Investment income
Review the mix of investments in your portfolio
Each type of investment income is taxed differently. Most interest must be accrued annually and is fully taxed. Dividends are only taxed as received and are eligible for a dividend tax credit. Capital gains are taxed when realized and, after the reduction of the capital gains inclusion rate to 50%, were generally taxed at a lower rate than dividends.
However, the capital gain vs. dividend comparison changed significantly in 2006 as the changes in the taxation of dividend significantly lower the tax rate that applies on eligible dividends. In general, most dividends paid by a Canadian public company after 2005 will be an eligible dividend. These dividends will be subject to a 45% gross-up (rather than the 25% gross-up that continues to apply for ineligible dividends) and are eligible for a much higher dividend tax credit (approximately 19% of the taxable amount federally vs. 13 1/3% for an ineligible dividend). Most provinces have also introduced a higher tax credit on eligible dividends. Overall, the changes will greatly reduce the top marginal tax rate on public company dividends. For more information on tax rates, see Tax Facts 2007 on www.bdo.ca.
Year-end is an excellent time to review the mix of investments in your portfolio to ensure that you’re getting the best returns on an after-tax basis.
Consider the timing of the taxation of interest-earning investments
Interest on investments purchased after 1990 must be accrued annually on the anniversary date of the investment, unless you receive the interest more frequently. For instance, interest on Canada Savings Bonds (CSBs) purchased on November 1, 2006, must be accrued as at October 31, 2007 and included in 2007 income. This applies even if you have not yet received the interest, such as with compound interest CSBs.
Also, some investment products pay interest at increasing rates over the term of the investment. For tax purposes, you may find that you must report the interest at an “average rate,” with higher income recognized in the earlier years, when the actual interest received is lower.
Be sure to take into consideration the timing of the receipt of income and the tax consequences when investing. Also, if you’re thinking of purchasing a Guaranteed Investment Certificate towards the end of 2007, you may want to consider delaying the purchase to early 2008 to defer the recognition of the income to 2009.
Review your outstanding debt to ensure that you make your interest expense deductible to the maximum extent possible
To be deductible, interest expense must relate to debt incurred to earn business or investment income. Interest on personal debts, such as mortgages or car loans and interest incurred to make RRSP contributions, are not generally deductible. Another point to keep in mind is that investment income doesn’t include capital gains. The CRA takes the position that interest on funds borrowed to invest in assets producing only capital gains isn’t deductible.
Review your loans outstanding at year-end and your overall cash position. Where possible, pay off non-deductible debt as quickly as possible. Avoid using excess funds to pay off business or investment loans, if you know you will have to make large personal expenditures in the near future. Where you have a choice, always borrow for investment or business purposes over personal uses.
Also, note that where you’ve sold an investment at a loss and continue to carry debt incurred to purchase the investment, you should leave these loans outstanding as long as you have other non-deductible debt that could be paid off first. Interest from debts relating to the loss on an investment (other than real estate or depreciable property) continues to be deductible as long as those debts remain outstanding and all of the proceeds from the loss asset are reinvested.
Consider delaying mutual fund purchases
If you’re considering purchasing units of a mutual fund, you may want to defer the purchase until early 2008 (or later in December 2007). Many mutual funds (and most equity funds) distribute income and capital gains once a year, during December. Consequently, if you purchase units of these funds just prior to a distribution, you will be allocated a full share of the mutual fund’s income and gains for that year. Deferring the purchase until after the mutual fund distribution will ensure that you won’t be allocated taxable income for 2007.
Next Section: Capital gains and losses
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