TAXATION OF DIVIDENDS
If you receive a taxable dividend from a corporation resident in Canada, you are subject to tax on the dividend at a preferential rate of tax. The effective rate of tax will be less than your regular marginal rate of tax. Therefore, for example, dividends will be subject to less personal tax than investment income such as interest or rental income. (If proposals released on July 18, 2017 are implemented, many dividends from private corporations will be taxed at a much higher rate, in situations where the person receiving the dividend is not involved in running the business. This "anti-income sprinkling rules" may or may not come into effect, and are discussed further in this article.)
The tax preference results from the application of the dividend tax credit. This credit, along with a "gross-up mechanism", provides you with a credit for the estimated corporate income tax already paid on the income that provides the dividend.
For these purposes, there are two different sets of dividend tax credits and gross-up amounts, depending on the type of dividend.
An "eligible dividend" is generally a dividend paid out of a corporation’s income that is subject to regular corporate tax rates (typically 25% − 30%, varying by province).
A non-eligible dividend is generally a dividend paid out of a corporation’s income that was eligible for the small business deduction on the first $500,000 of active business income of a CCPC, and thus subject to lower corporate tax rate (the small business rate is around 13% − 15%, varying by province).
You do not have to make the determination as to the type of dividend. The corporation paying you the dividend must indicate whether it is "eligible" or not. For an eligible dividend, the dividend is grossed-up by 38% − in other words, for every $100 of dividend you receive, you report income of $138 on your tax return. The federal dividend tax credit is the 6/11ths of the gross-up amount. The amount of the provincial credit depends on the province, but in rough terms, you get a credit for something close to the gross-up. A non-eligible dividend is grossed-up by 17%. The federal dividend tax credit is 21/29 of the gross-up amount. Again, the amount of the provincial credit depends on the province.
As noted, the purpose of the credit and gross-up mechanism is to provide the individual shareholder with a credit for the corporate tax already paid (or presumed to have been paid), thereby avoiding double taxation. The net result should amount to the “integration” (more or less) between the personal and corporate tax. This means that the total amount tax paid by the individual and the corporation should generally equal the amount of tax that would have been paid, had the underlying business income been earned directly by the individual.
Example – business income through corporation
Assume that you are in a 50% marginal tax bracket (combined federal and provincial) and that your corporation’s general tax rate is 27% (also combined federal and provincial).
Your corporation earns $138 of business income that is not eligible for the small business deduction. Using the 27% tax rate, it will pay about $38 in tax, leaving $100 that can be paid to you as a dividend.
The dividend is paid to you as an eligible dividend. You will include $100 plus the 38% gross-up, for a total inclusion of $138 (which, you will notice, is the same as the corporation's original income was). At a 50% personal tax rate, this would result in $69 of personal tax.
However, your dividend tax credit will reduce your tax payable. As noted, the federal credit is 6/11 of the $38 gross-up amount. Assume that the provincial credit is 5/11 of the gross-up. Your total credit will therefore equal $38, which will reduce your personal tax from $69 to $31.
Combined with the $38 in corporate tax paid, the total tax will be $69, which is 50% of the $138 of business income earned by the corporation. So "integration" has worked: you and the corporation have paid the same $69 in tax that you would have paid if you had earned the $138 directly.
Deferral makes the difference
Looking at the above numbers, you might wonder whether there is a tax advantage to running a business through a corporation. In many cases, there is. The initial corporate tax rate (whether the regular rate or the small business rate) is usually lower than the individual shareholder’s rate of tax. As a result, if some or all of the corporate income is reinvested in the corporation’s business, the shareholder level of tax will be deferred, leading to a distinct tax advantage that increases the longer the period of deferral. However, the July 18, 2017 proposals, if implemented, will impose a prohibitive tax rate on the corporation's investment income, so that you will in the end be worse off leaving money in the corporation. Again, it remains to be seen whether these proposals will be implemented.
Dividends from foreign corporations
If you receive a dividend from a corporation resident in another country, there is no dividend tax credit and no gross-up. You simply pay tax on the entire dividend at your marginal rate of tax.
However, if the other country levies a withholding tax on the dividend, you will normally receive a foreign tax credit in Canada to alleviate the potential double taxation. In general terms, the foreign tax credit leaves you paying a net of the higher of the two countries' rates.
You receive a dividend equal to C$100 from a corporation in the United States. You pay C$15 of United States withholding tax, which is withheld so that you actually receive only $85.
You include the $100 amount in your Canadian tax return and initially compute your Canadian tax payable on that amount. That tax is then reduced by your foreign tax credit, which in this simple example will equal the C$15 tax paid to the U.S.