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What is a Dividend Tax Credit?

Dividends are paid out of a company’s after-tax corporate profits. Corporate income is subject to federal and provincial corporate income taxes. In the Canadian tax system, all provinces and territories set their own corporate and personal income tax rates. Dividends distributed to shareholders are subject to personal income taxes on both the federal and provincial level. This results in dividends being taxed twice. In an attempt to compensate for this double taxation, shareholders receive a dividend tax credit.

A system that taxes dividends the way Canada’s does is called an ‘Integrated System’. An integrated system ensures that the income earned through a corporation and distributed as dividend earns the same amount of after-tax cash flow for the investor as if he had earned the income directly. However, in Canada dividends attract double taxation. The Canadian Tax System applies two mechanisms i.e. the gross up and the dividend tax credit to mitigate the double taxation effect.

The dividend tax credit is non-refundable. Upon receiving the dividend, the shareholder includes 144% (as of 2011) of the dividend in his taxable income. The additional 44% is referred to as the ‘gross-up’ amount. The entire ‘grossed-up’ amount is taxed at the investors marginal federal personal income tax rate. The shareholder can then claim a credit for the federal dividend tax credit rate on the grossed-up amount. Similarly, the grossed up amount is again taxed provincially as personal income tax and is credited for a provincial dividend tax credit. Every province sets its own separate dividend tax credit rates.

As corporate tax rates are being lowered, the dividend tax credit offset is being decreased commensurately to maintain tax equilibrium.

Eligible and Non-Eligible Dividends:

Dividends paid by Canadian Controlled Private Corporations (CCPC), and public corporations are called Eligible Dividends. Income earned by CCPCs up to $500,000 are taxed at the small business tax rate at both the federal and the provincial level. Small business dividends (also referred to as ‘non-eligible’ dividends) are grossed-up 125% and receive a federal tax credit and provincial tax credit. Every province has its own limit for small business income and small business dividend tax credit rates.

The rate of the dividend tax credit depends on the type of corporation paying the dividend. Hence, the effect of the dividend tax credit varies according to the type of company that pays it and the Province in which it is earned. Eligible dividends received by Canadian corporations are not included in the taxable income of the recipient company as it would lead to a double taxation on the dividend.

Dividend Tax Credit Rates as of 2011:

 

DTC as a % of Grossed-up Taxable Dividend

DTC as a % of Actual Dividends
Federal

16.44%

23.17%
Newfoundland

11%

15.51%
Prince Edward Island

10.5%

14.81%
Nova Scotia

8.85%

12.48%
New Brunswick

12%

16.92%
Quebec

11.9%

16.78%
Ontario

6.4%

9.02%
Manitoba

11%

15.51%
Saskatchewan

11%

15.51%
Alberta

10%

14.1%
British Columbia

10.31%

14.53%
Yukon

15.08%

21.26%
Northwest Territories

10.78%

15.19%
Nunavut

5.82%

8.2%

The following examples explain the effect of the dividend tax credit on dividends received from different types of corporations by two individuals paying federal marginal personal tax rates of 15% and 26% respectively and living in different provinces (with provincial tax rates of 10% and 17% and dividend tax credit rates of 8% and 10% respectively ).

If the dividends were received from the income of a CCPC taxed at a low corporate tax rate (i.e. at the small business tax rate), the difference in the effective dividend tax rates for the two individuals would be as follows:

 

Taxpayer’s Marginal Tax Rate (federal and provincial)

25%

43%
Dividends received

$300

$300
Add: 25% Gross-up

$75

$75
Grossed-up dividend subject to tax

$375

$375
Federal Marginal Tax (15% and 26%)

$56.25

$97.50
Provincial Marginal Tax (10% and 17%)

$37.50

$63.75
Total Taxation

$93.75

$161.25
Federal Dividend Tax Credit (13.33%)

$12.49

$21.49
Provincial Dividend Tax Credit (8% and 10% respectively)

$7.50

$16.12
Total Tax Payable

$73.76

$123.64
Effective Tax Rate

24.5%

41%

If the dividends were received from a Canadian public corporation, i.e. companies traded on the TSX, the differences in the effective tax rates would be as follows:

 

Taxpayer’s Marginal Tax Rate (combined federal and provincial )

25%

43%
Dividends received

$300

$300
Add: 44% Gross-up

$132

$132
Grossed-up Dividend subject to tax

$432

$432
Federal Marginal Tax (15% and 26%)

$64.80

$112.32
Provisional Marginal Tax (10% and 17%)

$43.20

$73.44
Total Taxation

$108.00

$185.76
Federal Dividend Tax Credit (16.44%)

$71.02

$71.02
Provincial Dividend Tax Credit (8% and 10% respectively)

$34.56

$43.20
Total Tax Payable

$2.42

$71.54
Effective Tax Rate

5.5%

16.5%

Dividend tax credits offset not only dividend income, but also the taxation of other income. This can result in negative effective tax rates for individuals with low incomes or who receive a high percentage of their income in the form of dividends. British Columbia had the largest negative marginal tax rate (in 2008) at negative 15.55% for people in the lowest income bracket.