Friday, July 3, 2015

Canadian Tax Primer 5: Different Tax Rates on Different Types of Income

Besides varying by province (see the Canadian Tax Primer 2 article), Canadian tax rates vary by the type of income earned.  The 2015 rates referred to below are for an individual resident in British Columbia and paying income tax at the top marginal rate (has over $150,000 of taxable income).  If the individual has a lower level of income, she will have correspondingly lower tax rates.

The highest rate (about 46%) applies to employment income, business income, interest income and dividends received from non-Canadian corporations.

A lower rate applies to dividends received from taxable Canadian corporations.  This is not an example of government generosity, however, or an example of the government encouraging investment.  The shareholder is merely paying part of the tax on the income.  In order to pay the dividend, the corporation had to earn income and likely had to pay income tax on that income.  Payment of a dividend is not a deductible expense for the corporation, so the dividend has to be paid out of the corporation’s after-tax income.
(a)        If the corporation pays the dividend out of active business income that has been taxed inside the corporation at the (lower) active business rate, tax on the dividend is about 36% of the dividend.  The shareholder will pay this tax.
(b)        If the dividend is paid out of corporate income that has taxed at the (higher) general corporate tax rate, tax on the dividend is about 29% of the dividend.  The shareholder will pay this tax.

When the corporate and personal taxes are combined, the overall tax should (in theory) be about the same as an individual would have paid if the individual had earned the income directly (rather than through a corporation).  This integration of the corporate and personal tax rates never works out perfectly in real life, but that is the overall goal of the system.

The lowest tax rate (about 23%) applies to capital gains.  For example, assume that you buy a long-term investment for $100 and sell the investment down the road for $500.  In this case, you would have a capital gain of $400 and would pay tax of about $92 (23% of $400).  This is a simplified way of expressing the rate.  As a technical matter, you bring only half of that $400 gain into income and you pay tax at the normal 46% rate on that $200 income inclusion.  But for our purposes, 46% of half is the same as 23% of the whole.

The 23% tax rate on capital gains is only part of the story, however.  The capital gain will have arisen over a period of time.  During that time, inflation will have eroded the purchasing power of a dollar.  In order to determine whether a $1 capital gain actually increases your purchasing power on an after-tax basis, you need to take inflation into account.  The Canadian tax system does not attempt to adjust for inflation other than by taxing capital gains at a lower rate.  This is a rough form of adjustment and might over- or under-compensate for inflation, depending on the period of time involved.

For example, assume that you purchased an investment in 1985 for $100 and sold that investment for $201.92 in 2015.  On paper, you have doubled your money and have made a capital gain of $101.92.  In fact, however, your purchasing power has merely stood still over the 30 years in question.  The increase in value is attributable solely to inflation:  see the Bank of Canada inflation calculator at  Even though you have made no real economic gain, you would still be obligated to pay capital gains tax on the inflation-induced capital gain.  After payment of the tax, you would have lost on the investment – because your purchasing power would have declined by the amount of the tax.  In order to have an actual after-tax economic gain, you need a rate of return that is equal to inflation plus the tax payable on the capital gain.

Inflation has to be taken into account in respect of any form of income – such as interest and dividends – if you are looking at returns over an extended period of time.  As indicated, interest is taxed as ordinary income and so is subject to a larger tax bite as well as the usual erosion of purchasing power through inflation.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.