How your investments are taxed, and a few coping strategies

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Ben Franklin famously quipped that “in this world nothing can be said to be certain, except death and taxes.” True enough, but we can make healthy choices to live a longer life and, similarly, you can manage the impact of taxes.

In this article, I will focus on taxes payable on your investment portfolio.

In Canada, if you are able to hold your investments in a registered account, such as a registered retirement savings plan (RRSP) or tax-free savings account (TFSA), this will help you avoid or delay taxes on your investments. As tax season approaches, let’s consider investments outside these investment vehicles – those accounts that are taxable.

The tax owing on the growth in your investment portfolio depends on the type of investment. Interest income, dividend income and capital gains all attract different levels of tax.

Here is the breakdown of how income received in non-registered or taxable accounts is taxed.

Interest-bearing investments

Interest income is mainly generated by the bonds in your portfolio, and any interest you earn has to be included in your taxable income for the year. This applies both to bonds that pay you a cash “coupon” during the year and those that accumulate interest and pay it out at maturity.

Interest-bearing investments may also result in a capital gain if you sell them during the year for more than you paid for them. This capital gain will then be reported and taxed (a loss would reduce your taxable income).

Dividend-paying investments

Shareholders can receive three types of dividend income from a Canadian corporation: capital dividends, eligible dividends and “other than eligible” dividends. Capital dividends are not subject to tax, so there is no need to report them on your individual tax return.

The mechanics of taxing dividends is a bit complex. An eligible or “other than eligible” dividend received is included in income at the actual amount plus a gross-up of 38 per cent for eligible dividends and 15 per cent for other-than-eligible dividends. Then a dividend tax credit is provided to offset the higher tax paid on the grossed-up dividend amount. The gross-up and dividend tax credit should result in a shareholder paying a rate of personal tax similar to if they had personally earned the income of the corporation.

If you are considering selling an investment in the next two to three years, it may make sense to trigger the taxes on that eventual gain.

The key thing to remember from a tax perspective is that after these adjustments, in most cases dividend income is taxed at the personal level at a lower rate than interest income. Dividend-paying securities also typically carry higher risk than interest-paying securities (generally common or preferred shares versus bonds), so the riskiness attached to dividend income must be considered along with the preferential tax treatment.

Depending on the province in which you reside, and the taxable dividend received, a taxpayer can also receive a certain amount of dividends from a Canadian corporation tax-free when they have no other sources of income. If you have a significant amount of funds available to invest, you should speak with an advisor to determine whether setting up an investment holding company would be beneficial in order to control the amount and type of dividend income received personally.

Capital gains and losses

The sale of an investment results in a capital gain or loss to an investor. Capital losses realized on the disposition of an investment can be applied against capital gains realized. Currently, 50 per cent of any net capital gains will be included in the income of an individual and therefore subject to tax at their marginal rate.

In any tax year, if your overall dispositions result in a net capital loss, these losses can be carried back for three years and applied against any net capital gains realized in those years, resulting in you receiving a refund of tax paid. Net capital losses that are not carried back are able to be carried forward indefinitely and applied against future years’ net capital gains.

Beware the superficial loss rule

If you are in the fortunate position of having a significant amount of realized capital gains in any tax year, you may want to review your portfolio late in the year to see if you are holding investments with unrealized capital losses that you may sell to help offset these gains. You must take care, however, to ensure that you are not changing or jeopardizing your investment strategy and that you are not subject to the superficial loss rules.

The superficial loss rule will apply if you, or a person affiliated with you (for example, your spouse or corporation), purchase identical assets during the period beginning 30 days before and ending 30 days after selling and you continue to hold the asset 30 days after the sale. When you realize a superficial loss, you cannot claim the loss and therefore you cannot use it to offset your capital gains. Always consult with your portfolio manager and accountant before pursuing a disposition strategy.

Should you consider paying capital gains taxes today?

As long as it fits within your investment goals, delaying the realization of taxable gains has generally been the rule of thumb in tax planning. This deferral of taxes is a way to preserve capital, allowing investors to earn compounding returns on that capital into the future. Further, if you are able to delay triggering those taxable gains until after retirement (when your employment income drops away), it offers the potential to reduce the tax paid.

Every so often, speculation arises that tax rates are going up. Capital gains realized by investors are currently subject to tax on one half (50 per cent) of the gain. Whether realized corporately or personally, capital gains currently have an effective tax rate of around 25 per cent at the highest marginal rate. This figure differs slightly depending on the province you live in.

You might have heard speculation that the capital gains rate could be increased by altering the “inclusion rate.” Here is a brief history of the capital gains tax in Canada:

• January 1, 2022 –  was the 50th anniversary of the capital gains tax.
• 1972 – it started with a 50-per-cent inclusion rate, and all prior capital gains were exempted.
• 1988 – the inclusion rate was increased from 50 per cent to 66.67 per cent.
• 1990 – the inclusion rate was increased again to 75 per cent.
• 2000 – the inclusion rate was reduced back to 50 per cent and has remained there since.

While no one has a crystal ball to see exactly what the tax future holds, if you are considering selling an investment in the next two to three years, it may make sense to trigger the taxes on that eventual gain. From the perspective of return on investment, the shorter the time frame to the actual sale, the better the outcome on locking in the tax rates today if those tax rates do increase in the future.

Gifting investments to a registered charity

If you are making a donation to a charitable organization, consider gifting securities instead of cash. When securities are donated instead of cash, the disposition of the securities is subject to a zero-per-cent inclusion rate. That is, no tax is incurred on the capital gain that arises from the donation, and the donor can still claim a donation amount equal to the fair market value of the donated securities. The charity is then able to sell the stock without paying tax. Check with your accountant and the charitable causes you support to see if this is an appropriate strategy for you.

While we all like to grumble about paying income taxes, the alternative – not earning any income at all – is an even less attractive option. Understanding how various elements are taxed may help you develop a strategy with your accountant and portfolio manager to reduce the overall impact on your portfolio.

The contents of this article are not intended to represent legal or tax advice. Please consult your adviser before employing any strategies discussed here.

Leanne Scott, CFA, provides discretionary portfolio management for foundations and wealthy individuals and their families with Leith Wheeler Investment Counsel in Vancouver. With more than 20 years of investment industry experience both in Canada and the UK, Leanne also holds an MBA and the Chartered Financial Analyst (CFA) charter.

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