How Income Tax Works In Canada

We have just passed the deadline for filing personal income tax returns in Canada and we are no doubt going to forget about them for another eight or nine months. That is not the smartest thing we can do.

There are few families where there is any larger expense in their annual budget than income taxes. Do they pay any attention to that? Not many do. Almost none do it themselves if they pay attention at all.

The thinking begins when they look at their tax return. And they must do that.

The observation needed

What I see is what the myriad complexity of the tax act requires me to put on the form. The question should be, “What could it look like?”

You won’t get the changes you could arrange by thinking about it. The income tax is not intuitive. It is thousands of pages of exceptions and three sections of intuition. Neither long, followed by more than 250 sections (thousands of subsections) of exceptions, definitions rules, and rates.

The easy intuitive parts are

Section 1 “This act may be cited as The Income Tax Act.'” Most beginning students can get past that one. I knew Edgar Benson Casually. He lived not far from e after he was Finance Minister. He once commented that section one should be amended to read, “The Accountants, Lawyers, and Life Insurance Company’s Relief Act” I suppose no section in the act is beyond amendment and you should take that into account while you think about it.

Section 2 defines who shall pay tax and on what

 (1) An income tax shall be paid, as required by this Act, on the taxable income for each taxation year of every person resident in Canada at any time in the year.

(2) The taxable income of a taxpayer for a taxation year is the taxpayer’s income for the year plus the additions and minus the deductions permitted by Division C.

That’s it for intuition. Every resident shall pay tax on their income for the taxation year. Everything you might want to know is found elsewhere.

There are three things in section 2 that you should have noticed. There are thousands of cases that relate to them.

  1. What is a resident?
  2. What is income?
  3. What is a taxation year?

If you ask the CRA or ask for a ruling on those questions, they will decline to provide a ruling as these matters are not a question of interpretation, but rather questions of fact. The next several thousand pages will lead you to answers but you won’t always be sure of what you find.

Nonetheless, it is a self-assessing system, and you, not they, are responsible for any errors.

One highly-rated tax specialist and former partner has commented, I can give you an 80% right answer in 15 minutes. I can give you a 99% right answer in 150 hours. There is no 100% right answer.

Simple tax plans

These rely on “the D’s”. Deduct, Divide, and Defer.

Deduct is not so difficult. There is a deduction permitted in the act or other is not. Let’s look at the interest you pay,

Suppose you have a $300,000 mortgage at 4%. $12,000 a year of interest and none of it deductible for tax purposes unless you find out how interest deductions work. The deduction might be deductible if you follow the rules.

  1. The amount of interest must be reasonable and legally due.
  2. You must pay it.
  3. The loan and therefore the interest paid relate to acquiring an income-producing asset.
  4. You must still own the assets or ones substituted for them.

Suppose when you bought your home you had $400,000 in bank term deposits or bonds above the down payment for the house. If you pay $150,000 down and finance the rest of the house purchase price with your mortgage you will have no deduction. You did not acquire an income-producing asset with the proceeds of the loan.

As an alternative suppose you disposed of $300,000 of the bonds and paid $400,000 cash for the house. Then you borrow $300,000 using the house as security and buy $300,000 of bonds. Now the interest is deductible because the purpose of the loan was to buy income-producing assets.

That the ending position is identical matters not. Only the four conditions for deductible interest matter.

How many other deductions can you have? Your imagination and your ability to fall within the definitions in the act will matter.

Dividing income is immensely profitable. With interspousal loans, you can easily move investment income from one spouse to another. You loan capital to the spouse for the designated rate, currently 1%, and they then use the capital to earn income. Watch for pension splitting and CPP sharing.

It is harder with children who are less than 18. Seek professional help if you want to divert corporate income.

Deferrals are sometimes permitted by definition in the act. RRSPs, RESPs and several others exist and are usually limited, but still useful. The idea is a dollar deferred is a dollar saved. The fundamental is you can earn investment yield on what would be the government’s money. The worst is you pay them the tax on what would have been entirely their investment income. YOu can work it out.

How tax shelters work

Everyone loves tax shelters. Some work.

There are four kinds.

Type 0 – no deduction and income is taxable as earned

Type 1 – Deduction of your capital but income is taxable as earned. Usually limited partnership and highly structured. Movies, exploration funds, and some rental properties appear in the fall each year.

Type 2 – No deduction of your capital and income is untaxed as earned. Sometimes not ever taxed. Think TFSA (very limited) and Life insurance, designed to fit.

Type 3 -deduction of capital and no tax on the income until withdrawn. This is where RRSPs fit.

Not all tax shelters are appropriate. Your circumstances will define which have benefits for you.

The bit to take away

Tax planning has long-run benefits. Most people use their savings to improve their after-tax yield or to increase the capital they have available. Over decades the difference is astounding. Pay attention and seek help as needed.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at

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