The concept of tax deduction had never been intuitive to me, but I recently finally got the idea.
Tax deduction seems to have the following characters.
- It reduces your taxable income
- It reduces your tax owed to government and to your province.
- It’s like a discount coupon when you purchase something
Spoiler alert: the conclusion of this post is that tax deduction is not a discount coupon but it works like a discount coupon, so you can assume that to be so for the most of cases.
Definition
Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and credits. The difference between deductions, exemptions and credits is that deductions and exemptions both reduce taxable income, while credits reduce tax.[1]
Ok so tax deduction is not a discount coupon. You pay same amount of money to shops but pay less to federal/provinces.
Scenario 1: Expense goods
Say you need 100 of $1.00 pens for your work at home. They belongs to Office expenses in Canada, so you can deduct 100%.
If your income (not the money you actually get in your hands) is $100,000, you pay $25,899 total tax (average tax rate 25.90%, and marginal tax rate 38.01%).
However in this case you expensed 100 pens, so your income becomes $99,900, so you only have to pay $25,861 total (average tax rate 25.89%, and marginal tax rate 38.01%).
By paying $100 you saved $38. This means the tax deduction system worked like 38% discount for your purchase.
Conclusion: Tax deduction works as discount coupon for business activity purchases. The discount rate follows your marginal tax, not your average tax.
NOTE: You probably don’t need 100 pens just for yourself. This is just an exaggerated for demonstration. If you actually do so, it doesn’t seem to be realistic and reasonable, so I don’t think it’s considered to be a business activity, unless your job involves significant amount of writings that actually consume these pens.
Scenario 2: Buy a condo and use it partially as home office
If you use 25% of the condo rooms (like 1 bedroom) just for your work and not for anything else, you can deduct the followings as your business expenses in Canada. Work-space-in-the-home expenses
- electricity
- maintenance
- property taxes
- home insurance
But not these:
- mortgage interest
- capital cost allowance
If your marginal tax rate is 38% like Scenario 1, tax deduction works like a 9.5% discount coupon for these 4 expenses.
Scenario 3: You are a small corporate owner.
As a corporate owner, you have roughly 2 choices.
- Pay as much salary as corporate income to yourself, to avoid corporate tax
- Pay as less salary as possible, to avoid personal income tax
But you would almost always choose the second one, because corporate tax is significantly lower than personal income tax.
- Corporation taxes in BC for small business: 9% federal + 2% provincial = 11%
- Corporation taxes in BC: 38% or 28% or 15% federal + 12% provincial = 27% ~ 50% (???)
Personal marginal tax rate in BC is
- 20.06% ~ 49.8%
- Federal: 15%, 20.5%, 26%, 29%, or 33%
- BC: 5.06%, 7.7%, 10.5%, 12.29%, 14.7%, 16.8%
So if you are a small business owner, the first priority is to keep your salary as little as possible, if you want to reduce the tax to pay in the year. You eventually have to pay all the rest out to yourself as salary (or as dividends) when you close the business though.
Anywhere, speaking of tax deduction, since corporate tax rate for small businesses is 11%, it’s not as powerful as individuals.
Personal expenses and deductions
It very depends on each people, but the typical personal expenses probably follows like the following trend
- Home mortgage ($10k~$20k?)
- Property Taxes / Maintenance Fee / Homeowners’ Insurance ($8K~$15K?)
- Car ($22k~$26K? or 0)
- Home equity line of credit interest if you invest ($0k~$20K)
- Cellular phone / internet services ($2K?)
- Hydro, public train/bus, medicine
And here’s how much you can deduct
- 0%
- Home mortgage
- Depends on the distance (e.g. 500km = 500 * 0.28 = $140)
- Car (based on driving distance for your business activity)
- 15%
- public train/bus
- Depends on the space (e.g. 25%)
- Property Taxes / Maintenance Fee / Homeowners’ Insurance
- Rent
- Hydro
- Depends on the hours used (e.g. 8/24 = 33%?)
- Cellular phone / internet services (based on how many hours you use for your business? (needs more research))
- 100%
- Home equity line of credit interest if you invest ($0k~$20K)
- Medicine (needs more research)
Well it’s very complicated…