Every year at tax time we have to "gross-up" our dividends and then apply the dividend tax credit (DTC) to figure out how much tax we owe. Why does Canada Revenue Agency make us perform these gymnastics? Also, is it my imagination or are tax rates on dividends climbing? - M.H.
It's not your imagination. Tax rates on dividends have indeed been creeping higher, and will continue to rise through 2012. To understand why, we need to answer the first part of your question.
The gross-up and tax credit system is baffling to many investors, but there's a good reason for it: It gives you "credit" for the tax the corporation is presumed to have already paid. Even if your broker and accountant do the calculations for you, it's worth knowing how the system works.
Let's look at a simple example. We'll restrict our discussion to "eligible" dividends that are paid by public Canadian corporations and which qualify for the "enhanced" dividend tax credit when held in a non-registered account. The following numbers are hypothetical and for illustrative purposes only.
Suppose XYZ Corp. makes a profit, before tax, of $100. Assuming a corporate tax rate of 30 per cent, the company would pay $30 to the taxman, leaving it with $70 after tax. The key thing to remember here is that the company has already paid $30 in tax.
Now suppose XYZ decides to pay out the remaining $70 as a dividend to an investor who's in a 40-per-cent tax bracket. If the investor paid tax at her full marginal rate on the dividend, she'd have to fork over $28 to the government. The combined tax hit on that $100 in pretax profit would therefore be $58 ($30 in corporate tax plus $28 in personal tax).
That wouldn't be fair, would it? Fortunately, the government isn't that greedy.
Enter the gross-up and tax credit system. Essentially, what the gross-up does is convert the actual amount of the dividend received – $70 in this case – into an amount that approximates the corporation's pretax earnings. The current gross-up rate is 1.44. Multiply 1.44 by $70 and you get $100.80, which is roughly what the company earned pretax.
Now that we've grossed-up the dividend – c'mon, you have to admit that was fun – we need to perform two more steps: 1) Calculate how much tax the investor would theoretically pay on this grossed-up amount and; 2) Subtract the dividend tax credit to reflect the tax the corporation has already paid. The net result is what the investor would actually pay in tax.
The first step is easy. At a 40-per-cent personal income tax rate, the investor would owe $40.32 in tax on the grossed-up dividend of $100.80.
The second step is a bit more complicated. Each province has its own DTC rate, on top of the federal government's DTC rate of 18 per cent for 2010 (or 17.9739 per cent if you want to be really, really exact). To keep things simple, we'll assume the investor lives in a province where the combined provincial and federal DTC is 30 per cent.
To figure out the amount of the credit, multiply the DTC rate of 30 per cent by the grossed-up dividend of $100.80, and you get $30.24.
Now – almost done! – subtract the credit of $30.24 from the tax of $40.32 on the grossed-up dividend, and you get $10.08, which is the actual amount of tax the investor will pay on the $70 dividend. The investor's effective tax rate on the dividend is therefore just 14.4 per cent ($10.08 divided by $70), which is a lot lower than her marginal tax rate of 40 per cent on other income.
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.
Notice that, in our example, the government collected a total of $40.08 in tax ($30 in corporate tax plus $10.08 in personal tax). Now imagine that, instead of receiving a dividend, the shareholder worked for the company and received the $100 as salary. Because it's employment income, she would have to pay tax at her marginal rate of 40 per cent – or $40 – which is virtually identical to what the government collected in the first scenario.
"It all goes back to what's called tax integration, meaning the method that you earn income, whether individually as a sole proprietor or through a corporation, should be indifferent [for tax purposes]" says Camillo Lento, a chartered accountant and lecturer in accounting at Lakehead University.
The good news is that the DTC slashes the investor's tax bill. The bad news is that tax rates on dividends are rising. Why? It's all because of a reduction in corporate tax rates, which are causing the gross-up and DTC rates to fall in a way that's not beneficial for investors.
For example, an Ontario resident with employment income of $80,000 will pay about 16.5-per-cent tax on eligible dividends in 2010, rising to 19.9 per cent by 2012. The same person living in British Columbia will see the tax rate on dividends rise to 10.6 per cent from 5.3 per cent (To see how dividend tax rates are changing in your province and income bracket, visit taxtips.ca)
In effect, what's happening is that, as corporate tax rates fall, investors are being asked to make up some of the difference by paying more tax.
Even with the increased tax rates, however, dividends are "still a good deal, tax-wise," says Dorothy Kelt, co-owner of TaxTips.ca. "We still recommend Canadian dividends."
John Heinzl