Interest, Dividends and Capital Gains: Three Different Taxes on the Same Dollar

Two people can earn exactly the same return on exactly the same amount of money in the same year and keep quite different amounts of it. Not because one of them was cleverer about markets, but because of how the return arrived. In Canada a dollar of interest, a dollar of Canadian dividend and a dollar of capital gain are three different things to the tax system, and the gap between them is not small. That single fact drives more of the practical difference in outcomes than most of what gets discussed about investing, and it is almost never explained to the person doing the investing. This article sets out how each of the three is treated, what that means for which account should hold what, and the timing advantage that only one of them has.

Interest, the plain one

Interest is included in income in full and taxed at your ordinary rate, the same rate that applies to employment income. There is no credit, no partial inclusion and no deferral: it is reported in the year it is earned, whether or not it was paid out.

That last point catches people with compound instruments. Interest that accrues without being paid can still be reportable annually, which produces a tax bill on income the household has not received in cash. It is worth knowing before buying an instrument that behaves that way rather than in the spring.

Because interest is the least tax efficient of the three, it is the strongest candidate for a registered account, where it is sheltered. A guaranteed investment held in a non registered account and a guaranteed investment held in a tax free savings account produce materially different after tax results from the same investment.

Dividends, and the gross up that surprises people

Dividends from Canadian corporations receive a special treatment designed to avoid taxing the same profit twice, once in the corporation and again in the shareholder’s hands. The mechanism is a gross up followed by a credit.

The gross up means the amount reported on the return is larger than the cash received. A dividend tax credit is then applied against the tax otherwise payable, and the intended result is a rate on that income that is lower than the rate on interest. There are two categories, eligible and non eligible, with different gross up and credit rates, and the corporation paying the dividend determines which it is.

The gross up is not cosmetic and it is where the practical trap lies. Anything in the system that is tested on reported income, the Old Age Security recovery tax and the Guaranteed Income Supplement above all, looks at the grossed up figure rather than the cash. A retiree living on Canadian dividends can trigger a recovery calculated on a number larger than the money they actually received. That is arithmetic rather than unfairness, and it is exactly the kind of interaction to model before an income mix is chosen rather than after.

Foreign dividends receive none of this. They are generally taxed as ordinary income, often with foreign withholding tax applied at source, and a foreign tax credit may be available. The distinction between a Canadian dividend and a foreign one is therefore a tax distinction as well as a geographic one.

Capital gains, and the two advantages

A capital gain is the increase in value of a property between what you paid and what you sold it for, and only a portion of it is included in income. That portion is the inclusion rate, and it is the subject of the companion article on this site because it has been the subject of a good deal of noise.

The partial inclusion is the first advantage. The second is often more valuable and gets less attention: a gain is not taxed until it is realised. As long as an investment is held, the growth is untaxed, and the decision about when to trigger the tax belongs to the holder rather than to a calendar.

That control is genuinely useful. A gain can be realised in a low income year, spread across years where the property allows it, or deferred indefinitely. It also means that frequent trading has a tax cost that a buy and hold approach does not, independent of any argument about returns.

The mirror image is a capital loss, which can be applied against capital gains rather than against ordinary income, with rules about carrying it back and forward. Those rules include restrictions designed to prevent a loss being claimed while the same position is effectively maintained, which is a detail worth understanding before a year end sale rather than after it.

Why this decides what belongs where

Inside a registered account, none of these distinctions matter while the money stays there. A registered retirement account shelters everything and taxes it as ordinary income on the way out. A tax free savings account shelters everything and taxes nothing on the way out. In a non registered account, the three treatments apply in full.

That produces the general shape that this site covers in its own article on asset location. The least efficient income has the strongest case for shelter. Income that already receives favourable treatment has the weakest case for using up scarce registered room. And an investment expected to grow a great deal has a particular argument for a tax free account, because the growth never gets taxed at all.

Two cautions belong with that. Tax treatment is one input among several, and a portfolio arranged for tax efficiency at the cost of being the wrong portfolio is not a good trade. And foreign holdings introduce withholding tax questions that interact with the account type in ways that are not intuitive, which is a question for a professional rather than a rule of thumb.

What to actually do with this

Look at where each kind of income is currently arriving, which most households have never done on one page. The tax slips tell you: interest, dividends and capital gains each arrive on their own slip or their own line.

Ask whether anything is in the wrong container. Interest bearing investments held in a non registered account while registered room sits unused is the most common and the easiest to fix.

And before any sale that will realise a large gain, ask what year it should land in and what else is in that year. The timing of a realisation is one of the few tax decisions an individual fully controls, and it is worth a phone call to a qualified tax professional before rather than a surprise afterwards.

Whose income is it, which is a separate question

Everything above asks what kind of income arrived. A second question sits underneath it, and households answer it wrongly all the time: whose income the law says it is.

The instinct is to put the investments in the name of whoever is taxed at the lower rate, and the attribution rules exist to stop exactly that. Where one spouse gives or transfers property to the other, the income it earns is generally attributed back to the person who provided the money, and for a spouse the capital gains generally follow. Money given to a minor child is treated similarly for income while gains are treated differently.

Ordinary arrangements remain open. A loan between spouses bearing interest at the rate the Canada Revenue Agency prescribes, with the interest actually paid each year by the deadline, is the usual one, and a single missed payment ends it for good. A spousal registered retirement savings plan is a different mechanism with its own rules. None of it should be attempted from an article: the paperwork has to be real rather than notional, so set any of them up with a qualified tax professional.

Distributions, and the cost base almost nobody keeps

A fund holding produces two things that look alike on a statement and behave very differently on a return, and confusing them is the quietest expensive mistake in a non registered account.

Income the fund earns is generally allocated to the holder and reported for the year, keeping its character, whether or not cash was paid out. A distribution that is reinvested is reported like any other, and because it has already been taxed it also increases the adjusted cost base. Forgetting that means paying tax twice on the same money: once when it was reported, and again as a larger gain on the eventual sale.

A return of capital works the other way. It is not income, it is your own money coming back, and it reduces the adjusted cost base rather than being reported. Take enough of it over enough years and a holding that felt like a steady payer produces a much larger gain on sale than its owner expected.

The fix is a folder. Keep the annual statements that show reinvested distributions and returns of capital, and note transfers between institutions. Ten minutes a year produces a defensible cost base decades later, and the number is worth confirming with a qualified tax professional before a large sale.

Two contracts where the same income arrives differently

Two arrangements sit outside the ordinary account and change how these three kinds of income reach a return.

A segregated fund contract allocates the income earned to the contract holder and the allocation keeps its character, so interest arrives as interest and gains as gains rather than as one undifferentiated amount. Losses can be allocated the same way, which is a real difference from a fund held in an ordinary account.

A non registered annuity is the other. Each payment is part return of the money that bought it and part earnings, and only the earnings portion is included in income, which is why the reported income is smaller than the payment.

Neither is recommended here. They are mentioned because a household comparing after tax outcomes across accounts should know these two report differently. The tax treatment of a particular contract is for a qualified tax professional.

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Continue Learning

Read The Capital Gains Inclusion Rate for what actually changed and what did not, Asset Location for how to arrange the accounts, and The Old Age Security Recovery Tax for the place where the dividend gross up bites. The Investment Options guide sets out the whole picture.