If you have ever sold a stock that you have made a profit on, you may not have paid an upfront tax, however, when you did your income taxes, you may have realized that you owed the Government money! This tax owed on the sale of a security for profit is known as a Capital Gains Tax (CGT). This post will aim to explain some of the features of CGT in Canada. Read on for details...
Applicable Securities and Accounts
In general, CGT will be assessed upon the sale of securities such as stocks, mutual funds, index funds, ETFs, bonds, or capital property (cottages, land, investment property, etc.). The most common and frequent CGT that investors experience is that related to securities, and will be the focus of this article. A complete discussion of CGT related to capital property is outside the scope of this article and can involve circumstances specific to an individual. For example, there is no CGT owed on the sale of a primary residence, but other investment properties may require CGT on sale.
CGT will typically only apply to securities held in a non-registered (investment) account. Securities held in an RRSP, RESP, Registered Pension, or TFSA are typically exempt from all CGT. This exemption from CGT is a powerful feature of the aforementioned accounts and should be utilized as often as feasible based on an individual’s unique financial circumstances.
Adjusted Cost Base (ACB)
At a basic level, the ACB can be viewed as the book value of a security, namely the total price that you paid for the units of the security when you purchased them. The ACB would be revised upward if you purchased more units of the security, or downward if you sold units of the security. In addition, the ACB would change on a per unit basis ($/share) if you purchase or sell shares of the security at differing prices.
The ACB is also revised for any reinvested distributions (often called return of capital), which are most relevant for mutual funds or ETFs. These reinvested distributions have the effect of decreasing the ACB (and thus increasing CGT owed upon sale of the security).
If you are unsure how to calculate your ACB, CJ Capital can assist you in determining where to find this information, or how to calculate it.
CGT and Capital Losses
A CGT needs to be paid when a security is sold for a price greater than its ACB. If the security is sold for a price less than its ACB, a capital loss will be deemed, which is equivalent of a negative CGT owed. This is referred to as a net capital loss, and can be carried back (up to 3 years) or forward to other taxation years (restrictions apply) to get a refund on previously paid CGT, or reduce CGT paid in the future.
Capital losses on some securities can be used to reduce CGT owed on other securities. As a result, in some instances, it may be strategic to sell a security at a capital loss in order to reduce or eliminate CGT on other securities. Of course it is not possible to generalize when this should be done, and so each individual's financial situation must be analyzed for the optimal treatment of taxes.
The CGT Calculation
The actual CGT rate is your marginal income tax rate, however, CGT in Canada are only assessed on half (50%) of the capital gain. As a result, assuming a marginal tax rate of 35%, the equivalent CGT rate would be only 35% * 50% = 17.5%.
This rate is drastically lower than a typical income tax rate, and (along with low dividend taxes) is responsible for Warren Buffet’s comment that he actually paid a smaller percentage in taxes (17.4%) than anyone else in his office (33% - 41%). The reason for this is that Mr. Buffet’s income was primarily derived from capital gains, dividends, and interest income, compared to a typical employee working for a salary. See the full article here: CJ Capital does not intend to get into the politics of such a discussion, however, we can help you to employ strategies to minimize your taxes owed.
The CGT calculation is best illustrated using an example. Assume an investor purchased an ETF one year ago for a cost of $500. During the past year, the ETF had a return of capital distribution of $50, and the investor purchased a further $100 of the ETF. At the end of the year (prior to the December 31 tax deadline), the investor sold all units of the ETF for a total of $1,000. The investor has a marginal tax rate of 35%.
- ACB = $500 (initial purchase) - $50 (return of capital) + $100 (additional purchase) = $550
- Capital Gain = $1,000 (selling value) - $550 (ACB) = $450
- CGT = $450 (Capital Gain) * 50% (inclusion rate) * 35% (marginal tax rate) = $78.75.
Assuming there were no offsetting capital losses, the individual would then pay the $78.75 as part of their income tax return.
Future articles will focus on the other types of taxes that investors are exposed to in Canada. Please contact CJ Capital with any CGT questions and we will be happy to help explain any of the concepts in this article in further detail.