Posted by Dave on June 8, 2010
As I frantically study for an exam on the Canadian Tax System tomorrow, I came across the above topic that I thought would be worth discussing.
Many people who are aiming for early retirement are planning on using dividends to at least partially replace income previously earned through employment. I think most people know that investing in Canadian public companies gives the benefit of dividend tax credits, and today I thought I would explain why there are dividend tax credits and how these credits fit in with the Canadian tax system.
The dividend tax credit system is set up to eliminate the potential of double taxation of investment income. Without special tax rules, dividends would be taxed once at the corporate level and then again at the shareholder level when dividends are paid. Although this would be ideal in the current economic climate (our government would end up with more tax dollars, which is something they are searching for at the moment) it is not all that equitable to businesses and individuals, hence Canada’s integrated tax system.
The best way to explain this premise I think is an example. For this theoretical example, I’ve simplified some of the information, but it should provide an explanation of what I’m talking about.
A corporation earns $100, of which all after tax dollars are to be allocated to dividends. The gross-up rate being used in the example is 1.45, which is the rate used on active publicly-traded corporations for last year. The tax credit calculated is 31%, which is what was applied in British Columbia for 2009:
Federal Tax rate on $100 19.50
Provincial tax on $100 11.50
Dividend Available 69.00
Grossed up at 1.45* 100.00
Dividend tax credit 31.00
So, essentially what the dividend tax credit ensures is that the $31.00 already collected by the Canada Revenue Agency is not collected on again. Dividend income itself is taxed on the individual, but if you follow the math, the individual would have a credit from the $69.00 received and would only be taxed on $38.00 of dividend income in this simplified example.
The dividend tax credit is only available to Canadian dividends. The Canada Revenue Agency really doesn’t care if they’re double taxing you on foreign dividends, as another government received the benefit of the corporate portion ($31.00 from the example above). The ramification of this double taxation means that other than allowing your portfolio to become more diversified on a currency basis, you lose out if you’re investing in a foreign company if there is a comparable domestic stock that could be bought.
The dividend tax credit also makes it much more beneficial (tax-wise) compared to other sources of income (such as interest) which don’t have similar credits available.
Of note, dividend credit is going to be decreasing over the next few years, as corporate taxes are declining and in order to match the lower amount of taxes being paid by corporations, shareholders will get less as a credit. The following amounts show the federal dividend tax credit amounts on dividends paid from a public corporation in Canada (provincial amounts vary across the country).
2009 = 27.5%
2010 = 25.88%
2011 = 24.12%
After 2011 = 22.35%
So, I hope I have provided some information as to why we have a dividend tax credit and the overall implications of the credit on the Canadian tax system. Any questions?