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I've been wondering about the following scenario. Let's say you invest $10k in stock market. At the end of year 1, your investment has grown to $11k. The government taxes a percentage of that new income, so let's say you're left with $10.8k. At the end of year 2, your stocks has dropped to $9k because they weren't doing well. So the government doesn't tax you anything in year 2. In year 3, your investment goes up to $9.5k. Will the government tax you on the $500 gain from $9k to $9.5k?

I'm thinking the answer is yes, because taxes happen on a yearly basis, and may not look at your financial performance in previous years? But on the other hand, I've heard of people mention things like the government will look back as far as 7 years if you're audited, and I remember a phrase called tax claw-back that let's you use your recent financial history to affect the taxes you have to pay in the future?

As another follow up, I live in Canada and I have USD funds and CAD funds in my business bank accounts. Because the exchange rate is always changing, that means I'm potentially earning or losing value on the USD. And I'm curious if the answer I get to my question above applies to this situation as well.

I'll also ask my accountant, but I have a hard time understanding him because I lack a lot of accounting knowledge.

Your understanding is somewhat flawed, you aren't taxed annually based on the value of your investments. Capital gains tax is based on realized gain, so it's only when you sell that you have capital gains implications. In Canada you can carry forward capital losses to offset future capital gain, so if your example was selling at end of each year, your down year would help offset the subsequent up year. The capital loss from one year typically can only offset capital gain in a future year, not ordinary income.

There are edge cases and intricacies of course for some situations but in general that's how capital gains tax works, dividends and interest are handled differently.