Tax is like the proverbial elephant in the room. While not the most pleasant subject, you cannot ignore it ad infinitum. Sooner or later, the taxman is sure to come knocking at your door.
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Paying taxes may seem like putting your hard-earned money into a black hole called the Canada Revenue Agency. However, your tax dollars go a long way to fund many of the public services you enjoy.
Taxes fund roads, bridges, public libraries, parks, swimming pools, arenas, healthcare, ambulance services, police, fire services, national defence, old age security, employment insurance, social assistance, child benefits, etc.
Paying taxes is a civic duty, and everyone should pay their fair share. However, you should not pay more than you need to.
Understanding how taxes work in Canada will help you pay your fair share, no more and no less.
Levels of Taxation in Canada
There are three Government levels in Canada that levy taxes – federal government, provincial and territorial governments, and municipalities.
The federal and provincial/territorial governments collect the bulk of the taxes you pay. These government levels levy various taxes on consumption such as sales tax, gas tax, liquor tax, custom duties on imported goods, land transfer tax, and income taxes.
The municipal governments’ taxation is limited to property tax, licenses, and fees.
Tax Categories in Canada
Progressive: Under this tax system, the more you earn, the more you pay in taxes. It follows an accelerating schedule commonly referred to as income tax brackets. The purpose of a progressive tax is to have higher-income earners pay a higher percentage of taxes than lower-income earners.
The personal income tax in Canada is progressive.
You are always better off earning more, even if you get bumped into a higher tax bracket. You will pay more in taxes in a higher tax bracket, but your take-home pay will still be more.
Regressive: Under this tax system, the more you earn, the lower the percentage of your income you pay in taxes. A regressive tax system depends on the value of an asset owned or purchased and not on income level.
Examples of regressive taxes in Canada include sales tax and property tax.
Proportional or Flat: Under a flat tax system, everyone pays the same tax rate regardless of income level. Some experts suggest that it stimulates innovation and, thus, the economy as there is no tax penalty for making more money.
An example of a flat tax in Canada is the Federal corporate income tax.
Types of Taxes in Canada
- Income tax: Governments impose it on income generated by individuals and businesses. In Canada, income tax is progressive and levied at the federal and provincial/territorial levels of Government.
- Personal income tax: Imposed on income earned by individuals, primarily levied on salaries and wages.
- Business income tax: Imposed on income earned by corporations, partnerships, small businesses and self-employed people.
- Property tax: It is a tax paid by individuals and corporations on assets that they own. The most common type of property tax is on real estate. It is an ad-valorem tax, meaning that the tax agents will calculate it based on the assessed value of a property, asset, or service. In Canada, property tax is regressive and levied by the municipal governments.
- Sales tax: It is a consumption tax imposed by governments on the sale of goods and services. Sales taxes are typically collected by retailers and submitted to the respective governments.
A sales tax is regressive.
There are two types of sales tax in Canada: Goods and Services Tax (GST) and Provincial Sales Tax (PST).
Some Canadian provinces combine GST with PST to create a Harmonized Sales Tax (HST).
- GST: It is a 5% federal tax paid on most goods and services purchased
- PST/HST: The tax rates and the items taxed vary from province to province
- Custom duty or tariff: It is the tax paid when you import certain goods into Canada.
- Taxes may also include the contributions by employers and employees to social programs such as Employment Insurance (EI), Canada Pension Plan (CPP), and Quebec Pension Plan (QPP).
Income Tax in Canada
A brief history
Before World War I, there were no income taxes in Canada. Canada joined the war in 1914. To finance war expenses, the government began collecting corporate taxes in 1916.
The increasing war expenses led to a temporary Income Tax War Act in 1917. This Act covered both personal and corporate income.
After the war ended, war-related expenses such as veterans pension and debt interest continued to grow.
Fast forward to 1948, the Income Tax Act was still in place but no longer considered temporary. And thus, we continue to pay income taxes to the present day.
A progressive Income Tax System
Canada’s income tax system is graduated, meaning the Government will generally tax you more if you earn more.
Both the Federal and Provincial income tax systems are progressive.
Federal Income Tax Brackets (2020)
|Tax Bracket – Taxable Income||Incremental Amount||Federal Tax Rate|
|$48,536 – $97,069||$48,534||20.5%|
|$97,070 – $150,473||$53,404||26.0%|
|$150,474 – $214,368||$63,895||29.0%|
|Over $214,368||Depends on income||33.0%|
The provincial income tax brackets vary by province. Visit the Government of Canada’s tax website to check the income tax brackets in your region.
Below is an illustration of the progressive income tax system based on the 2020 Federal income tax brackets.
|Tax Bracket||Federal Tax Rate||Tax on $50,000 Income||Tax on $100,000 Income||Tax on $200,000 Income|
|$48,536 – $97,069||20.5%||$300||$9,949||$9,949|
|$97,070 – $150,473||26.0%||$nil||$726||$13,885|
|$150,474 – $214,368||29.0%||$nil||$nil||$18,530|
|Total Federal Tax||$7,580||$17,955||$49,644|
|Avg. Federal Tax Rate||17.9%||21.9%||24.8%|
The table illustration above demonstrates that your average tax rate increases as earnings grow. However, the take-home pay will always be higher despite an increasing tax rate. As such, it is still better to earn more money.
Note that Provincial tax brackets are different from the Federal ones. The sum of the two determines your total income tax payable.
Further, there are different tax treatments for income received from various sources. Therefore, the progressive tax system in Canada can become a bit confusing. If in doubt regarding your taxes, always consult with a professional tax accountant.
Advantages of a Progressive Tax System
- Encourages a fair distribution of the tax burden. Those who earn more carry a larger share than those who earn less.
- Provides more revenue for the Government as compared to a flat tax system.
Disadvantages of a Progressive Tax System
- May discourage innovation and investment as incremental earnings are taxed heavily. I High-income earners may perceive it as a penalty for hard work.
Income not taxed
Not all income is subject to tax. Below is a list of some non-taxable income in Canada:
- Most lottery winnings
- Amounts received from a TFSA
- Most proceeds from a life insurance policy
- GST/HST credit and Canada child benefit
- Most gifts and inheritances
Tax treatment for different income sources
Many people are surprised to learn that different income sources are subject to varying tax treatments. As a result, your income tax calculation may not necessarily be straightforward.
Below are the primary income sources that you may have and their respective tax implications.
According to the CRA, employment income consists of salaries, wages, commissions, bonuses, tips, gratuities, and honoraria.
In Canada, employment income is subject to the marginal tax rates or tax brackets.
A T4 slip, which is provided by your employer annually, shows your employment income. It will also indicate the taxes paid by your employer on your behalf and any deductions made from your pay.
Investment income includes earnings from four primary sources: capital gains, dividends, interest income, and rental income.
1. Capital Gains:
Refers to profits that arise when you sell an asset you own price higher than what you paid for it. Such investments may include stocks or real estate holdings.
There are two types of capital gains: realized and unrealized. Realized capital gains occur when you sell an asset at a profit. Unrealized capital gains arise when your investment goes up in value, but you have not sold it.
The good news is that only realized capital gains are subject to tax. Further, only 50% of the capital gains are subject to tax. So if you earn a capital gain of $100, you only need to add $50 to your taxable income.
Capital losses arise when you sell an asset at a lower price than what you paid for it. They can be used to offset capital gains and thus lower your taxable income.
You can carry capital losses back three years or use it to offset any future capital gains.
A dividend is a distribution of a company’s profits to its shareholders. Typically, companies have already paid taxes on the net profits distributed out as dividends.
To avoid double taxation, you will receive a dividend tax credit for dividends received from Canadian companies. Only Canadian stocks held outside of a tax-sheltered account such as RRSP or TFSA are eligible for a dividend tax credit.
The purpose of a dividend tax credit is to subsidize the tax already paid by the companies on your dividend income.
Dividends received from U.S. companies are subject to a flat U.S. non-resident withholding tax of 30%. Under the Canada-U.S. treaty, you are eligible for a reduced withholding tax rate. To qualify for the preferential withholding tax rate, you must complete and sign an IRS Form W-8BEN.
A T5 slip will show your dividend income.
3. Interest Income:
Includes income received as a result of lending out your money. You may receive interest income from bonds, GICs, savings and checking accounts, lending money to other people, etc.
There is no special treatment for interest income. The tax treatment for interest income is the same as for ordinary income.
A T5 slip will show your interest income
4. Rental Income:
This is income received from renting out your property. Rental income is treated as business income. As such, you pay tax on income net of expenses such as maintenance, repairs, financing costs and property taxes.
You should report rental income and expenses in a Statement of Rental Income Form T776.
Self-employment income is earnings from working for yourself. The tax rate on self-employment income is generally the same as employment income. However, unlike employment income, you report self-employment income net of expenses. As a result, the cost of running a business will lower your taxable income.
Pension is generally treated the same way as regular employment income. However, special age or disability exemptions may shield a portion of pension income from taxation.
Ways to reduce your taxes
You pay taxes based on your taxable income, not total revenue. There are various legal ways to reduce your taxable income and, in effect, lower your tax burden.
1. Maximize your deductions and credits
Deductions directly lower your taxable income and, thus, are more valuable, the higher your income grows.
In other words, the higher your tax bracket, the more significant the impact of a deduction. As such, if you anticipate being in a higher tax bracket later, consider deferring your deductions.
Examples of standard deductions include RRSP and employer pension contributions, child care expenses, charitable donations, medical expenses, capital losses, union dues, etc.
Tax credits are amounts that lower your taxes payable. As such, the value of a tax credit does not depend on the level of your income. There are two types of credits:
- Refundable tax credits: The CRA will pay you such tax credits, even if you do not have any taxes payable. You will receive a cheque in the mail or direct deposit in your account. An example of a refundable tax credit is the GST/HST tax credit.
- Non-refundable tax credits: Such tax credits reduce or cancel your tax payable. However, non-refundable tax credits are not applicable if you do not owe any taxes. Common non-refundable tax credits include personal tax credit, tuition credit, interest on student loans, etc.
2. Change your income source
As discussed earlier, different income types have varying tax implications. Employment income and interest income have the least favourable tax treatments. As such, consider pursuing more favourable income sources such as capital gains, rental income, and self-employment income.
3. Use tax-advantaged accounts
Tax-advantaged accounts help to defer your taxes. Deferring taxes enables your funds to grow faster if appropriately invested.
An RRSP account is the best way to defer your taxes in Canada. It also offers the added benefit of withdrawing your cash later during retirement when you will likely be in a lower tax bracket.
Although funds invested in a TFSA are after-tax dollars, it allows your investments to grow and compound tax-free.
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