Eligible Dividends And The TFSA
Many equity investors follow a rule of purchasing common shares that pay dividends. Dividends provide investors with monthly or quarterly cash flow to help meet their income needs or to reinvest for future growth. Eligible dividends generally have favourable tax treatment over employment or interest income; however, many individuals continue to shelter dividends from tax through a Tax Free Savings Account (TFSA). This article explores two implications of receiving eligible dividends in a TFSA.
Eligible Dividends
The Canada Revenue Agency (CRA) defines an eligible dividend: “An eligible dividend is any taxable dividend paid to a resident of Canada by a Canadian corporation that is designated by that corporation to be an eligible dividend.” (For more information, visit the CRA’s website: http://www.cra-arc.gc.ca/eligibledividends/)
Taxation Of Dividends
The tax treatment of eligible dividends attempts to mitigate the impact of double taxation. Specifically, eligible dividends are paid out of after-tax corporate income. Therefore, simply applying an individual’s marginal tax rate to their eligible dividends received will result in double taxation (tax at the corporate level and individual level).
A gross-up and dividend tax credit mechanism is used in order to mitigate the issue of double taxation and to achieve integration. First, eligible dividends received by an individual are grossed-up by 38%. Second, a federal tax credit of 20.73% of the actual dividend is received (in addition to a provincial tax credit which varies by province). Third, tax is paid on the grossed-up dividend at an individual’s marginal tax rate.
The dividend gross-up is an attempt to convert the dividend received to its pre-corporate tax amounts, while the dividend tax credit is an attempt to provide an individual with the taxes paid at the corporate level. For example, assume ABC Corp earns $100 in pre-tax income and pays combined federal and provincial corporate taxes at a rate of 27.5%. ABC Corp will have $72.50 in after-tax income to distribute in the form of a dividend. Assume that the entire $72.50 is paid to ABC Corp’s sole shareholder in the form of an eligible dividend. The shareholder will receive an eligible dividend of $72.50, which will be grossed up by 38% to $100, receive a federal dividend tax credit of $15.03 and a provincial tax credit of $12.46, and pay tax on the grossed-up dividend at his/her marginal tax rate. The combined federal and provincial tax credits will approximately equal the corporate taxes paid ($15.03 + $12.46 = $27.49).
Dividends Received By Individuals In Low Income Tax Brackets
The dividend gross-up and tax credit mechanism results in some important implications for TFSA holders. The first implication is for lower income individuals. It is possible for lower income individuals to actually receive a tax refund on eligible dividends received. For example, in Ontario, individuals earning $44,701 or less in 2015 will have a negative marginal tax rate on eligible dividends received1.
Dividends received in a TFSA are not subject to tax. However, individuals in tax brackets that result in negative marginal tax rates on eligible dividends will not receive any refund either. Therefore, individuals in this situation should consider whether there are any other benefits to holding dividend-paying stocks in a TFSA that will offset the tax benefits of holding these stocks outside of the TFSA (e.g., a benefit could be the tax exemption on any capital gains earned on the dividend-paying stock).
Dividends Received By Individuals In High Income Tax Brackets
One of the more contentious areas of the dividend gross-up and tax credit mechanism is its impact on the Old Age Security (OAS) pension recovery tax (“OAS clawback”). Individuals earning $72,809 or more in 2015 will be subject to an OAS clawback of 15% for every dollar earned in excess of the $72,809 threshold. The entire OAS benefit will be clawed back once an individual earns $117,954.
The OAS clawback calculation uses the grossed-up dividend amount in the calculation as opposed to the actual dividend received. Accordingly, an individual who receives a $100 eligible dividend will be subject to a clawback based on the $130 grossed-up dividend. That is, an individual will have $19.50 (15% of $130) of their OAS clawed back as opposed to $15 (15% of $100).
Individuals can use a TFSA in order to avoid the gross-up impact on the OAS clawback. Specifically, if an individual earns a $100 eligible dividend in a TFSA, that amount can be withdrawn without having any impact on the OAS clawback. Unlike a Registered Retirement Savings Plan (RRSP), withdrawals from the TFSA are not taxable and will not impact the OAS clawback calculation.
Conclusion
Overall, barring any other offsetting benefits, this article suggests that individuals in lower income tax brackets should consider holding dividend-paying stocks outside of a TFSA while higher income earners receiving OAS payments should consider holding dividend-paying stocks inside the TFSA. Of course, there are also other factors that could impact your decision to invest dividend-paying stocks in a TFSA and each individual should assess their own unique situation. For more detailed information on all the rules discussed in this article, please contact a professional tax advisor and/or visit the Canada Revenue Agency’s webpage.
Camillo Lento, PhD, CPA, CA, CFE, Faculty of Business Administration, Lakehead University, Thunder Bay, ON (807) 343-8387, clento@lakeheadu.ca
1 For illustration only. This assumes that the only tax credits available are the basic personal amount and dividend tax credit. The impact of dependent children, the age credit, spouse or common law partner income levels, etc. can impact this threshold.