Tax Articles
Tax Reductions on Dividend Income
Bruce Ball, Tax Partner, BDO Dunwoody LLP
Jun 15, 2007
Last year, two major tax changes were implemented to deal with the government’s concern over the rapid expansion of income trusts (and other flow-through entities). One change was well publicized – beginning in 2011, these flow-through entities will be subject to a tax that is much like the tax payable by public companies. However, there was good news for public company investors. In late 2005, the government announced that the tax rules around dividends would be overhauled. This announcement addressed a long standing problem for public company investors – when the corporate tax paid by the corporation and the personal tax you pay on dividends are combined, this is almost always higher than what you would have paid if you had earned the income directly. This was one of the major advantages provided by an income trust (since only one layer of tax applied to an income trust at the investor level).
The new dividend rules will help put public company investments and income trust investments on a more level playing field. We’ll take a look at the beneficial effect of the changes on public company investors first, and then point out a couple of downsides that might arise.
The Good News
When an individual receives a dividend, a more complicated tax calculation applies when compared to interest or other income sources. To recognize the tax paid by the dividend paying corporation, the dividend income is “grossed-up” and a dividend tax credit (DTC) allowed. However, the DTC was not set at the right level for public company dividends, and this resulted in more tax overall as discussed. To remedy this, effective for “eligible dividends” received after 2005 (which will include most public company dividends), the gross-up will be increased to 45% and the federal DTC will be increased to approximately 19% of the grossed-up amount. Most provinces have introduced similar changes. Some public and many private companies will still pay “ineligible dividends”, which will be subject to the old rules.
To illustrate the benefit, let’s take a look at a single Ontario investor for 2007 having $65,000 of income, who receives an additional $20,000 of investment income:
| Single Individual Resident in Ontario in 2007 |
Additional Income as: |
Tax Without Added Income |
Tax With Added Income |
Tax Costs |
$ |
% |
Eligible dividend |
$15,476 |
$18,818 |
$3,342 |
16.7% |
Ineligible dividend/Old rules |
15,476 |
20,279 |
4,803 |
24.0% |
Interest |
15,476 |
23,442 |
7,966 |
39.8% |
Clearly, an eligible dividend produces much less tax when compared with dividends under the old rules and interest ($1,461 and $4,624 less respectively). The chart at the end of the article shows the effective rates for top rate investors in all jurisdictions.
The Bad News
The news, however, isn’t all good. With a higher gross-up, the new rules will have a negative impact on income-tested amounts such as the medical credit, provincial tax credits and the GST credit. For seniors, the OAS repayment could increase and the age credit could be reduced. To illustrate the effect on a senior, let’s now assume the investor is over 65 and OAS benefits of $5,900 are included in income:
| Single Senior Resident in Ontario in 2007 |
Additional Income as: |
Tax Without Added Income |
Tax With Added Income |
Tax Cost |
$ |
% |
Eligible dividend |
$15,610 |
$21,471 |
$5,861 |
29.3% |
Ineligible dividend/Old rules |
15,610 |
22,527 |
6,917 |
34.6% |
Interest |
15,610 |
25,266 |
6,656 |
48.3% |
Due to negative impact of the higher gross-up, a senior will be subject to a higher repayment of OAS benefits and the age credit will be ground down. In this case, the saving from having an eligible vs. ineligible dividend declines from $1,461 to $1,056 (a difference of $405). Similarly, the saving when compared to interest is also lower ($3,795 vs. $4,624).
Another potential issue for some taxpayers will be alternative minimum tax (AMT). In fact, one could become subject to AMT by simply having eligible dividends as their only source of income. In other cases, where an investor is already subject to AMT, an eligible dividend will make the AMT/regular tax difference higher.
These new rules address a long-term problem, and are welcome. But, it will take time before the impact of these rules is fully understood.
Investment Income Comparisons for 2007
Jurisdiction |
2007 Combined Top Marginal
Rates
|
|
|
|
|
|
|
B.C |
43.70 |
18.47 |
21.85 |
3.45 |
3.60 |
Alta. |
39.00 |
17.45 |
19.50 |
3.69 |
3.79 |
Sask. |
44.00 |
20.35 |
22.00 |
3.52 |
3.59 |
Man. |
46.40 |
23.83 |
23.20 |
3.52 |
3.49 |
Ont. |
46.41 |
24.64 |
23.21 |
3.56 |
3.49 |
Qué. |
48.22 |
29.69 |
24.11 |
3.68 |
3.41 |
N.B. |
46.95 |
23.18 |
23.48 |
3.45 |
3.47 |
N.S. |
48.25 |
28.35 |
24.13 |
3.61 |
3.41 |
P.E.I. |
47.37 |
24.44 |
23.69 |
3.48 |
3.45 |
Nfld. |
48.64 |
32.52 |
24.32 |
3.81 |
3.39 |
Yukon |
42.40 |
17.23 |
21.20 |
3.48 |
3.65 |
N.W.T. |
43.05 |
18.25 |
21.53 |
3.48 |
3.63 |
Nunavut |
40.50 |
22.24 |
20.25 |
3.83 |
3.73 |
* Equivalent return is the return required as an eligible dividend or capital gain so that the same after-tax return is achieved when compared with interest of 5% for a top rate individual resident in each of the provinces/territories listed. |
