In Canada there are two types of dividends: “non-eligible dividends” and “eligible dividends.”
Eligible dividends are subject to a larger “gross-up” than non-eligible dividends, but as a result, they are eligible for a larger dividend tax credit. In other words, eligible dividends receive preferential tax treatment.
Non-eligible dividends receive a smaller gross-up and smaller dividend tax credit. We will discuss the mechanics of this later in the article and compare the calculation of both non-eligible and eligible dividends.
Canadian Controlled Private Corporations (CCPCs) pay their shareholders either non-eligible or eligible dividends, and this is based on the level of income that they earn. CCPCs have the Small Business Deduction (SBD), through which they can earn up to $500,000 at a lower rate of tax.
This lower rate is currently 11 per cent (nine per cent federal and two per cent provincial in BC). Any active business income earned above $500,000 is taxed at a higher rate. If a CCPC wishes to pay out dividends with after-tax profits from which the lower tax rate was paid, these are non-eligible dividends. This is because of the concept of integration.
Under integration, the aim is for $1 of income earned in a corporation, and paid out to a shareholder, to be taxed the same as if the shareholder earned $1 directly. If a company pays less in tax on active business income under $500,000, then when this is paid out to the shareholder, that shareholder must pay more tax in their hands. This is achieved by paying out a non-eligible dividend which receives a smaller gross-up and dividend tax credit.
When a company pays out a dividend from after-tax profits of active business income earned over $500,000, the company has already paid a higher rate of tax on that income. The result is the shareholder then receives a larger gross-up, and a corresponding larger dividend tax credit to make up for this. Since the corporation has paid more tax, less tax is paid in the shareholder’s hands.
If a CCPC receives eligible dividends from other corporations, it can also pay these dividends out as eligible dividends. The same goes for investment income (also known as passive income). Any passive investment income is automatically taxed at a higher rate, regardless of the amount received, and results in refundable tax being paid.
As well, dividends received by shareholders of publicly traded Canadian companies are classified as eligible dividends.
Illustration – eligible dividends
To illustrate the dividend gross-up and tax credits, we will first show what happens when $10,000 of eligible dividend income is received from a CCPC.
|Eligible dividend income||$10,000|
|Eligible dividend gross-up (38% x $10,000)||$3,800|
|Taxable amount of eligible dividend ($3,800 + $10,000)||$13,800|
|Combined federal and provincial tax, assuming highest marginal B.C. tax bracket of 53.5 per cent ($13,800 x 53.5%)||$7,383|
|Minus combined federal and provincial dividend tax credit, eligible dividends, 15 per cent federal and 12 per cent provincial in B.C. ($13,800 x 27%)||$(3,726)|
|Net federal and provincial tax, after dividend tax credit||$3,657|
|Net amount, after-tax ($10,000 - $3,657)||$6,343|
|Average tax-rate on dividend ($3,657 / $10,000)||36.57%|
Tax on eligible dividends is first calculated by grossing-up the amount of the dividend by 38 per cent. Then, the full grossed-up amount is taxed at your marginal tax rate. The dividend tax credit is calculated as a percentage of the full grossed-up amount, or in the above example, 27 per cent of $13,800.
It is because of the dividend tax credit that dividends are a more attractive form of investment income to receive than interest. If the same individual had received $10,000 in interest income, they would pay $5,350 in tax on that interest income ($10,000 x 53.5 per cent). This is because dividends are paid with the after-tax profits of a company, whereas interest income is a deductible in calculating net income for tax purposes, so when it’s received by an individual, no tax has been paid on that amount yet.
Illustration – non-eligible dividends
The same principles from eligible dividends apply in calculating non-eligible dividends, the difference being the amount of the gross-up and the amount of the dividend tax credit.
To compare the two, we’ll see what after-tax amount $10,000 of non-eligible dividends provides.
|Non-eligible dividend income||$10,000|
|Non-eligible dividend gross-up (15% x $10,000)||$1,500|
|Taxable amount of non-eligible dividend ($1,500 + $10,000)||$11,500|
|Combined federal and provincial tax, assuming highest marginal B.C. tax bracket of 53.5% ($11,500 x 53.5%)||$6,153|
|Minus combined federal and provincial dividend tax credit, non-eligible dividends, 9% federal and 1.96% provincial in B.C. ($11,500 x 10.96%)||$(1,260)|
|Net federal and provincial tax, after dividend tax credit||$4,892|
|Net amount, after-tax ($10,000 - $4,892)||$5,108|
|Average tax-rate on dividend ($4,892 / $10,000)||48.92%|
The difference between these two figures is $1,235 ($6,343 - $5,108), or 12.35 per cent. With the non-eligible dividends, the individual is paying 12.35 per cent more tax; however, these funds were taxed at the SBD lower rate within the corporation.
As you can see from above, eligible and non-eligible dividends are treated differently. It’s important to know the differences between them and how it can impact the amount of tax you pay so you can plan accordingly with your Portfolio Manager.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timecolonsit.com. Call 250-389-2138, email email@example.com or visit greenardgroup.com/secondopinion.