Viewed in isolation from other income sources, the preferred tax rates accorded to Canadian dividends can appear to be a gift from the government. Rest assured, though, that we are not simply being plied by our politicians. There is a logical method to the apparent madness of the process for calculating those tax bills.
Still, the inputs underlying that logic can sometimes fall out of balance. Such is the case with the treatment of so-called “ineligible” dividends from private corporations, as identified in the 2013 Federal Budget. As a result, adjustments will be coming in 2014 that will lead to a small increase in net dividend tax rates for small-business owners.
The integration model
With two types of taxpayers – individuals and corporations, each facing different levels of taxation – there is a risk of double taxation in our system. The model built into the system that reconciles this two-stage taxation is called “integration,” and it has two principal components:
- Gross-up – The actual dividend received by a shareholder from a Canadian corporation is increased by an arithmetic factor designed to add back the taxes paid by the corporation. The resulting figure is the amount of taxable dividend that is used to calculate the individual’s initial tax liability
- Dividend tax credit – Another arithmetic factor is then applied to reduce the individual tax liability by the amount of corporate tax paid
Past reforms – Eligible dividends
Until 2005, one set of factors for gross-up and tax credits applied to all Canadian-source dividends. Specifically, there was no distinction between original income that had been subject to the full general corporate rate versus income that had made use of the small-business deduction.
While it may not have been apparent to the individual shareholder/taxpayer, the effect was an element of double taxation. To address the issue, beginning in 2006, dividends from large corporations became “eligible” for an enhanced gross-up and associated tax credit. Both of these were adjusted to align with the series of reductions in the general corporate rate from 2010 through 2012.
For 2013, the federal gross-up is 38% and the dividend tax credit is 6/11 (approximately 55%) of the grossed-up amount. Provinces use the federal gross-up, but apply their own tax credit rate that aligns with their respective corporate tax rates. These would be the rates applicable for an investor earning Canadian dividend income in an investment portfolio. There are no pending changes to these factors.
Current reforms – Ineligible dividends
Ineligible dividends are those that arise out of corporate income that has benefited from the small-business deduction. The term “ineligible” is not actually a defined term, but is simply used to distinguish from the eligible dividend treatment described above. Again, the procedure is the same, but the factors are different.
When eligible treatment was introduced in 2006, the existing factors were left unchanged and have remained so right up to the present. In fact, those factors overcompensate individuals who receive dividends from a corporation that has used the small-business rate on active business income.
Accordingly, the government will change the factors applicable to ineligible dividends beginning in 2014. As with eligible dividends, provinces will continue to employ the federal gross-up factor and make appropriate adjustments to their respective tax credit rates. The accompanying table summarizes the changes for the calculation of federal tax, with dollar examples at top federal income-bracket level.
* The credit is calculated as a fraction of the grossed-up amount.