All about dividend taxation

Ask an average person what a dividend is and, if they don’t know, they’ll at least say it’s something positive. For the most part, they’d be right.

Dividends are distributions of a corporation’s after-tax earnings to its shareholders. They’re optional to distribute, but corporations often use them to entice or pay shareholders.

Dividend taxation can be confusing, but it’s part of our tax system’s theory of integration: the idea that an individual should pay the same amount of tax whether income is earned personally or through a corporation.

Consider that corporations are distributing earnings that they’ve already paid tax on. For the sake of fairness, dividends are subject to a special gross-up and tax credit calculation. When an individual receives a dividend, the amount received is grossed-up to a higher amount, depending on the type of dividend, to approximate the tax the corporation has paid. Personal tax is then calculated on this grossed-up amount. To compensate for this, individuals can claim a dividend tax credit, which reduces their tax otherwise payable.

The theory of integration doesn’t usually work out precisely as intended, with individuals either realizing tax savings or paying a tax cost from corporate earnings paid out as dividends.

Example

Assume Joe is in a 35% tax bracket and invests in shares of Pubco, a public company. Pubco earns $1,000 and pays corporate tax at a rate of 26.5% in Ontario. Joe has received a $735 eligible dividend from Pubco, which nets Joe less than earning $1,000 personally.

Table 1: Dividend income versus regular

	Eligible dividend	Regular income
Original intended payment	$1,000	$1,000
Less: Corporate tax paid @ 26.5%	$265	N/A
Proceeds	$735	$1,000
Less: Tax owed	$355 (35% of grossed-up amount, which is $1,014.30*)	$350 (35% of income)
Plus: Dividend tax credit	$254 (25.02% of grossed-up amount, as per the Income Tax Act)	N/A
Final proceeds	$634	$650
Total tax cost	$366 ($101 personal** and $265 corporate)	$350
*$735 x 1.38, since eligible dividends are grossed up by 38%. **$101 = $355 – $254

Planning ideas

• In Ontario, a person can earn up to $35,000 in non-eligible dividends, or $50,000 in eligible dividends and pay no tax (other than health premiums) as long as they have no other income.
• A shareholder doesn’t have to do anything to receive dividend income other than invest in shares, so a corporation doesn’t have to give the person voting power or management responsibility. By contrast, other income-splitting measures, such as paying a salary to family members, are subject to reasonability tests for tax purposes, which is potentially a disadvantage.
• Many income-splitting opportunities, such as those involving family trusts, are based upon the payment of dividends to family members with lower income levels.
• If a person is entitled to a spousal tax credit, dividend income can sometimes be transferred between spouses on their tax returns to minimize tax.

Planning pitfalls

• For seniors receiving Old Age Security benefits, the dividend gross-up system can cause the loss of benefits if the dividend gross-up causes a senior to have income above the clawback threshold.
• Dividend income doesn’t create RRSP room.
• The payment of a dividend by a corporation is not a deductible expense to the corporation, while salary income is.
• Dividend income isn’t helpful to an individual who wants to claim child care expenses as a tax deduction, since dividends are not considered earned income for that purpose.
• Minimum tax (see AE, March 2017) can sometimes be triggered when an individual has significant dividend income, since dividends are taxed at a more preferential rate than other forms of income.
• Keep in mind that tuition credits must be fully claimed before dividend tax credits, and unused dividend tax credits cannot be carried forward.

Types of dividends

Eligible dividends—Dividends declared from earnings that were taxed at the general tax rate. Shareholders must be notified that a dividend is eligible at the time of payment, whether through website information for a public company or through letters to shareholders for a private company. For the 2016 tax year, eligible dividend income is grossed-up by 38% on an individual’s tax return. The top marginal tax rate on eligible dividends in Ontario is 39.34%.

Non-eligible dividends—Dividends declared from earnings taxed at the small business tax rate. For 2016, non-eligible dividend income is grossed-up by 17% on an individual’s tax return. The top marginal tax rate on non-eligible dividends in Ontario is 45.3%.

Capital gains dividend—A distribution by a Canadian mutual fund of its capital gains. Since the distribution is actually a capital gain, only half of the capital gain distributed will be subject to tax on an individual’s tax return.

Foreign dividend—Dividends from foreign corporations received by Canadian residents are considered to be foreign income, not dividends, for tax purposes. Foreign income is taxed at the same rates as salary or interest income, meaning no dividend tax credit is available. However, a foreign tax credit may be claimed for foreign tax withheld from the dividend payments.

Capital dividend—A tax-free dividend paid by a Canadian-controlled private corporation (CCPC) when the CCPC files an election form. The capital dividend arises from 50% of the capital gains realized by a CCPC. This amount is distributed tax-free since the CCPC has already been taxed on the capital gains.

by Stephanie Dietz, CPA, CA, CFP, who specializes in tax and estate planning at Stephanie Dietz Professional Corporation.