Integration – Page 2 – Doug Carroll

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.

Taxing Canadian dividends

With the turn of the calendar this New Year’s Day, we flipped the page to the next chapter in the ongoing evolution of Canadian dividend taxation.

We witnessed the low-water mark in 2009 for eligible dividend taxation across the country. Come April, top tax bracket residents in five provinces will pay less tax on dividends than on capital gains.

Now, as we move forward to 2012, all provinces and territories will adopt increased effective rates applying to eligible dividends.

Integration model

The two-stage treatment of dividends is an application of tax integration theory, whereby a taxpayer should be indifferent whether income is earned directly or as a shareholder via a corporation.

The Canadian income tax system uses a model that assumes the shareholder is a top- bracket taxpayer. This, however, has implications for lower-bracket taxpayers.

The integration model is designed to correct for potential double taxation where income is earned in a corporation and then distributed to a shareholder. The corporation pays tax on that income; therefore, a mechanism is needed to reconcile that earlier corporate tax payment when the income is realized in the shareholder’s hands.

On the shareholder’s top line, the dividend gross-up emulates the pre-tax value of the income to the corporation, upon which the shareholder calculates tax owing. The dividend tax credit reduces this preliminary tax liability by the estimated tax already paid by the corporation to arrive at the bottom-line tax due. Only Canadian corporations (presumed to have paid Canadian taxes) are entitled to this treatment; dividends from foreign corporations are fully taxable.

Since 2006, our income tax system has distinguished Canadian dividends as ineligible and eligible. Ineligible dividends arise out of small business corporations entitled to the small business rate and have separate gross-up and tax credit rates.

Eligible dividends are the subject of the most recent legislative changes. Though eligible dividends can also be generated from small business corporations, most taxpayers receive them via portfolio investments.

Adjustments for 2010

In 2010, the federal gross-up and dividend tax credit rates applying to dividends will both be adjusted downward. This is designed to keep the system in balance as corporate tax rates come down from 19% to 18% this year, to 16.5% in 2011 and 15% in 2012.

The gross-up figure will come down from 45% to 44% this year, to 41% next year, and will eventually reach 38% in 2012. This federal gross-up also applies when calculating provincial/territorial gross tax due, though somewhat indirectly in Quebec.

Concurrently, the federal dividend tax credit applying to the grossed-up dividend will fall from roughly 19% to about 18% this year, just under 16.5% next year, and will come to rest at just over 15% in 2012.

Each province and territory independently sets its own dividend tax credit to use in determining net provincial/territorial tax liability.

The net effect of the federal adjustments and provincial/territorial coordination is that the effective rate on dividends will increase in 2010, except in New Brunswick where the government is collapsing the number of brackets and reducing rates as part of an overhaul of the system leading up to 2012.

Legislative developments apart [DASH] which may very well be coming, given recent and prevailing economic events [DASH] the upward trend is expected to continue in all provinces and territories from 2010 through 2012.

Lower bracket taxpayers

The integration model is based on the shareholder being at the top marginal tax rate. Obviously, this is not always the case.

For taxpayers in lower tax brackets, the combination of the gross-up and tax credit generally results in an even lower effective rate on dividends. While it varies in different provinces and territories, the marginal tax rate for annual income of $60,000 is at or near 30%, whereas the effective rate on eligible dividends is at or below the single-digit threshold. As with all investments, a number of factors must be considered when assessing their suitability for individual clients. For example, potential clawbacks need to be considered for older investors. However, even with these recent changes, dividend-producing investments continue to warrant consideration and inclusion in a tax-informed investment portfolio.

Taxing Canadian dividends The continuing evolution

With the turn of the calendar to 2010, we also turned the page to the next chapter in the ongoing evolution of Canadian dividend taxation.

The year 2009 was the low-water mark for eligible dividend taxation, with all provinces and territories set to see increased effective rates as we move toward 2012.

Integration model recap

The tax integration model is a mechanism used to eliminate potential double taxation on income earned in a corporation, followed by a dividend distribution to a shareholder.

The dividend gross-up emulates the pre-tax value of the income to the corporation

The shareholder calculates tax owing based on the grossed-up dividend

The dividend tax credit is applied to reduce this preliminary tax liability by the estimated tax already paid by the corporation

Since 2006, Canadian dividends have been distinguished as “ineligible,” generated out of income where the small business corporate rate has been applied, and “eligible.” Though eligible dividends can also be generated out of small business corporations, most taxpayers would receive them via portfolio investments.

Adjustments for 2010

Beginning in 2010, both the federal gross-up and tax credit rates applying to eligible dividends will be adjusted downward:

Year 2009 2010 2011 2012

Gross-up 45% 44% 41% 38%

Tax credit* 19% 18% 16.5% 15%

* These percentages are approximate; Actual calculations use fractions

The federal gross-up also applies in calculating provincial/territorial gross tax due, though somewhat indirectly in Quebec. Each province and territory independently sets its own dividend tax credit to use in determining provincial/territorial tax liability.

Considerations for taxpayers below the top bracket

It is important to understand that the integration model is based on the shareholder being at top marginal tax rate, and that at lower income levels the effective rate on dividends is also lower. For example, at the $60,000 income level the average federal-provincial combined rate is at or near 30%, whereas the effective rate on eligible dividends is at or below the single-digit threshold.

While potential clawbacks have to be factored in, particularly for senior-aged investors, clearly dividend-producing investments continue to warrant consideration and inclusion in a tax-informed investment portfolio, even with these recent changes.