Canadian Stocks Dividends
Canadian Stocks Dividends
Investing With Taxes In Mind: Understanding The Tax Difference Between Dividends and Interest Income
What do we mean when we say: “Not all investments are created equal. Some are more equal than others.”
By this we mean to say that the government does not treat all investments equally. The government provides favourable tax treatments to certain income streams and none at all to others.
Dividends are one asset class that the government favours. By offering a favourable tax treatment on dividend income, the government motivates investors to invest in companies and businesses and thereby helps the economy to grow.
In Canada, investors receive something that is called a Dividend Tax Credit that is applied to dividends earned from Canadian stocks. Generally it reduces the amount of tax owed to the government by half.
For example, let’s say a high paying lawyer earns income from dividends in the amount of $10,000. Had the lawyer earned this $10,000 from his business, most likely he would have had to pay at least $4,000 in taxes. But because he earned the income from dividends, the government makes the distinction and instills a tax credit. In effect, the tax credit reduces the tax burden by almost $2,000.
In contrast, let’s say that the same high paying lawyer invests in a bond and earns $10,000 in interest income. In this case, the government treats the interest income exactly as if the lawyer had earned it from his practice. There is no mechanism in place to help the investor reduce his tax burden.
It is interesting to note the difference in tax treatment between dividends and interest income.
Many of you may be wondering why the government makes the distinction at all. After all, whether an investor buys stock or makes a loan, both methods are providing a key service to our business community– access to capital. So why make the distinction?
The main reason for the favourable tax treatment on dividends is due to something called ‘double taxation’. Basically, the government recognizes that taxes on dividend income is paid twice – once by the corporation that issues the dividend (remember: dividends are paid from after tax profits) and another time, by the individual investor who receives the dividend. In essence, the government acknowledges the inequity associated with double taxation and offers a tax credit to make it more equitable.
This is not the case with interest income. Whereas dividends are paid out with after-tax income to the corporation, interest is paid out with before-tax income. For example, a company that generates operating income (that is revenues less cost of goods sold) of $100,000 would normally have to pay tax on $100,000 assuming no other expenses. But if that same company now has interest payments of $20,000, the company would only have to pay tax on reported income of $80,000. Hence, in the eyes of the government, it is out-of-pocket this tax amount. And therefore, government feels less of a need to reduce the tax burden on the individual investor who receives the interest paid out by the corporation.
Understanding the taxation difference between dividend and interest income is the first step in making sure your portfolio is tax efficient where Tax Efficiency means minimizing the amount of taxes that we owe in a way that is legal and in accordance within the confines of Revenue Canada.
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