Changes to small business dividends

The income tax system identifies two types of taxpayer: individuals and corporations. But taxes levied at the corporate level are ultimately borne by individuals, so, the dividend gross-up and tax-credit procedure accounts for previously paid corporate taxes when the shareholder/individual calculates personal taxes.

The eligible dividend regime was introduced in 2006 and the federal gross-up and tax-credit rates on ineligible dividends had remained unchanged until this year.

Now the gross-up has changed from 25% to 18%, and the federal tax credit has gone from 2/3 to 13/18. Provinces use the federal gross-up, so this also affects their tax-credit rates.

Based on enacted and announced changes, the graph below shows the effective tax rate shareholders face at the top bracket in each province. These changes are designed to integrate with the actual small-business rate used in calculating the original corporate income.

In theory, an individual taxpayer should be indifferent about earning income personally or through a corporation. This should hold true whether the distribution takes the form of salary or dividends.

In practice, things had fallen out of kilter, resulting in a preference for dividends in most provinces. The new rules narrow the gap between salary and dividends, and in some cases swing the pendulum towards salary. Also, these are not the only considerations in deciding on the salary/dividend mix. Read more: SMALL BUSINESS DIVIDENDS COST MORE