Our Tax System

Canada has a progressive, or graduated tax system. Higher income levels are taxed at higher rates. For 2001, income is taxed at a federal rate of 16% on the first $30,754, 22% on income between $30,754 and $61,509, 26% on income between $61,509 and $100,000, and 29% on income in excess of $100,000. With the exception of Alberta, which has a flat tax of 10%, the provinces also have their own graduated rates.

We also have a system of non-refundable credits that provide a 16% credit against your federal tax for certain personal amounts that vary depending on your individual circumstances. For 2001, there is a basic personal amount of $7,412. There is also an age amount of $3,619 for taxpayers who are 65 or older, although this is reduced by 15% of net income in excess of $26,941. Other amounts include the spouse or common-law partner amount, the amount for an eligible dependant, the disability amount, CPP and EI premiums, tuition fees, the education amount, medical expenses and charitable donations.

The provinces also have their own system of non-refundable tax credits. In the case of New Brunswick, Manitoba and the territories, these parallel the federal non-refundable credits. The other provinces have systems that are either more or less generous than the federal system. Alberta, for example has a basic personal amount of $12,900 whereas Nova Scotiašs basic personal amount is only $7,231.

The Marginal Tax Rate

For tax planning purposes, we refer to the marginal tax rate, which is defined as the rate of tax payable on the last dollar earned. This figure tells you how much money you get to keep if you make an extra dollar, or how much you save in taxes by reducing your taxable income by a dollar.

Let's suppose you have employment income of $25,000. If you were a resident of Alberta, your marginal tax rate on interest income would be approximately 26%. That is, if you earned an extra dollar in interest income, you would pay 26 cents in tax on that dollar. However, if you earned more than $5,754 in interest (bringing you over $30,754 in taxable income), you would pay approximately 32 cents on every dollar in excess of $5,754.

Investment Income

Investments come in many forms. T-bills, mortgage funds, mutual funds, guaranteed investment certificates (GICs), shares, and real estate are all typical sources of investment income. Many of us may be risk-averse and therefore choose to invest in low-risk investments, such as GICs. Experienced investors will most likely hold a diverse portfolio of investments containing low-, medium-, and high-risk investments. The most common types of investment income are interest, capital gains, and dividends. Each is taxed differently, and familiarity with the tax treatment for each can be useful for planning purposes.

Interest Income

Interest income attracts the highest level of tax. GICs, Canada Savings Bonds, and cash in the bank are typical examples of investments that earn interest income.

Capital Gains

Capital gains attract less tax than interest income because only one half of capital gains are taxable. Capital gains are triggered when a capital property is sold for proceeds greater than the original cost of the property. For example, if you purchased shares for $10,000 and sold them for $12,000, you would have a capital gain of $2,000. Only $1,000 ($2,000 x 50%) would be included in your taxable income.

Dividends

Dividends also attract less tax. This is due to the fact that dividends are paid out of a corporation's after-tax income. Because the corporation has already paid tax on the income, the investor receives a tax credit to compensate for the tax already paid. The dividend tax credit benefits lower income taxpayers more than higher income taxpayers.

There is a possibility that you can choose to include dividends received by your spouse in your own income for tax purposes and reduce your family's overall tax bill by doing so. This can only be done if the spousal amount claimed on your return is increased as a result of claiming the dividends.

Carrying Charges and Interest Expenses

You should ensure that you are taking advantage of allowable tax deductions for expenses related to your investments. Fees paid for the management or safe custody of investments are allowable deductions. So is a safety deposit box fee, if the box is used for the storage of investment securities. Accounting fees are also eligible if they relate to preparing and maintaining investment records. Investment counsel fees are also deductible. However, the cost of investment periodicals, investment newspapers, and RRSP administration fees are not eligible carrying charges.

Interest charges on funds borrowed to produce investment income may be eligible for a deduction as well. This includes interest paid to your employer for Canada Savings Bonds bought through payroll deduction plans and interest borrowed to purchase stocks, bonds, and other securities. You cannot claim the interest charged on loans to purchase an RRSP or RESP.

Tax Implications of Investing in Mutual Funds

A mutual fund is a trust which allows individual investors with limited time, capital and expertise to pool their resources in order to acquire part ownership (called "units") in a diversified portfolio which is managed by professionals. The value of the mutual fund unit at any given time is generally equal to the total value of the investments in the fund divided by the number of units. For example, if a fund has cash, stocks and bonds worth $1,500,000, and has sold 100,000 units, the value of each unit is $15. Investors buy the units at fair market value, and the value of the investment can rise or fall, as the values of the underlying investments rise or fall.

The mutual fund earns various kinds of income throughout the year: interest from money on deposit or invested in interest-bearing investments; dividends from stock owned by the fund; or capital gains from the buying and selling of stocks and other securities owned by the fund. Out of this income, the trust pays the annual expenses of the fund, such as management fees, accounting fees and other costs.

So that the fund does not have to pay tax, the income that is left after deducting expenses is paid out to investors at least once each year. This income retains its character as interest, dividend, or capital gains when it is flowed through to investors. Although you must pay tax on such income, you are entitled to the tax benefits accorded to these special types of income as well.

The income may be paid in cash or may be re-invested in the fund to buy more units. Either way, the income is reported on an information slip that summarizes each of the various types of income for the year.

Taxation of Mutual Funds

The tax you pay on each dollar of income from a mutual fund depends on the type of income received, as well as on your tax bracket and province of residence. Keep in mind that a dollar's worth of interest income is taxed differently than a dollar's worth of dividends or capital gains.

Selling Your Mutual Funds

When you sell or redeem your mutual fund units, you may have a capital gain or loss, depending on whether the units have gone up or down in value since you bought them. The sale transaction is reported on a statement or information slip, but will not show the amount of your gain or loss unless all your transactions were made through that same company. If you purchased or sold your fund through different brokers, you will have to calculate the amount yourself, using the account statements issued to you over the years.

If you reinvested the income earned by the fund to acquire additional units, remember to add the amount to your adjusted cost base in order to determine your capital gain or loss, otherwise you will be paying tax on this amount twice.

If you made a capital gains election on any mutual fund units that you owned on February 22, 1994, you can shelter your gain to the extent there is an "exempt capital gains balance" for that fund still remaining. Otherwise, you must pay tax on 50% of the total gain.