In Canada our taxation system sets different tax rates for several major forms of income. With the exception of property taxes on real estate, we don't have an asset tax or wealth tax. Taxes on assets are actually charged on the income or capital gains derived from those assets in each year that income is realized.
For investors, it is important to note that we have several account-based options available to us for investing. Each account works differently and offers different tax advantages and disadvantages. In the past I have covered taxation and strategies on registered accounts such as the TFSA and RRSP.
Now lets take a look at non-registered investment accounts (also the investment account that will be used for the Smith Manoeuvre) and how investment income is affected by taxes within this standard brokerage account.
Non-registered Investment Accounts
A non-registered investment account can go by many names depending on your brokerage. It is a standard brokerage account with no special tax treatment. Some of the names I have seen used by Canadian brokerage firms for non-registered accounts include:
- Joint investment account
- Individual investment account
- Regular investor account
- Standard investment account
- Margin account
- Cash account
In a non-registered investment account, any income received and all capital gains realized in a given tax year must be declared on your income tax return. This even includes interest earned on your personal chequing or savings account.This is one of the primary differences when comparing to RRSPs and TFSAs where income and realized capital gains held in the account are not reported or subject to taxation.
If you have a non-registered investment account at an online brokerage, your brokerage will typically upload a couple tax forms onto your account every spring following the end of the last tax year. These forms may include a T5 Statement of Investment Income, a T3 Statement of Trust Income, and a T5008 Statement of Securities Transactions. Each of these forms provides information that you must declare to Canada Revenue Agency on your income tax returns.
Different forms of income are taxed at different rates in Canada. There are three broad categories of income which apply to investments: Other Income, Capital Gains, and Canadian eligible dividends.
Other Income is taxed at the highest rates of the three forms of income discussed here. Other Income includes employment income, business income, foreign income (including foreign dividends), and interest income. All these forms of income are added on top of any employment or pension income and are taxed at standard marginal tax rates for your province.
Interest income is the most common form of Other Income related to investments. It is often derived from bonds, GICs, or bond ETF holdings. However, it is also seen buried in distributions from REITs and real estate ETFs.
As a high tax form of income, interest income should be reduced as much as possible in non-registered investment accounts. If you need to invest in bonds in a non-registered account, choose a tax efficient bond option. This could include using a swap-based ETF such as HBB.TO which converts all interest returns to embedded capital gains behind the scenes. You could also invest in discount coupon or strip bond ETF such as ZDB.TO or BXF.TO which tries to tilt some of the bond returns to capital gains rather than interest.
Foreign income is another common form of investment income which is taxed as Other Income. Foreign income is most often realized by holding foreign-listed stocks, bonds, or ETFs directly, or buying a Canadian-listed ETF which invests in foreign stocks, bonds, or ETFs for you.
The actual foreign income is the dividends or interest distributed to you by these foreign assets. Foreign income is taxed at two levels. First, before you even get the money in your brokerage account, the foreign government where the company resides taxes the distribution by way of a withholding tax that usually is in the range of 15% of the total distribution amount. Then, the remaining 85% (or so) is taxed as foreign income by the Canadian government. The foreign withholding tax cannot be avoided, except for certain countries when the foreign asset is directly held in an RRSP; however, when the investment is in a non-registered account you can claim the tax paid back on your income tax return.
Many investors misunderstand withholding tax and income tax on foreign income. To simplify, don't shy away from diversifying internationally just because of these taxes. That said, try be as tax efficient as possible by not choosing high dividend or high interest foreign investments. Aim for ETFs or stocks which pay a dividend yield of 2% or less. This caps your tax drag to approximately 0.3% per year on the withholding tax and, depending on your income level and province, around 0.5% to 0.7% on the income tax. The total tax penalty of 1% or less is still worth the diversification benefits that international investing provides.
Capital Gains Income
Capital gains income is taxed at a very preferential tax rate and has several other important advantages. First, capital gains are only taxed when you actually realize the gain. That is when you sell some or all of an investment that has gone up in value. As long as you don't sell, you are not taxed on the gain. Second, capital gains can be realized strategically to increase your cost base, which in turn reduces your future deferred taxes. Additional purchases of the same investment also increases your cost base. Finally, capital gains are taxed the same regardless of where the investment is from. This means a capital gain on a stock investment in a Canadian company is taxed at the exact same rate in the exact same manner as a capital gain on a U.S. stock or ETF investing in foreign markets.
When you do sell an investment which has gone up in value, just 50% of the profits from the sale are taxed. This is called the inclusion rate. For example, if you purchased $50,000 worth of one ETF and after ten years that position has grown in value to $100,000, when you sell you only pay taxes on $25,000. [($100,000 - $50,000)*0.5]. This means your total tax bill on a $50,000 profit would be no more than $13,500 even in the highest taxed provinces at the highest income levels.
Since an investment portfolio tilted to capital gains provides a lot of flexibility and super-low tax rates, you should often choose investment growth over investment income. Control over realizing capital gains and the limitless deferral of those gains can allow substantial compounding, tax-free wealth over long periods of time.
Canadian Eligible Dividends
Dividends paid to investors by Canadian publicly-listed companies are taxed at very preferential tax rates thanks to the dividend tax credit. The dividend tax credit is a mechanism which credits back to the investor an amount approximately equal to the corporate tax rate which the company already paid. This prevents a form of double taxation (corporate income tax plus personal income tax on the dividend).
These low tax dividends can be realized if you buy Canadian-listed companies directly on the stock exchange, or if you buy ETFs which hold a portfolio of Canadian companies.
The personal tax rates on these dividends for the investor can be very low--even negative at low income levels in some provinces. Negative tax rates can help you offset income taxes on other forms of income. If your income consists of Canadian eligible dividends only, you can effective earn nearly $50,000 of dividend income and pay zero income taxes in many provinces (B.C., Alberta, Saskatchewan, Ontario, New Brunswick, and Prince Edward Island).
However, there's a catch. Dividend income gets grossed up by 38% on your tax return before the dividend tax credit is applied. This means $50,000 in dividend income actually looks like a $69,000 income. Be careful about earning a large amount of dividend income because it could impact your benefits including Child Benefits, OAS benefits, and GIS benefits among other provincial social security benefits resulting in much higher true tax rates than you think.
You will almost always being paying some income taxes when you have investments in a non-registered investment account. However, a portfolio tilted towards capital gains and Canadian eligible dividend income will still be highly tax efficient due to low tax rates on these forms of income.
If you are very efficient in your investment strategy in a non-registered account, you can expect taxes to reduce your investment returns by approximately 0.5% per year. That relatively small cost is well worth the diversification, flexibility, and investment benefits that broadly diversified portfolios in non-registered investment accounts can provide.
Generally speaking, non-registered investment accounts are not the best place to engage in frequent buying and selling, investing in bonds or GICs, or investing in high dividend foreign stocks or ETFs. These strategies or assets can be impacted by much higher tax drags and meaningfully reduce your overall returns.
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