The Dividend Series – Dividend, Investment Income & Taxation – Part A
We will commence with some key definitions for a better understanding of the contents.
Ask any Canadian what a dividend is and, if they don’t know, they’ll at least say it’s something positive. For the most part, they’d be right.
Dividends are distributions of a corporation’s after-tax earnings to its shareholders. They’re optional to distribute, but corporations often use them to entice or pay shareholders.
Dividend taxation can be confusing, but it’s part of our tax system’s theory of integration: the idea that an individual should pay the same amount of tax whether income is earned personally or through a corporation.
Consider that corporations are distributing earnings that they’ve already paid tax on. For the sake of fairness, dividends are subject to a special gross-up and tax credit calculation. When an individual receives a dividend, the amount received is grossed-up to a higher amount, depending on the type of dividend, to approximate the tax the corporation has paid. Personal tax is then calculated on this grossed-up amount. To compensate for this, individuals can claim a dividend tax credit, which reduces their tax otherwise payable.
The theory of integration doesn’t usually work out precisely as intended, with individuals either realizing tax savings or paying a tax cost from corporate earnings paid out as dividends.
Example
Assume Martha is in a 35% tax bracket and invests in shares of Manfco, a public company. Manfco earns $1,000 and pays corporate tax at a rate of 26.5% in Ontario. Martha has received a $735 eligible dividend from Manfco, which nets Martha less than earning $1,000 personally.
Table 1: Dividend income versus regular
| Eligible dividend | Regular income | |
|---|---|---|
| Original intended payment | $1,000 | $1,000 |
| Less: Corporate tax paid @ 26.5% | $265 | N/A |
| Proceeds | $735 | $1,000 |
| Less: Tax owed | $355 (35% of grossed-up amount, which is $1,014.30*) | $350 (35% of income) |
| Plus: Dividend tax credit | $254 (25.02% of grossed-up amount, as per the Income Tax Act) | N/A |
| Final proceeds | $634 | $650 |
| Total tax cost | $366 ($101 personal** and $265 corporate) | $350 |
*$735 x 1.38, since eligible dividends are grossed up by 38%.
**$101 = $355 – $254
Planning ideas
- In Ontario, a person can earn up to $35,000 in non-eligible dividends, or $50,000 in eligible dividends and pay no tax (other than health premiums) as long as they have no other income.
- A shareholder doesn’t have to do anything to receive dividend income other than invest in shares, so a corporation doesn’t have to give the person voting power or management responsibility. By contrast, other income-splitting measures, such as paying a salary to family members, are subject to reasonability tests for tax purposes, which is potentially a disadvantage.
- Many income-splitting opportunities, such as those involving family trusts, are based upon the payment of dividends to family members with lower income levels.
- If a person is entitled to a spousal tax credit, dividend income can sometimes be transferred between spouses on their tax returns to minimize tax.
Planning pitfalls
- For seniors receiving old age security benefits, the dividend gross-up system can cause the loss of benefits if the dividend gross-up causes a senior to have income above the claw back threshold.
- Dividend income doesn’t create RRSP room.
- The payment of a dividend by a corporation is not a deductible expense to the corporation, while salary income is.
- Dividend income isn’t helpful to an individual who wants to claim childcare expenses as a tax deduction, since dividends are not considered earned income for that purpose.
- Minimum tax (see AE, March 2017) can sometimes be triggered when an individual has significant dividend income, since dividends are taxed at a more preferential rate than other forms of income.
- Keep in mind that tuition credits must be fully claimed before dividend tax credits, and unused dividend tax credits cannot be carried forward.
Types of dividends
Eligible dividends
Dividends declared from earnings that were taxed at the general tax rate. Shareholders must be notified that a dividend is eligible at the time of payment, whether through website information for a public company or through letters to shareholders for a private company. For the 2016 tax year, eligible dividend income is grossed-up by 38% on an individual’s tax return. The top marginal tax rate on eligible dividends in Ontario is 39.34%.
Non-eligible dividends
Dividends declared from earnings taxed at the small business tax rate. For 2016, non-eligible dividend income is grossed-up by 17% on an individual’s tax return. The top marginal tax rate on non-eligible dividends in Ontario is 45.3%.
Capital gains dividend
A distribution by a Canadian mutual fund of its capital gains. Since the distribution is actually a capital gain, only half of the capital gain distributed will be subject to tax on an individual’s tax return.
Foreign dividend
Dividends from foreign corporations received by Canadian residents are considered to be foreign income, not dividends, for tax purposes. Foreign income is taxed at the same rates as salary or interest
What is Refundable Dividend Tax on Hand (“RDTOH”)?
RDTOH is a mechanism built into the income tax system in order to achieve integration. This concept ensures that income tax payable on investment income is essentially the same whether earned in a corporation and flowed out to its shareholder(s) or earned personally by the shareholder(s), i.e. where in the current environment investments are held in the company name and income is not paid as dividends but reinvested , benefiting the shareholder through deferred payment of taxes at lower small business corporate tax rates.
The RDTOH can be viewed as an account that accumulates refundable tax paid by a private company on its investment and dividend income. Investment income (including interest, rents, royalties, and the taxable portion of capital gains) earned by a Canadian Controlled Private Corporation (“CCPC”) is taxed at approximately 50%. A portion of this tax (calculated as 30.67% of taxable investment income) is added to the RDTOH account. In addition, taxable dividends (often referred to as “portfolio” dividends) received by a CCPC are subject to a refundable tax (Part IV tax) at a rate of 38.33%. The full amount of Part IV tax is also added to the RDTOH account. (Note that dividends received from connected corporations can, in certain instances, also attract Part IV tax.) Amounts in the RDTOH account are refundable to the corporation when a taxable dividend is paid to a shareholder at the rate of $1 of refund for every $2.61 of taxable dividends paid. The refunds are commonly referred to as “dividend refunds” and are deducted from the RDTOH account.
RDTOH should be taken into consideration in any concept comparing an insurance strategy to a corporate owned alternative investment.
The current RDTOH rules
To ensure that there is no advantage for an individual to earn investment income (e.g. interest, dividends, rental income, etc.) in a CCPC, instead of directly, a refundable tax is levied on that corporate investment income, in addition to regular corporate income tax. Accordingly, a corporation’s up front tax paid is approximately equivalent to the taxes that would be paid by an individual earning that income directly.
This refundable tax is tracked in a corporation’s RDTOH account. The refundable tax is recovered by the corporation only when a taxabledividend (eligible or non-eligible) is paid or deemed to be paid to the individual shareholder(s) of the corporation. This refund of tax is referred to as a dividend refund.
Eligible dividends are distributed from a corporation’s general rate income pool (GRIP) and are subject to a lower individual tax rate.
The table below illustrates the tax savings of paying an eligible dividend as opposed to paying a non-eligible dividend in 2019 (based on top combined federal and provincial/territorial dividend tax rates).
General rate income pool (GRIP)
A Canadian-controlled private corporation (CCPC) or a deposit insurance corporation may pay eligible dividends to the extent of its general rate income pool (GRIP) and no excessive eligible dividends were incurred under Part III.1 tax. The GRIP is calculated at the end of the tax year. However, a corporation can pay eligible dividends over the course of the year as long as, at the end of the year, the eligible dividends paid do not exceed its GRIP.
Note
The GRIP is a balance that generally reflects taxable income that has not benefited from the small business deduction or any other special tax rate.
Use Schedule 53, General Rate Income Pool (GRIP) Calculation, to determine the GRIP and file it with your T2 return. You should file this schedule if you paid an eligible dividend in the tax year, or if your GRIP balance changed, to ensure that the GRIP balance on our records is correct.
You can view GRIP balances using the “View return balances” service at:
- My Business Account, if you are the business owner
- Represent a client, if you are an authorized representative or employee
Coming Next……..What does the Future Hold ?…..Part B of the dividend series
