TAX TRIBULATIONS
Four Income Tax Act pitfalls to steer clear of.
Our income tax system is what’s known as a self-assessment regime. We’re required to complete the forms provided by the Canada Revenue Agency (CRA), usually by April 30 each year, and calculate the amount we owe.
That suggests we should be reasonably conversant with the rules laid out in the Income Tax Act. Most people are not. It’s not our fault. The act runs to hundreds of pages and thousands of paragraphs. Most of it is incomprehensible if you’re not a chartered accountant. There are twists, turns, loopholes and pitfalls on every page. Some of them could cost unwary investors hundreds or thousands of dollars. Here are four to avoid. Phantom dividend income. Dividends from taxable Canadian corporations are eligible for a tax break, known as the dividend tax credit, if they are received in a non-registered account.
But the complicated way in which the credit is calculated could have a negative impact on your tax bill.
This happens because eligible dividends are “grossed up” by 38 per cent in calculating federal taxable income.
(Ineligible dividends, typically from a small business, are subject to a17-per-cent gross-up this year.)
So let’s say you receive $10,000 in eligible dividends in 2016. When it comes time to file your tax return, you will have to show that income as $13,800 because of the gross-up. That figure will be included in your taxable income even though you never received that extra $3,800. That’s why I call it “phantom income.” You’ll receive the dividend tax credit later in the return, but that extra income could have some unpleasant consequences.
Consider, for example, someone who is collecting Old Age Security (OAS) and whose total income is right on the cusp of the $73,756 level at which the clawback kicks in. That extra $3,800 puts them over the top. That person would be assessed a 15-per-cent-OAS clawback tax on money he/she never saw. TFSA Trap #1. Tax-Free Savings Accounts have been around since 2009, so you’d think that by now we’d know all the rules. Think again.
Take the recontribution rule, for example. Any time you withdraw funds from a TFSA, that amount is added to your contribution limit in the next calendar year. The key word is “next.”
Let’s say you have maxed out your contribution limit and you withdrew $5,000 from your TFSA last spring for a down payment on a car. Last week you got word that you received a $7,000 bonus based on your third-quarter sales record. Great!
You go to your bank and recontribute the $5,000 you withdrew in the spring. Oops! You forgot the “next.”
The folks at the CRA frown when they receive the bank’s report itemizing the activity in your account. Then they send you a letter demanding tax at the rate of 1 per cent per month on the overcontribution. Back in the early days of TFSA, the CRA tended to forgive people who didn’t understand the rules. Not any more.
Your only solution is to get the money out of the plan as fast as possible (there is a special form to complete) to minimize the damage. TFSA Trap #2. Dividends from U.S. companies are subject to a 15 per cent withholding tax unless they are received in a retirement account.
The big surprise here for many people is that TFSAs are not considered “retirement accounts” under the Canada-U.S. Tax Treaty. RRSPs, yes. RRIFs, yes. TFSAs, nope.
As a result, expect to have 15 per cent deducted from all U.S. dividends earned in your TFSA. To add to your frustration: there is no way to recover it. You can’t claim a foreign tax credit since a TFSA is tax-sheltered. You’re on the hook for the loss. It turns out TFSAs are not always tax-free! The mutual-fund mirage. A reader recently wrote to ask why it is a bad idea to buy mutual fund units in a non-registered account in early December. The reason is you could end up being taxed on your own money.
Let’s say you bought 100 units of Fidelity Canadian Balanced Fund (B series) in early December 2015 at a price of $24. A couple of weeks later, on Dec. 18, the company makes a distribution of $1.80 per unit to investors. Smart play, right? You just made 7.5 per cent on your money in a few days.
Actually, no, you didn’t. Rather, you made the tax department a little richer at your expense.
When Fidelity made the distribution, the net asset value per unit dropped by the amount of the payment. Before the money was paid, you owned 100 units valued at $24, for a total of $2,400. After the payment, the units were valued at $22.20 ($24 minus $1.80) and you had $180 in cash.
Your total investment was still worth $2,400, but the CRA considers the distribution to be income and you have to pay tax on it. You haven’t made a penny, but you owe the government anyway.
No wonder so many people are turning to tax professionals to do their returns! Gordon Pape’s column appears every two weeks.