Interest equivalency

A tax tool for comparing interest to other investment returns

Rate of return on a portfolio is often front and centre in an investor’s mind. Understandable as this is, ultimately it’s about how much of those returns the investor will keep. The difference between the two is tax, which in turn depends on the type of income earned and the investor’s tax bracket.

This article deals with an individual earning income in a non-registered account, also known as an open account or cash account. With a range of variables in play, it can be difficult to follow the steps from initial return through tax calculation to spendable after-tax cash. A useful tool to help connect the arithmetic is interest equivalency.

Interest – Taking into consideration the tax trade-off

Interest is appealing for the part of a portfolio where certainty is the prime concern. For example, the issuer of a guaranteed investment certificate (GIC), agrees to pay a set amount of interest for the period of the contract.

This certainly provides valuable comfort to the investor, but an important trade-off from a tax perspective is that interest faces the full tax rate at any given income bracket.

Preferred taxation – Capital gains & Canadian dividends

Compared to interest, Canadian dividends and capital gains receive favourable tax treatment. They come at it from different routes, with the benefits emphasized at different income levels. Canadian dividends provide the best after-tax yield at low to mid brackets, giving way to capital gains at higher and top brackets.

Capital gains

There are two features that lead to the favourable tax experience from capital gains:

1. Deferral – While a security is held, no tax arises on changes in its price. This is also true if the investor holds a mutual fund that fluctuates according to price movement of its underlying securities. But a redemption/sale is a taxable event, and if the value has increased then the investor will realize a capital gain at that time.
2. Reduced inclusion rate – When there is a disposition, capital gains are said to be realized in that year, but only a portion of the capital gain is taxable. The “taxable capital gain” is derived by applying the income inclusion rate, which has ranged between 1/2 and 3/4 since 1971, but has been stable at 1/2 since 2000. The 2024 Federal Budget increased it to 2/3, while still allowing the 1/2 rate on the first $250,000 of an individual’s annual capital gains. (For trusts and corporations, the 2/3 rate applies to all capital gains.) The 1/2 rate is used in the examples to follow, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

The first feature allows tax-deferred growth. It is the second that is used in the interest equivalency calculation.

Canadian dividends

Like interest, Canadian dividends are taxed in the year earned, but the tax is calculated in two steps:

1. Gross-up – The ‘gross-up’ factor adds back the corporate tax, so the investor’s bracket can be used to calculate the tax as if the investor had earned the income that was really earned by the corporation.
2. Tax credit – The investor then gets a tax credit for the tax that the corporation has already paid.

This two-step process protects against double-taxation. The government’s revenue is split between the corporate tax and the personal tax, which is why an investor pays less on a dividend compared to the full rate for interest.

How interest equivalency works

Interest equivalency shows what amount of preferred income will give an investor the same after-tax spendable cash as a dollar of interest. Alternatively, it can be expressed as the higher amount of interest that equates to a dollar of preferred income. Either way, the result is expressed in dollars and cents.

Formula

Interest equivalency is shown in the following table at top tax bracket for each province, but it can be calculated at any income level by applying the following formula that uses marginal tax rates (MTR):

Interest equivalency = ( 1 – MTR^interest ) ÷ ( 1 – MTR^preferred )

Proof

It may be easier to see how this works by looking at an example, here using Alberta in the first row of the table:

Informing yourself with this tool

To be clear, interest equivalency is a tool used to compare investment returns; it is not a suggestion against interest returns in a portfolio. All income types have their respective features, benefits and risks. The tool can help advisors and investors understand, compare and discuss investment options and recommendations in a portfolio.

Canadian dividends provide investors tax-efficiency

Home bias with a rational rationale

Investors are often comforted by investing in what is familiar. For Canadians, that may include investing a greater share of their portfolio in Canadian securities.

Whether or not it is intentional, this home bias can provide benefits beyond comfort, by also rewarding the investor from a tax perspective.

WHAT – Focus on non-registered investments

In a registered account like a Registered Retirement Savings Plan (RRSP), there is no tax distinction among the types of income. No tax applies to the income earned within the plan, then all withdrawals are fully taxable.

It’s different with non-registered accounts, where the method and amount of tax varies according to the type of income. In these accounts, Canadian dividends are tax-preferred, especially for those at low to middle income.

WHY – Corporation adds a taxpayer level

The recipient of any income is responsible for paying tax. If all income was earned directly by individuals, or natural persons, then things would be straightforward.

However, there are also artificial persons—or corporations—which may first earn and pay tax on income before passing it on to real people. The way it is passed on by the corporation is by paying dividends to its owner/shareholders, in this case the portfolio investors.

HOW – Integration mitigates double-taxation

With both individuals and corporations being required to pay tax on the income they receive, there is a risk of double-taxation. This is further complicated by the way each is taxed: corporations are taxed at a flat rate, and individuals pay tax at graduated rates that get progressively higher as income rises.

To reconcile this two-stage taxation, our system has a set of rules that integrates personal and corporate taxes. It’s known as the integration model and it has two main components:

1. Gross-up –A dividend received by a shareholder from a Canadian corporation is increased by an arithmetic factor designed to add back the taxes paid by the corporation. By doing so, it’s as if the investor earned the income that was really earned by the corporation. This ‘taxable’ dividend is what is used to calculate the investor’s initial tax liability – but wait…
2. Dividend tax credit – Another arithmetic factor is then applied to reduce the individual’s tax liability by the estimated tax that the corporation has already paid. The government has only collected part of its revenue from the corporation, so in effect the investor is topping that up.

For investors in low to middle income brackets, this can result in much less tax than would apply to interest income or foreign dividends. And at very low income, the credit may exceed the tax as calculated above, allowing the excess credit to be applied against tax otherwise due on the person’s other income. The combined effect of the gross-up and dividend tax credit are shown in the table on the next page.

History – Two types of Canadian dividends

For decades, one set of factors for gross-up and tax credits applied to all Canadian-source dividends. But since 2006, dividends from a corporation that has paid its taxes at the general corporate rate have been entitled to more favourable ‘eligible’ gross-up and tax credit rates. This better recognizes the revenue the government has already collected from Canadian public corporations, and in turn provides relief to investors on taxation of the associated dividends received in their portfolios.

By contrast, where a corporation has used the small business rate, the ‘ineligible’ gross-up and tax credit rates apply. These are mostly owner-operator businesses, so not the type of dividends normally earned in an investment portfolio.

Governments adjust the gross-up and dividend tax credit figures occasionally, to maintain alignment with any changes in corporate tax rates.

Illustration – Eligible dividends in a non-registered account

This following table shows the combined federal-provincial marginal rates for a dollar of income, without breaking over bracket thresholds. Figures are rounded to integers for ease of relative comparison of the income types, though actual rates may have more decimal places.

WHY NOT – Foreign dividends

Comparatively, dividends from foreign corporations are fully taxable to Canadian investors. A foreign corporation will have paid tax to its own government. As Canada receives none of that revenue, there is no reason for it to give a credit on foreign dividends paid to Canadian residents.

Paying small business corporation dividends – Federal budget may be a call to action

One of the surprises in this year’s Federal Budget was the announced increase in the small business deduction for corporations. Or in more common language, the small business tax rate is coming down.

This will be welcome news to small business owners who will benefit from being able to reinvest more of their after-tax dollars within their corporations. While this is a win in the context of required reinvestment for business purposes, the effect is not so clear where it is a discretionary decision to forego dividends and invest to earn passive income.

And beyond that, this development could cause a reconsideration of existing investment accounts held at the corporate level. Continuing to hold these funds in the corporation could result in the shareholder paying up to 2% more if dividends are delayed beyond this year.

Small business tax adjustments

The small business rate on the first $500,000 per year of qualifying active business income of a Canadian-controlled private corporation (CCPC) is going down from 11% to 9%. The reduction will be implemented in half-percentage point in stages from 2016 to 2019.

In turn, corporate income that has benefited from the small business rate is treated as a non-eligible Canadian dividend when paid out to the shareholder. To maintain balance for the integration of corporate and personal taxes, the gross-up and dividend tax credit (DTC) for non-eligible dividends will also be adjusted. (See table.)

These are changes at the federal level. However, as the same gross-up is applied when calculating the shareholder’s provincial tax on the dividend, one would expect provinces to adjust their dividend credit rates accordingly.

Federal small business tax adjustments

2015 2016 2017 2018 2019

Small business rate 11% 10.5% 10% 9.5% 9%

Gross-up 18% 17% 17% 16% 15%

DTC 11% 10.5% 10% 9.5% 9%

Implications for dividend policies

In a given year, a shareholder (as director) may declare a dividend out of retained earnings, or continue to retain such funds in the corporation. All else being equal (so the saying goes), the shareholder portion of income tax is deferred by retaining those funds corporately. However, all else is not equal as we come into 2016 and roll through the next three years.

Consider a corporation that earns income in the current year, paying the 11% small business rate (focused on federal portion only). On dividend of those funds in the current year, the DTC will be an equivalent of 11%. However, if the dividend is delayed one year to 2016, the DTC will be the reduced 10.5%, meaning corporation and shareholder bear an extra 0.5% tax. And of course that becomes as much as 2% if one delays to 2019.

This adds a wrinkle to the dividend/retention decision this year and in the next three years, though of course it is for the particular business owner to decide whether it is material. An obvious tradeoff arises if current dividends push the shareholder up through marginal tax brackets.

With respect to existing corporate investment accounts, the need for a decision is arguably more pressing. This is retained money that has already paid its corporate tax, and has essentially been waiting to be subject to personal tax on dividend to shareholder. As the corporate investments are likely part of eventual retirement, an early withdrawal may be undesirable, even in the face of this additional tax cost. On the other hand, the reduction of the gross-up from 18% to eventually 15% will mean that later dividends will have less of a clawback effect on income tested benefits.

A thorough review will be necessary to determine the net effect on a given business owner. And to repeat, it remains that person’s prerogative whether this is sufficiently material to take action.