Canada, like most progressive countries, offers great incentives for savers. TFSAs, RRSPs, and tax advantaged income from investments are designed to encourage investment and saving. Pity most Canadians save almost nothing because they're obsessed with chipboard and Caesarstone.
Common Types of Investment Income
Canadian Dividends: Great Tax Advantages
Canadian dividends are distributions from Canadian-based companies which are paid to you after the company has paid corporate taxes on that income. Because it's already been taxed, the government adjusts the tax rate lower for us. In most provinces if you earn less income than the first tax bracket increase ($46,000 now), you actually pay negative tax rates. The GoC won't literally cut you a check, but you can offset taxes on other income--CPP, pension income, capital gains, or RRSP income for example.
Dividends are generally paid regularly (monthly, quarterly, or annually) so you must pay taxes on them the entire time you hold the investment. This somewhat reduces your overall return on investment. Even if you reinvest your dividends (DRIP), you still pay taxes on them!
Capital Gains: Great Tax Advantages
Capital gains are the underlying increases in value of your investments. If you bought an ETF unit for $30 and it climbed to $50, you have a $20 capital gain on that unit. You only pay taxes when you sell your investment (realize the gain) on half your total capital gain--$10 in this case. If you don't sell your units, you can defer your taxes for a very long time. This is great for retirement because you can realize the gains when your income is low.
Return of Capital: Great Tax Advantages
Return of capital (RoC) is another form of distribution that's common in REITs and some tax advantaged mutual funds. It is a fancy term for getting your own money back. You don't get taxed on return of capital distributions at all because you already paid taxes before you invested.
Return of capital decreases the cost-basis of your investment. If you bought a REIT unit for $30 and received a $5 RoC distribution, your unit cost for tax purposes drops to $25. RoC acts like a deferred capital gain and is taxed like capital gains. If your cost-basis drops down to $0, you get taxed on the RoC distribution at half your marginal tax rate (just like capital gains).
Foreign Dividends: No Tax Advantage
Foreign dividends are distributions received from companies not based in Canada. They are taxed at your full tax rates like employment income, RRSP income, CPP/OAS income, etc. However, they can carry a slight advantage because you can deduct the tax paid to the foreign government from your own taxes when you hold these investments in a Cash/Margin Account.
You are generally limited to claiming back foreign taxes paid up to 15% of the income received. If the foreign withholding tax rate was higher than 15%, you may be able to claim the balance as an "Other deduction" under S. 20(12).
For example, a U.S. stock paying $1 in dividends will have 15% of the dividend withheld as foreign tax paid, so you only receive 85 cents. While you report the full $1 as taxable income, you can deduct the 15 cents you paid in foreign tax from your tax bill. It's not really a tax advantage, but it does prevent double taxation at the personal level.
Side note: U.S. taxes are not withheld on investments in RRSP accounts.
Interest Income: No Tax Advantage
Interest income are distributions received from interest bearing investments: typically bonds, money-market loans, or GICs. You pay taxes at your full marginal tax rate on all interest income as you receive the money. Reinvested interest income is still taxed.
Other Income: No Tax Advantage
Other income is typically paid by REITs and some ETFs as part of their regular distributions. It can be a mixture of interest income and other gains that the corporation or underlying holdings have not already paid taxes on. Other income is fully taxed at your marginal rate.
With this knowledge, on Wednesday we will discuss structuring a portfolio in a Cash/Margin account for efficient taxation.