How is passive income taxed in Canada?
Author: Jason Heath, CFP
Passive income generally includes interest, dividends, rental income and capital gains. These income sources may be subject to different tax rates depending on your income level, province or territory of residence, and how the assets are held.
Income in non-registered accounts
Investment income earned in taxable investment accounts that are held personally is reported on your T1 tax return each year. Different types of incomes are taxable at different rates.
The most highly taxed source of income is interest or foreign dividend income. Both are taxed at your marginal tax rate, just like employment income. At $100,000 of income in Ontario, for example, a dollar of interest or foreign dividends is taxed at about 34%.
Foreign dividends typically have withholding tax before you receive the dividends. Foreign withholding tax is generally eligible to claim as a foreign tax credit on your tax return to avoid double taxation. You effectively get credit for the tax already paid to the foreign government.
Canadian dividends receive special tax treatment. At that same $100,000 income level for an Ontario resident, tax payable is only about 12%—much lower than other income sources. An investor keeps more of their after-tax income when investing in Canadian stocks than in foreign stocks.
When an investor sells a stock, bond, mutual fund, exchange traded fund (ETF) or other asset for a capital gain, one half of that capital gain is generally tax-free. There may be full capital gains exemptions for the sale of qualified small business corporation shares or farm properties. If an investor sells an investment for a capital gain and their taxable income is $100,000 in Ontario, the tax payable is about 17%. A significant capital gain can push an investor’s income up into higher tax brackets, with incrementally higher tax rates payable on the gain.
It bears mentioning that some mutual funds, ETFs, real estate investment trusts (REITs) or limited partnerships may flow through capital gains to investors even if they have not sold their investments. This is because these structures may own underlying assets themselves and when they are sold within the investment itself, the taxation of a capital gain may be reported on a T3 slip by the investor.
Income from corporations
Corporations are different from individuals in terms of the way their passive income is taxed. Unlike personal taxpayers who are subject to higher tax brackets on higher levels of income, passive income is taxed at the same rate for corporations regardless of the amount.
One indirect exception is if a corporation’s passive income exceeds $50,000 for the year. In this case, the corporation’s small business deduction is reduced by $5 for every $1 of passive income in excess of this $50,000 limit. This can lead to a higher tax rate on a corporation’s active business income. The $500,000 small business deduction is fully depleted when passive income reaches $150,000.
A corporation’s investment income is generally taxable at between about 47% and about 55%, depending on the corporation’s province of residence. This includes interest, foreign dividends and rental income.
Canadian dividend income earned by a corporation is generally subject to about 38% tax, although dividends paid between two related corporations may be tax-free (i.e. paying dividends from an operating company to a holding company).
For a corporation, capital gains are 50% tax-free—just as they are for individuals—such that corporate tax on capital gains ranges from about 23% to about 27%.
Rental income is fully taxable to individuals and corporations at their respective tax rates. So, this means 34% for an Ontario resident with $100,000 of income, for example, and between 47% and 55% corporately depending on the corporation’s province or territory of residence.
The caveat is that only net rental income is taxable. A rental property investor can deduct eligible rental expenses including, but not limited to, mortgage interest, property tax, insurance, utilities, condo fees, professional fees, repairs and related costs.
Income in an RRSP
Registered retirement savings plan (RRSP) accounts are tax-deferred with tax payable on withdrawals. However, there are tax implications to owning investments in your RRSP and other registered retirement accounts.
Foreign dividends are generally subject to withholding tax before being paid into your account or an RRSP investment at rates ranging from 15% to 30% (in the case of a mutual fund or ETF). In a taxable account, this withholding tax does not matter as much because you generally claim a foreign tax credit to avoid double taxation. In an RRSP, the foreign withholding tax is a direct reduction in your investment return with no way to recover the tax. This does not mean you should avoid foreign investments in your RRSP. It is simply a cost of diversifying your retirement accounts.
One exception is U.S. dividends. If you buy U.S. stocks or U.S.-listed ETFs that owned U.S, stocks, there is no withholding tax on dividends paid in your RRSP. If you own an ETF that owns U.S. stocks that trades on a Canadian stock exchange, or you own a Canadian mutual fund that owns U.S. stocks, there will be 15% withholding tax on the dividends of the underlying stocks before they are paid into the fund.
Income in a TFSA
Income from Foreign investments owned in your TFSA will have a withholding tax of 0% to 30%. Unlike with an RRSP, there is no exception for U.S. stocks or U.S.-listed ETFs that own U.S. stocks in a TFSA.
Otherwise, TFSA interest, dividends and capital gains are tax-free. Withdrawals are tax-free.
One exception is if you are day trading in your TFSA. If you engage in frequent buying and selling of investments in the account, you may be considered to be operating a business. This could cause your TFSA profits from trading to be fully taxable as business income.
Canada’s attribution rules regarding gifts, loans and money transfers can cause passive income earned by one taxpayer to be taxable to another taxpayer. A common example is when a high-income spouse gives cash or assets to a lower-income spouse to invest.
Spousal attribution will cause income earned by the receiving spouse to be taxed back to the gifting spouse. This includes future interest, dividends or capital gains in a taxable non-registered account as well as rental income. Tax-sheltered accounts like RRSPs and TFSAs are exempt.
Attribution can apply to gifts to minor children as well. If a parent puts money into an account for a minor child and invests it for them, the interest and dividends are attributed back to the parent and taxable to them. An exception would be if a parent contributes to a registered education savings plan (RESP) for that child’s education. Capital gains, however, are taxed to the child.
How passive income is taxed in Canada
In summary, passive income can result in different tax implications for Canadians, including attribution of that income to another taxpayer, an increase in tax payable for a corporation’s active business income, and tax rates that vary depending on the type of income earned. Tax-sheltered accounts are not always completely tax exempt, either.
It can pay for an investor to understand the tax implications of their passive investments so they can avoid tax traps and boost their after-tax returns.