Dividends play an important role in a remuneration strategy. While most business owners and investors understand the basics of dividend payments, the taxation of these payments can be much more complex than ordinary income such as salary or interest. You must first understand the taxation of the corporation paying these dividends and the mechanisms built into our tax laws before understanding the tax treatment on your personal return.
Dividends are corporate distributions that are paid from after-tax earnings. This means that dividends are not a deductible expense to the corporation in the same way that a salary is. Each year the after-tax earnings of the corporation are added to the retained earnings balance which can be distributed to shareholders by declaring dividends. This distinction is important as it explains the added complexity of dividend taxation; as the corporation has already paid tax on the corporate earnings, how do you avoid double taxation when the dividends are reported on your personal return?
One of the fundamental concepts in our tax system is “integration”. At a high level, integration means the combined corporate and personal income taxes on earnings paid out as dividends should be the same as the personal taxes on a salary. If you have ever received a T3 or T5 slip reporting dividend payments from Canadian corporations, you may have noticed that there are typically three amounts reported: actual amount of dividends, taxable amount of dividends and dividend tax credit. The actual amount of dividends is the amount reflected by the company as a distribution from retained earnings. The taxable amount of dividends and the dividend tax credit are calculated in an attempt to achieve integration.
The taxable amount of dividends is grossed-up from the actual amount to account for the corporate income taxes already paid. In theory, the taxable amount approximates the equivalent salary that would have been paid from pre-tax corporate earnings. The taxable amount is reported on your personal income tax return and subject to tax at marginal rates. The dividend tax credit is then calculated as an approximation of the corporate income taxes previously paid and is applied against your personal income taxes payable. The amount of the gross-up and dividend tax credit is dependent on the type of dividend paid.
There are two types of taxable dividends paid by Canadian corporations: eligible and non-eligible. Eligible dividends are paid from corporate earnings that were previously taxed at the general rate, sometimes referred to as the high rate, while non-eligible dividends are paid from corporate earnings that were previously taxed at the low rate. Dividends from public corporations are usually eligible dividends while dividends received from Canadian-Controlled Private Corporations (CCPCs) may be non-eligible if paid from earnings that were taxed at the low rate due to the Small Business Deduction (SBD) or investment earnings that were subject to refundable taxes. As of 2021, the dividend gross-up is 38% for eligible dividends and 15% for non-eligible dividends. The dividend tax credit is then calculated as either a percentage of the dividend gross-up or as a percentage of the taxable dividend depending on provincial legislation. These amounts vary based on provincial tax rates.
CCPCs are required to track their General Rate Income Pool (GRIP). GRIP includes earnings that were not eligible for the SBD and therefore were taxed at the general rate, as well as eligible dividends received from other companies. Non-CCPCs are required to track their Low Rate Income Pool (LRIP). LRIP usually consists of earnings that were taxed at the low rate when the corporation was previously a CCPC, such as prior to going public, and non-eligible dividends received from other corporations.
Based on the above, eligible dividends are subject to a lower effective tax rate on your personal return as the corporate earnings were subject to tax at the higher general rate. As of 2021, the highest rate of tax in Canada on an eligible dividend is approximately 43% while non-eligible dividends may be subject to tax as high as 49%. Therefore, as an individual, you would prefer to receive eligible dividends. However, there are a few key rules to keep in mind.
A corporation is required to designate a dividend as eligible either before or at the time the payment is made and must notify all shareholders receiving the eligible dividends of this designation. Notification is commonly done by issuing a letter to the shareholders, on the cheque stubs for the payment or through the corporation’s website. Simply reporting the payments as eligible on a T3 or T5 slip is not sufficient.
Eligible dividends can only be paid to residents of Canada. As the whole concept of the gross-up and tax credit mechanism is to equate the Canadian corporate and personal income taxes paid, these rules do not apply to dividends paid to non-residents. This is an important planning consideration as dividends must usually be declared on a certain class of shares and paid to all shareholders of that class. It may be advisable to reorganize your corporation to ensure that your Canadian resident shareholders can continue to benefit from these rules in an optimal manner.
Finally, non-CCPCs with a LRIP balance are required to pay dividends out of this pool until it is reduced to zero before designating any dividends as eligible.
Excessive eligible dividend designations are subject to tax at a rate of 20% of the excessive amount. A schedule is filed with the corporation income tax return each year that a taxable dividend is paid to ensure the company remains in compliance with these rules.
Understanding the rules regarding taxable dividends allows you to better prepare for tax time and forms one component of an owner-manager remuneration strategy. There may be other factors applicable to your situation to consider when devising a well-rounded financial plan for both you and your business.
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