Many people want to know how dividends are taxed in Canada. This article will discuss and clarify how dividends are taxed in Canada to the average person. We believe you’ll be surprised at how simple it is. To keep things straightforward, we’ll look at federal taxes.
That being said, provincial taxation works in the same way as federal taxation, except that the rates are different.
Furthermore, the purpose of this article is to provide general information. It is not a substitute for your investigation and analysis. It does not imply that you are qualified to deal with corporate tax issues.
A dividend is money paid to shareholders from a corporation’s profits. The owners of a Canadian corporation are called the shareholders.
The shareholders elect a Board of Directors. The Board approves dividends of Directors via a Board Resolution. The Board Resolution will usually specify a dollar amount for the dividend to be paid per share. A Board of Directors, for example, would decide to pay Class A Common Shareholders a dividend of $2.50 per share.
In summary, a dividend is money paid to shareholders on a per-share basis from a corporation’s earnings.
The most common type of dividend is the standard cash dividend, in which a company makes a cash payment to its shareholders. On the other hand, a dividend does not have to be in the form of cash and can be any value transfer from a company to its shareholders if it is announced as such by the Corporation’s directors.
These non-cash dividends are known as dividends in kind, and they may take the form of extra stock, special property, or notes payable. Furthermore, a dividend will be either an eligible or non-eligible dividend, depending on the form it takes.
This affects the tax rate the Individual will pay on those dividends. Finally, a type of non-taxable dividend known as a capital dividend may be issued when a corporation has realized capital gains, life insurance policy proceeds, or capital dividends from another corporation.
According to reports, as of the 2019 tax year, investors in Canada can expect to pay as much as 29% on their dividends if they are in the highest income tax bracket.
It may not be clear why this is important right away, but trust us when we say it will be crucial in the next section. Corporations classified as Canadian Controlled Private Corporations (CCPCs) in Canada are eligible for a special tax break known as the small business deduction.
For CCPCs with their first $500,000 inactive business revenue, this is a huge tax break. We won’t go into any more detail about this. Just keep in mind that the small business deduction lowers a corporation’s tax liability significantly.
Dividends are divided into two categories in the tax world: eligible and non-eligible dividends. Don’t overthink it; this is just for tax purposes. After all, it’s still a dividend, as we discussed in the previous section. The way they are taxed, however, is different.
Personal income tax rates on eligible dividends are generally lower than those on non-eligible dividends. Here’s why:-
Dividends paid to shareholders who have not benefited from the small business deduction or any other special tax rates are considered eligible dividends.
The income tax system is set up to pay less tax on eligible dividends than non-eligible dividends because the Corporation pays more tax on the profits before paying the dividends.
Non-eligible dividends, on the other hand, are distributions of earnings to shareholders who have benefited from small business deductions or different special tax rates.
Because the profit of a Canadian corporation is taxed at a lower rate, the income tax system is set up so that non-eligible dividends are taxed at a higher rate than eligible dividends.
The principle of tax integration is a crucial concept in Canadian tax law. In a broad sense, integration is the notion that regardless of how an individual organizes his affairs, the final income tax rate of a particular stream of income once it reaches his hands should be roughly the same.
More specifically, this means that the total income tax on a stream of income would be the same if earned directly by an individual or earned in a company and then paid out to that Individual as a salary or dividend.
If an individual makes income directly, the tax is merely at the Individual’s marginal tax rate; however, where a corporation earns income and pays it to the Individual as a salary after tax Ontario, the Corporation can subtract the wages as an expenditure, therefore paying no tax on that sum, and the Individual pays at his marginal rate once again.
On the other hand, dividends are paid from a corporation’s after-tax profits (with the exception of dividends from the Capital Dividend Account), implying that the Corporation has already paid corporate income tax on that income. As a result, if the Individual paid his total marginal tax rate on the dividends he received, that stream of revenue would have been subjected to corporate and individual taxes, resulting in double taxation.
The Canadian income tax system uses a dividend gross-up and a Dividend Tax Rate Canada Credits Mechanism to achieve tax integration, which essentially results in the individual paying a lower amount of tax on a dividend he receives to account for the tax that the Corporation has already paid.
Because companies in Canada pay different tax rates depending on whether they qualify for the small business deduction or the manufacturing and processing deduction, the dividend gross-up and dividend tax credit must be modified to reflect the dividend issuing corporation’s specific tax rate.
As a result, companies that do not qualify for the small business deduction pay a higher corporate tax rate, and the dividends that they declare are referred to as eligible dividends because they are subject to more favourable tax treatment for the people receiving the dividend, subject to some conditions discussed below.
Non-eligible dividends, on the other hand, are dividends paid by Canadian Controlled Private Corporations (CCPCs) that qualify for the small business deduction, and recipients of these dividends face less favourable tax treatment than those who receive eligible dividends.
A non-CCPC, on the other hand, can own shares in a CCPC and receive ineligible dividends from it; those amounts are tracked in a separate account called the Low-Rate Income Pool or LRIP, and the non-CCPC is prohibited from issuing any eligible dividends while the LRIP balance is positive.
A non-CCPC must pay out ineligible dividends to decrease its LRIP balance, and once the LRIP balance is gone, the non-CCPC will reissue eligible dividends. While the specifics of how this is calculated are complex, the general idea is that CCPCs pay a lower tax rate on active business income than non-CCPCs.
When profits are given to shareholders as non-eligible dividends, the shareholders pay personal income tax on those dividends at a higher rate than for eligible dividends but lower than if it were a salary. However, as shown below for an individual paying tax at the top marginal tax rate in Ontario, the total tax paid by the Corporation and the Individual who gets the dividend is nearly identical.
When it comes to the taxation of dividends in Canada, a few other terms come up. Unless you’re a practicing accountant who prepares and files corporate income tax returns regularly, all you need is a basic understanding of the definitions.
The dividend gross-up essentially means that the CRA looks at your dividends and says, “Yeah… I understand you got a $1,000 non-eligible dividend, but let’s pretend it was $1,160 and tax you on that, okay? Oh, no! Those are taxable dividends, right? Instead, let’s pretend it’s $1,380!”
Yes, that’s precisely how it works – sounds awful, doesn’t it? Fortunately, there’s something called a dividend tax credit to offset this.
Taxes have a habit of being overly complicated. Remember how the CRA determined that the taxable amount of dividends needed to be increased during the gross-up? The CRA, on the other hand, can be a bit erratic.
Later, they know they were a little too “extreme,” so they give you some of it back in the form of a dividend tax credit. You will be eligible for both a federal and provincial dividend tax credit.
This account keeps track of a CCPC’s earnings that are taxed at the overall corporate income tax rate. The GRIP amounts can be paid out as eligible dividends by the CCPC.
This account keeps track of earnings made by a non-CCPC that were taxed at a lower rate. Before it can pay eligible dividends, a non-CCPC must reduce the LRIP to zero through non-eligible dividends.
In the tax system, integration is a crucial concept. Essentially, integration means that the tax rate on taxable income will be the same regardless of how it flows through corporations and businesses to an individual. This is why there are distinctions between eligible and non-eligible dividends and the dividend gross-up and dividend tax credit.
That isn’t to say that tax planning isn’t worthwhile; there are opportunities to be had through the notion of tax deferral. Consider it this way: you will pay taxes, but tax deferral allows you to choose when you pay them. Tax planning should offer benefits and opportunities to ensure that you do not pay more than your fair share of taxes.
Now that you know what dividends are let’s talk about some of the things a business owner or investor might consider when it comes to dividend income.
Hopefully, you now have a better understanding of how Canadian dividends are taxed. Now that you know what dividends are, it’s time to hire a tax professional to help you maximize your tax profile.