Dividend Gross-Up and Dividend Tax Credits – A Toronto Tax Lawyer Analysis
Tax Integration in Canada
A key concept in Canadian tax law is the idea of tax integration. Essentially, tax integration tries to achieve a similar total tax rate for a particular stream of income once it reaches the individual taxpayer level. What that means is that whether a particular income stream is earned directly by an individual as a sole proprietor or whether the income was earned by a corporation and then paid out to the individual as a salary or dividend, the ultimate aggregate tax rate on that income should be approximately the same. Where an individual earns the income directly, he simply pays tax at his personal marginal tax rate. Where a corporation earns the income and pays it to the individual as a salary, the corporation can deduct that salary as an expense, and thus pays no tax on that amount, and the individual again pays tax at his personal marginal tax rate. The situation becomes more complicated is when a corporation pays its shareholders with dividends. Dividends are paid from a corporation’s after tax profits, meaning that the corporation would have already paid corporate income tax on that income. If the individual receiving the dividend income then paid tax at his full marginal tax rate on that income, that income stream would be subject to double taxation. In order to alleviate this problem and achieve tax integration, the Canadian income tax system utilizes a dividend gross-up and a dividend tax credit mechanism that takes into account the corporate tax that has already been paid. This is accomplished by reducing the amount of tax the individual pays on that dividend such that the total taxes paid would be roughly the same as if that dividend had instead been earned directly or as a salary.
The Dividend Gross-Up
The function of the dividend gross-up and related dividend tax credit is to account for the portion of tax that a corporation has already paid on a stream of income before the dividend is paid. The basic federal tax rate for corporations in Canada is 38%, but after the federal tax abatement of 10% and general tax reduction of 13%, it is reduced to 15%; furthermore, for Canadian-Controlled Private Corporations (CCPCs) earning active business income, the small business deduction is also available, which lowers the federal corporate tax rate to 10% as of 2018.
The federal tax abatement applies where the corporation pays provincial tax and essentially provides room for each province to set their corporate tax rate. Each province has its own tax rates for CCPCs and non-CCPCs, with Ontario’s combined federal and provincial tax rate for CCPCs being 13.5% and 26.5% for non-CCPCS. In order to reconcile the difference in tax paid at the corporate level, dividends are differentiated into eligible and non-eligible dividends. Eligible dividends are those issued by non-CCPCs and are taxed at a lower rate than non-eligible dividends which are issued by CCPCs. This is specifically achieved by having a different dividend gross-up rate and a different dividend tax credit rate for eligible and non-eligible dividends.
The dividend gross-up functions by approximating the amount of income a corporation would have had to have earned in order to issue a particular dividend. For example, if an individual receives a dividend of $100 from a non-CCPC – that $100 would have already been subjected to the basic federal corporate tax of 38%.Thus, the base amount of income that needed to be earned in order to issue a $100 dividend would have been $138 and so the dividend gross-up for eligible dividends is 38%. Accordingly, the individual who received the $100 dividend would then need to report $138 on his tax return for that year (the dividend plus the gross-up). For an individual who receives a non-eligible dividend from a CCPC, the corresponding amount of dividend gross-up would be 16% in 2018, so an individual receiving a $100 non-eligible dividend would then report $116 of income on his tax return for that year.
|Amount Included in Income||$138||$116|
The Dividend Tax Credit
However, to account for the tax that the corporation issuing the dividend has already paid, the individual receiving the dividend is then entitled to both a federal and provincial dividend tax credit. The federal dividend tax credit for an eligible dividend is 15.02% of the grossed up dividend and the Ontario dividend tax credit for an eligible dividend is 10% of the grossed up dividend both of which would negate that amount of tax owing from the individual after their final tax owed for the year is calculated. For a $100 dividend received with a grossed-up value of $138, the combined federal/Ontario dividend tax credit would be $34.53. The top combined federal/Ontario marginal tax rate for individuals is 53.53% for those earning over $220,000 per annum, which means an individual in that bracket who earns $100 of eligible dividends would owe $73.87 (53.53% of $138), but with the dividend tax credit taken into account, would only owe $39.34. Effectively, the individual would have only paid a 39.34% tax rate on the $100 dividend.
Because the dividend gross-up is 38% regardless of the actual tax rate of the corporation (which varies due to the different provincial corporate tax rates), tax integration will be imperfect. In order to issue a $100 dividend in Ontario, an Ontario non-CCPC would have had to earn $136.05 before tax (26.5% tax on $136.05 is $36.05; $136.05-$36.05=$100). As such, the corporation would have paid $36.05 in tax and the individual would have paid $39.34 in tax for a total of $75.39, which is an effective tax rate of 55.54% – a rate slightly higher, but almost equivalent to the top marginal personal tax rate in Ontario of 53.53%.
The federal dividend tax credit for a non-eligible dividend is 10.03% and the Ontario dividend tax credit for a non-eligible dividend is 3.12%. As such, an individual would receive a combined federal/Ontario dividend tax credit of $15.25 on a $100 non-eligible dividend. Going through the same exercise as above, this would mean that an individual at the top marginal tax rate in Ontario would have taxes owing of $62.09 on the $100 non-eligible dividend, but accounting for the $15.25 dividend tax credit, would need to pay $46.84, an effective tax rate of 46.84%. When considering the combined amount of tax actually paid on the income stream that resulted in the $100 non-eligible dividend, $115.61 would need to be earned by a CCPC in Ontario in order to issue a $100 dividend, resulting in $15.61 of corporate tax and $47.84 of personal tax for a combined total of $63.45 of tax paid on $115.61 of income, or an effective tax rate of 54.70% – a rate slightly higher than the top marginal personal tax rate in Ontario and slightly lower than the effective rate of tax on eligible dividends, but again roughly equivalent to both. Our top Toronto tax firm can help individuals and corporations structure their affairs in the most efficient way possible.
|Grossed-Up Dividend (%)||$138 (38%)||$116 (16%)|
|Top Personal Marginal Tax Rate||53.53%||53.53%|
|Tax Owed on Dividend||$73.87||$62.09|
|Combined Federal/Ontario Dividend Tax Credit (%)||$34.53 (25.02%)||$15.25 (13.15%)|
|Final Tax Owing||$39.34||$46.84|
|Effective Tax Rate on Dividend||39.34%||46.84%|
|Combined Corporate/Personal Total Tax Rate||55.54%||54.7%|
Tax Tip – Tax Free Dividends for Income Below $42,000
Due to the way the dividend tax credit functions, individuals who have lower marginal tax rates receive a comparatively bigger benefit from earning income through dividends than individuals with higher marginal tax rates from corporations that they do not control. To illustrate this, consider an individual in Ontario who earns $42,202 and has a combined federal/Ontario marginal tax rate of 24.15%. That individual receives a $100 eligible dividend. The dividend is grossed-up as above and the dividend tax credit that he receives is similarly $34.53. The individual similarly calculates the amount of tax he would owe based on his marginal tax rate of 24.15% on the grossed up amount of $138 which results in taxes owed of $33.33. After accounting for the dividend tax credit, the government actually owes that individual $1.20 which, while non-refundable, can be credited against the tax he owes for the other income that he earned. On the other hand, in the earlier example, an individual with a top marginal combined tax rate earning a $100 eligible dividend would pay 39.34%. As such, the individual with the 24.15% marginal tax rate has a 24.96% lower tax rate on an eligible dividend than his regular income while the individual with the top marginal tax rate of 53.53% has only a 14.19% lower tax rate on eligible dividends than on his regular income. For non-eligible dividends, the tax free cut off is much lower, at only $10,354, so this type of planning may not be as beneficial. This is only relevant where the individual receiving the dividend does not own the corporation and is indifferent to the amount of tax the corporation itself paid, as integration ensures that the combined tax rate of the corporation and the individual is similar to the individual’s personal tax rate. Speak to one of our experienced Toronto tax lawyers and optimize the way you receive your income.
Published by: Jamin Chen
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."