Make the most of tax breaks for equities

Capital gains and Canadian dividends get preferential treatment.

Matthew Elder 11 April, 2016 | 5:00PM

Equity profits have been hard to come by lately. So it's more important than ever to ensure you are making the most of the tax breaks available on the capital gains and losses you report following the sale of a security, and on dividend income.

With the deadline for filing 2015 income-tax returns drawing near, it's time to make sure you have all the information needed to ensure you pay as little tax as possible on last year's investment income. It's also an opportunity to review your situation from a taxation standpoint and adjust your strategy and portfolio with an eye to reducing your tax bills in future years.

A stock investment generally produces two types of income that must be reported on your tax return: capital gains and dividends.

Capital gains

If you sold a stock at a profit during the year, you must report the gain on your tax return. In simple terms, this is the difference between the price you paid for it and your selling price. But computing the taxable amount of the profit is more complicated.

First, you must determine the stock's adjusted cost base (ACB), which is the price you paid for it plus any expenses you paid to acquire it, typically brokerage commissions. Your capital gain is your sale price, less the ACB and any expenses incurred to sell it (again, in most cases brokerage commissions). Only half of the net capital gain is taxable.

For example, say you sold shares of XYZ Inc. for $10,000, double the $5,000 you paid for them five years ago. If your brokerage commission on the purchase was $150, your ACB is $5,150. If the commission on the sale was $250, your net gain is reduced to $4,600, of which $2,300 is taxable. At a marginal tax rate of, say, 45%, your tax bill would be $1,035, meaning you would pocket a profit of $3,565 after tax.

That example is based on a one-time share purchase. If, however, shares in XYZ were acquired at different times, you would have had to keep an updated record of the investment's ACB as it evolved following additional purchases and sales. The following is an example of how an investment's ACB would evolve over a 15-year period, excluding transaction costs:

ACB for investment in shares of XYZ Inc.
Date Transaction Transaction
cost/proceeds ($)
Cumulative
cost/proceeds ($)
Share
balance
ACB per
share ($)
2001 Buy 100 shares @ $15 1,500 1,500 100 15.00
2006 Buy 150 shares @ $20 3,000 4,500 250 18.00
2008 Sell 200 shares @ $19 -3,800 700 50 14.00
2014 Buy 350 shares @ $21 7,350 8,050 400 20.13

If in 2015 you sold 100 shares at $22 apiece for $2,200, you would report a capital gain of just $187 ($2,200 minus $2,013), based on the ACB of $20.13 a share at the time of that sale. (See table above.)

Things can get even more complicated if you realized capital losses during 2015. A loss from a money-losing stock sale -- or a loss from any other capital investment -- can be used to reduce capital gains. One-half of capital losses from a past year also can be used to offset taxable gains in any future year. So if you don't need any or all of your 2015 losses to reduce the year's capital gains, you can keep them on the shelf for use in a future year. Moreover, you can use any capital losses realized last year or in any of the previous three years (2012 to 2014).

Note that the 50% inclusion rate for capital losses applies only to losses realized since 2001 and/or before 1988. Two-thirds of losses realized during 1988 and 1989 were taxable and three-quarters of losses from 1990 to 2000. (Special rules apply for determining the inclusion rate for losses incurred during 2000.) Note that you have to apply net capital losses of earlier years before using losses from later years.

"You want to make sure you use your losses -- but also to be sure to use them within the most optimal tax year," says Anik Bougie, a senior financial advisor and tax lawyer with Kerr Financial Group in Montreal. "For example, with tax rates rising for the 2016 taxation year, it could be beneficial to save any losses for when you know they will have a greater tax impact. Tax-planning work is necessary to determine this."

Taxable capital gain and loss amounts are not provided on government-prescribed information slips. Instead, you or your advisor will have to refer to your portfolio records to produce the necessary information, which then is reported on Schedule 3 of your federal tax return (Schedule G on the Quebec return).

Dividend income

Many established publicly traded companies distribute a portion of their after-tax earnings as dividends, often on a quarterly basis. Your investment brokerage will issue you a T5 slip early each year, summarizing the dividends paid to you during the previous year. Dividends received from Canadian corporations are eligible for the dividend tax credit, which results in a significant tax break to you, the investor.

The tax credit is designed to compensate for the fact that the corporation has already paid tax on the profits represented by the dividends. Dividends received from both publicly traded and large private Canadian corporations generally are eligible for the credit.

The result is that eligible dividends received by an Ontario taxpayer, for example, are taxed at a maximum rate of 33.8% (depending on taxable income). That compares favourably with tax rates of as much as 49.5% for "ordinary" income, including that from interest-bearing securities and employment. Combined federal-provincial tax rates vary by province.

The mechanism for determining the tax payable on dividend income is somewhat convoluted. The amount of dividends received is first "grossed up" on your tax return, which reflects the notional amount of pre-tax earnings received by the paying corporation. For federal purposes the gross-up for 2015 is 38%, which means you add 38% to the actual dividend income received and report this total on your tax return. The federal dividend tax credit of 15% is then applied. Similar credits are provided at the provincial level, which results in the above-mentioned combined federal-provincial tax rates on dividends.

The gross-up and tax-credit rates are different for Canadian-controlled private corporations that pay tax at the small-business rate. These "non-eligible" dividends are grossed up federally by 18%, and then an 11% credit is applied.

Dividends paid by U.S. and other foreign-based corporations are not eligible for the credit and are taxed as ordinary income at your full marginal tax rate.

"All dividends are reportable and taxable in the year they are received, even if they are automatically reinvested," says Bougie. It's important, she adds, to remember to include any amounts added to your stock position through a dividend reinvestment plan (DRIP) in your ACB calculation for capital-gains purposes.

"Also, be careful with offshore accounts with DRIP investments," Bougie adds. "These accounts may not issue tax slips but still need to be reported for income tax and T1135 purposes."

If your stock portfolio is held jointly with your spouse, remember to divide equally the amounts reported on your information slips so that these numbers can be reported on your respective tax returns.

However, in all but one province you are permitted to transfer your spouse's dividend income to your tax return, which may allow you to reduce his or her taxable income and therefore increase the amount of your spousal tax credit," Bougie says. "Simulations should be done to compare both options -- with and without transfer of dividend income -- to ensure this will result in lower overall taxes, and does not trigger a clawback of Old Age Security benefits. This transfer is not available on the Quebec income-tax return."

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Matthew Elder

Matthew Elder