As a taxpayer in Canada, it is important to understand what your after-tax income is in order to effectively budget. Although there are income tax calculators available online, we believe that our clients should be aware of the key components of calculating after-tax income so that they can take steps to plan their affairs and minimize their tax obligation. The goal of this article is to provide you with a general understanding of how your after-tax income is calculated.
After-tax income is calculated by the following:
- Your gross income for the calendar year and then subtracting tax deductions available to you.
- A marginal tax rate that corresponds to your reduced gross income is then applied to determine your tax obligation.
- Your tax obligation can then be reduced by available tax credits, which will lower the amount of tax you owe.
- Your after-tax income is calculated by subtracting the amount of tax payable from your gross income for the calendar year.
The calculation for your after-tax income is found below:
After-Tax Income = Gross Income –Tax Payable [(Gross Income – Tax Deductions) X Marginal Tax Rate)] – Tax Credits]
WHAT TYPES OF INCOME ARE INCLUDED IN GROSS INCOME?
Section 3 of the Income Tax Act sets out the basic rules for calculating a taxpayer’s gross income for the calendar year. Generally, the following sources of income are considered in calculating a taxpayer’s gross income:
- Capital gains
- Other (e.g., pension income).
As there are different rules that apply to each source of income in the Income Tax Act, the source of a taxpayer’s income must be properly identified.
Recognizing employment income is quite straightforward as you will receive a T4 slip from your employer for these amounts. A key distinction that many of our clients have difficulty with is determining whether an amount should be classified as “business” or “property” income.
The Income Tax Act defines business and property as follows:
- Business: includes a profession, calling, trade, manufacture or undertaking of any kind, and in some cases an adventure or concern in the nature of trade
- Property: property of any kind (e.g., real, personal, immovable or movable, and tangible or intangible)
As the above definitions for business and property do not provide a clear distinction between these two sources of income, the courts have provided the following general principles to assist taxpayers in making this distinction:
- Income will likely be classified as property income when the taxpayer does not have to provide active or business-like intervention to produce the income; consequently, property income can be understood as passive income resulting from the mere ownership of property that involves little commitment of time or attention from a taxpayer;
- Income from business can be understood as active income resulting from the organization and systematic effort from a taxpayer;
- The level of activity associated with acquiring property income, which involves a greater level of activity, may lead to its being classified as business income;
- Where the investment of funds are necessary for a taxpayer to conduct its business, the income from these investments will likely be classified as business income; and
- The distinction between property and business income is a question of fact.
ACTIVITY FOR PROFIT OR HOBBY?
Further, attention must be given to the nature of the income-producing activity to distinguish between activity that was pursued for profit (a commercial activity) and activity that was pursed for personal motives or as a hobby. If the activity was pursued for profit, what you earned is taxable. Alternatively, if it is determined that your activity was undertaken solely as a hobby, the amount will be considered a tax-free windfall. The CRA’s publication, P-176R Application of Profit Test to Carrying on Business, sets out the following criteria to assist in determining if the activity was undertaken in pursuit of profit:
- The profit and loss experience in past years;
- The amount of gross income, if any, reported over several years;
- The length of time over which a profit could reasonably be expected to be shown must be relevant to the nature of the activity;
- The extent of activity in relation to that of businesses of a comparable nature and size in the same locality;
- The amount of time spent on the activity in question;
- The individual’s qualifications;
- The qualification of the individual for public assistance given to those who are carrying on a business in that field of activity;
- The individual’s intended course of action, as evidenced by his/her efforts showing an intention to make a profit;
- The capability of the venture as capitalized to show a profit after charging depreciation, and the development of the operation and commitments for future expansion according to the individual’s available resources;
- The degree or effort in promoting and marketing the products or services supplied by the individual;
- The type of expenditures claimed and the relevance and reasonableness in relation to the activity; and
- The nature of the product or service supplied, such that it has a profit potential.
Lastly, if amounts earned by you are not traceable to one of the sources of income mentioned above, the amounts are generally not considered income and are considered a non-taxable windfall (e.g., gifts and lottery winnings).
TAX DEDUCTIONS vs TAX CREDITS
The main difference between tax deductions and tax credits is that tax deductions reduce the amount of your gross income and tax credits directly reduce the amount of tax payable. For greater clarity on this distinction, reference can be made to the formula for calculating after-tax income above. By knowing all the tax deductions and tax credits that are available to you, you will be able to take full advantage of every opportunity to lower the amount of tax you owe and subsequently increase your after-tax income.
You can review the complete list of available tax deductions and tax credits to available to tax payers at the federal level here. You can review the complete list of available deductions and tax credits available to taxpayers in the province of Ontario by clicking here .
Although self-employed taxpayers can claim more deductions (e.g., deducting reasonable business expenses paid to earn business income) than taxpayers who are solely salaried employees, a common tax deduction that is available to salaried employees is the Registered Retirement Savings Plan (“RRSP”) deduction. An RRSP allows your savings to grow tax free in a special plan that is registered with the Government of Canada. Contributions that are made to RRSPs are tax deductible, and any money you earn in the RRSP is usually exempt from tax as long as the funds remain in the plan. Speak to your tax advisor or a lawyer at Kalfa Law to ensure you are making full use of this tax deduction.
TAX CREDITS: REFUNDABLE & NON-REFUNDABLE
When reviewing the available tax credits, you will notice that you may be eligible for both non-refundable tax credits and refundable tax credits. The main difference between the two types of credits is that a refundable tax credit will allow you to receive money back equal to the amount you do not owe in taxes while non-refundable tax credits will not allow you to receive any money back. Further, non-refundable tax credits cannot generally be carried over to future tax years. Consequently, attention should first be given to utilizing your non-refundable tax credits before your refundable tax credits.
MARGINAL TAX RATE
In Canada, taxpayers are taxed according to marginal rates that are applied to different tax brackets of income. Reference can be made to a previous article on marginal tax rates by clicking here, which provides a detailed breakdown on the federal and provincial tax rates that are applicable for the 2018 calendar year. As different types of income are subject to different marginal tax rates, attention should be given to ensure your sources of income are properly categorized into one of the six sources of income referenced above. Generally, the more income you earn, the higher the tax rate. Reference can be made to the table below for a summary of the combined Ontario-Federal income tax rates for 2018.
For greater clarity on determining your after-tax income, speak with your tax advisor or lawyer at Kalfa Law. By working with a qualified tax professional, a comprehensive tax plan can also be created to both minimize your current tax payable and future tax obligations.
-Julian Franch, Associate Lawyer
© Kalfa Law 2019