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 http://www.bankofcanada.ca/rates/related/inflation-calculator/?page_moved=1. 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.