One of the fundamental realities of financial planning is that the tax man treats income differently, depending on its source. Income from capital gains or dividends faces a lower tax burden than income from employment or interest-bearing investments, an advantage referred to as "tax efficiency." For Canadian investors, the federal Dividend Tax Credit provides much of that efficiency. Depending on the investor, it can reduce dividend taxation to a very low figure.
For publicly-traded companies, the sale of shares is a low-cost way of raising capital for their own operations and expansion. Some fortunate firms have investors clamoring for shares, but for most it's a competitive marketplace. Companies can make their shares more attractive by paying a small percentage of their retained earnings to each shareholder, in the form of a dividend. They'll sometimes maintain a dividend even in years when they're unprofitable, to reassure investors that they're fundamentally sound. It's a form of profit-sharing, and provides a steady stream of income to the investor. Dividends can be taken in cash or re-invested, depending on the investor's goals.
The Dividend Credit
The dividend tax credit is designed to address the difference between corporate and personal tax rates. Dividend are paid out of a company's retained earnings, which are after-tax dollars. They'll be taxed again as income in the investor's hands, and the dividend credit attempts to avoid duplicate taxation on those funds. The mechanism is straightforward in theory. The dividend amount is "grossed up" from its actual amount to its approximate original amount, before corporate taxes were paid. The investor's taxable income is calculated from the grossed-up amount, and the credit is calculated from the actual dividend dollar amount.
As with any tax-related calculation, the actual percentages vary from one year to the next. For the 2012 taxation year, eligible dividend amounts are grossed up by 38 percent, and the credit is calculated at 20.73 percent of the original dividend. For illustration purposes, assume $10,000 in dividend income. Multiplied by 1.38, that $10,000 grosses up to $13,800. It's taxable at 15 percent, giving a tax bill of $2,070. A credit of 20.73 percent, calculated on the original $10,000, works out to $2,073, effectively negating the taxable income. It's a non-refundable credit, so balances in the taxpayer's favor aren't paid out.
Eligible vs. Non-Eligible
The credit is based on Canada's corporate taxation structure, but not all corporations are taxed the same way. Public Canadian corporations, or foreign-controlled corporations operating in Canada, generate eligible dividends. Canadian-controlled private corporations, abbreviated as CCPCs, can generate eligible or non-eligible dividends depending on their circumstances. They're non-eligible if the corporation's income was already taxed at the more favorable small-business rate, or eligible if the funds were taxed at the general corporate rate. The tax credit on non-eligible dividends is grossed up by 25 percent, and credited at 16.67 percent. Using the same $10,000 example, it would yield a credit of $1,667 against taxable income of $1,875.
Although the calculation is simple in theory, there are a few other factors to consider. The 15 percent tax rate is applicable to dividend income of up to $40,970, then it goes up to 22 percent. There are additional rate increases at incomes of $81,941 and $127,021. Each province also has its own dividend tax credit, so the tax you pay on a given amount of dividend income will vary depending where you live. For older investors, the grossed-up amount can trigger clawbacks of federal benefits such as Canada Pension Plan payments, by artificially increasing taxable income. The net effect can still be favorable, but dividend income should be carefully planned.
- Canada Revenue Agency: Line 120 - Taxable Amount of Dividends (Eligible and Other Than Eligible) From Taxable Canadian Corporations
- Tax Tips.ca: Enhanced Dividend Tax Credit
- Tax Tips.ca: Non-Eligible (Small Business) Dividend Tax Credit
- Grant Thornton: Tax Planning Guide 2012-2013 -- Taxation of Dividends
- The Globe and Mail: You Do the Math -- Almost $50,000 in Earned Dividends, $0 in Tax
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