Taxing Canadian dividends

With the turn of the calendar this New Year’s Day, we flipped the page to the next chapter in the ongoing evolution of Canadian dividend taxation.

We witnessed the low-water mark in 2009 for eligible dividend taxation across the country. Come April, top tax bracket residents in five provinces will pay less tax on dividends than on capital gains.

Now, as we move forward to 2012, all provinces and territories will adopt increased effective rates applying to eligible dividends.

Integration model

The two-stage treatment of dividends is an application of tax integration theory, whereby a taxpayer should be indifferent whether income is earned directly or as a shareholder via a corporation.

The Canadian income tax system uses a model that assumes the shareholder is a top- bracket taxpayer. This, however, has implications for lower-bracket taxpayers.

The integration model is designed to correct for potential double taxation where income is earned in a corporation and then distributed to a shareholder. The corporation pays tax on that income; therefore, a mechanism is needed to reconcile that earlier corporate tax payment when the income is realized in the shareholder’s hands.

On the shareholder’s top line, the dividend gross-up emulates the pre-tax value of the income to the corporation, upon which the shareholder calculates tax owing. The dividend tax credit reduces this preliminary tax liability by the estimated tax already paid by the corporation to arrive at the bottom-line tax due. Only Canadian corporations (presumed to have paid Canadian taxes) are entitled to this treatment; dividends from foreign corporations are fully taxable.

Since 2006, our income tax system has distinguished Canadian dividends as ineligible and eligible. Ineligible dividends arise out of small business corporations entitled to the small business rate and have separate gross-up and tax credit rates.

Eligible dividends are the subject of the most recent legislative changes. Though eligible dividends can also be generated from small business corporations, most taxpayers receive them via portfolio investments.

Adjustments for 2010

In 2010, the federal gross-up and dividend tax credit rates applying to dividends will both be adjusted downward. This is designed to keep the system in balance as corporate tax rates come down from 19% to 18% this year, to 16.5% in 2011 and 15% in 2012.

The gross-up figure will come down from 45% to 44% this year, to 41% next year, and will eventually reach 38% in 2012. This federal gross-up also applies when calculating provincial/territorial gross tax due, though somewhat indirectly in Quebec.

Concurrently, the federal dividend tax credit applying to the grossed-up dividend will fall from roughly 19% to about 18% this year, just under 16.5% next year, and will come to rest at just over 15% in 2012.

Each province and territory independently sets its own dividend tax credit to use in determining net provincial/territorial tax liability.

The net effect of the federal adjustments and provincial/territorial coordination is that the effective rate on dividends will increase in 2010, except in New Brunswick where the government is collapsing the number of brackets and reducing rates as part of an overhaul of the system leading up to 2012.

Legislative developments apart – which may very well be coming, given recent and prevailing economic events – the upward trend is expected to continue in all provinces and territories from 2010 through 2012.

Lower bracket taxpayers

The integration model is based on the shareholder being at the top marginal tax rate. Obviously, this is not always the case.

For taxpayers in lower tax brackets, the combination of the gross-up and tax credit generally results in an even lower effective rate on dividends. While it varies in different provinces and territories, the marginal tax rate for annual income of $60,000 is at or near 30%, whereas the effective rate on eligible dividends is at or below the single-digit threshold. As with all investments, a number of factors must be considered when assessing their suitability for individual clients. For example, potential clawbacks need to be considered for older investors. However, even with these recent changes, dividend-producing investments continue to warrant consideration and inclusion in a tax-informed investment portfolio.