With interest rates lingering at all-time lows since the financial crisis, dividend investing has enjoyed somewhat of a resurgence. Yields are so low, income investors have turned to dividend-paying companies as a substitute for low paying bonds and other types of guaranteed investments.
It’s also important to understand that dividends are considered investment income and are taxable when held in a non-registered account. This is a fact that many investors seem surprised by and fail to consider prior to making their investment purchase. The good news is that Canadians are taxed less on dividends than on any other taxable investment income because the companies have already paid tax on the dividends. However, not all dividends are treated equally and attempting to understand dividend taxation can be complicated.
Eligible Dividends vs. Non-Eligible Dividends
Dividends, also known as distributions, are after-tax payments that you receive as a shareholder of a company. Dividends fall into two categories: eligible dividends and ordinary, or non-eligible and both have different tax implications. Fear not, you do not need to figure out eligibility yourself.
According to the Canadian Income Tax Act, firms must designate and notify shareholders that its dividend is ‘eligible’ prior to the dividend being paid. In other words, it is the corporation itself that declares eligibility, it isn’t on the back of the shareholders to determine. Companies will typically declare eligible dividends at the time of their dividend announcement or use a static statement such as “all dividends are eligible until deemed otherwise”. This type of statement can typically be found on the company’s website, annual reports, or other shareholder publications.
Although shareholders do not determine eligibility, they are certainly impacted. Non-eligible dividends are not considered for the enhanced dividend tax credit, more on that later. Both eligible dividends and non-eligible dividends have different gross-up percentages.
As mentioned previously, dividends are an after-tax distribution to shareholders. To integrate a degree of fairness to dividend taxation, the government has instituted something called the theory of integration. In simple terms, it implies that a taxpayer should be taxed the same regardless if the income is earned directly (think salary) or by way of distribution as a shareholder. Likewise, it is intended to account for double taxation and attempts to reconcile taxes already paid by the company.
Eligible dividends and non-eligible dividends are grossed-up to the approximate amount that the company has paid. The individual is then taxed on that grossed-up amount based on their personal marginal tax rate.
In 2017, the eligible dividend gross-up amount is 38%, while the non-eligible dividend is 17%. As an example, say you received $1,000 in both types of dividends in 2017. You would be taxed on the following:
$1000 *.38 * 100 = $1,380
$1000 * .17 * 100 = $1,170
Dividend Tax Credit
Now, I know what you are thinking; the gross-up seems completely unfair. In the example above, you are essentially adding an extra $550.00 to your income. Enter the Dividend Tax Credit (DTC). The DTC is intended to reconcile the taxes that the company has already paid on the dividends. In theory, once the DTC is factored in, you should end up paying the same amount in taxes had you received the income as salary. It is by no means perfect, but in some cases investors in the lower income bracket can end up with a negative tax rate on dividends that can be used to offset other taxes owing.
How does it work? Eligible dividends are entitled to a 15.02% federal tax credit on the grossed-up amount. Each province also kicks in their own DTCs and they vary by province. What about non-eligible dividends? Don’t fret, they are also eligible for a DTC. In 2017, the federal rate was 10.5217% while Manitoba had the lowest DTC at 0.7835% and Ontario the highest at 7.05%.
Here is a DTC rate table for 2017[table id=19 /]
It is important to note, that foreign dividends, originating from firms outside the country are NOT eligible for the dividend tax credit. Make sure you are aware of this when you are buying your stocks. They are fully taxable on the grossed-up amount. Likewise, most foreign dividends are subject to a withholding tax, which varies by country. But that is a discussion for another time!
Real Estate Investment Trusts (REIT)
Outside of the type of dividend, Canadian REITs and REIT ETFs introduce another level of complexity to your taxes. Although you receive a cash payment, REITs refer to this payment as a distribution. The reason is that on top of dividends, a REITs distribution can contain return of capital, interest, capital gains or other income, each of which have different tax implications. They may also contain both foreign and domestic income that is once again taxed differently. It is for this reason that we recommend you hold REITs in a registered account such as a TFSA or RRSP. Keep investing simple!