Published: 9 July 2006
This past tax season revealed the rebound of the stock market and investments in general, much to the surprise of many of our clients. It wasn't until after the third similar comment that I realized that many people are unaware how the income earned by their investments outside of their RRSP's affects their personal income tax situation.
Investments can be broken down into the following categories: Stocks, dividends, GIC's and term deposits, mutual funds, flow through shares, and income trusts. Each of these investments is treated differently for tax purposes so understanding the specifics of their taxation may have you consider one investment over another.
You buy them one day, sell them on another and maybe, if you are lucky, you get paid dividends by the company in whose stocks you have invested. The difference between the price you paid for the stock vs. the price you sold at is your capital gain (if you sold higher than you bought at) or your capital loss (if you sold for less than you bought them for.) 50% of your capital gain will be added to all of your other income in that calendar year to determine the total income that you pay tax on. If the capital gain “jumps” you into a higher tax bracket or if you have done nothing else to reduce your overall tax burden, you may find that you owe income taxes. If you have a capital loss, you can only offset that loss against capital gains. You can carry those losses back 3 years and forward indefinitely so it is important to always file for your losses when they occur.
If the company in which you own shares pays a dividend, the amount of the dividend is income to you. A difference in reporting applies if the corporation is a Canadian company or a foreign company. A dividend from a foreign company is treated as regular investment income and is taxed at the applicable Canadian dollar equivalent. In contrast, a Canadian company that pays a dividend will add 25% to the amount paid – that bumped amount becomes the taxable dividend amount and is the amount that is included in your income. But why am I paying tax on 25% more than I received!?! Although you do pay tax on more income than what you actually received, you are also receiving a dividend tax credit equal to 16.67% of your actual dividend and that credit is a direct reduction in the taxes you pay.
The income invested is already after-tax money so you will never pay tax on your initial investment. The interest earned on those funds will, however, be subject to income taxes. Again the total interest earned is added to all of your other income in that year and is then taxed at the applicable tax rate.
If your mutual fund investment pays a distribution, you will be taxed on the income based on the type of distribution made. For example, if your mutual fund earned capital gains and interest income, your investment slip will reflect capital gains and interest income. The amount earned is not necessarily paid to you in the form of a cheque that you cash but rather the income may have been used to buy more of the same mutual fund units. In this case, you may not think you have earned any income but in fact you have, as your investment increased when the distribution earned was used to buy more mutual fund units. When you sell your units, the resulting profit or loss on the units themselves will not be reflected on the investment slip from the mutual fund company. I recently had a case where a client had invested $20,000 in early 2000 but sold in 2002 when the units had lost over half their value. She never realized that the loss was not recorded until she had a capital gain in 2004 and wanted to apply those losses to that gain. This was done but not until we re-filed her 2002 return for her.
If you invest in certain types of industries, The Canada Revenue Agency allows the losses incurred to flow though to you as the investor. Hence an investment in a mining company will result in that company's losses to flow through to you, the investor. Capital gains and loss rules apply the same way to these shares as to any other types of shares.
This type of investment has become the favourite of many investors due to the regular stream of income that is generated. The danger is with the type of income paid to you. You may have noticed on your slips this year a new box filled out – Box 42. This is the return of capital amount. Lets use the example of a purchase in January of 100 Income Trust units at $10 per unit. Your total cost is $1,000, monthly you receive payments of $50 and at the end of one year you sell all the units for $1500. The normal assumption is that you have income to report of $600 ($50 x 12 months) and a capital gain of $500 ($1500 sale price -$1000 cost.) However, if the $50 per month included a return of capital of $400 as shown in box 42, you actually only have income to report of $200 ($600 received less $400 return of capital) and you actually have a capital gain of $900 ($1,500 sale price – ($1000 cost less $400 return of capital.) As the name implies, box 42 is a return of the capital you invested in the firm. As such, the cost of your shares is reduced by the amount of your return of capital in box 42. If you owned these income trusts for several years you may find that you have already been paid back almost all or more than the amount of your initial investment. If that is the case, you will have a capital gain, even if you have not sold the income trust units, in the year your cost is repaid and in all subsequent years.
So now that you know how investments are taxed, you can decide what type of investment is better for you. Although stocks are taxed at the lowest tax rate, there is more risk associated with investing in the stock market than with GIC's. Be sure to discuss what is best for you with your financial advisor or your professional tax accountant.
This article was written by Gabrielle Loren -- a partner with Loren & Company, CGA's located in North Vancouver, BC and can be reached at firstname.lastname@example.org, at 604-904-3807 or check out their website at www.loren.bc.ca