN TAXATION 24 29 SUMMARY In this chapter, we discussed the following key aspects of Canadian taxation: Canada taxes the world income of its residents and the Canadian-source income of non-residents. All taxpayers must calculate their taxable income annually based on four general types of income: employment income, business income, capital property income, and capital gains and losses. Taxpayers’ marginal tax rate (the rate paid on each additional dollar earned) is based on their combined provincial and federal tax rate. A capital gain arises from selling a capital property for more than the adjusted cost base plus any costs of disposing of the property. Disposition of worthless securities results in an allowable capital loss; however, superficial losses are not eligible as capital losses, and must be deferred. Tax deferral plans allow taxpayers to delay paying tax on income until some point in the future, typically at retirement. A tax-free plan such as a TFSA allows income from property, up to a limit, to be fully exempted from tax. Contributions to tax deferral plans are limited by legislation and are generally based on taxable income. Tax deferral plans include the following types: RRSPs, in which contributions are tax deductible up to allowable limits, and income accumulates tax deferred while it remains in the plan RPPs, which are established by companies to provide pension benefits for their employees when they retire RESPs, which pay for the post-secondary education of a beneficiary RRIFs, from which the holder must make minimum, annual taxable withdrawals based on a formula specified by the government PRPPs, which are designed to fill the gap in employer-sponsored pension plans Income splitting involves transferring income from a highly taxed family member to a spouse, child, or parent who is in a lower tax bracket. Attribution rules may be triggered. Other tax planning strategies include setting up spousal RRSPs, having the higher-taxed spouse claim tax-deductible investment expenses, making loans to family members, sharing government pension benefits, making gifts to children or parents. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 24 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 24 FAQs. © CANADIAN SECURITIES INSTITUTE