Tag: Dividend

Tax on dividends rising – Changes for small business owners

Small business owners will generally be paying a little more on the dividends they extract from their corporations beginning in 2014.  

In the 2013 federal budget, the government expressed its concern that individuals were being over-compensated by receiving dividends from a corporation than if the individual had earned that income personally.  Changes were proposed, and now enacted, in an effort to bring the system of integrating corporate and personal taxes back into alignment. 

To be more precise, these changes target corporate income that has made use of the small business deduction.  Previous changes had already addressed corporate income that had been subject to the full corporate tax rates – the so-called eligible dividend regime introduced in 2006 and rolled-out over the following six years.

Ineligible dividends in 2014, and on

In our income tax system we have two main types of taxpayers: individuals and corporations. Despite that taxes are levied at the corporate level, ultimately those taxes are borne by individuals.  The dividend gross-up/tax-credit procedure accounts for previously paid corporate taxes when the shareholder/individual calculates personal taxes due.  

Since the introduction of the eligible dividend regime in 2006, the federal gross-up and tax credit rates on ineligible dividends had remained unchanged.  Beginning in 2014, the gross-up will change from 25% to 18%, and the federal tax credit will go from 2/3 to 13/18.  The provinces use the federal gross-up, so have been prompted to adjust their respective tax credit rates.  

Based on enacted and announced changes (and subject to potential change in upcoming 2014 budgets), this table shows the effective tax rate shareholders face at top bracket in each province:

Top bracket rates – Ineligible dividends
(Combined federal-provincial)

Province     2013      2014

BC            33.7%    38.0%
AB            27.7%    29.4%
SK            33.3%    34.2%
MB           39.1%    40.8%
ON*          32.6%    36.5%
QC            38.5%    39.8%
NB            33.0%    36.0%
NS            36.2%    39.1%
PE            38.6%    38.7%
NL           30.0%    31.0%

The other side of the story

In fairness to the tax authorities, these changes are not arbitrary.  They are designed to integrate with the actual small business rate that will have been used in calculating the original corporate income.   

In theory, an individual taxpayer should be indifferent about earning income personally, or through a corporation that then distributes to the individual.  This should hold true whether the distribution is in the form of salary to that person as an employee, or as a dividend to that person as shareholder/owner. 

In practice though, things had gotten a bit out of kilter, leading to a preference toward dividends in most provinces in recent years.  The effect of the changes will be to narrow the distinction between salary and dividends, and in some cases to slightly swing the pendulum past perfect integration and toward salary.  

Bearing in mind that these are not the only considerations in deciding on the salary/dividend mix, here is the starting point those owner/managers can use for that analysis:  

Tax savings or cost of using dividends
(A positive figure favours dividends)

Province    2013    2014

BC            1.0%    -0.6%
AB            1.2%    -0.3%
SK            2.0%     1.2%
MB            0.6%    -0.9%
ON*          3.4%     0.1%
QC            -0.3%   -1.3%
NB            1.6%     0.9%
NS            4.2%     2.1%
PE            1.4%     1.3%
NL           1.8%     0.9%

* Ontario is expressed at the top federal bracket rate, rather than the significantly higher Ontario rate of $500,000+. 

Canadian dividend taxation – Rule changes are designed to restore balance

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.

Practical applications of corporate class mutual funds

Corporate class mutual funds have unique features that make them stand out from other investment options. Chief among the tax benefits of these features are the:

  • Ability to rebalance holdings within the corporation without triggering dispositions, due to the exchangeability of share classes at adjusted cost base; and
  • Expectation of lower current distributions, due to the netting of gains and losses across share classes under consolidated corporate accounting.

While these are key details for an advisor’s knowledge, seldom does a client explicitly request benefits or features, let alone ask for an asset class or particular product. Rather, clients view financial advisors as problem solvers: the client has a current concern or future expectation and looks to the advisor to resolve the issue or at the very least suggest options that assist in moving toward a satisfactory resolution.

With that in mind here are a few situations where an advisor may have the opportunity to discuss the merits of corporate class funds as an addition, alternative or complement to a client’s current condition or investment approach.

Personal annuities

An annuity can provide guaranteed lifetime income, the price being the commitment of a lump sum of capital. You can also purchase a guarantee in case you die early. So what’s the cost of betting against yourself on both ends?

It may provide a reality check to compare the annuity income against the drawdown of a continuing managed portfolio. In the RRSP world, a person can hedge expectations by allocating between the security of a registered annuity and the flexibility of a RRIF. Either way, all eventual flows are fully taxable.

For non-registered funds, the taxes are a little more complicated. Generally for personal annuities, each payment is a fixed proportion of non-taxable capital and fully taxable interest. By comparison, a systematic withdrawal out of a corporate class mutual fund yields both non-taxable capital and one-half taxable capital gains, with the taxable portion increasing over the years.

Using reasonable return assumptions, a comparison of those annuity flows against the projected draw from the mutual fund corporation can provide some context for the cost of those guarantees. Whether or not this review changes a client’s course, this type of analysis will assure a more fully informed decision.

Managing foreign dividends

In an article earlier this year (Fundamentals, March 2011: “Is home bias simply rational self-interest?”), I adverted to the interaction between foreign dividends and corporate class funds. I have had a few advisor conversations on the topic since then and thought this would be an appropriate place to flesh out those earlier comments.

Foreign dividends are treated as regular income, which from an investment perspective is the same rate applied to interest. Accordingly, a top-tax-bracket investor receiving foreign dividends faces a tax rate of nearly double the rate applicable to Canadian eligible dividends. The rate disparity is even more pronounced at lower brackets once the two-stage mechanics of the gross-up and tax credit procedure are applied.

Another possibility is for an investor to hold foreign interests through shares of a Canadian mutual fund corporation. Foreign dividends are income to the corporation itself, and the corporation can apply its expenses against that income to reduce its potential to pay taxes. The investor thus expects capital appreciation, with only one-half of eventual capital gains then being taxable.

Passive investments within private corporations

Private corporations may be entitled to a low tax rate on active business income, but passive investment income is subject to the full corporate rate plus a penalty tax. With their tax-deferral benefits and low distribution expectations, mutual fund corporation shares would be an ideal consideration for private corporations.

In terms of accessing the funds, a T-series overlay could be used to receive a greater amount of non-taxable return of capital in early years, deferring capital gains until later.

As corporations face flat taxation – as opposed to the graduated bracket treatment of individuals – the tax-deferral opportunity can therefore be particularly effective in the private corporation context.

For some numerical support on these examples and discussion of other practical uses of corporate class shares, you can view the replay of our recent webcast on the topic – and obtain continuing education credit in the process.