Dividends are a type of income that receives special tax treatment. Dividend income is not taxed as ordinary income or as capital gains. Instead, it is subject to a specific mechanism whereby it is taxed at a lower level than ordinary income but at a higher level than capital gains.
Essentially, a dividend corresponds to the distribution of profits from a corporation to its shareholders. ?
The Principle of Integration
The mechanism of dividend taxation is based on the principle that regardless of whether income is earned by a corporation or an individual, the tax treatment ultimately remains the same. This is the principle of integration.
If an individual earns income from a sole proprietorship, they will be taxed accordingly.
However, if the same business income were earned by a corporation and then distributed to the same individual in the form of a dividend, the business income would be taxed once in the corporation and then a second time, as a dividend, in the hands of the individual.
When receiving a dividend, the corporation that pays it has already paid a certain portion of tax. The mechanism of dividend taxation aims to make the shareholder pay the remaining portion.
How? Through a mechanism of gross-up and tax credit. In practice, if an individual earns dividend income, they must gross-up the dividend before including it in their income, calculate their tax payable, and then apply a tax credit.
A small note, the tax credit is not refundable.
Furthermore, the gross-up of the dividend also increases the net income. Since social and tax benefits are established based on net income, receiving a dividend will always have a more negative impact on the Marginal Effective Tax Rate (METR) than ordinary income would have had.
METR is somewhat the tax rate “once everything is accounted for,” including benefits for children, childcare expenses, personal credits, and others. Its impact can be particularly significant for parents of young children.
Designated or Not?
Tax rules provide for different gross-up and tax credit rates depending on the type of dividend.
Designated dividends result from the income of a corporation that has been taxed at the higher tax rate, essentially profits exceeding $500,000 or profits from a public corporation, such as a publicly traded company.
Since designated dividends result from income that has been taxed at a higher rate within the corporation, the gross-up and tax credit mechanism aims to make the shareholder assume a lower tax burden.
As for other than designated dividends, these result from the income of a corporation that has been taxed at a reduced tax rate, generally the first $500,000 of operating income of a private corporation.
In the case of other than designated dividends, the gross-up and tax credit mechanism aims to make the shareholder assume a higher tax burden.
From the shareholder’s perspective, it is more advantageous to receive a designated dividend. ?
Foreign Dividends
Foreign dividends, dividends from a non-Canadian corporation, do not benefit from the special treatment applicable to Canadian dividends. They do not have a gross-up or tax credit. The foreign dividend received is taxed as ordinary income, similar to interest income. The country from which the dividend originates will withhold tax at the source, but this can be recovered through a foreign tax credit.
Capital Dividend Account (CDA)
When a corporation realizes a capital gain, only half of the gain is taxable. To comply with the principle of integration, the non-taxable portion of the gain can be paid to the shareholder tax-free.
Be careful not to confuse a capital dividend with a capital gains dividend from an investment corporation (i.e., a mutual fund corporation). The former will not be taxable, while the latter will retain its nature of capital gains, and half of the amount received will be taxable.
For a Corporation
A Canadian dividend received by a Canadian private corporation will not be subject to the same treatment as for individuals. Roughly, the dividend will be included in the corporation’s income and then deducted from its taxable income, except that a “temporary” tax will be payable. It is a “temporary” tax because it is eventually refundable. Simple, isn’t it? ?
