Investment Income: A Tax Nightmare

Gordon Pape | May 27th, 2013

Income tax season is infuriating! It’s not that I resent paying taxes – they’re essential to maintaining a well-ordered society. What bothers me is the infernal complexity of the system. It is riddled with inconsistencies and mind-bending calculations. Ever tried to figure out pension income splitting without the help of a tax software program? Impossible!

If there’s one area that drives people to keep a bottle of gin handy while doing their returns, it’s investment income. Talk about a crazy quilt! There is absolutely no uniformity in the way you report your investment returns and calculate the tax due on them. The variables include type of income, the nature of your accounts, geographic source, tax treaties and even your province or territory of residence.

To help you through this minefield, I’ve prepared a guide to investment taxation. Scan through it and read the sections that apply to you.

Interest

This is the easiest, so let’s dispense with it first. Interest income from all sources is taxed as regular income at your marginal rate. There are no tax breaks of any kind.

Capital gains

Half of all the capital gains you earn are subject to tax. The other half is yours to keep. The net result is a lower overall rate on the total amount of any gain. For example, an Ontario resident with taxable income of $50,000 has a 2012 marginal tax rate of 31.15 per cent on regular income. But the rate on capital gains is 15.58 per cent, according to the Ernst & Young on-line tax calculator.

You can reduce the amount of taxable gains by deducting any applicable capital losses and legitimate expenses. For example, brokerage commissions incurred for selling shares are deductible. For real estate sales, brokerage commissions, legal fees, advertising expenses and costs directly related to property improvements (but not routine maintenance) are deductible for capital gains purposes. Check the Canada Revenue Agency publication titled Capital Gains for full details. It can be found at www.cra-arc.gc.ca/E/pub/tg/t4037/README.html.

Canadian dividends

Eligible dividends from taxable Canadian corporations receive a special tax credit if the money is paid to a non-registered account. The calculation of this dividend tax credit (DTC) is cumbersome and can create some undesirable side-effects.

Step one is what is called the “gross-up.” It means that you don’t report the amount of money you actually receive but an amount that is 38 per cent higher. So, if you received $5,000 in dividend income in 2012, the amount that will appear on your return at line 120 is $6,900 ($5,000 times 138 per cent). The extra $1,900 is what I call “phantom income” – you never actually receive it, but it ends up as part of your net income. That means it could have an impact on your
eligibility for various income-tested tax credits (e.g., GST credit, age credit). It could also push some people to a level where they are subject to the Old Age Security clawback. This is the ultimate irony – you could end up having OAS clawed back on income you never received!

The second step is to calculate the DTC. This is done by multiplying the grossed-up amount by 15.0198 per cent. So, going back to our example, in this case, the DTC would be $1,036.37. This is deducted during the calculation of your basic federal tax.

If the dividends are deemed to be non-eligible (the company that pays them will advise you), the calculation is somewhat different. If you only receive payments from large, publicly traded corporations, don’t worry about this. They will all be eligible.

The effective tax rate you pay on dividends will be determined to a large degree by where you live. A Quebec resident with a $50,000 taxable income in 2012 will be hit for 19.22 per cent on each dollar of dividend income. But someone in British Columbia, Alberta, Yukon or Northwest Territories will pay about half that at 9.63 per cent. Go figure!

U.S. dividends

Some American companies offer very attractive dividends, but you need to check out their after-tax value before you decide if they’re worth the investment. U.S. dividends are treated as ordinary income – the dividend tax credit does not apply. They will be taxed at your marginal rate in exactly the same way as interest.

Moreover, 15 per cent of dividends on common stocks will be deducted at source and remitted to the U.S. government. This applies to all non-registered accounts and also – this may come as a surprise – to Tax-Free Savings Accounts (TFSAs). For non-registered accounts, the withholding tax can be claimed as a foreign tax credit. But you’re out of luck when it comes to TFSAs. There is no way to get that money back. In this case, a TFSA is not really tax-free.

Dividends from most U.S. preferred shares are not subject to withholding.

Return of capital (ROC)

Some of the investment income you receive may be classified as return of capital. This is often the case with part of the payments from real estate investment trusts (REITs) and from some mutual funds and ETFs.

The good news is that no tax is immediately assessed on ROC payments. But you aren’t off the hook forever – the tax people will get you at some point. So this is really a tax deferral.

Here’s how it works. Let’s say you paid $20 each to buy shares in a REIT. In the first year, you receive a distribution of $1. Of that, $0.40 is designated as return of capital. That amount must be subtracted from the original price you paid for your shares to arrive at an “adjusted cost base” (ACB). In this case, the ACB is $19.60 ($20 minus $0.40). Every year you receive an ROC payment, you must recalculate your ACB in the same way.

When you finally decide to sell your shares, any capital gain or loss will be based on the ACB, not on the price you originally paid. Let’s say that in this case, you resold the shares for the same $20 price you paid for them. In the interim, you received ROC payments worth $2, reducing your ACB to $18. For tax purposes, you will be deemed to have a capital gain of $2 a share.

American Depository Receipts (ADRs) These are proxies for shares of foreign companies that do not trade directly in the U.S. They include well-known firms like Korean electronics manufacturer Samsung, Baidu (China’s equivalent of Google) and oil giants Royal Dutch Shell and British Petroleum.

Because they are listed on the NYSE, many people assume ADRs are treated like U.S. stocks for tax purposes. That is not the case. They represent foreign equities and the withholding tax on dividends will vary according to the country in which the company is incorporated and the provisions of any tax treaty between that nation and Canada.

Moreover, ADR dividends paid into retirement plans (e.g., RRSPs) do not enjoy the withholding tax exemption that applies to U.S. dividends. You’ll be dinged for the tax and won’t be able to recover any part of it because the foreign tax credit doesn’t apply to payments made to registered plans. The result can be an unwelcome surprise when you review your brokerage statement.

If you are considering investing in ADRs, first find out what the applicable withholding rate will be. And don’t put them in your RRSP, TFSA or RRIF.

U.S. limited partnerships Some Canadian investors have been attracted to U.S. limited partnerships (LPs) because of the high yields they offer. For example, at the time of writing Boardwalk Pipeline LP was paying eight per cent. USA Compression Partners went public in January with a nine per cent yield. With GIC rates hovering around two per cent, it’s no wonder people are attracted to these LPs.

These partnerships are easy to buy – many trade on major U.S. exchanges, such as the NYSE and Nasdaq, so any broker can purchase them on your behalf. The problem is that most brokers have little or no understanding of the tax implications in adding this type of security to a portfolio.

According to a detailed report on the implications of cross-border investing published by RBC Wealth Management Services a couple of years ago, payments from American LPs may be subject to a non-resident withholding tax equal to the top U.S. rate. In 2013, that was raised 39.6 per cent as part of the “fiscal cliff” deal. This tax also applies to payments made to a registered plan.

On top of that, RBC says that if you invest in one of these, “you are generally required to file a non-resident U.S. personal income tax return annually.” So while the yields may look juicy, I suggest you avoid the temptation.

If you’ve gotten this far, you can understand why I said at the outset that the tax treatment of investment income is a minefield. If you are not sure of the implications of buying a particular security, find out before making a commitment. The last thing you need is to create a problem with the CRA or, even worse, the IRS.

Gordon Pape’s new books are Money Savvy Kids and an updated edition of Tax-Free Savings Accounts. They are available in all bookstores as well as in electronic formats.