Taxation.pdf

Canadian Investment Funds Course Unit 10: Taxation Introduction When working with your clients on investment planning, it is important that you understand how taxation will impact their investments and financial standing. In this unit, you will learn about the Canadian tax system. You will also beco...

Canadian Investment Funds Course Unit 10: Taxation Introduction When working with your clients on investment planning, it is important that you understand how taxation will impact their investments and financial standing. In this unit, you will learn about the Canadian tax system. You will also become familiar with the rules surrounding taxation of investment income and learn about how mutual funds are taxed. This unit takes approximately 1 hour to complete. Lessons in this unit: Lesson 1: Canadian Tax System Lesson 2: Taxation of Investment Income Lesson 3: Taxation of Mutual Funds © 2021 IFSE Institute 355 Unit 10: Taxation Lesson 1: Canadian Tax System Introduction When working with your clients to create financial plans and make investment recommendations, it is important to have an understanding about taxation and the impact of taxes on your clients’ income and investments. In this lesson, you will learn about the Canadian Tax system. This lesson takes approximately 20 minutes to complete. By the end of this lesson, you will be able to: explain Canada's progressive tax system describe the difference between tax avoidance and tax evasion describe the key elements of the Canadian tax system including the following: - 356 total versus taxable income marginal and average tax rates federal and provincial tax rates tax deductions versus tax credits © 2021 IFSE Institute Canadian Investment Funds Course How Canadians are Taxed 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. Where Your Tax Dollar Goes – 2016/2017 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 are used to pay the interest charges on Federal government debt. The chart below highlights how many cents of each dollar go towards various program areas: © 2021 IFSE Institute 357 Unit 10: Taxation 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 a Dealing Representative, it is important to understand the importance of tax planning as part of an overall financial strategy. Tax Planning, Tax Avoidance, and Tax Evasion 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. Example Alexa has a popular part-time business selling home made jewelry at the local market. For the last few years, she has sold about $30,000 annually. She knows she has made some profit after covering her expenses, but she hasn’t kept track. She decided not to include it in her personal taxes. Here are some examples of some legal tax avoidance approaches: 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; 358 © 2021 IFSE Institute Canadian Investment Funds Course splitting income with other family members, when handled properly; and selecting investments that provide a better after-tax rate of return. Example Ben has some special medical expenses he would like to claim. While some of the medical expenses were covered by the provincial health insurance program, others were not including some prescription drugs. He reviews the eligibility of the prescription drugs and includes it on this year’s income tax. Since tax rules are subject to change at all levels of the government, it is very important to continuously familiarize yourself with any announced changes. That way, you can advise your clients with the most effective investment recommendations. Calculating Tax 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, childcare expenses, support payments, carrying charges, and moving expenses. In general, taxable income is calculated as follows: Taxable Income = Total Income – Tax Deductions © 2021 IFSE Institute 359 Unit 10: Taxation 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. Example Ben’s total income this year is $55,000. After reviewing his financial information for the past year, Ben realizes that he has tax deductions that add up to $5,000. As a result, he determines his taxable income to be $50,000, calculated as $55,000 - $5,000. Marginal and Average Tax Rates Marginal Tax Rate The marginal tax rate represents the amount of tax that an individual pays on the 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: 2020 Federal Income Tax Taxable Income Marginal Tax Rates First $48,535 or less Over $48,535 to $97,069 15% 20.5% Over $97,069 to $150,473 26% Over $150,473 to $214,368 29% Over $214,368 and over 33% 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 As a Dealing Representative, you should be familiar with the concepts of average and marginal tax rates. Understanding the tax implications for your clients helps you advise them on their mutual fund investment strategy. 360 © 2021 IFSE Institute Canadian Investment Funds Course Example Ben’s taxable income this year is $50,000. With respect to his federal income taxes, Ben will pay tax at a rate of 15% on his first $48,535 of taxable income. He will pay tax at a rate of 20.5% on his remaining income of $1,465, calculated as $50,000 - $48,535. Ben’s taxes payable will be: $48,535 x 15% = $7,280.25 $1,465 x 20.5% = Total $300.33 $7,580.58 Ben’s marginal tax rate is 20.5%. That is, for every additional dollar he had earned above $50,000, he would have paid tax at a rate of 20.5%. However, most of Ben’s income was taxed at the lower marginal tax rate of 15%. The average tax rate represents how much tax is payable as a percentage of taxable income. Average Tax Rate = (Tax Payable ÷ Taxable Income) x 100 Ben’s average tax rate is 15.16%, calculated as: Average Tax Rate = ($7,580.58 ÷ $50,000) x 100 Federal and Provincial Tax Rates In addition to federal income taxes, a taxpayer must also pay provincial taxes. In general, marginal tax rates in every province are applied similarly to how the federal government applies its marginal tax rates. 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. Example Ben’s taxable income this year is $50,000. With respect to his federal income taxes, Ben will pay tax at a rate of 15% on his first $48,535 of taxable income. His federal tax payable on the initial $48,535 is $7,280.25 ($48,535 x 15% = $7,280.25). He will pay tax at a rate of 20.5% on his remaining income of $1,465 ($50,000 - $48,535 = $1,465). His federal tax payable on the last $1,465 is $300.33 ($1,465 x 20.5% = $300.33). The total amount of his federal tax payable is $7,580.58 ($7,280.25 + $300.33 = $7,580.58). © 2021 IFSE Institute 361 Unit 10: Taxation If Ben is an Alberta resident his combined marginal tax rates will be: Taxable Income Federal Marginal Tax Alberta Marginal Tax Combined Marginal Tax 15% + 10% = 25% 20.5% + 10% = 30.5% Over $97,069 up to $131,220 26% + 10% = 37% Over $131,220 up to $150,473 26% + 12% = 38% Over $150,473 up to $157,464 29% + 12% = 41% Over $157,464.01 up to $209,952 29% + 13% = 42% Over $209,952 up to $214,368 29% + 14% = 43% $214,368 up to $314,928 33% + 14% = 47% Over $314,928 33% + 15% = 48% First $48,535 Over $48,535 up to $97,069 Ben’s provincial tax payable would be $5,000, calculated as $50,000 x 10%. Recall from the previous example, his federal tax payable was $7,580.58. His combined federal and provincial tax payable will be $12,580.58, calculated as $7,580.58 + $5,000 = $12,580.58. Ben’s average tax rate is 25.16%, calculated as: Average Tax Rate = ($12,580.58 ÷ $50,000) x 100 Average Tax Rate = 25.16% Notice that Ben’s average tax rate of 25.16% is lower than his marginal tax rate of 30.5%. The calculation for combining marginal tax rates is similar in other provinces. However, the number of marginal tax rate categories, or brackets, will be different among provinces based on how income tax policy has changed over time in each province. 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. 362 © 2021 IFSE Institute Canadian Investment Funds Course 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 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. 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. Recall, Average Tax Rate = (Tax Payable ÷ Taxable Income) x 100 A tax deduction will reduce taxable income, the denominator. A tax credit will reduce tax payable, the numerator. In either case, the average tax rate will decrease. Example Jose’s taxable income this year is $100,000 and he pays tax at an average tax rate of 40%. The following table compares a $5,000 tax deduction with a $5,000 tax credit. Deduction Income $100,000 $100,000 Tax Deduction ($5,000) n/a Taxable Income $95,000 $100,000 Tax @ 40% $38,000 $40,000 n/a ($5,000) $38,000 $35,000 Tax Credit Tax Payable © 2021 IFSE Institute Tax Credit 363 Unit 10: Taxation From this comparison, we can see that a $5,000 tax credit reduces our tax payable more than a $5,000 tax deduction. The example above is highly simplified to illustrate the difference between a tax credit and a tax deduction. Whether one is more advantageous than the other will depend on an individual's own situation. For instance, if you make a large RRSP contribution, the resulting tax deduction could mean your net income is in a lower tax bracket. In this case, a tax deduction may be more advantageous than a tax credit. Types of Tax Credits There are two types of tax credits: refundable non-refundable Refundable credits are tax credits that are paid directly to individuals, if they are not needed to reduce their tax payable. For example, 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. Transferable Tax Credits Tax Credits Eligible for Carry Forward Tuition, education and textbook amount Medical expenses amount Pension income amount Tuition, education and textbook amount Age amount Charitable contribution amount Disability amount 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 364 © 2021 IFSE Institute Canadian Investment Funds Course 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. Example Ben’s taxable income this year is $50,000. Ben’s provincial tax payable is $5,000, and his federal tax payable is $7,580.58. However, Ben has $15,000 in federal tax credits and $20,000 in provincial (Alberta) tax credits. Ben will be able to reduce his tax payable as follows: Federal tax payable: $7,580.58 – ($15,000 x 15%) = $5,330.58 Provincial tax payable: $5,000 – ($20,000 x 10%) = $3,000 After taking into consideration his non-refundable tax credits, Ben’s average tax rate is 16.66%, calculated as: Average Tax Rate = ($5,330.58 + $3,000) ÷ $50,000 x 100 Average Tax Rate = 16.66% Although Ben’s average tax rate has decreased to 16.66%, his combined federal and provincial marginal tax rate is still 30.5%. © 2021 IFSE Institute 365 Unit 10: Taxation Lesson 2: Taxation of Investment Income Introduction As a Dealing Representative, your clients will expect you to know how taxation will affect their investment income. In this lesson, you will learn about the differences in how registered and non-registered accounts are taxed. You will also learn about the tax treatment for different types of income. This lesson takes approximately 20 minutes to complete. By the end of this lesson, you will be able to: differentiate between the taxation of registered and non-registered accounts describe the tax treatment for interest income describe the tax treatment for Canadian dividend income describe the tax treatment for other income including foreign income describe the tax treatment for capital gains and capital losses 366 © 2021 IFSE Institute Canadian Investment Funds Course 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 The table below highlights the tax implications of contributions, investment earnings, and withdrawals for these registered accounts. Type of Account Are Contributions Tax Deductible? Are Investment Earnings Taxable Every Year? Are Withdrawals Tax-Free? Tax-free Savings Account (TFSA) No No Yes Registered Education Savings Plan (RESP) No No Educational Assistance Payments (EAP) withdrawals and withdrawals from the investment returns are taxable; withdrawals of subscriber contributions are tax-free Registered Retirement Savings Plan (RRSP) Yes No No Registered Retirement Income Fund (RRIF) N/A No No © 2021 IFSE Institute 367 Unit 10: Taxation Type of Account Registered Disability Savings Plan (RDSP) Are Contributions Tax Deductible? No Are Investment Earnings Taxable Every Year? No Are Withdrawals Tax-Free? Disability Assistance Payments (DAP) withdrawals and withdrawals from the investment returns are taxable; withdrawals of contributor contributions are tax-free There are no particular tax benefits associated with non-registered accounts. Contributions are not taxdeductible and investors must pay tax on the plan's investment income as they earn it. 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 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. Example Lina owns a one year fixed-rate Guarantee Investment Certificate (GIC) of $5,000 that will pay 2% or $100. Lina must pay taxes on the interest income at her top marginal tax rate. 368 © 2021 IFSE Institute Canadian Investment Funds Course Dividend Income 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. Dividend Gross-Up and Tax Credit Mechanism Non-eligible gross-up and dividend tax credits considerations have changed as of January 1, 2019. The tax payable on eligible and non-eligible dividends can be determined using the following table: Federal Dividend Tax Credit Gross-Up and Tax Credit Gross-Up Dividend tax credit as % of grossed-up dividend Eligible Dividend (2012 and later) Non-Eligible Dividend (As of 2019) 38% 15% 15.02% 9.03% In order to compute the federal tax payable on dividend income, the dividend is multiplied by the gross-up percentage to get the grossed-up taxable dividend. Tax payable is then calculated by multiplying the investor’s marginal tax rate and the grossed-up taxable dividend. Next, the grossed-up taxable dividend is multiplied by the respective dividend tax credit rate. This amount is subtracted from the investor’s tax payable to determine their federal tax payable. Why the Gross-Up and Tax Credit? Recall that dividends are paid out of the after-tax net income of the corporation. Since the corporation has already paid tax before the dividend was paid to shareholders, it would be unfair for shareholders to have to pay tax at their regular marginal tax rate on Canadian dividends. This would result in taxes being paid twice to © 2021 IFSE Institute 369 Unit 10: Taxation the federal government. The gross-up and tax credit mechanism was designed to minimize the double taxation of dividends paid by Canadian corporations. Note that the dividend tax credit is non-refundable. In lower tax brackets, this might result in a negative marginal tax rate for eligible individuals. Since the federal government does not normally receive corporate income tax payments from foreign corporations, the dividends paid by these corporations are not given any special tax treatment when they are paid to Canadian shareholders. Example Pavel received a $1,000 eligible dividend from a large public Canadian corporation, and a $1,000 noneligible dividend from a Canadian–controlled private corporation (CCPC). Pavel’s federal marginal tax rate (MTR) is 29%. What will be his federal tax payable for each of these dividends? Eligible Dividend Non-Eligible Dividend Dividend $1,000 $1,000 Gross-up +$380 +$150 Taxable Dividend $1,380 $1,150 Tax payable at 29% MTR $400.20 $333.50 Less: Dividend Tax Credit -$207.28 -$103.85 $192.92 $229.65 Federal Tax Payable The federal tax that Pavel must pay on the eligible dividend he received from the large public Canadian corporation is less than the federal tax he must pay on the non-eligible dividend. Other Income Some other types of income include: interest and dividend income from foreign sources rental income partnership income spousal support payments business income 370 © 2021 IFSE Institute Canadian Investment Funds Course 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. For investment purposes, the cost of an investment is referred to as its adjusted cost base (ACB) which is adjusted for tax-related items such as acquisition costs, reinvested distributions, and return of capital distributions. Capital Gain: Market Price > Adjusted Cost Base (ACB) Capital Loss: Market Price < Adjusted Cost Base (ACB) © 2021 IFSE Institute 371 Unit 10: Taxation Example Uday and Oksana are active investors. Yesterday, Uday sold shares of a company for $5,000. The cost of the shares is $3,000. At the same time, Oksana sold shares of a company for $6,000. The cost of the shares is $10,000. Their respective capital gain and loss would be calculated as follows: Uday’s capital gain is $2,000, calculated as $5,000 - $3,000. Oksana’s capital loss is $4,000, calculated as $6,000 - $10,000. 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 must 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 allowable 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 allowable 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. It is important to consider the tax consequences when making any adjustments to a non-registered portfolio which will result in a deemed disposition. A deemed disposition can result in unintended consequences (like creating unnecessary increases in taxable income). However, re-balancing a non-registered portfolio can also create tax efficiencies (like taking advantage of unrealized gains or losses). Keep in mind that this only applies to non-registered accounts since registered accounts (e.g. RRSPs and TFSAs) are already tax-advantaged. 372 © 2021 IFSE Institute Canadian Investment Funds Course Example Last year, Terry bought and sold two mutual funds as follows: Cost Sale Price Capital Gain (Capital Loss) Taxable Capital Gain Allowable Capital Loss Prime Canadian Equity Fund Optima International Fund $11,000 $14,000 $5,000 $16,000 ($6,000) $2,000 - $1,000 ($3,000) - Terry can use her allowable capital loss of $3,000 to reduce her taxable capital gain of $1,000 to $0. Since her allowable capital loss exceeds her taxable capital gain by $2,000, she will have a net allowable capital loss of $2,000 for the year. Terry can use this net allowable capital loss to reduce her taxable capital gains from the previous three tax years. She could also carry forward this net allowable capital loss to reduce future taxable capital gains. Note that capital losses are handled differently in an investor’s year of death or terminal return. Pursuant to s. 111 (2) of the Act, all capital losses realized in the year of death, including capital losses created as a result of the deemed realization rules, may be deducted from capital gains realized in the year. For the year of death and the immediately preceding year, net capital losses may be used to reduce income. There is no restriction if there is a carry forward of net capital losses from a year prior to death. Those losses may also be deducted in the return prior to the terminal return. © 2021 IFSE Institute 373 Unit 10: Taxation Lesson 3: Taxation of Mutual Funds Introduction As a Dealing Representative, it is very important that you have a good understanding of taxation as it applies to mutual funds. In this lesson, you will learn about the tax treatment of mutual funds. This lesson takes approximately 20 minutes to complete. By the end of this lesson, you will be able to: describe how income distributed from mutual fund trusts is taxed (flow-through) distinguish between capital gains derived from redemptions and those distributed by mutual fund trusts discuss what happens to capital losses in mutual funds describe how income is taxed in a mutual fund corporation discuss the benefits of holding funds within a corporate structure discuss the tax treatment of return of capital discuss the year-end tax trap 374 © 2021 IFSE Institute Canadian Investment Funds Course 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: distributions redemptions A 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. Example A portfolio manager purchases 10,000 shares of TUX Ltd. in January for $100,000. In October, the portfolio manager sells all the shares for $150,000. In December, they distribute the $50,000 capital gain to all unitholders, calculated as $150,000 - $100,000. A redemption occurs when the mutual fund investor sells units of the mutual fund. If the market price is greater than the cost of the mutual fund, the investor realizes a capital gain. Example An investor purchases $5,000 of the Premia Canadian Equity Fund in January. In December, the investor sells the mutual fund for $6,000. From the sale, the investor has a capital gain of $1,000, calculated as $6,000 - $5,000. 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. © 2021 IFSE Institute 375 Unit 10: Taxation Example Earlier this year, the fund manager for Equinox Canadian Equity Fund sold 50,000 shares of MED Ltd. And 100,000 shares of TAL Ltd. The fund realized a taxable capital gain of $25,000 on the MED shares and an allowable capital loss of $30,000 of the TAL shares. As a result, the fund has a net capital loss of $5,000, calculated as $25,000 - $30,000. Since all previous capital gains have been distributed by the fund, the net capital loss will be carried forward indefinitely. Summary: Income Distribution and Redemption Mutual fund investors may realize interest income, dividends, capital gains, and capital losses on their funds. The table below summarizes what an investor may receive in the case of a distribution or redemption. Interest Income Dividends Capital Gains Capital Losses Distribution Yes Yes Yes No Redemption No No Yes Yes 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: Actual Amount Gross-Up Amount Dividend Tax Credit Eligible Dividends Box 49 Box 50 Box 51 Non-Eligible Dividends Box 23 Box 32 Box 39 NOTE: The information provided in this table above is for information purposes only and is not testable material. 376 © 2021 IFSE Institute Canadian Investment Funds Course Capital gains are reported in box 21 and the non-taxable portion of capital gains is reported in Box 30. Since foreign income is not eligible for any special treatment, it is included in Box 26, other income. The exhibit below displays a T3 Slip. Sample T3 Source: Canada Revenue Agency (http://www.cra-arc.gc.ca/E/pbg/tf/t3/t3flat-12b.pdf). Reproduced with permission of the Minister of Public Works and Government Services Canada, 2014 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 that 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. © 2021 IFSE Institute 377 Unit 10: Taxation Return of Capital A mutual fund can make distributions to unitholders which are not derived from income, dividends, or capital gains earned within the fund’s portfolio. This type of payment is a “return of capital” for income tax purposes, sometimes called a capital dividend (though the payment is not derived from dividend income). A return of capital distribution is distinctly different than a regular dividend derived from preferred or common shares. Dividends are paid from a corporation’s retained earnings (i.e. the corporation’s after-tax profit). However, a return of capital distribution is not derived from dividends, capital gains, or other income generated from the underlying investments within the fund. Rather, a return of capital distribution represents a payment made from the investment capital held within the fund on behalf of unitholders. In essence, the unitholders’ investment capital is paid back, or “returned”, to them as a distribution payment. As with all other types of distributions, the net asset value per unit (NAVPU) is reduced by the amount of the distribution when a return of capital is paid. In addition, a return of capital distribution will also reduce the original cost of the units (also known as the adjusted cost base) when the fund is held in a non-registered account. A return of capital distribution is not taxable when it is paid to the investor nor reported on the T3 Slip issued by the fund to the investor. However, a capital gain (or loss) will be realized when the investor eventually redeems the units. The capital gain will be greater (or the capital loss smaller) when a return of capital has been paid because the adjusted cost base was reduced. Example Nikos paid $1,000 to purchase 100 units of High Peaks Fund at a price of $10.00 per unit. At the end of the year, the fund paid a distribution of $1.00 per unit for a total amount of $100 ($1.00 x 100). The distribution per unit consisted of $0.50 in dividends from taxable Canadian corporations, $0.30 as interest income, and $0.20 as a return of capital. The return of capital reduced the adjusted cost base of Nikos' fund by $0.20 per unit, to $9.80. When the fund is sold, the lower adjusted cost base will increase the amount of the capital gain by $0.20 per unit. While return of capital distributions will not be reflected on the investor’s T3 Slips, they will be reflected on the investor’s monthly or quarterly statements. Year-end Tax Trap Scenario 1 Most mutual funds distribute their capital gains and income in December. All registered unitholders that own a fund before the ex-dividend date receive the distribution. If your client purchases a mutual fund just before the ex-dividend date, you have a tax liability for that year even though the total value of their holdings is the same as before the distribution. 378 © 2021 IFSE Institute Canadian Investment Funds Course Example On December 30, Sami invested $1,000 in a no-load mutual fund with a net asset value per unit (NAVPU) of $20. As a result, he received 50 units, calculated as $1,000 ÷ $20 per unit. On December 31, the fund paid out a capital gains distribution of $1 per unit when the NAVPU was still $20. This had the effect of reducing the NAVPU to $19, calculated as $20 - $1. As a result, Sami now held 50 units of the fund worth $19 each for a total of $950, calculated as $19 per unit x 50 units. In addition, Sami now has a pre-tax capital gains distribution of $50, calculated as 50 units x $1 per unit. Sam's pre-tax wealth is still $1,000 but it is now split between $950 worth of mutual funds and $50 in capital gains. Even though Sami has only held units in the mutual fund for one day, he has already incurred a taxable capital gain of $25, calculated as $50 x 50%. Had Sami waited until January 1, the NAVPU would have dropped to $19. He would have had invested his $1,000 and received 52.63 units, calculated as $1,000 ÷ $19 per unit. By delaying his purchase, he would have avoided an immediate taxable capital gain. Year-end Tax Trap Scenario 2 If a mutual fund does not distribute capital gains and income in December, the year-end tax trap will still exist. In this case, there is still a distribution, but the money is immediately reinvested in the fund. As a result, the investor will own more units of the mutual fund, but each unit will be worth less. Example On December 30, Sami invested $1,000 in a no-load mutual fund with a net asset value per unit (NAVPU) of $20. As a result, he received 50 units, calculated as $1,000 ÷ $20 per unit. Suppose that instead of paying out a $1 per unit capital gains distribution to Sami, the mutual fund manager reinvests the capital gains within the fund. Sami would still receive a distribution worth $50, calculated as 50 units x $1. As a result, Sami’s mutual fund units would now be worth $950, calculated as $1,000 -$50. In addition, the NAVPU would decrease to $19 per unit, calculated as $950 ÷ 50 units. However, since the capital gains were reinvested, Sami will instead receive additional units in the mutual fund. Sami will now own 52.6316 units of the mutual fund, calculated as $1000 ÷ $19. Sami has a realized capital gain of $50, calculated as (52.6316 - 50) x $19. In effect, Sami has used his distribution to purchase an additional 2.6316 units of the mutual fund. Year-end Tax Trap Scenarios Compared The table below summarizes the year-end tax trap scenarios. The difference between the two scenarios is that Sami would have received $50 in scenario 1, whereas he would have reinvested $50 in scenario 2. © 2021 IFSE Institute 379 Unit 10: Taxation Units Owned NAVPU Market Value of Investment Realized Capital Gain Scenario 1 Year-end Capital Gains Distribution Scenario 2 Year-end Capital Gains Reinvestment 50 52.6316 $19 $19 $950 $1,000 $50 $50 An investor should exercise caution when purchasing units of a mutual fund near the end of the year if the fund will be paying capital gain distributions. Waiting until January 1 of the following year to purchase shares will ensure there is no unnecessary taxable capital gains tax. 380 © 2021 IFSE Institute Canadian Investment Funds Course Summary Congratulations, you have reached the end of Unit 10: Taxation. In this unit you covered: Lesson 1: Canadian Tax System Lesson 2: Taxation of Investment Income Lesson 3: Taxation of Mutual Funds Now that you have completed these lessons, you are ready to assess your knowledge with a 10-question quiz. To start the quiz, return to the IFSE Landing Page and click on the Unit 10 Quiz button. © 2021 IFSE Institute 381