If you own shares in a Canadian corporation and earn dividend income, you may be eligible to receive the dividend tax credit. Qualifying dividend income eligible for the dividend tax credit, results in you paying less personal tax than you would on interest income or non-qualifying dividends paid out by foreign corporations.
The apparent rationale for this is that Canadian corporations have already paid taxes on the earnings they are distributing as dividends to shareholders. Thus, Revenue Canada passes on a tax break to those claiming the dividends on their personal tax returns, to adjust for the fact that the corporations have already been taxed on the income they are paying out to shareholders as a dividend.
What is a Dividend?
A dividend is a payment made to a corporation’s shareholders. The dividend usually represents a portion of the corporation’s earnings paid to all of it’s shareholders or a certain class of shareholder. For instance, some listed companies may have ‘Class A’ and ‘Class B’ stocks. These classes differentiate the voting rights of shareholders. Dividends may be payable on one class of stock and not another.
Dividends are usually paid quarterly in a cash payment to shareholders, although some companies pay dividends once (annually) or twice (semi-annually) per year. Sometimes companies may give out stock dividends through distributing additional shares, also known as stock splits.
What is the Dividend Tax Credit?
The dividend tax credit is a n non-refundable tax credit calculated based on Canadian dividends included in income. It is a non-refundable tax credit that is used to reduce your federal or provincial taxes. The tax credit does not generate a payment from the Canada Revenue Agency where no taxes are payable but where taxes are payable the tax credit can reduce your tax debt to zero and result in a refund of personal income taxes already paid.
The dividend tax credit may also be transferrable to your spouse or common-law partner, subject to certain conditions.
The dividend tax credit is not claimable on foreign dividends received and included in income.
The Dividend Tax Credit falls into two categories:
1. Eligible Dividend Tax Credit
This tax credit is for dividends paid out by Canadian public corporations, as well as by Canadian-controlled private corporations that are “subject to the general corporate tax rate.” These types of ‘eligible’ dividends receive a somewhat higher dividend tax credit than dividends considered to be ‘other than eligible’ – see #2 below.
2. Other Than Eligible Dividend Tax Credit
This tax credit is for dividends paid out by Canadian-controlled private corporations considered to be regular or small businesses, “to the extent that their business is subject to tax at the small business rate.” These types of ‘other than eligible’ dividends receive a dividend tax credit that is lower than dividends under the ‘eligible’ category, but more beneficial treatment over interest income or non-qualifying dividends paid out by foreign corporations.
Tax Tip: To take advantage of the lower tax rate due to the dividend tax credit, it may be advisable to hold dividend-paying Canadian corporations outside of your registered accounts. Your financial advisor should be consulted before making a decision either way on this.
Tax Treatment for Eligible and Other Than Eligible Dividends
Revenue Canada calculated the dividend tax credit for eligible and other than eligible dividends (2013) as follows:
1. Tax Treatment for Eligible Dividend Tax Credit (2013)
According to Revenue Canada, “Eligible dividends (generally those received from large corporations) are grossed-up by 38% and a federal dividend tax credit is calculated as 6/11 of the gross-up (or 15.0198% of the grossed-up dividends).”
2. Tax Treatment for Other Than Eligible Dividend Tax Credit (2013)
According to Revenue Canada, “Dividends other than eligible dividends are grossed-up by 25% and a federal dividend tax credit is calculated as 2/3 of the gross-up (or 13.3333% of the grossed-up dividends).”
Note: The Federal 2013 Budget indicated that the then-current dividend tax credit and gross-up factor overcompensated individuals for income taxes presumed to have been paid at the corporate tax level on active business income, notes TaxTips.ca. Therefore, for dividends paid in 2014 and later years, the gross-up factor is reduced from 25% to 18%, and the tax credit is revised from 2/3 of the gross-up amount to 13/18 of the gross-up amount. (Our thanks to Edmonton Alberta based Tax Consultant Hugh Neilson for providing us with this CRA link about the changes.)
In a 2011 article in The Globe and Mail titled Getting a grip on the dividend gross-up author John Heinzl begins with, “The gross-up and tax credit system is baffling to many investors …” He goes on to discuss how gross-up works and, close to the end of the article, points out “The gross-up and DTC system benefits the taxman as well. It ensures that, regardless of how the company distributes its profit, the government still collects roughly the same amount of tax.”
For more on gross-up check out John’s article by clicking here.
Additional information sources:
MoneySense – Delectable Dividends and Tax Savings by David Ashton