Dividend Gross-Up and Dividend Tax Credits

Introduction

A fundamental concept in Canadian tax law is tax integration, which aims to ensure that income earned through different structures (directly by individuals or through corporations) is taxed at roughly the same rate once it reaches the individual taxpayer level. This principle prevents the double taxation of corporate income distributed as dividends to shareholders. To achieve this, the Canadian tax system uses the dividend gross-up and dividend tax credit mechanisms. This article explores these concepts in detail and explains how they impact the taxation of eligible and non-eligible dividends.

What is Tax Integration?

Tax integration ensures that whether income is earned:

1. Directly by an individual (e.g., as sole proprietor income), or
2. Through a corporation and distributed as salary or dividends,

The total tax burden remains approximately the same.

For salaries, integration is straightforward: corporations deduct the salary as an expense, and the recipient pays tax at their marginal tax rate. For dividends, however, integration requires additional steps because dividends are paid from after-tax corporate income. Without integration mechanisms, dividend income would be subject to double taxation: first at the corporate level and then at the individual level.

To address this, Canada’s tax system uses:

1. Dividend Gross-Up: Reflects the corporate taxes already paid.
2. Dividend Tax Credits: Reduces the individual’s tax liability to account for corporate tax already paid.

The Dividend Gross-Up Mechanism

The dividend gross-up adjusts the amount of dividend income reported by individuals to reflect the corporate income required to pay the dividend.

Types of Dividends:

A. Eligible Dividends:

1. Paid by corporations taxed at the general corporate rate.
2. Gross-up rate: 38%.

B. Non-Eligible Dividends:

1. Paid by Canadian-controlled private corporations (CCPCs) benefiting from the small business deduction.
2. Gross-up rate: 16%.

Example:

An individual receives a $100 dividend:

1. Eligible Dividend: Grossed up by 38%, resulting in $138 reported income.
2. Non-Eligible Dividend: Grossed up by 16%, resulting in $116 reported income.

Dividend Tax Credits

The dividend tax credit (DTC) offsets the individual’s tax liability on grossed-up dividend income, accounting for corporate taxes already paid.

Tax Credit Rates: 

A. Eligible Dividends:

1. Federal credit: 15.02% of the grossed-up dividend.
2. Provincial credit (e.g., Ontario): 10% of the grossed-up dividend.

B. Non-Eligible Dividends:

1. Federal credit: 10.03% of the grossed-up dividend.
2. Provincial credit (e.g., Ontario): 3.12% of the grossed-up dividend.

Example Calculation:

For a $100 eligible dividend grossed up to $138, the combined federal and Ontario tax credit is $34.53.

Combined Corporate and Personal Tax Impact

Despite integration, slight discrepancies exist between combined corporate and personal tax rates for eligible and non-eligible dividends. This arises due to variations in provincial tax rates and other factors.

Tax-Free Dividends for Low-Income Individuals

The dividend tax credit provides significant benefits to individuals in lower tax brackets. For example:

1. In Ontario, individuals with income below $42,202 can receive eligible dividends tax-free due to the combined DTC exceeding their marginal tax liability.
2. For non-eligible dividends, the tax-free threshold is significantly lower, around $10,354.

Pro Tax Tips

A. Understand Eligibility:

1. Verify whether dividends are eligible or non-eligible, as this impacts the gross-up and tax credit rates.

B. Optimize Income Splitting:

1. Distribute dividends strategically among family members in lower tax brackets to maximize tax-free dividends.

C. Consider Corporate Tax Rates:

1. Evaluate the impact of federal and provincial corporate tax rates when planning dividend distributions.

D. Seek Professional Advice:

1. Work with a Canadian tax professional to structure income streams effectively and maximize after-tax returns.

FAQs

What is the difference between eligible and non-eligible dividends?

Eligible dividends are paid from income taxed at the general corporate tax rate, while non-eligible dividends are paid from income benefiting from the small business deduction

How does the dividend gross-up work?

The gross-up reflects the pre-tax corporate income required to pay a dividend, increasing the amount reported as income for tax purposes.

What is the purpose of the dividend tax credit?

The dividend tax credit offsets the individual’s tax liability to prevent double taxation on corporate income.

Conclusion

The dividend gross-up and tax credit system is a cornerstone of Canada’s tax integration framework, ensuring fairness and minimizing double taxation. By understanding how these mechanisms work, individuals and corporations can optimize their income strategies and reduce overall tax liability. For personalized advice and planning, consulting a Canadian tax professional is highly recommended.

This article is written for educational purposes.

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