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Changes Proposed to Dividend Tax Credit Rules and Rates

Keeping the limitations of the dividend tax credit in mind, the Canadian government’s 2007 Economic Statement, announced reductions to the federal general corporate income tax rates to 15% by 2012 in a gradual manner over 4 years. To reflect the reduction in corporate income tax rates, dividend gross-up factors and dividend tax credit rates were also adjusted in 2008 budget.  In the 2008 Federal Budget it was proposed to reduce the gross-up rate for the enhanced dividend tax credit and to reduce the dividend tax credit rate, beginning in the 2010 tax year. As a result of the decreased gross-up and dividend tax credit rates, the rate of tax on eligible dividends will increase over the next few years. The following table presents the current dividend tax credit rates and the rates proposed from 2010 to 2012, assuming that the top federal marginal income tax rate remains unchanged at 29%.

Federal Dividend Tax Credit (DTC) – Current and Proposed

Rate Changes
Years

2010

2011

2012
Gross-up Rate

44%

41%

38%
DTC as % of Grossed-up Dividends

17.98%

16.44%

15.02%
DTC as % of Actual Dividends

25.88%

23.17%

20.73%

The following table represents the effect of the changes proposed in the 2008Federal Budget on marginal tax rates of eligible dividends, assuming that the personal income tax rates remain unchanged.

Federal Marginal Tax Rates on Dividends Eligible for the Enhanced DTC

Taxable Income

Other
Income
Tax Rate

Eligible Dividends Marginal Tax Rates

2010

2011

2012
First $37,885

15%

-4.28%

-2.02%

-0.03%
Over $37,885 up to $75,769

22%

5.80%

7.85%

9.63%
Over $75,769 up to $123,184

26%

11.56%

13.49%

15.15%
Over $123,184

29%

15.88%

17.72%

19.29%

To align their dividend tax rates with the amended federal tax rates for general and small business income, British Columbia, Alberta, Manitoba, Ontario and Prince Edward Island have scheduled changes to their provincial dividend tax credit rates. British Columbia has increased its tax rate on all taxable dividends by decreasing its dividend tax credits, consistent with the reductions to its general and small business deduction rates. Alberta, Manitoba and Prince Edward Island have increased their tax rates on small business dividends by reducing the small business dividend tax credit rates.

The following chart illustrates the combined federal and provincial marginal tax rates on eligible dividends from 2010 to 2012 (for the highest income tax levels in each province):

 

Province 2010 2011 2012
British Columbia 21.45% 23.91% 26.11%
Alberta 16.11% 18.61% 20.86%
Manitoba 25.09% 26.74% 28.12%
Ontario 23.65% 25.33% 26.74%
Prince Edward Island Not yet known Not yet known Not yet known

While Alberta and Ontario have reduced their dividend tax rates on eligible dividends from 2009 to 2012, Nova Scotia and New Brunswick are reviewing their tax systems.

Introduction of the GRIP and LRIP

CCPCs are now required to track the income from which they can pay eligible dividends through a new notional account referred to as the General Rate Income Pool (GRIP). The GRIP was introduced for those CCPCs that earn income in excess of the limit set for small business tax rates and includes the after-tax income of CCPCs that was taxed at the general corporate tax rate. The GRIP will also include eligible dividend income received by the corporation which was earlier excluded in the calculations of eligible dividends paid by corporations. Going forward, a professional corporation will only be able to pay eligible dividends from its GRIP account. While the GRIP includes the earnings taxed at the general corporate tax rate, the Low Rate Income Pool (LRIP) includes the income of public corporations and other non-CCPCs which have benefitted from the small business tax rate and therefore not paid as eligible dividends. Hence, the responsibility of determining whether a dividend is an eligible dividend rests on the paying corporation.

Aligning FTEs and CCPCs Tax System

As mentioned in our article on the benefits and limitations of the dividend tax credit, until 2007, distributions from FTEs had a tax advantage over dividends paid by CCPCs which led to a phenomenal growth of FTEs in Canada and conversion of several corporate businesses into FTEs. Investors in FTEs paid less combined personal and corporate taxes than public corporations. The purpose of preferential tax treatment for eligible dividends was to introduce a level playing field between FTEs and incorporated companies. Measures continue to be taken through reduction in general corporate tax rates and increased dividend tax credits. As of 2011, this has produced the desired results, and many FTEs are now converting back to a corporate structure.

Partnership income subject to the new tax will now be treated as eligible dividends. Partnership allocations will also be classified as ‘eligible dividends’ in the hands of the partners for the purpose of the new enhanced dividend tax credit. These new rules will be applicable from 2007 on FTEs that were publicly traded from October 2006.

The 2008 and subsequent federal budgets have decreased the general corporate tax rate which will be phased in until 2012. To keep in step with changes, several provinces have decreased the dividend gross-up rate and the dividend tax credit rate. While the tax burden for corporations has been lightened, the net impact on individual investors will be that they will pay higher rates on personal income tax from dividends starting in 2010. The following article gives a brief overview of the implications of the recent changes made in the gross-up rates and dividend tax credit rates to individual taxpayers and corporations.