The Canadian tax system is progressive, which means it charges higher taxes to high-income earners. But that applies to active income earned from salary, self-employment, or business. However, the rules differ for passive income from investments. Your tax liability on investment income depends on the type of investments you hold, and in which account you hold them.

Tax liability on both active and investment income is affected by the province you live in and your marginal tax rate. The wealthy use the investment tax structure to build a tax-efficient portfolio for wealth creation. Hence, an average salaried Canadian earning $90,000 a year pays a 24.4% marginal tax rate, whereas a business owner earning millions pays 26.1%, even when Canada’s highest tax rate is in the 44%-50% range.

To build wealth, you need to understand how taxation works for investment income.

How Taxation Works for Investment Income in Canada

Investments generate passive income through interest, dividends, rent, and capital gains. All these income types are taxable, but they use different formulas to calculate tax.

Interest Income

You earn it in savings deposits, Guaranteed Investment Certificates (GICs), government bonds, and other interest-bearing instruments. All these instruments earn interest income from loans, which makes it predictable and recurring. As a result, they are taxed like salary at your marginal tax rate. It is the most tax-inefficient investment income, but also the least risky.

So, if your marginal tax rate is 26%, a $1,000 interest income will have a tax liability of $260, resulting in after-tax income of $740.

Dividend Income

You earn dividends when you buy shares of companies, which makes you a part owner. Large public companies pay eligible dividends on which they have already paid corporate tax. Private corporations may give non-eligible dividends on which the shareholder bears the entire tax burden. The company paying the dividend identifies whether it is eligible or non–eligible. This income is reported on T3, T5, T4PS, or T5013 tax slips.

If you earned an eligible dividend, you have to add back the tax paid by the company by multiplying the dividend amount by 1.38. Add this amount to taxable income, and calculate the tax at your marginal tax rate. Then deduct the 15% federal dividend tax credit and the applicable provincial tax credit from the dividend income to determine your tax liability.

So if your marginal tax rate is 26%, a $1,000 dividend income will be grossed up to $1,380 ($1,000 x 1.38). A 26% tax on the grossed-up income comes to $358.8. The 15% federal dividend tax credit reduces the tax liability to $151.8, resulting in after-tax income of $848.2. Note that a provincial credit may also apply.

Foreign Dividend Income

If you earn dividends from foreign stocks, the Canadian dividend credit won’t apply. It means you pay the marginal tax rate on foreign dividend income, making it tax inefficient. If you earn dividends from US stocks, the Internal Revenue Service (IRS) will deduct a 30% withholding tax. Thanks to the US-Canada tax treaty, this tax rate is reduced to 15%, and you can deduct the tax paid to the IRS from your Canadian income using a foreign tax credit.

Capital Gain

Capital gain is realized when you sell an investment – stocks, real estate, art, jewellery, crypto, gold – for a higher price than its adjusted cost base. Only 50% of the gain is added to your taxable income. So if you earn a $100,000 capital gain, you pay the marginal tax rate on $50,000.

Calculating After-Tax Investment Income

As you can see, not all investment income is taxed at the marginal tax rate. For an individual with a 26% marginal tax rate, $1,000 in investment income from interest, dividends, and capital gains will have different tax liabilities.

ParticularsDividendInterestCapital Gain
Taxable Dividend$1,000$1,000$1,000
Grossed-up Dividend/Taxable gain$1,380$500
Tax at 26% marginal rate$358.8$260$130
Federal Tax Credit (15%)-$207
Actual Tax Liability$151.8$260$130

Capital gains are the most tax-efficient investment income, followed by Canadian dividends. Interest income and foreign dividends are not tax-efficient at all.

Note: These calculations are for illustrative purposes. The actual tax amount will vary depending on your circumstances. Consult a professional financial advisor who can help you plan your portfolio based on your tax situation.

Tax Deductions on Investment Income

You can make your investment income more tax-efficient by using the following deductions:

Capital Loss: If you sell your investment for a loss, you can use this capital loss to deduct capital gains. You can carry the capital loss back for three years and forward indefinitely. So even a loss-making investment can offset capital gains and provide returns through lower tax.

Interest Expense: If you take out a loan to buy investment assets, you can deduct the interest paid on the loan from your investment income. Many Canadians use borrowed funds to buy real estate for investment purposes and earn rental income.

Rental Property Deductions: As a landlord, you can deduct mortgage interest, property tax, insurance, advertising, maintenance, repairs, and travel costs incurred to maintain the property from your rental income. Like with all deductions, you must maintain detailed records and receipts for each expense.

How Registered Accounts Make Investments Tax-Efficient

The CRA offers several registered accounts, such as a Tax-Free Savings Account (TFSA), a Registered Retirement Savings Plan (RRSP), and a First Home Savings Account (FHSA). All three have contribution limits. Surplus contributions are taxable at 1% per month.

The amount contributed to these accounts is sheltered from tax on investment income. It means no tax on interest, dividends, and capital gains. Since your investment income is not taxed, you cannot claim capital loss or interest expense deduction on investment income. However, there is one exception for US dividend income: it is tax-exempt in an RRSP, but the 15% withholding tax applies in a TFSA.

While registered accounts offer tax shelter, they are not fully immune to taxes:

  • You can contribute only after-tax income to a TFSA. Since you already paid tax on the TFSA contribution, the withdrawals are tax-free.
  • You can deduct RRSP contributions from your taxable income. However, withdrawals are taxable.
  • You can deduct FHSA contributions from taxable income and withdraw tax-free if the withdrawal is for a first-home down payment. If you don’t buy a house, you can transfer the FHSA balance to an RRSP.

How to Build a Tax-Efficient Investment Portfolio

Because different types of investment income are taxed differently and tax-sheltered accounts offer advantages, you can strategically place your investments in accounts that give you the maximum tax advantage. You can also time your withdrawals accordingly. Tax efficiency in an investment portfolio helps you enjoy the full benefit of compounding. By diversifying investment income across interest, dividends, and capital gains, and across registered accounts, you can allow your money to earn more money tax efficiently.

However, tax is not the only factor to consider. Your financial goals, investment horizon, and risk appetite also hold importance. A professional financial advisor can align your portfolio with your financial goals and tax situation, optimize returns, and build wealth.

Contact Black and Gill LLP in Toronto to Help You Build a Tax-Efficient Wealth Management Portfolio

Talk to a professional wealth advisor to help you structure your portfolio alongside your investment income, tax liability, and financial needs. To learn more about how Black and Gill LLP can provide you with the best taxation and wealth management services, contact us online or call us at 416-477-7681.