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How does the negative tax on dividends work?

Globe and Mail reporter John Heinzl.

In your recent video touting "Five reasons to love dividends" the table indicated that an Ontario resident with an income of less than $42,201 would have a negative tax rate of 6.86 per cent on eligible dividends. I make less than $42,000 and I am wondering what this means for me. If I buy dividend shares (in my TFSA, for instance), will I get about 7 per cent additionally from the government? Does it work for dividend ETFs as well?

First, let me clear up some confusion. If you hold dividend stocks in a tax-free savings account (or registered retirement savings plan or registered education savings plan) there is no tax on dividends so the marginal tax rate is irrelevant. The tax rate only comes into play if you hold the stocks in a non-registered (for example, taxable) account.

Assuming that's the case, the government will not send you a cheque for negative tax of 7 per cent. That's because the negative tax rate arises from the dividend tax credit, which is a non-refundable credit. However, you can use the negative tax on dividends to offset other taxes payable.

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In addition to Ontario, several other provinces – including British Columbia and New Brunswick – have a negative marginal tax rate on dividends for low income earners. However, in some cases – namely Alberta, Saskatchewan, Nova Scotia and Prince Edward Island – the negative tax rate is very small.

Regarding exchange-traded funds, if the ETF distributes eligible dividends – as many Canadian equity ETFs do – then these amounts would qualify for the dividend tax credit and could also be taxed at negative marginal rates, depending on the investor's province and income level.

As a dividend investor, how do you track your adjusted cost base (ACB)? Do you use a spreadsheet to track dividend reinvestment plans (DRIPs) and return of capital? Also, if your U.S. holdings are on a DRIP, how do you keep track of each reinvested dividend at that day's exchange rate to track the ACB?

My general rule of thumb is to keep tax-reporting headaches to a minimum. For investments that distribute return of capital (such as some exchange-traded funds and real estate investment trusts), I hold them in a TFSA or RRSP to avoid having to track the ACB. Similarly, if I used DRIPs (which I don't), I would probably hold these stocks in a registered account as well, again to avoid the ACB hassles. (Note: Only "synthetic" broker-operated DRIPS, which do not permit fractional share purchases, are available in registered accounts. For "true" DRIPs, you must enroll your shares with the company's transfer agent, and these shares cannot be held in an RRSP or TFSA.)

That said, if your portfolio is relatively simple and you are handy with a spreadsheet – or even a pencil and a calculator – you can keep your ACB up to date with a bit of work. The key thing, in my experience (I had several DRIPs in the past) is to keep all of your records. For synthetic DRIPs, many brokers are doing a better job nowadays of tracking clients' ACBs (also known as book value or average cost). If you're unsure, give your broker a call. There are also web-based services such as adjustedcostbase.ca and acbtracking.ca that can do the calculations for you.

As for calculating the ACB of U.S. holdings, I recommend that investors hold U.S. stocks in an RRSP or registered retirement income fund. This not only eliminates the need to track the ACB, but it avoids the 15-per-cent U.S. withholding tax that applies to U.S. dividends received in non-registered accounts, tax-free savings accounts and registered education savings plans.

If you must hold your U.S. DRIP stocks in a non-registered account, it may be permissible to use the average annual exchange rate – as opposed to the exchange rate in effect for each transaction – to calculate your ACB. But to be completely safe, tax experts recommend that you use the exchange rates in effect on the date of each dividend reinvestment.

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About the Author
Investment Reporter and Columnist

John Heinzl has been writing about business and investing since 1990. A native of Hamilton, he earned a master's degree from the University of Western Ontario's Graduate School of Journalism and completed the Canadian Securities Course with honours. More

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