People invest to make money so it’s important to understand the different kinds of income generated by financial assets. Investors can receive interest, like bond coupons or interest payments on a GIC. They could also receive dividend payments from stocks they own. And, there are also capital gains, which occur when investors sell an investment for more than they paid for it.
Generally, there is a cost to borrow money, which creates interest revenue for the lender. That’s the case with bond coupon payments, for instance, which give the lender (or bondholder) interest income. Anyone from big corporations to individual investors, who own bonds directly or bond ETFs and mutual funds, are “lenders” and earn interest income.
Investors may or may not be compensated for holding cash – it depends on the broader interest rate environment how much interest income they’ll receive, if any.
Interest income is fully taxable in Canada — meaning that you must pay tax on every penny of interest income received outside of tax-sheltered plans. Of the three main types of investment income, interest income it is the least favourably taxed.
Foreign interest income
Interest income is taxed as ordinary income, regardless of the source of that income being inside or outside of Canada. It must be reported in Canadian dollars though, using an appropriate exchange rate to determine the converted amount.
Dividends are used by companies to share profits with their shareholders. They can be paid out monthly, quarterly, semi-annually or annually. Shareholders in Canadian corporations who receive dividends from their share positions must include these amounts in their income.
Canadian dividends eligible for the dividend tax credit
In certain cases, investors qualify to receive the Federal Dividend Tax Credit, which can reduce the amount of tax you owe (individual tax bracket and other earnings are also factors here). Eligible dividends are typically paid out by public corporations, from income that’s been taxed at a higher corporate tax rate.
Corporations pay taxes on their earnings and then take a portion of the money and pass it on as dividends, but investors have to pay tax on it again. To avoid double taxation the Canada Revenue Agency (CRA) gives investors a break on dividend taxes to offset those taxes already paid by a corporation.
Canadian dividends not eligible for the dividend tax credit
Technically referred to as “Other Than Eligible Dividends,” which means the corporation paid less taxes and so by extension, individual investors will receive a lesser tax credit. This type of dividend payment tends to come from private corporations on income that is taxed at a lower corporate tax rate.
Canadian investors who own U.S. dividend-paying stocks benefit from an exception under the Canada-U.S. Tax Treaty. U.S. corporate dividends are not subject to withholding taxes when paid on investments held in retirement accounts, like RRSPs or RRIFs (TFSAs are not pure retirement accounts, so not covered by this treaty). Otherwise, the reduced withholding tax rate for qualifying Canadians on U.S. dividends is 15%.
All other foreign dividends are fully taxable. Furthermore, these foreign dividends are usually subject to withholding taxes that are applied before the dividends are paid to Canadian investors (15% to 25%). And these withholding taxes cannot be recovered regardless of the type of account they’re received in.
3. Capital Gains
Capital gains are the profit earned on the sale of an asset that increased in value during the holding period or the difference between the selling price and the adjusted cost base (ACB) of the investment position.
Capital gains can occur by virtue of investors choosing to sell an asset themselves or being invested in professionally-managed funds where a portfolio manager is responsible for all selling decisions.
Capital gains are the most-favourably-taxed type of investment income. In Canada the capital gains inclusion rate is 50%, which means investors only have to include half of their total capital gains in their taxable income, which is then taxed at their individual marginal tax rate.
For the most part, foreign capital gains are not subject to withholding taxes.
Investors might also receive interest and dividend income as well as capital gains from holdings in mutual funds and ETFs, via distributions. Distributions are the means by which commingled investment funds transfer income to investors. Typically happens monthly or quarterly for interest income, quarterly for dividends, and annually towards the end of the fund’s tax year, for capital gains.
These distributions are not subject to direct taxation when received in tax-sheltered accounts like RRSPs, RRIFs and TFSAs. However, fund investors will still be subject to indirect withholding taxes on foreign dividends.
Multiple income types
It should be pointed out that a single investment can produce multiple types of income, in particular the combination of one or the other with capital gains, should the asset be able to be sold for more than its acquisition and carrying costs.
That’s why it’s important to understand how investment income works as well as the various amounts that appear on your tax slips.