Dividend Types under the Canadian Income Tax Act – A Toronto Tax Lawyer Analysis
Introduction – Dividend Types under the Canadian Income Tax Act
The most common type of dividend of which one might be aware is the standard cash dividend – a payment of cash from a corporation to its shareholders. However, a dividend does not have to be in the form of cash and can take the form of any type of value transfer from a corporation to its shareholders if it is declared as a dividend by the directors of the corporation. These non cash dividends are called dividends in kind and for example, a dividend may be in the form of additional stock, specific property, or notes payable. Additionally, regardless of the form the dividend takes, a dividend can be either an eligible or non-eligible dividend, which essentially affects the tax rate the individual will pay on those dividends. Finally, where a corporation has realized capital gains, life insurance policy proceeds, or capital dividends from another corporation, a type of non-taxable dividend, called a capital dividend, can be issued.
Eligible Dividends vs. Non-Eligible Dividends
An important concept in Canadian tax law is the idea of tax integration. In a general sense, integration is the idea that the ultimate income tax rate of a particular stream of income once it reaches the hands of the individual should be approximately the same tax rate regardless of how he decides to organize his affairs. More concretely, that means the total income tax on a particular stream of income will be the same regardless of whether it was earned directly by an individual, or earned in a corporation and then paid out to that individual as a salary or as a dividend. Where an individual earns income directly, the tax will simply be at the individual’s marginal tax rate and where a corporation earns the income and pays it to the individual as a salary, the corporation can deduct the salary as an expense, and thus pays no tax on that amount, and the individual again pays at his personal marginal rate.
However, dividends (except for dividends from the Capital Dividend Account) are paid from a corporation’s after tax profits, meaning that the corporation would have already paid corporate income tax on that income. So, if the individual then paid his full marginal tax rate on the dividend he receives, that stream of income would have been subjected to both the corporate tax as well as individual tax and thus have been subjected to double taxation. In order to achieve tax integration, the Canadian income tax system employs a dividend gross-up and a dividend tax credit mechanism which essentially results in the individual paying a lower amount of tax on a dividend he receives in order to account for the tax that the corporation has already paid.
This is complicated by the fact that corporations in Canada pay different tax rates depending on whether they qualify for the small business deduction or manufacturing and processing deduction, and so the dividend gross-up and dividend tax credit have to be adjusted to account for the particular tax rate of the dividend issuing corporation. As such, corporations that do not qualify for the small business deduction would have paid the higher corporate tax rate and thus, the dividends that they declare can be subject to more favourable tax treatment to the individuals receiving the dividend, subject to some conditions discussed below, and are referred to as eligible dividends. On the other hand, dividends issued by Canadian Controlled Private Corporations (CCPCs) that receive the small business deduction are referred to as non-eligible dividends and individuals who receive these dividends are subject to less favourable tax treatment than individuals receiving eligible dividends. One caveat is that a CCPC might hold shares of a non-CCPC and receive eligible dividends from that non-CCPC, so those amounts are tracked in a special account called the General Rate Income Pool, or GRIP, and the CCPC can then pay out eligible dividends to its shareholders up to the amount of GRIP that it has.
On the flip side, a non-CCPC can also have shares and receive ineligible dividends from a CCPC – those amounts are tracked in another special account called the Low-Rate Income Pool, or LRIP, and the non-CCPC is restricted from issuing any eligible dividends while it has a positive LRIP balance. In order to reduce its LRIP balance, a non-CCPC must pay out ineligible dividends and once the LRIP balance is eliminated, then the non-CCPC may once again issue eligible dividends. While the details of how this is all calculated is complicated, the gist of it is that CCPCs pay a reduced rate of tax relative to non-CCPCs on the active business income that they earn. But when their profits are distributed to their shareholders as non-eligible dividends, the shareholders pay personal income tax on those dividends at a rate higher than for eligible dividends, but lower than if it was a salary. However the aggregate total tax paid by the corporation and the individual who receives the dividend is approximately the same as seen by the chart below for an individual paying tax at the top marginal tax rate in Ontario. Call our top Toronto tax law firm to learn more about the tax treatment of dividends.
|Corporate Tax Rate||Personal Tax Rate||Combined Tax Rate|
Forms of Dividends
Additionally, the form of a dividend can vary widely. A dividend in its most basic form is simply a transfer of value from a corporation to its shareholders pursuant to a dividend declaration from the directors of the corporation. This transfer may be in the form of cash, but may also be a dividend in kind in the form of stock, property, or notes payable. A stock dividend is an issuance by a corporation of its stock to its shareholders. For stock dividends, the value of the dividend is calculated by the fair market value of the stock. For example, if an individual is issued a dividend of 1000 common shares of the corporation which are each worth a fair market value of $50, then the individual would have received a dividend worth $50,000 and the ultimate tax liability stemming from that dividend would depend on whether it was eligible or non-eligible as well as the individual’s marginal tax rate. A property dividend is a non-cash dividend, which technically includes stock dividends, but is more typically used to refer to distributions of equipment, inventory, or real estate, but also things like artwork or jewellery. For the individual, the value of the dividend is similarly calculated as the fair market value, but for the corporation, the distribution of property will be a disposition and thus trigger a taxable event. As such, the corporation will realize a gain or loss on the disposed property calculated as the current fair market value of the property minus the corporation’s adjusted cost basis in the property. Where a loss is being realized, this may prove to be an advantage to the corporation if the corporation is highly profitable, as the loss can be used to offset the corporation’s other gains or income. Dividends may even come in the form of notes payable which is a promise by the corporation to pay the shareholder at a later date – a type of debt. The note payable may accrue interest or not depending on the particulars, but this type of dividend can be useful in various types of corporate planning and corporate reorganizations. However, it is important to keep in mind that the note payable is considered income to the individual who receives it and that individual must include the value of the note payable in his Canadian income tax return for that year.
Regardless of the type of corporation or the form of the dividend, corporations can issue tax-free capital dividends so long as they have a sufficient capital dividend account balance. The capital dividend account stems from capital gains realized by the corporation as well as other non-taxable amounts earned by the corporation such as the proceeds from life insurance and capital dividends issued to the corporation from another corporation. Under Canadian Income Tax law, only half of a capital gain is taxable, while the other half is non-taxable and this applies to both corporations and individuals. As such, for capital gains, corporations only pay tax on the taxable half of the capital gain. However, as discussed earlier, the tax integration considers the combined taxation of a particular stream of income both when it is earned in a corporation and when it is later flowed out into individual taxpayers. Thus, the non-taxable half of the capital gain should still be non-taxable when it is flowed out to the corporation’s shareholders. This is achieved by recording the non-taxable portion in the corporation’s capital dividend account and allowing the corporation to issue non-taxable capital dividends to its shareholders.
Tax Tip – Dividend Types
While tax integration generally achieves its goal of taxing income equally regardless of how it reaches an individual, that does not mean there is no room for tax planning and optimization. Corporations pay lower tax rates than individuals and can be a great way to defer taxes on active income. Furthermore, careful planning as to how and when to issue dividends can ultimately reduce the amount of tax an individual pays. Our experienced Toronto tax lawyers can help business owners structure their business and their compensation to reach the best tax results – speak to one of our top Canadian tax lawyers and learn how we can help.
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."