Insights From ETFs Dividend Tax Credit for Eligible Dividends
Under Canadian income tax, the dividend tax credit is an important feature allowing eligible Canadian taxpayers to reduce tax liabilities on eligible corporate dividends, including both federal and provincial tax liabilities. In this article, we examine the concept of dividend tax credit in Canada, its purpose, eligibility requirements, and tax implications.
What is the Dividend Tax Credit?
A dividend tax credit is a way for Canadian taxpayers to reduce the amount of taxes owed on eligible dividends received from Canadian corporations. (Dividends received from foreign corporations do not qualify.) Dividends are considered income and are fully taxed at the marginal tax rate. In contrast, capital gains are taxed at only 50% of the value of the gain.
The dividend tax credit is non-refundable and reduces the amount of taxes owed.
Dividends paid out by corporations are paid after the corporation has ìpaidî corporate taxes. The dividend tax credit was created to avoid the double taxation of corporate earnings that otherwise takes place at both the corporate level and individual levels. The full value of the distributed dividends is included as income. To compensate for the corporate taxes, 138% of the dividend amount is included in income. The additional 38% is the ìgross-upî, representing the amount of corporate taxes paid on the dividends. The dividend tax credit is calculated on the grossed-up amount.
Eligibility for Dividend Tax Credit
Not all dividends from Canadian corporations are eligible for dividend tax credits. Some exclusions include unit distributions, and capital gains dividends. Dividends paid by foreign corporations do not qualify. Canadian corporations must be designated by Canada Revenue Agency for their dividends to qualify for the dividend tax credit. Generally, public corporations that do not receive the small business deduction and pay corporate tax at higher rates than small businesses are eligible.
The dividend tax credit is included to reflect the higher rate of corporate taxes paid, so the individual receiving the dividend pays less. A corporation can designate a portion of a taxable dividend or the whole amount to be an eligible dividend. Similar requirements exist for private corporations paying dividends.
On an individual basis, the taxpayer must be a resident of Canada at the time of receiving the eligible dividends. Non-residents are not eligible for the dividend tax credit.
Tax Implications of the Dividend Tax Credit
Corporations who have paid out dividends will issue a T5-Statement of Income, which is indicate whether the dividends are eligible or ineligible for the dividend tax credit, as well as the value of the dividends paid. An investor could also receive A T3-Statement of Trust Income Allocations and Designations, or a T5013-Statement of Partnership Income.
The dividend tax credit reduces the amount of tax a taxpayer owes on eligible dividends from Canadian corporations. The calculated tax credit depends on the grossed-up dividend amount (138% of the dividend paid.)
The grossed-up dividend amount is the actual dividend amount received by the taxpayer multiplied by a factor that represents the amount of corporate tax paid on the earnings that generated the dividend. The federal dividend tax credit as a percentage of taxable dividend is 15.0198% for eligible dividends. The provincial dividend tax credit rates vary by province but generally range between 4% and 10%. In total, the total dividend tax credit rate for eligible dividends in Canada range from 19% to 25%.
Include the dividend amount on line 12000 of the T1-General Income Tax Return and claim the dividend tax credit on line 40425 and complete form 428 to claim the applicable provincial portion.
Let’s look at an example. Suppose a Canadian resident receives $1,000 in eligible dividends from a Canadian corporation. The grossed-up rate for eligible dividends is 38%, and for non-eligible dividends is 15%. So, the $1,000 eligible dividend has a gross-up value of $1,000 x 1.38 = $1,380.
Without Dividend Tax Credit
Assuming no dividend tax credit, for a federal and provincial combined tax rate of 20.05%, the tax on $1,000 in cash dividend after gross-up would be $1,380 x 20.05% = $276.69.
With Dividend Tax Credit
The federal tax credit = $1,380 x 15.0198% = $207.27
In Ontario, for example, the provincial tax credit of 10% means = $1,380 x 10% = $138.
Total tax credit = $207.27 + $138 = $345.27
Tax after credit = $276.69 - $345.27 = -$68.58
Yep, that’s right, negative tax. The lowest two tax brackets in Ontario offer a negative tax rate on eligible dividends.
The negative tax rate is beneficial when there is other income, and the negative is used to negate income taxes. The tax credit is non-refundable, so if there is no other income, you may lose some or all of the dividend tax credit. So, in a way, eligible dividends can also help lower income tax, benefiting those in retirement as well.
Benefits of the Dividend Tax Credit
There are several benefits of the dividend tax credit.
1 A dividend tax credit creates an incentive for investors to invest in Canadian corporations that pay eligible dividends. This, in turn, helps Canadian companies to raise capital and invest in their growth, which in the long run helps the economy,
2 The dividend tax credit reduces some tax burden on Canadian taxpayers that receive these eligible dividends, particularly those relying on these as a source of income. The dividend tax credit can also be more generous than the tax credit for other types of investment income, such as interest income and capital gains.
3 The tax break also helps prevent double taxation of corporate earnings. Without the dividend tax credit, Canadian companies are subject to taxation on their earnings at the corporate level, and individual taxpayers who receive dividends from those corporations would be subject to taxation on the same earnings at the individual level. This can result in a significant tax burden for both the companies and their shareholders,
4 Lastly, the dividend tax credit also helps investors minimize their tax payments while maximizing returns. By understanding the tax implications of investing in Canadian companies with eligible dividends, taxpayers can make informed investment decisions, manage their tax liabilities, and plan their investments. The tax credit can also be used to reduce overall income taxes paid by using the negative credits to reduce other income.
In conclusion, the dividend tax credit is an attractive and essential feature of the Canadian tax system providing a tax incentive for Canadians to invest in Canadian corporations and receive eligible dividends. The tax credit reduces the tax burden on taxpayers and helps prevent double taxation. The gross-up is done to turn your dividend income into pre-tax income, as the corporation has already paid taxes on it, and then you receive a tax credit to make it fair overall. Overall, the dividend tax credit is a valuable feature of our tax system that benefits Canadian taxpayers and the economy.
Barkha Rani, CFA, 5i Research Inc.
Disclosure: Authors, directors, partners and/or officers of 5i Research have a financial or other interest in XIT and ZRE.