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Benefits and Limitations of Canada’s Dividend Tax Credit

While the dividend tax credit system was implemented to eliminate the double tax effect on dividends from a company’s after-tax profits, the system can also create tax disadvantages. The following section discusses the benefits and limitations of Canada’s current dividend tax credit system.

Differences in Tax System of Different types of Corporations

While incorporated companies have to pay tax on their earnings and on the distributed dividends, Flow-Through Entities (FTEs), including sole ownership, partnerships, or income trusts were historically exempt from paying any taxes, thus increasing the after-tax cash flow for investors compared to incorporated companies.

Distributed income from FTEs was subject to personal taxes only. An owner in a company that is structured as a partnership may choose to receive income as a salary and pay income tax only, instead of receiving dividends and paying taxes twice, first on corporate income and then on distributed dividends. Also, partner’s salaries are allowed to be deducted for the purpose of calculating taxable income which reduces the firm’s taxable net profit. Similarly, the owner of an incorporated business may choose to take part of the profit as salary instead of receiving dividends since dividends are also subject to corporate tax rates.

Preference of FTEs over Corporations

Publicly-traded FTEs and their investors have historically enjoyed substantially lower combined income tax rates than large corporations and their shareholders. This has resulted in a phenomenal growth in the number of FTEs over the past few years in Canada.

However, for the purpose of reducing the tax disparity and to discourage CCPCs from converting themselves into FTEs such as Income Trusts, the 2006 Federal Budget reduced the rate of federal tax on dividends from large Canadian corporations. The gross-up rates and dividend tax credit rates were simultaneously increased. Several large Canadian corporations who converted themselves into an FTE structure to take advantage of low tax rates have now begun to revert back to a standard corporate structure.

The Partial Offsetting Effect

An integrated tax system should make shareholders indifferent to investing in FTEs or incorporated companies. While the gross-up and tax credit mechanism was implemented to eliminate the double taxation effect, the gross-up of 25% assumed a corporate income tax of only 20% and hence, the recipients of dividends from large corporations (which pay higher taxes) have only had a part of the tax credited. Also, the dividend tax credit is based on the small business corporate income tax rate which only creates tax neutrality for small Canadian-controlled private corporations.

Until 2005, the Canadian tax system was largely integrated with respect to annual active business income of up to $300,000 earned by a Canadian-controlled private corporation and paid to its individual Canadian shareholders. Active income earned by CCPCs and public corporations in excess of the business limit did not integrate. Thus, individuals did not get a dividend tax credit sufficient to offset the corporate tax paid, resulting in excess overall tax to individuals of approximately 12% in Saskatchewan and 13% in Alberta.

Effect on Corporations and Individual Investment Choices

Due to the dividend tax disadvantage, public and large private corporations find it cheaper to raise capital as debt rather than preferential and equity capital since interest provides tax benefits. Until 2005, dividends were more highly taxed than capital gains, with the average top marginal personal capital gains tax rate being approximately 23%. Investors in high tax brackets therefore preferred to forego dividends in favour of high capital gains in later years. In order to bring parity between the taxation of dividends and capital gains, in 2006, the federal government increased the federal dividend gross-up rate to 45% and the federal dividend tax credit rate to 18.97% for dividends paid by public corporations and private corporations from high-taxed sources of income.

As a combined effect of increase in gross-up rate and dividend tax credit rates, eligible dividends attracted lower marginal tax rates than capital gains in almost all the provinces. In fact, the marginal tax rate on eligible dividends was mostly negative for individuals with low incomes. In an effort to create a tax-neutral environment for equity financing, it was suggested that all provinces should adjust their provincial tax and dividend tax credit rates to the newly announced changes in the federal tax and credit rates.

Inconsistencies between Net Income and Taxable Income:

At the corporate level, certain expenses are treated differently for tax purposes.  Expenses such as prior years’ losses, heavy investment in new physical assets, exploration expenses in the natural resource sector, and research and development incentives can reduce the actual tax payable well below the nominal rate in relation to book profit. Since, the taxable income is not always the same as the corporate net income; corporations may not always pay full income tax rates on their book profits. However, the gross-up-and-credit system assumes that they do. The differences between nominal and effective tax rates on book profits tend to even out over time.

Reduction in Government Benefits

Canada and its provinces have different net income thresholds for different social programs. The net income amount is often used in calculating eligibility for income-tested benefits. The 2006 federal budget increased the gross-up rate and dividend tax rate from 25% to 45% which resulted in increased net income for tax purposes. Taxpayers that received dividends but fell under lower personal income tax brackets had to forgo such social benefits since the gross-up inflated their net income above the threshold limit.