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By: Abhi Deshpande



 

Dividends are an important part of investment strategy and become a common component of retirement income. They are also especially relevant for many professionals that own or are part of professional corporations such as lawyers, doctors, engineers, etc. Dividends also play a key role for investors that fund small businesses.


However, the way dividends are taxed and the associated tax credit calculation is quite convoluted and onerous. If you are trying to compare the numbers that show up on your tax return with the dividends you actually received, it can become a challenging task.


The reason for this is that in Canada, dividends received are initially grossed up (increased) by a CRA prescribed percentage. Income tax is then calculated on this grossed up amount. Once that is calculated, a tax credit is computed to derive the net taxes to be paid on the dividends. To arrive at the total net tax due there are various areas in the T1 where calculations are performed (luckily almost all of this is done by tax software these days). Let’s try to understand the calculation and the reason for complexity..


The Dividend Gross-Up Percentage is based on Eligible vs Ineligible Dividends


When you receive a dividend, the corporation paying it will share information about the dividend with you. If it's a large public corporation you will likely get a T-slip (ex: T3, T5, etc). If you receive a dividend from a small private corporation you will get some form of communication either via a letter or an email to provide additional information. Either way, one of the items communicated to you will be whether the dividend is an “Eligible” or an “Other Than Eligible” dividend (“ineligible”). This is an important distinction because your gross-up percentage and tax credit percentage are based on this distinction. Before we get into the percentages and tax calculation, it is important to discuss the difference between Eligible and Ineligible Dividends. Note, if you don’t need to understand the distinction, you can simply skip down to the T1 Dividend Tax Calculation below.


Eligible vs Ineligible Dividends


Whether a dividend is Eligible or not depends on the type of corporation that is making the payment. Please refer to the Appendix at the bottom to see more details on the types of Corporations that are common in Canada (non-CCPC Private Corporations, CCPCs and Public Corporations).


According to the Canadian Master Tax Guide (2021) paragraph 6050: A non-CCPC Private Corporation can pay Eligible dividends in any amount unless it has some retained earnings on hand for which a Small Business Deduction (SBD) was claimed. Please see the definition of the SBD in the appendix at the end. Since a non-CCPC Private Corporation cannot claim the SBD this will be quite rare. One such instance can be if a Private Corporation was a CCPC before changing to a non-CCPC Private Corporation and during that time it took advantage of the SBD. But again, this will be uncommon.


A CCPC on the other hand can benefit from the Small Business Deduction (SBD) available in Canada for its income up to $500,000. This is a tremendous tax benefit and most CCPCs take advantage of it. Therefore, a CCPC can only pay Eligible dividends on the part of retained earnings that have not benefited from the SBD (i.e. the income above $500,000). Needless to say that this is a complex calculation but should typically be uncommon for small corporations and small professional corporations which make up most of the CCPCs.


Public Corporations cannot take the SBD tax deduction and therefore will always pay Eligible dividends.


In general, depending on the circumstances and income of CCPCs, dividends from a CCPC typically would be Other Than Eligible Dividends (ineligible) and dividends from Non-CCPC and Public Corporations will be Eligible.



T1 Dividend Tax Calculation


Now that we have defined the differences between Eligible and Other than Eligible (Ineligible) dividends, let's discuss how taxable dividends and the associated tax credit are calculated on the tax return.


The total Taxable Eligible dividends are initially grossed-up (increased) by 138% before the tax is calculated for them. Then a tax credit is subsequently calculated at 15.0198% of the grossed-up Eligible dividends. The net of these two numbers is the actual tax that is paid. [Note that the tax rates are subject to change by the CRA].


Similarly, the Ineligible dividends are grossed up by 115% prior to the tax calculation. Then a tax credit is calculated at 9.0301% of the grossed-up Ineligible dividends. The net of these two numbers is the actual tax that is paid.


For example, let’s assume that you are in the 33% tax bracket. If you received $10,000 of Taxable Eligible dividends and the same amount of Taxable Other than Eligible dividends your Total Taxable dividend amounts would be calculated as follows:



Example of Federal Tax Calculation of Eligible and Other Than Eligible Dividends in Canada
Example of Federal Tax Calculation of Eligible and Other Than Eligible Dividends in Canada


Notice how the calculated Taxable Dividends are much higher than what you actually received (i.e. $10,000 of each type). This results from the gross-up that we discussed above. Your tax rate, in this case assumed to be 33% is applied to this increased dividend amount. However, the good thing is that the grossed-up dividend amount is also then used to calculate the associated Dividend Credit. Once again, the Dividend Credit percentages are also fixed by the CRA and are subject to change for a particular tax year.


Once the Dividend Credit is calculated, it is deducted from the dividend Taxes Calculated to arrive at the Net Tax to be Paid.


One key point to note as a useful tax planning tool is that the net tax rate on the Eligible dividends is approx 8% lower than the tax on the rest of your income which was 33%. Similarly the net tax rate on Ineligible dividends is lower by about 5%. This benefit will almost always be the case. The dividends you receive will be taxed at a lower percentage than your ordinary income. The theory behind this is that the difference has been taxed to the net income of the Corporation, which issued the dividends.


As you can see, for the purposes of personal investment planning, dividends can be a great way to receive income in a beneficial manner. During retirement, when your income is traditionally lower, getting even a lower tax on your dividends can be very meaningful. If you are a professional with ownership in a CCPC or a Private Corporation then dividends can be a great tool to help defer your taxes and/or plan timely withdrawals of funds from the corporation. The tax calculation and eligibility of the dividends can be complicated, however, they are certainly a very beneficial investment planning tool.



 

APPENDIX - DEFINITIONS:



CORPORATIONS


[Source:https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/corporations/type-corporation.html]


Public Corporation

The corporation is a public corporation if it meets all of the following requirements at the end of the tax year:


  • it is resident in Canada and either:

  • it has a class of shares listed on a designated Canadian stock exchange or

  • it has elected, or the minister of National Revenue has designated it, to be a public corporation and the corporation has complied with prescribed conditions under Regulation 4800(1) of the Income Tax Regulations on the number of its shareholders, the dispersing of the ownership of its shares, the public trading of its shares, and the size of the corporation

    • If a public corporation has complied with certain prescribed conditions under Regulation 4800(2), it can elect, or the minister of National Revenue can designate it, not to be a public corporation.


Private Corporation

The corporation is an private corporation if it meets all of the following requirements at the end of the tax year:


  • it is resident in Canada

  • it is not a public corporation [see above]

  • it is not controlled by one or more public corporations (other than a prescribed venture capital corporation, as defined in Regulation 6700 of the Income Tax Regulations)

  • it is not controlled by one or more prescribed federal Crown corporations (as defined in Regulation 7100)

  • it is not controlled by any combination of corporations described in the two previous conditions


Canadian-Controlled Private Corporation (CCPC)

The corporation is a CCPC if it meets all of the following requirements at the end of the tax year:


  • it is a private corporation [see above]

  • it is a corporation that was resident in Canada and was either incorporated in Canada or resident in Canada from June 18, 1971, to the end of the tax year

  • it is not controlled directly or indirectly by one or more non-resident persons

  • it is not controlled directly or indirectly by one or more public corporations (other than a prescribed venture capital corporation, as defined in Regulation 6700 of the Income Tax Regulations)

  • it is not controlled by a Canadian resident corporation that lists its shares on a designated stock exchange outside of Canada

  • it is not controlled directly or indirectly by any combination of persons described in the three previous conditions

  • no class of its shares of capital stock is listed on a designated stock exchange


SMALL BUSINESS DEDUCTION (SBD)


[Source:https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/budget-2018-equality-growth-strong-middle-class/passive-investment-income/small-business-deduction-rules.html]


  • The SBD reduces the corporate income tax for Canadian-controlled private corporations (CCPC).

  • A corporation’s SBD for a taxation year is generally calculated by multiplying its SBD rate (19%) by the lesser of its:

  • income for the year from an active business carried on in Canada (gross revenue) or

  • taxable income for the year or

  • business limit for the year.

    • A CCPC’s business limit for a taxation year is $500,000, prorated for the number of days in the year.


FEDERAL TAX ABATEMENT (FTA)


  • The federal tax abatement is equal to 10% of taxable income earned in the year in a Canadian province or territory.

  • The federal tax abatement reduces Part I tax payable. Income earned outside Canada is not eligible for the federal tax abatement.


 

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