TAXATION OF INVESTMENT INCOME

TAXATION OF INVESTMENT INCOME AFTER READING THIS DOCUMENT, YOU WILL: Understand the various sources of investment income and how they are taxed; Understand strategies for reducing taxable investment income; Recognize the taxation associated with each contract type. Updated: June 2012 1

Summary 1 Taxation of Investment Income... 3 1.1 Interest Income... 3 1.2 Eligible Dividend Income... 4 1.3 Non-Eligible Dividend Income... 5 1.4 Capital Gains... 5 1.5 Income From Foreign Sources... 6 2 Reducing the Taxable Investment Income... 6 2.1 Capital Losses... 6 2.2 Leverage Loans... 7 2.3 Portfolio Management Fees... 11 3 Taxation by Contract Type... 11 3.1 Non-Registered Contracts... 11 3.2 Registered Contracts... 11 3.3 Registered Education Savings Plans (RESPs)... 11 4 Taxation of Investment Funds... 12 4.1 Investment Funds and Interest Income... 12 4.2 Investment Funds and Dividend Income... 12 4.3 Investment Funds and Capital Gains... 12 4.4 Investment Funds and Income From Foreign Sources... 13 5 Taxation Upon Dissolution of Relationship... 13 5.1 Divorce... 13 5.2 Common-Law Partners... 14 5.3 Death... 14 2

1 Taxation of Investment Income All types of non-registered investments generate taxable income for taxpayers. The taxable income may be in the form of interest income, dividend income, capital gains or income from foreign sources. These various types of investment income are not all subject to the same tax rules. 1.1 Interest Income This type of income, whether from Canadian or foreign sources, is taxed at a rate of 100%. This means that every dollar received in interest income must be added to the taxpayer's income and taxed at that person's marginal tax rate. As you can see, interest income does not benefit from any particular tax advantages. The after-tax return of an investment that only generates interest is calculated as follows: t = marginal tax rate / 100 i = rate of return on investment After-tax return = i (1 t) For example, a person who holds an investment that bears interest at 3.75% and whose marginal tax rate is 45% will have a net return of: 3.75% (1 0.45) = 2.06% Interest is taxable annually, whether it's a simple interest or a compound interest investment. It's generally not beneficial to make compound interest investments outside a tax-deferred plan (RRSP, RRIF, etc.), since the accrued interest is taxed annually even though it's not cashed in until the investment matures, which basically amounts to paying tax in advance. Simple interest investments have at least one advantage: the cashed in interest provides the liquidity needed to pay the tax on that interest. 3

Example of a compound interest investment: $10,000, 3-year term, compound interest, rate of 3.00% At maturity: Principal: $10,000 Interest paid at maturity: $300.00 Interest taxable annually: Year 1: $300.00 (3% x $10,000) Year 2: $309.00 (3% x ($10,000 + $300)) Year 3: $318.27 (3% x ($10,000 + $300 + $309.00)) 1.2 Eligible Dividend Income Eligible dividends are defined as income paid by: 1. A public company, or by any other company that is not a Canadian-controlled private corporation (CCPC) and whose income is subject to the general corporate tax rate; 2. A Canadian-controlled private corporation (CCPC), provided its income (other than investment income) is subject to the general corporate tax rate. The dividend must be increased ("grossed up") to then qualify for a dividend tax credit. The tables below summarize the tax payable on the eligible dividend income for Quebec, and the highest marginal tax rate for an eligible dividend: Gross-up and tax credit rates in Quebec: Federal Quebec Eligible dividend gross-up 45% 45% Dividend tax credit 19% 11.9% 4

Highest marginal tax rate for an eligible dividend: Federal 12.11% Quebec 17.55% Total combined 29.66% 1.3 Non-Eligible Dividend Income Non-eligible dividend income (or other dividends) is simply defined as a dividend other than the eligible dividend. It is subject to the same gross-up and credit guidelines; only the respective rates are different. The tables below summarize the tax payable on the non-eligible dividend income for Quebec, and the highest marginal tax rate for a non-eligible dividend: Gross-up and tax credit rates in Quebec: Federal Quebec Non-eligible dividend gross-up 25% 25% Dividend tax credit 13.33% 8% Highest marginal tax rate for a non-eligible dividend: Federal 16.36% Quebec 20.00% Total combined 36.36% 1.4 Capital Gains A capital gain occurs when the proceeds of the sale exceed the acquisition price plus all expenses relating to the acquisition and disposition (fund redemption fees, for example). There is a capital loss when the opposite situation occurs capital losses will be discussed later in this document. 5

The realized capital gain is not 100% taxable. Only 50% of the gain should be added to the taxpayer's income and taxed at the person's marginal tax rate. For example, a person redeems an investment in full and obtains $10,000. The original cost of the investment was $7,500: The realized capital gain is $2,500, which is the difference between the selling price of $10,000 and the acquisition price of $7,500. Given that only 50% of the realized capital gain is taxable, our taxpayer will have to add $1,250 to his income for the year. 1.5 Income From Foreign Sources As we mentioned earlier, interest income from foreign sources is subject to the same taxation rules as interest income from Canadian sources. Dividend income from foreign sources is also included in the category of income taxed at 100%. No gross-up needs to be done and no dividend tax credit is available for dividends from foreign sources. Capital gains from foreign sources are treated the same way as capital gains from Canadian sources. Only 50% of the gain from foreign sources should be added to the taxpayer's income and taxed at the person's marginal tax rate. 2 Reducing the Taxable Investment Income When it comes time to set up a non-registered portfolio, certain strategies can be used to maximize the net (after-tax) return. Below are the three most well-known and popular strategies for reducing the taxable investment income: 2.1 Capital Losses A capital loss occurs when the acquisition price plus all expenses relating to the acquisition and disposition (fund redemption fees, for example) exceeds the proceeds of the sale. 6

Capital losses reduce the taxable income because they can cancel out the capital gains realized on other investments. Since only 50% of the capital gain is taxable, only 50% of the realized loss is deductible. Let's look at the example used earlier, but reverse the situation: A taxpayer redeems an investment in full and obtains $7,500. The original cost of the investment was $10,000: The realized capital loss is $2,500, which is the difference between the acquisition price of $10,000 and the selling price of $7,500. Since only 50% of the realized capital loss is deductible, our taxpayer can cancel out up to $1,250 in capital gains from another source. If, in a given fiscal year, the capital losses are higher than the capital gains (or there are no capital gains), the unused balance is not lost. Taxpayers can use them against previous years' tax returns (up to 3 years back) or keep them for future deductions (with no limitation period). Capital losses can cancel out capital gains only during the taxpayer's lifetime. Upon the taxpayer's death, if there is a remaining capital loss balance (after cancelling out the capital gains), these losses may be deducted from any other type of income for the year of the taxpayer's death or the previous year. If there is still a balance remaining, however, it cannot be rolled over to the spouse, the estate or the beneficiaries. Let's say that when our taxpayer dies, there is a remaining capital loss of $1,250. This loss can first be used to cancel out any capital gains. If there is still a balance remaining, it can cancel out dividend, interest or even employment income. However, if all options to cancel out income have been exhausted and there is still a capital loss balance remaining, this amount is extinguished. It cannot be transferred. 2.2 Leverage Loans Using leverage loans is an investment strategy that focuses on writing off the interest expenses. The objective is to write off the interest paid as a financial expense on the person's tax return 7

and increase the gains if the rate of return on the investment is higher than the cost of borrowing the money. The leverage effect or overinvestment acts in two ways: it increases the potential gains and the potential losses. The risks associated with this strategy have been explained many times, but it's important to repeat that it's essential to qualify your client before implementing a leverage strategy. The tax treatment of interest differs according to the level of government. The federal government allows taxpayers to write off interest against any form of income, while the Quebec government only allows interest to be written off against investment income. Like capital losses, if in a given fiscal year the interest paid is higher than the income generated, the unused balance is not lost. Taxpayers can use them against previous years' tax returns (up to 3 years back) or keep them for future deductions (with no limitation period, or until death). Let's look at a few examples to illustrate the leverage effect and its advantages: First let's look at the increase in total assets that can be achieved using this kind of strategy: Initial leverage amount: $50,000 Amortization: 20 years Interest rate on loan: 7.25% Return on investment: 7.25% Taxable portion of return: 40% Marginal tax rate: 45% Monthly interest payment on loan: $302.08 Accumulated balance after 20 years: $202,729.07 Repayment of loan: ($50,000) Net balance of investment: $152,729.07 To obtain the same portfolio value based on a return of 7.25%, the person would have to save $418.97 per month. Conversely, investors who save the equivalent of the monthly interest payment on the loan, i.e. $302.08 per month for 20 years, would accumulate a portfolio worth $110,119 (return of 7.25 %). Now let's have a look at the tax savings: 8

Year Balance at Start of Year Gross Income (7.25%) Balance at End of Year Balance of Loan at Start of Year Interest Cost (7.25%) Gross Repayment (annual) 1 $50,000.00 $3,625.00 $53,625.00 $50,000.00 $3,625.00 $3,625.00 2 $53,625.00 $3,887.81 $57,512.81 $50,000.00 $3,625.00 $3,625.00 3 $57,512.81 $4,169.68 $61,682.49 $50,000.00 $3,625.00 $3,625.00 4 $61,682.49 $4,471.98 $66,154.47 $50,000.00 $3,625.00 $3,625.00 5 $66,154.47 $4,796.20 $70,950.67 $50,000.00 $3,625.00 $3,625.00 6 $70,950.67 $5,143.92 $76,094.59 $50,000.00 $3,625.00 $3,625.00 7 $76,094.59 $5,516.86 $81,611.45 $50,000.00 $3,625.00 $3,625.00 8 $81,611.45 $5,916.83 $87,528.28 $50,000.00 $3,625.00 $3,625.00 9 $87,528.28 $6,345.80 $93,874.08 $50,000.00 $3,625.00 $3,625.00 10 $93,874.08 $6,805.87 $100,679.96 $50,000.00 $3,625.00 $3,625.00 11 $100,679.96 $7,299.30 $107,979.25 $50,000.00 $3,625.00 $3,625.00 12 $107,979.25 $7,828.50 $115,807.75 $50,000.00 $3,625.00 $3,625.00 13 $115,807.75 $8,396.06 $124,203.81 $50,000.00 $3,625.00 $3,625.00 14 $124,203.81 $9,004.78 $133,208.59 $50,000.00 $3,625.00 $3,625.00 15 $133,208.59 $9,657.62 $142,866.21 $50,000.00 $3,625.00 $3,625.00 16 $142,866.21 $10,357.80 $153,224.01 $50,000.00 $3,625.00 $3,625.00 17 $153,224.01 $11,108.74 $164,332.75 $50,000.00 $3,625.00 $3,625.00 18 $164,332.75 $11,914.12 $176,246.87 $50,000.00 $3,625.00 $3,625.00 19 $176,246.87 $12,777.90 $189,024.77 $50,000.00 $3,625.00 $3,625.00 20 $189,024.77 $13,704.30 $202,729.07 $50,000.00 $3,625.00 $3,625.00 Based on the investment income and the interest costs set out in the previous table, we can now calculate the tax impact of the investment with the leverage effect. 9

Year Tax Payable 1 Tax Deduction 2 Net Tax Impact 1 $652.50 $1,631.25 -$978.75 2 $699.81 $1,631.25 -$931.44 3 $750.54 $1,631.25 -$880.71 4 $804.96 $1,631.25 -$826.29 5 $863.32 $1,631.25 -$767.93 6 $925.91 $1,631.25 -$705.34 Balance of interest not deducted if investment income from other sources is insufficient (in Quebec only) 7 $993.03 $1,631.25 -$638.22 8 $1,065.03 $1,631.25 -$566.22 9 $1,142.24 $1,631.25 -$489.01 10 $1,225.06 $1,631.25 -$406.19 11 $1,313.87 $1,631.25 -$317.38 12 $1,409.13 $1,631.25 -$222.12 13 $1,511.29 $1,631.25 -$119.96 14 $1,620.86 $1,631.25 -$10.39 15 $1,738.37 $1,631.25 $107.12 16 $1,864.40 $1,631.25 $233.15 17 $1,999.57 $1,631.25 $368.32 18 $2,144.54 $1,631.25 $513.29 19 $2,300.02 $1,631.25 $668.77 20 $2,466.77 $1,631.25 $835.52 1 The tax payable corresponds to the taxable portion of the return realized on the investment multiplied by the client's marginal tax rate. (Example for Year 1: $3,625.00 x 40% * 45% = $652.50) 2 The tax deduction corresponds to the interest paid on the loan multiplied by the client's marginal tax rate ($3,625.00 x 45% = $1,631.25). 10

2.3 Portfolio Management Fees First of all, these should not be confused with investment fund management fees. Since these fees are deducted from the fund's assets, no deduction is possible. However, individuals who are well off have access to high-end portfolio management services, commonly known as Private Investment/Portfolio Management. This type of investment involves portfolio management fees as opposed to fund management fees. Since they are deducted from the individual's portfolio, they are deductible for the taxpayer. The deduction rules are the same as those that apply to interest on a leverage loan, i.e. it can be deducted against any type of income at the federal level, and against investment income only in Quebec. 3 Taxation by Contract Type 3.1 Non-Registered Contracts This type of contract is not tax sheltered, and is therefore subject to the forms of taxation described previously. 3.2 Registered Contracts Any amounts invested in a registered contract (RRSP/LIRA/Locked-in RRSP/RRIF/LIF/Locked-in RRIF) are not subject to any form of taxation. With these types of contracts, it's the withdrawals that are taxable. The taxation takes the form of income tax, regardless of the source of the income withdrawn. 3.3 Registered Education Savings Plans (RESPs) Like the other types of registered contracts, RESPs are a tax shelter. No tax is payable until the funds are withdrawn. What's special about RESPs is that it's not necessarily the subscriber who is taxed. It may be the beneficiary (the student) who is taxed on the value of the amount withdrawn. If the withdrawals are made in the form of Educational Assistance Payments (EAPs), the student will be taxed on the amounts received. EAPs are made up of the investment income generated 11

and the various grants received. However, if the withdrawals are made in the form of Accumulated Income Payments (AIPs) or by closing the plan, it's the subscriber who will be taxed. AIPs are made up of the investment income generated only. The taxation takes the form of income tax, regardless of the source of the income withdrawn. There will also be an additional tax of 20% for AIPs. The amounts contributed to the RESP go back to the subscriber, with no taxation. 4 Taxation of Investment Funds Whether it's a segregated fund or a mutual fund contract, the taxation rules are the same. First of all, the individual is taxed annually on the income generated by the fund. The Company keeps track of this income and records it on a tax slip. Subsequently, if the person makes a full or partial withdrawal from the investment fund, the difference in the market value is taxable (or deductible) for the investor. ***Taxation of segregated funds and mutual funds is discussed in more detail in IA-Q "Comparison of the Taxation of Segregated Funds and Mutual Funds"*** 4.1 Investment Funds and Interest Income Interest income is a source of income generated by all funds, if only by the liquidity portion that must be maintained in the fund. However, we can say that it's a source of income generated primarily by income funds. 4.2 Investment Funds and Dividend Income This source of income is offered by equity funds. Whether it's an eligible or non-eligible dividend, the Company makes sure to indicate the various dividends paid by equity funds on the tax slip. 4.3 Investment Funds and Capital Gains Bond funds and equity funds are the two types of funds likely to generate a capital gain. 12

A fund's realized capital gain comes from the transactions carried out by the fund manager, either by rolling over the securities contained in the fund, or through specific events like corporate mergers. 4.4 Investment Funds and Income From Foreign Sources Foreign bond funds and global equity funds are the two types of funds likely to pay out an income from foreign sources. Lastly, diversified (or balanced) funds generate all types of income previously mentioned. 5 Taxation Upon Dissolution of Relationship The tax treatment upon dissolution of relationship is very different depending on whether the individuals were previously married or common law partners. In Quebec, the laws governing dissolution of relationships are established by the Civil Code, which does not recognize common law partners. 5.1 Divorce For the sake of simplicity, let's start with retirement savings registered contracts. These contracts are subject to the "partition of family assets" rules. If a balance needs to be transferred from one spouse to another, there is no tax impact. Non-registered investments and or TFSA are not shared according to the "partition of family assets" rules. However, depending on the matrimonial regime, the assets may still be shared. If the matrimonial regime is "separation as to property", the assets are not shared. However, if the regime is "partnership of acquests", the assets could be shared. Like with registered investments, if a balance needs to be transferred from one spouse to another, there is no tax impact. The transfer can be made at the adjusted cost base, for non registered savings, thus avoiding disposition and the related taxes. 13

5.2 Common-Law Partners As mentioned earlier, dissolution of relationship in Quebec is governed by the Civil Code, which does not recognize common-law partners. Balances will not be transferred unless there is an agreement in place between the common-law partners. 5.3 Death On the first death, the investments can be rolled over to the spouse with no tax impact. If there is no spouse, registered investments can be rolled over to minor children, provided the amounts are converted to an annuity certain until the children turn 18. Non-registered investments, however, can only be rolled over to the spouse. If there is no spouse, there is a disposition of the investments and the related taxes are payable. In opposite to divorce, the definition of spouse is according to the tax legislation, which recognizes common law partners, and same sex partners. 14