Finance Minister Levels Income Trust Playing Field: Major Changes Proposed on Taxation of Dividends
November 2005
Release No: 05-05
Introduction
With an expected non-confidence vote looming, Federal Finance Minister Ralph Goodale announced changes to the taxation of dividend income received by individuals and trusts on November 23, 2005. This change is aimed at leveling the playing field between public companies that pay dividends to investors and income trusts that pay out ordinary income, but the change will affect the general taxation scheme for dividend income.
The issue revolves around what is known as integration. Where a tax system is integrated, it does not matter how a taxpayer receives income. For example, if a business is incorporated, integration is said to exist where the corporate tax on the business income plus the personal tax on a dividend of the after-tax corporate income is equal to the personal tax that would be paid if the individual earned the business income directly.
Currently, integration does not exist where corporate income not eligible for the small business deduction is paid out to a shareholder on an after-tax basis as a dividend. That is, it is better from a tax rate perspective for an individual to earn the income directly. Income trusts are a solution to this problem, as the income trust structure allows investors to effectively be taxed directly on business income. Rather than dealing with income trusts directly, the Government has decided to deal with the integration problem.
How Does the Change Work?
In recognition of the fact that a corporation pays dividends out of after-tax income, the personal/trust income tax system provides relief for the corporate tax using a dividend gross-up and dividend tax credit (DTC). The idea is to gross income back up to what the corporation received and to provide a credit for the tax it paid. Currently, the gross-up is based on the assumption that combined Federal and provincial tax is 20 per cent. However, this is only the case for small business income – regular corporate income is taxed at a much higher combined rate.
To better reflect current Federal tax rates, the Government proposes to introduce an enhanced gross-up and DTC for eligible dividends received by individuals and trusts. An eligible dividend will be grossed-up by 45 per cent, meaning that the shareholder includes 145 per cent of the dividend amount in income. The DTC in respect of eligible dividends will be 19 per cent, based on the 2010 Federal corporate tax rate as proposed in Budget 2005 and the mini-budget earlier this month. The existing gross-up (25 per cent) and tax credit (16 2/3 per cent) will continue to apply to other dividends.
The impact of this change is highlighted in a Department of Finance calculation, which we have reproduced at the end of the Fast Fact. An important point to keep in mind is that the calculation assumes provinces will take similar steps, as there is a lack of integration at the provincial level as well. Also, full integration will not be achieved until the proposed corporate tax cuts are fully implemented. Overall, it is estimated that the average tax rate on dividends for a top-rate individual will decline from approximately 32 per cent to 21 per cent.
What Are Eligible Dividends?
Basically, this change will apply for dividends received after 2005 from corporations that pay high rate tax – public companies and other companies that are not Canadian-Controlled Private Companies (CCPCs). Also, Finance made reference to dividends from large CCPCs, as these corporations don’t qualify for the small business rate.
However, where a corporation is taxed on some income at the general corporate rate and the rest at the small business rate, Finance indicated to us that they have not yet worked out how dividends paid by such a corporation will be taxed. In particular, they will likely take steps to ensure that income taxed at the small business rate is not subject to the new rules when it is paid out as a dividend. Although this seems straightforward in principle, there are a number of complicating factors to be dealt with. Finally, the Finance announcement indicates that:
- The payment of investment income will not be eligible for the enhanced gross-up and DTC. Presumably, dividends that give rise to a dividend refund will be excluded from the new rules.
- Where a corporation that would not otherwise be eligible receives an eligible dividend from aother corporation, it will be possible to pass on this dividend to shareholders as an eligible dividend.
Conclusion
Although the change is welcome, there are a number of details that still have to be set, and these will have a major impact on corporate owner-managers. We will provide more information once these details have been set. Finally, this may not be the last word on income trusts, as the Government does have concerns over the build up of income trust investments in pension plans, RRSPs and RRIFs.
If you have questions about these proposed changes, contact your BDO Advisor.
Current and Proposed Tax Treatment of Dividends From Large Corporations and Taxable Distributions of Income Trusts (Source: Federal Department of Finance)
| |
Large Corporations |
|
| |
Current |
Proposed |
Income Trusts |
Corporate Level |
|
|
|
| Income (A) |
100 |
100 |
100 |
| Corporate tax (B) |
(32)1 |
(32)1 |
0 |
| Amount distributed to investor (C) |
68 |
68 |
100 |
| |
|
|
|
Canadian Taxable Individual Investor |
|
|
|
| Amount included in income (D) |
85 |
99 |
100 |
| Personal income tax (E) = (46%2 of D) |
39 |
46 |
46 |
| Dividend tax credit (F) |
(17)3 |
(32)4 |
0 |
| Net personal income tax (G) = (E - F) |
22 |
14 |
46 |
| Total tax paid (H) = (B + G) |
545 |
46 |
46 |
1 The combined average federal-provincial corporate income tax rate in 2010 including the Budget 2005 proposed corporate tax rate reductions and proposed provincial tax changes.
2 The average top federal-provincial personal income tax rate.
3 The assumed 20 per cent DTC rate approximates the combined average federal-provincial small-business rate.
4 Assumes that provinces will also provide an enhanced DTC for eligible dividends.
5 Because the combined average federal-provincial corporate income tax rate for large corporations is proposed to be 32 per cent in 2010, the dividend gross-up/credit mechanism, which is based on an assumed 20 per cent corporate income tax rate, does not fully compensate individuals for taxes paid at the corporate level.
