Investors need to appreciate the new dividend tax rules

The core issue is the linkage, or “integration”, between corporate and personal taxation. Corporations pay taxes on their profits and then distribute those profits to their investors as dividends. The next question is how to tax the individual on this dividend. One school might say to give the dividend tax-free to investors, as the corporation already has paid tax. Another school says to tax investors the same as any other source of income. The third school says, yes, tax investors but give them recognition (a tax credit) for the corporate tax previously paid. Canada has taken this approach.

The long-standing problem, however, has been that, given that public and private companies bore significantly different corporate tax rates, “perfect” integration with their respective investors required different systems for each. When one system is applied to both, it either favours one of them with over-integration or hurts the other with under-integration. The Canadian system long has favoured private companies and hurt public companies.

Since 2006, there is now a dual integration system for Canadian public and private companies. Investors in private companies engaged in entrepreneurship enjoy the “old” system on the first $400,000 of annual profits, now called “ineligible”. Investors in public companies enjoy a new, richer system, called “eligible”. The accompanying chart gives some perspective on the implications of each system. The top row shows the 2008 BC personal marginal tax bracket ranges. The other rows show the marginal tax rates in BC for an incremental dollar of different kinds of investment income at different income levels (NB: This chart varies significantly from province-to-province).

Implications for Stock Market Investors

A number of observations are worthwhile. First, the tax rate on eligible dividends is now lower than it is on capital gains, across all marginal tax brackets. Second, in comparing the two sets of tax rates for dividends, we underscore how over-taxed public company dividends have been all of these years. Third, eligible dividends are totally tax-free for incomes under $70,000, and only slightly taxed between $70-75,000. Fourth, the top tax rate on eligible dividends is 18.4%. Fifth, the “zero” (*) tax rate on incomes under $70,000 has a brand new additional implication – in fact, the dividend tax rate at the first three brackets is not zero, but negative: -15.56%, -11.59% and –1.44% respectively.

The way a tax return works is that the tax credit received on dividends applies to the total tax bill resulting from total income. This means that, for incomes under $70,000, eligible dividends are not only tax-free but actually reduce the tax on other income of the taxpayer. A “leakage” problem occurs when the taxpayer does not have enough other sources of income to soak up the excess dividend credits. For instance, someone in the lowest bracket earning only eligible dividends could leave as much as $5,600 of tax credits on the table.

A foregone tax reduction of this size may inspire tax planning initiatives that have not been previously necessary in the world of only ineligible dividends. For instance, in this circumstance the tax law long has permitted a couple to transfer the dividend income (and the related tax credits) from the lower income spouse to the higher income spouse. If the transferee spouse can enjoy the tax credits and pays little or no tax on these extra dividends, the benefit for the couple would be the tax break on whatever dependent credits can now transfer, which can be quite sizable. But this only works if there is a couple!

Another tax planning strategy to address sizable leakage is to manage taxable income in some fashion. One version of this critically requires proactivity during the tax year while the other version requires some cleverness when preparing the tax returns in the following Spring. Proactive steps would involve generating some taxable income to soak up the credits. This might, for instance, involve cashing out some RRSP funds! While this might seem heretical, in fact, it might make sense to use the proceeds to contribute to the new Tax-Free Savings Accounts which join our world in 2009. Alternately, unrealized capital gains could be harvested to generate more income.

Some income management strategies can be executed at tax preparation time. For instance:

  • Defer RRSP deductions on contributed amounts
  • Defer CCA on rental or self-employment income
  • Accelerate the taxation of a previous capital gains reserve
  • Defer some credits, like donations and medical expenses
  • Transfer eligible credits to your spouse
  • Elect pension splitting with a transferee spouse
  • Defer permissive tax shelter deductions
  • Defer loss carryforward claims

Lastly, for investors with exclusively, and large, eligible dividends, the interplay of federal tax, provincial tax and Alternate Minimum Tax (AMT) can leave one’s head spinning. Finding an optimum and tax-free strategy is pretty well impossible. This is new, because the old ineligible dividend system never attracted the wrath of AMT. For instance, while the chart above indicated that an incremental amount of eligible dividends was tax-free up to $70,000, if one’s income is solely eligible dividends, the AMT changes that result. In fact, only $49,000 of such dividends are tax-free; above this, the AMT kicks in. At $70,000, the AMT tax bill would approximate $4,100 instead of being free and, furthermore, the provincial tax credits are not fully enjoyed.