Dividends are generally the distribution of profits earned by corporations and distributed to the shareholders of the corporation. When the after-tax profit is distributed in the form of dividends, it is taxed again in the hands of shareholders. Minimizing this double taxation is the rationale behind the government’s dividend tax credit to “level the playing field” with other types of investments, thus making it more attractive for Canadian investors to invest in Canadian-controlled private corporations.  

Dividends from publicly-traded Canadian corporations are provided special tax treatment. This involves a gross-up of the dividend income received by the tax payer by 25%. For example, if you received an eligible dividend income from a public Canadian corporation of $400, the taxable amount of that dividend is $500 ($400 x 125%).  While the impact of the gross-up appears to be unfair, the second step of the process involves the calculation of the dividend tax credit on the grossed-up amount. This dividend tax credit is 13.33 % of the grossed-up amount or 16.67% of the actual dividend and in our example would generate a dividend tax credit of $66.65 to be applied to reduce the federal tax otherwise payable. Dividend tax credits are non-refundable and if they can’t be used against income in that year they are lost.  

Dividends received from non-resident corporations must be included in income in Canadian dollars, but are not eligible for the gross-up calculation or the dividend tax credit.
Dividend income is usually advantageous, though as with all tax policy there may be tax consequences, both positive and negative. In the hierarchy of the Canadian tax system dividends therefore are between interest income (which is taxed at the highest marginal tax rate) and capital gains (which receive the most favourable tax considerations, as discussed in one of my previous columns). The effect of the gross-up on dividend income would artificially increase your income and could effect payments you receive for Old Age Security which have a clawback after a certain threshold. It can be especially disadvantageous for lower income levels as the grossed-up dividend income could result in lower transfer payments.

Taxation affects a significant number of decisions regarding investing and financial planning. The basics of the Canadian tax system are relatively straightforward, but this example illustrates how inter-related the tax system is with the rest of the transfer system.  Dividend income can be one alternative to reduce your overall taxes, but it always pays to consult a professional to make sure it makes sense for you.
 
 

The information contained in this article was obtained from sources believed to be reliable; however we cannot guarantee that it is accurate or complete. This article is provided as a general source of information and it should not be considered personal investment advice or taxation advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax related matters. The views expressed are those of the author and not necessarily those of Credential Asset Management, Inc.

October 24, 2008