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24.2 Canadian Taxation System

Detailed guide on the Canadian Taxation System, covering tax treatment of interest income, dividends, and capital gains or losses.

THE CANADIAN TAXATION SYSTEM

1 | Differentiate between the tax treatment of interest income, dividends, and capital gains or losses.

The Canadian federal government imposes taxes on income by federal statute under the Income Tax Act. All Canadian provinces have separate statutes that impose a provincial income tax on their residents and on non-residents who conduct business or have a permanent establishment in that province. The federal government collects provincial income taxes for all provinces except the following two:

  • Quebec, which administers its own income tax on both individuals and corporations
  • Alberta, which administers its own income tax on corporations

Canada imposes an income tax on foreign income earned by its residents and on certain types of Canadian-source income on non-residents. Companies incorporated in Canada under federal or provincial law are usually considered to reside in Canada. Also, foreign companies with management and control in Canada are considered resident in Canada and are therefore subject to Canadian taxes.

Tax Treatment of Different Income Types

Interest Income

Interest income is fully taxable at the recipient’s marginal tax rate. This means that every dollar of interest earned is added to the total taxable income for the year, and it is taxed according to the individual’s respective income bracket.

Dividends

Dividends receive more favorable tax treatment due to the Dividend Gross-Up and Tax Credit system. This mechanism avoids double taxation of dividends received by individuals. There are two types of dividends in Canada:

  1. Eligible Dividends: These generally come from public corporations and are grossed up by 38%. The individual then applies a federal dividend tax credit.
  2. Non-Eligible Dividends: These usually come from private corporations and are grossed up by 15%. A smaller federal dividend tax credit applies in this case.

This tax treatment effectively lowers the tax rate on dividends, making them a more attractive source of income.

Capital Gains or Losses

Capital gains or losses are realized when a capital asset is sold greater or less than the purchase price.

  • Capital Gains: Only 50% of a capital gain is included in the taxpayer’s income and taxed at their marginal tax rate. This is known as the capital gains inclusion rate.
  • Capital Losses: These can only be used to offset capital gains in the same year. If the capital losses exceed the capital gains, they can be carried back three years or carried forward indefinitely to offset capital gains in other years.

Glossary

  • Income Tax Act: The legislation governing federal income tax in Canada.
  • Marginal Tax Rate: The tax rate applied to the last dollar earned and thus the rate of tax paid on the marginal income.
  • Eligible Dividends: Dividends paid by public corporations or other corporations eligible for certain tax credits.
  • Non-Eligible Dividends: Dividends paid on shares that don’t qualify for an enhanced dividend tax credit.
  • Capital Gains Inclusion Rate: The percentage of a capital gain that is included in taxable income.

Key Takeaways

  1. Interest Income is fully taxable at the marginal tax rate of the recipient.
  2. Dividends benefit from a gross-up and tax credit system, reducing the tax burden.
  3. Capital Gains: Only 50% of capital gains are taxable.
  4. Provincial Tax Differences: Quebec and Alberta administer their own corporate income taxes.

Frequently Asked Questions (FAQs)

What is the difference between eligible and non-eligible dividends?

Eligible dividends generally come from public corporations and benefit from a higher gross-up and tax credit, reducing the effective tax rate more significantly. Non-eligible dividends come from private corporations with smaller tax credits.

How are capital losses handled?

Capital losses can only offset capital gains. If the capital losses exceed the capital gains in a given year, they can be carried back three years or carried forward indefinitely.

Mathematical Formulas

Capital Gains Calculation: If the net selling price is \( S \) and the adjusted cost base is \( ACB \), then the capital gain (G) is:

$$ G = S - ACB $$

The taxable capital gain \(T\) is:

$$ T = 0.5G $$

Visual Aid

    graph TD
	    A[Sources of Income] -->|Fully Taxable| B(Interest Income)
	    A -->|Favorable Tax Treatment| C(Dividends)
	    C --> D(Eligible Dividends)
	    C --> E(Non-Eligible Dividends)
	    A -->|50% Taxable| F(Capital Gains)
	    F --> G(Capital Losses)

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## Which government body imposes taxes on income under the Income Tax Act in Canada? - [ ] Provincial government - [x] Canadian federal government - [ ] Municipal government - [ ] International taxation body > **Explanation:** The Canadian federal government imposes taxes on income by federal statute under the Income Tax Act. ## Which provinces administer their own income tax for corporations? - [x] Quebec and Alberta - [ ] Quebec and Ontario - [ ] Alberta and British Columbia - [ ] Ontario and British Columbia > **Explanation:** Quebec administers its own income tax on both individuals and corporations, and Alberta administers its own income tax on corporations. ## Which provinces do not have the federal government collecting their provincial income taxes? - [ ] Ontario and Quebec - [x] Quebec and Alberta - [ ] British Columbia and Alberta - [ ] Ontario and Alberta > **Explanation:** The federal government collects provincial income taxes for all provinces except Quebec and Alberta. ## What type of income is subject to Canadian taxes for non-residents? - [x] Certain types of Canadian-source income - [ ] All global income - [ ] Only foreign-source income - [ ] No income > **Explanation:** Canada imposes an income tax on certain types of Canadian-source income for non-residents. ## Based on their legal incorporation, which companies are usually considered to reside in Canada? - [x] Companies incorporated in Canada under federal or provincial law - [ ] Foreign companies with management and control outside Canada - [ ] Companies operating solely in other countries - [ ] Companies with no physical presence in Canada > **Explanation:** Companies incorporated in Canada under federal or provincial law are usually considered to reside in Canada. ## What basis does Canada use to impose taxes on its residents? - [ ] Only domestic income - [ ] Only capital gains - [x] Both domestic and foreign income - [ ] Only foreign income > **Explanation:** Canada imposes an income tax on foreign income earned by its residents. ## How are foreign companies with management and control in Canada treated for taxation purposes? - [ ] Exempt from Canadian taxes - [ ] Only liable for domestic income tax - [x] Considered resident in Canada and subject to Canadian taxes - [ ] Subject to provincial taxes only > **Explanation:** Foreign companies with management and control in Canada are considered resident in Canada and are therefore subject to Canadian taxes. ## What is the role of the Quebec government regarding income tax? - [ ] Collects provincial taxes for all provinces - [ ] Administers federal income tax - [x] Administers its own income tax on individuals and corporations - [ ] Transfers tax collection to Alberta > **Explanation:** Quebec administers its own income tax on both individuals and corporations. ## The Canadian taxation system includes which of the following characteristics? - [ ] Regional tax exemption - [x] Federal and provincial statutes for income taxation - [ ] Only federal taxes without provincial roles - [ ] No tax imposition on foreign companies > **Explanation:** The Canadian taxation system involves federal and provincial statutes that impose income tax on residents and non-residents with business or permanent establishments in the provinces. ## Under what conditions can non-residents be subject to Canadian income tax? - [ ] Only through federal statute - [ ] Only on permanent establishments outside Canada - [x] On certain types of Canadian-source income - [ ] Complete exemption for non-residents > **Explanation:** Non-residents can be subject to Canadian income tax on certain types of Canadian-source income.

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In this section

  • 24.2.1 Calculating Income Tax
    Understanding the process of calculating income tax in Canada, including steps on taxable income, allowable deductions, tax credits, and net tax payable.
  • 24.2.2 Types Of Income
    Learn about the four types of income and how they are taxed under Canadian tax laws. Detailed insights on Employment Income, Business Income, Income from Property, and Capital Gains/Losses.
  • 24.2.3 Taxation Of Income
    Comprehensive guide on the taxation of income in Canada, detailing federal and provincial tax rates, calculations, and illustrations.
  • 24.2.4 Taxation Of Income From Property
    Learn about the taxation of income from property including registered plans, interest income, dividends from taxable Canadian corporations, and dividends from foreign corporations. Discover the intricacies of capital gains, and methods to minimize taxable investment income.
  • 24.2.5 Tax-deductible Items Related To Investment Income
    Explore the various tax-deductible expenses related to investment income, including allowable carrying charges and those you cannot deduct. This guide provides comprehensive details to help you make informed decisions regarding tax deductions.
Tuesday, July 23, 2024