Mitigate taxes paid on your investment income

Much of the information you will find on this website is dedicated to helping guide Canadian investors to make informed investment decisions to maximize their investment income and profitability. The unavoidable reality of earning any kind of income is the taxman. He is always looking for ways to get his share, so you as investor, owe it to yourself to search out every possible way within the law to minimize the amount of tax you have to pay on your income tax returns, now and in the future.

Let’s call it a tax minimizing strategy. In thinking about your own personal strategy, you need to know that dividends on Canadian stocks and all capital gains are taxed at rates lower than interest income and dividends on foreign stocks.

In this information article, we will look at the tax treatment of different investment vehicles with an eye for trying to earn your outside of RRSP investment income at the lowest tax rate possible.

In most instances, investors should already be involved in Registered Retirement Saving Plan investments. If you are not, then it is certainly worthwhile examining sections of this site dealing with the advantages of owning RRSP investments first. Apart from the tremendous tax advantage of participating in an RRSP, you will soon find out there are situations in which an RRSP can be used to improve the amount of tax liability you incur from regular investments. {mospagebreak}

The tax treatment of different investments follows:

 

1. Interest paying bonds.

Tax is payable each year on interest income received. The Canada Revenue Agency requires a calculation of the adjusted cost base (ACB) to determine the amount of interest income which must be included in your taxable income. You can buy bonds on the market at a discount, at a premium, or at face value. What you pay for that bond includes the price of the bond plus any interest it has accrued since the date of the most recent interest payment, so your ACB is equal to the amount paid minus the accrued interest. In other words, you are buying accrued interest.

The ACB is important to you and your minimal tax strategy.

If you purchase a bond at face value and keep it to maturity, you will not realize a capital gain or loss. A bond purchased at a premium and held to maturity will result in a capital loss equal to the amount of the premium, and conversely, a bond purchased at a discount results in a capital gain equal to the discount amount.

When bonds are sold before maturity, part of the proceeds will be for interest accrued since the last interest payment date and therefore is included in your income as interest income. Other of the proceeds will result in a capital gain or loss according to the ACB calculation. Capital losses can only be used to reduce or eliminate capital gains. They cannot be used to reduce other income.

Considering these factors, it makes good sense to plan to acquire bonds being sold at a high premium because this will result in a higher capital loss when the bonds mature.  {mospagebreak}

2. Strip bonds.

These bonds receive different tax treatment than regular interest paying bonds. They are not as tax efficient and because of complicated bookkeeping, are best held inside an RRSP where annual tax calculations are not required. The price of strip bonds are set at a discount from their value at maturity. This is in effect interest, but for tax purposes, is not treated as such. For taxation, the ACB of the bond will increase each year by the amount of discount amortized, until at maturity, the ACB will be equal to the maturity value so there is not any capital gain or loss. A capital gain or loss could only be realized if the bond is sold prior to maturity, and this is limited because it is determeined by deducting the ACB from the sales proceeds.

What makes your bookkeeping complicated is that the discount to maturity is amortized over the period to maturity and a portion is included in income each year by dividing the discount by the number of years to maturity and including equal amounts into income for each full year the bond is owned. Partial years are pro-rated.

3. Treasury Bills or T-bills.

Similar in treatment as strip bonds, T-bills are purchased at discount from their value at maturity, so the difference between the maturity value and purchase price is taxed as interest income. Selling a T-bill prior to maturity results in a capital gain or loss. Because all of the income from these instruments is taxable, it is best owning them inside of an RRSP.

4. Shares in Canadian corporations.

Dividends from shares in Canadian corporate stocks get a favoured tax rate through a dividend tax credit. This results in considerably less personal income tax on dividend income than on interest income and less tax than on foreign stock dividend income.
Because of this favourable tax saving treatment, wherever possible, this portion of your investment portfolio should be held outside of your RRSP’s.

5.  Shares in foreign corporations.

Dividends paid by foreign corporations must be fully brought into income and are therefore 100% taxable. The dividend tax credit does not apply. Credit is given only for the amount of witholding tax paid to the foreign government. Capital gains or losses on foreign stock holdings are also a little more complicated to calculate. The ACB on foreign shares must be calculated in Canadian dollars using the exchange rate on the date of purchase. Upon the sale of these shares, the exchange rate on the trading date is used, so a portion of the capital gain or loss is attributed to the gain or loss on foreign exchange. Your tax minimization plan should include holding dividend paying foreign shares inside your RRSP and non-dividend paying foreign shares outside of your RRSP so you can take advantage of the low tax rate on capital gains.  {mospagebreak}

5. Flow-through shares.

These are an investment that provide a rare opportunity to legitimately shelter from taxation while offering the possibility of unusually  high returns. Right off the top, that probably sounds too good to be true, but there is a logic behind this instrument.

Flow-through shares are issued by Canadian mining and energy companies to raise funds to back the high cost of exploration. During the long period of exploring for and testing of mineral deposits, lots of cash goes out without any income being generated. The income statements for these companies do not need the tax deductions that an income generating company needs to have, so they issue shares that allow the tax deductions to flow through to investors. As a result, flow through shares offer federal and provincial tax deductions equal to 100% of the investment. That is the saving at the outset, but to reap the full benefit, investors must hold their shares for more than a year to realize the download savings. Then, when the shares are sold, the 50% rate on
capital gains means the tax attributed to the investment is only half of the original tax saving. The net result is very attractive indeed.

Always keep in mind the reality of this industry sector. Risk. Not all exploration undertakings pan out to become profitable ventures. The other side of the coin is that those which do can reward the investor with rapid and tremendous growth.

You should examine the validity of a place for this type of investment in your portfolio. Base your decision on the quality of the investment as well as the tax advantages. In most cases it should not account for more than 15% to 20% of your total investments, unless you happen to revel in high risk returns.

That is the background on some of the investment instruments available and useful to you in your tax minimization strategy. There are also some allowable  maneuvers you should be aware of.

Allowable tax strategy maneuvers.

You have already seen that all capital gains and dividends paid by Canadian companies are taxed at lower rates than foreign dividends and interest income.

You know that only 50% of capital gains are included in taxable income and capital losses can only be used to offset other capital gains.

Flexibility.

There isn’t any tax on the book value of your capital gains. You only report the gain and pay the tax when the investment is sold. You have the flexibility to control your capital gains by choosing when it is advantageous to sell. Remember, you are not taxed on capital gains until the year in which your investment is sold, so you have control over which year is best to receive the income.

If you have no income other than capital gains, you can earn up to $18,000 without attracting any federal tax.

If you have no income other than Canadian dividends, you can earn up to $49,000 without having to pay federal income tax.  {mospagebreak}

Make use of your investment losses.

If you have a capital loss on an investment, you might want to sell it to utilize the loss to offset capital gains on other investments. Capital losses can be used in the current year, carry them forward indefinitely to offset future capital gains, or carry back the losses and apply them against capital gains reported in any of the three previous years.

Interest on borrowed funds.

Interest and carrying charges incurred earning income from securities investments is a deductible expense. The definition of income is either interest or dividends and does not include capital gains.

To prove eligibility, borrowed money must be traceable to the purchase of the investment. Be sure to maintain a paper trail on the use of borrowed funds.

You must be able to trace borrowed money directly to the purchase of the income-producing investments.  It is important to keep a clear paper trail of the use of borrowed funds. Even when the securities are no longer owned, interest expense may still be deducted.

Deduction of carrying charges.

You can deduct safe-keeping charges such as safety deposit boxes, fees paid for the management of your investments, fees paid for investment counseling, the cost of tax return preparation and the associated accounting costs.

Selling to utilize losses.

If the share price of certain of your investments is such that selling them will result in a loss, you may want to consider this tactic in order to utilize the loss to offset other gains. This is particularly useful in a year in which it would be advantageous to incur a loss.

But, what if these are shares you like the prospects of, and would like to hang on to? After disposing of the shares to utilize the loss, you can buy them back as long as you take precautions to avoid having your loss deemed a superficial loss which is not deductible.

The shares must have been in your portfolio for more than 30 days before disposing of them and they cannot be re-acquired until 30 days after.

You can repurchase the same shares in your RRSP at any time without causing a superficial loss. You must sell and repurchase because you can not just transfer the shares to your RRSP at a loss. {mospagebreak}

Synopsis.

In all of these tax mitigating provisions, it is clear the investor must have a good idea of his tax situation at any given time and a plan set down to respond in the best possible way. You need to develop your own strategy or  roadmap, if you prefer, to get from tax vulnerability point A to investment profitability point B. It may, at first seem a daunting task to stay abreast of all the developments that come along. Be assured, as you become accustomed to keeping an eye on your investment plan, the right decisions do become easier and less complicated to make.