The following article in this two-part series on taxation looks at how ordinary investment income is taxed, based on Canada’s Income Tax Act rules.

In Canada, the specific tax treatment for investment income depends on the type of investment income and the type of recipient (typically, individuals or corporations). The main types of investment income are dividends, capital gains, rental income, and interest income.

Dividends

Dividends are the distributions of after-tax corporate income to shareholders. Dividends are either stock, in-kind, or cash, but they’re all taxed similarly. Individual taxpayers are subject to the gross-up and dividend tax credit system. The goal of the system is to eliminate double taxation. Dividends are grossed up to become taxable dividends, which should equal pre-tax corporate income. A dividend tax credit representing corporate tax paid is then claimed to reduce the tax payable.

Dividend Tax Credit System for Individual Taxpayers

Corporations are allowed to deduct dividends from another corporation, making the dividends tax-free. Again, the goal of this deductibility is to avoid double taxation. However, corporations must pay a refundable tax of 33.3 percent if the dividends are considered portfolio dividends. For example, if a private corporation invests its surplus cash in a public company, then it’s very likely the company’s dividends would be considered portfolio dividends. The concept of portfolio dividends hinges fairly significantly on the concept of control, which means much more than ownership of 51 percent of the voting shares of a corporation, as seen in many court cases and in Canada Revenue Agency (CRA) technical interpretations. However, when a corporation invests in a company it controls, the corporation is not subject to the refundable tax of 33.3 percent.

To further understand the gross-up and dividend tax credit system, corporations need to be aware that there are now two types of dividends in Canada: eligible and non-eligible. They come with different gross-up rates and dividend tax credits because of the different tax rates corporations are subject to. The implications for corporations are complicated because they’re now required to keep track of eligible and non-eligible dividends that they can distribute to shareholders, and the penalties for doing it incorrectly can be severe. To further complicate things, the mechanism prescribed to keep track of the two types is not overly intuitive or straightforward.

Capital Gains

Capital gains represent investment income earned through longer-term passive investments in assets. The current capital gains inclusion rate is 50 percent, which means capital gains are 50-percent tax-free. Individuals simply report 50 percent of the capital gains as taxable income.

Corporations, too, report 50 percent of the capital gains as taxable income. However, it’s possible for corporations to distribute the non-taxable portion of capital gains (50 percent, currently, based on the 50 percent inclusion rate) tax-free to shareholders. But the corporation must hold an election to be able to distribute this non-taxable portion.

The most controversial question regarding capital gain is, “When is a gain a capital gain but not business income?”

The most controversial question regarding capital gains is, When is a gain a capital gain but not business income? There are absolutely no clear rules in the Income Tax Act that differentiate capital gains from business income. For example, suppose a corporation buys an office but decides later on to sell it with a gain. It’s unclear, sometimes even after careful analysis of the facts of the situation, whether the gain should be taxed as capital gain or as business income—which has a huge impact on the final tax liability of the corporation. The same complication applies to individuals. (The significant number of court cases clearly indicates that this is a contentious area of the Canadian tax system.)

Individual investors who engage in frequent trading should note that their trading income could be classified as business income rather than capital gains. The idea that the trading income of individual investors is always only 50 percent taxable (i.e., taxed as capital gains) is a myth.

Interest Income and Rental Income

Interest income is the fee charged to rent money. Rental income is the fee charged to rent space or assets. In general, there are no special tax treatments for individuals and corporations regarding to interest income and rental income. Individuals and corporations simply include their interest and rental incomes in their taxable income. However, for corporations that qualify for a small-business deduction, it’s far more complicated.

The small-business deduction allows Canadian-controlled private corporations to be taxed at a much lower corporate rate (15.5 percent in Ontario) on active business income but not on property income, which often means interest and rental incomes. Interest and rental incomes are taxed not only at the regular corporate tax rate, but with an additional refundable tax of 6.67 percent. This results in a final tax rate of 46.67 percent (2015 Ontario rate).

However, interest or rental incomes can be taxed as active business income when they’re ancillary to an active business. For example, interest income earned from accounts receivable would normally be taxed as active business income. There are no clear rules in the Income Tax Act to easily determine when interest or rental income would be taxed as property income or as active business income.

This task falls to tax accountants, who should help their clients to structure their business affairs in such a way that, as much as possible, interest or rental income is taxed as active business income.

There is some developing news in this area. Through the intense lobbying efforts of the Canadian Self Storage Association, the Department of Finance is currently consulting Canadians (both industry experts and the general public) as to whether that industry’s income should be formally classified as active business income across the board. (The Income Tax Act will need to be amended if the Department of Finance decides to proceed with the proposal.)

Currently, the classification depends on the facts of each specific situation, and, as expected, there have been many court cases in past years challenging CRA decisions that treat income earned by some self-storage companies as property income rather than as active business income.

In Part 2 of this series, I’ll explore the difficulty of applying the tax rules to the investment income of derivatives when the rules were primarily written for ordinary investment income.