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Investment Income
It is important to recognize that different types of investment income are not taxed in the same manner. For example, Canadian dividends and capital gains are taxed at more favourable rates than interest income and foreign income.
Since various types of investment income receive different tax treatment, you should look beyond the investment's pre-tax rate of return and consider the after-tax return.
This assessment of investment rates of return should be done on an individual basis, taking into consideration your income level and marginal tax rate as well as any other tax benefits that may be available.
While evaluating investments based on their after-tax return is important, you should also consider such other factors as the investment's risk, the opportunity for capital appreciation, liquidity and so on.
It is important to note that in most cases, you will retain more after-tax income from capital gains than either Canadian-sourced dividends or interest income.
At top marginal rates, the after tax amount retained from $1,000 of interests and foreign income is approximately $535, from $1,000 of dividends from Canadian corporations is approximately $683, and from $1,000 of capital gains is approximately $768.
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Interest Income
Interest income can be paid at varying frequencies during the year, such as semi-annually or monthly, and is taxable in the year it is received. It is also possible that you may not actually receive interest income in the year but will still be required to declare this "accrued" interest on your tax return.
The following section outlines the reporting requirements for interest-yielding investments made prior to 1990 and those investments made in 1990 and later.
Investments Made in 1990 and Later
For investments made in 1990 and later years, accrued interest is required to be reported annually. That means you must report income on compounding securities like GICs, strip coupon bonds and CSBs every year.
Where the term of the investment is not more than one fiscal year, income should be reported in the year the interest is received (e.g. T-Bills).
Investments Made Prior To 1990
Interest income received on investments purchased prior to 1990 can be reported by either of two methods:
1. Cash method: This method requires that interest income be reported in the year that it is received. However, interest must be included in income every three years, even if it is not yet received.
2. Accrual method: This method requires that interest income be reported in the year it is deemed to be earned, even if it has not been received.
Investments that require the annual accrual of compound interest include compound Canada Savings Bonds, strip coupons and GICs.
In the year that a compound interest paying investment matures, the taxable amount in the year is equal to the amount of interest received, less the amount of interest declared in prior tax years. This ensures that the interest income is only taxed once. If this investment is sold prior to maturity, a capital gain or loss may have to be recognized in addition to the interest income.
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Dividend Income
Dividends received from Canadian corporations are effectively taxed at a lower rate than interest income, due to the dividend tax credit that is applied to the federal and provincial tax payable.
The use of a tax credit is meant to recognize that the corporation paying the dividends has already paid tax on its earnings which are now being distributed to its investors. Dividend income received from foreign companies does not receive the dividend tax credit and therefore is taxable at the same tax rates as interest income.
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The Dividend/Interest Relationship
It is important when evaluating investments to compare the after-tax return on various types of investments. A factor can be calculated to compare the after-tax return on interest and Canadian dividend-yielding investments. The current range is between 1.23 and 1.32, and will vary somewhat between provinces.
In other words, an interest rate would have to be approximately 28% higher than a dividend yield for after-tax returns to be similar, assuming all other factors are equal. Remember, however, that the risk associated with receiving dividend income will, in all likelihood, be different than the risk associated with receiving interest income.
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Capital Gains and Losses
Note: This information only relates to non-depreciable assets.
A capital gain will occur upon the sale of an asset for proceeds in excess of the cost base of the asset. The capital gain is further reduced by any costs incurred to sell the asset (e.g. transaction fees).
Taxable Capital Gains
To determine what amount of capital gain will be taxable in the year, you must first calculate the net capital gain recognized in the year. This is calculated by summing your total capital gains and subtracting total capital losses. A taxable capital gain is equal to half of the net capital gain effective October 18, 2000. It is taxable at the marginal tax rate applicable in the year.
Superficial Loss Rule
If you sell an investment at a loss, but wish to reacquire that same investment (due to long term potential), the superficial loss rules may come into effect. A superficial loss will occur when a security is sold for a loss and the identical property is acquired during the period beginning 30 days before the disposition and ending 30 days after the disposition of the original security. This rule also applies if an investment is sold at a loss and acquired by your spouse or a corporation controlled by you or your spouse.
Triggering the superficial loss rule will result in the denial of the capital loss. The denied capital loss will be added to the cost base of the substituted investment. However, if you delay your repurchase until after the 30-day period, the capital loss can be claimed.
A capital loss will be lost forever in situations where you have triggered the loss by transferring securities to your own or your spouse's RSP. In this situation, a better approach would be to sell the security to trigger the capital loss, contribute the proceeds to the RSP and then, repurchase the investment within the registered account. The superficial loss rule should not apply in this situation.
Using Capital Losses to Offset Capital Gains
Realized capital losses must first be used to offset capital gains realized in the same tax year. If a net capital loss is remaining, it can be carried back and applied against capital gains in any of the three previous calendar years. If a net capital loss still remains, it can then be carried forward indefinitely and used to offset capital gains in future years.
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