Note: This article is part of Morningstar's May 2016 Income Investing Week special report.
Dividends have long been popular as a tax-friendly source of income. Once upon a time, if you wanted dividends you purchased preferred shares of large corporations. But increasingly, common shares have emerged as the biggest source of dividend income, which of course comes with the added benefit of potential capital appreciation of the underlying stock. (Preferreds typically have little potential for capital growth.)
However, not all dividends are treated equally. The tax advantage of Canadian dividends comes from federal and provincial dividend tax credits. To claim the federal dividend tax credit, you must first "gross up" the amount of dividends received. You then compute a dividend tax credit based on this inflated amount. (These amounts are calculated for you on T3 and T5 tax slips.)
For dividends received from a Canadian public corporation, the gross-up is 38% of the amount received, and a tax credit of 15% is computed on the grossed-up amount. The tax credit works out to nearly 21% of the actual dollar amount of the dividend.
Why must this circuitous route be taken to gain this tax credit?
"Fundamentally, Canadian income-tax policy is to tax income earned through a corporation in the same manner it would have been taxed if it had been earned by an individual directly carrying on the same business," says Brian Brophy, a tax partner with Deloitte's private-client tax practice. "Corporations are generally subject to taxation on their income just as individuals are, albeit under a different set of applicable tax rates."
The gross-up component estimates the pre-tax income earned by the corporation, and then the tax-credit component gives the dividend-holder credit for the estimated tax paid by the corporation. "The end result is that the individual typically pays less personal tax on the actual dividend they received," Brophy says, "compared with their income from other sources to recognize that an amount of corporate tax has already been paid in respect of the same dollar of income earned in the business carried on by the corporation."
As with other tax credits, the value of the dividend tax credit depends on your province of residence and your taxable income. While all Canadians pay federal tax at the same rates, as high as 29%, each province and territory levies its own income tax, at varying rates. The number that matters is the combined federal-provincial tax rate, which for an individual is his or her marginal tax bracket.
For example, an Ontario resident with taxable income under $150,000 will pay 29.5% combined federal and provincial tax on eligible dividend income received during 2015. (Higher rates apply for those with greater taxable income.) That compares with 46.4% that he or she would pay on employment or other "ordinary" income.
In British Columbia, eligible dividends are taxed at 25.8% (for those with less than $150,000 of taxable income), compared with the tax rate of 43.7% on ordinary income.
In Quebec, the rate is 35.2%, regardless of income level, compared with 49.9% on ordinary income. Residents of Yukon and Alberta pay the least tax on eligible dividend income, 15.9% (versus 42.2% on ordinary income) and 19.3% (39%) respectively.
The eligibility for dividend tax credits depends on the source of the dividends. The following is a summary of how dividends received from sources other than a Canadian public company (as discussed above) are taxed:
Dividends paid by Canadian-controlled private corporations (CCPCs)
While dividends paid by a CCPC also are subject to the gross-up/tax-credit mechanism, in some cases they may be entitled to a lower rate of corporate taxation on certain income earned in Canada. "To the extent a CCPC has been subjected to a lower rate of corporate tax on its income, the dividend tax credit allowed is generally less, in order to account for the lower burden of corporate tax," Brophy says.
A corporation can pay "eligible" dividends, which means they are eligible for the higher gross-up and tax credit, or "other than eligible" dividends, which are paid from income earned by the corporation that has been taxed at a preferred or reduced corporate tax rate, and thus qualifies for a lower dividend tax credit.
The gross-up and tax credit for these other-than-eligible dividends are 18% and 11% respectively. (These amounts will be reduced gradually over the next four taxation years to 15% and 9% respectively in 2019 and beyond.) For income received during 2015, in Ontario this translates to 36.5% tax on this income, while in B.C. it is 35.5% and in Quebec 39.5%.
A CCPC also may pay a non-taxable capital dividend to its Canadian-resident shareholders. "When either a corporation or individual sells a capital property, generally only 50% of the gain is taxable," Brophy says. "The capital-dividend mechanism enables a corporation to pay the non-taxable portion of the capital gain to its Canadian-resident shareholders tax-free."
Dividends paid to non-residents
Dividends paid by a Canadian corporation (public or private) to an individual who is not a resident of Canada -- even if he or she is a Canadian citizen -- are not eligible for the dividend tax credit. "The premise behind the dividend tax-credit mechanism is to ensure that the tax ultimately paid on a dividend received by a Canadian resident individual equates to the tax burden he or she would have incurred if the income had been earned directly by the individual as opposed to through a corporation," Brophy says. "Therefore, different rules apply to dividends paid to non-residents of Canada."
Income paid to a foreign resident is generally subject to a 25% withholding at source, although this amount may be less, depending on a tax treaty that may be in effect between Canada and the investor's country of residence.
Dividends from foreign sources
Dividends paid by a foreign-based corporation to a Canadian resident are ineligible for the dividend tax credit and therefore are taxed as ordinary income. What's more, the country in which the corporation is based may withhold tax at source. You can claim a foreign tax credit to reduce or eliminate the impact of double taxation on this income.
Brophy notes that Canadian subsidiaries of foreign-based companies may pay dividends to their parent company, which then subsequently may pay these dividends to a shareholder who is a Canadian resident. Despite all or a part of these dividends being potentially derived from Canadian sources originally, the dividends will nevertheless be characterized as foreign-source income to the Canadian investor. So they won't qualify for a dividend tax credit.
Taxation of U.S.-source dividends
Like any other foreign-source income, dividends from U.S.-based corporations listed on a U.S. stock exchange are ineligible for the dividend tax credit. They are taxed as ordinary income.
A Canadian resident who is not considered to be a resident of the U.S. for tax purposes generally does not have to file a U.S. tax return to report U.S. dividend income, Brophy says. This is not the case, he notes, for some other types of U.S.-based income, such as real estate.
Normally, the U.S. Internal Revenue Service (IRS) withholds tax of 30% on dividends paid to U.S. non-residents. However, under the Canada-U.S. Tax Treaty, that rate is typically reduced to 15% for dividends paid to Canadian individual residents. To qualify for this reduced rate, you must complete IRS form W-8BEN and submit it to the company from which you receive these dividends.
