Simplifying the new dividend math: But don't count on the provinces doing their bit

National Post

2005-11-30



Do the new dividend rules have you totally confused? Judging by the response
to last week's column showing the new dividend tax credit calculations, you can
take comfort in the fact that you're not alone. Here's how the new math works.

Let's begin with a quick review and example of the concept of integration.
The principle of integration means that, in theory, an individual should be able
to realize the same amount of cash after tax by earning income personally or
through a corporation.

The current "gross-up" and dividend tax credit system is based on a
theoretical integration model that taxes corporate income at 20%. The current
system, while not perfect, works pretty well in most provinces when it comes to
private corporations. These can take advantage of the small-business tax rate,
which approximates 20% on the first $300,000 of "active income" (as opposed to
passive or investment income).

If you are in the top bracket and earn $100 of income personally and pay tax
at the top average tax rate in Canada of 46%, you would have $54 cash left to
spend.

If the same $100 was earned by a small business eligible for the preferential
corporate tax rate of 20%, the corporation would have $80 left after tax to pay
to its shareholder as a dividend.

Under the current rules, that shareholder would "gross up" the $80 of
dividend income by 25% to $100 -- the same amount of income the corporation
earned before tax. The purpose of the gross-up, therefore, is to put the
shareholder in the same position she would have been in had she earned the $100
personally.

That being said, to compensate the shareholder for the corporate tax already
paid on the $100 by the corporation, the shareholder may claim a federal
dividend tax credit of 13.33% of the grossed-up dividend and a provincial
dividend tax credit that, on average, is worth about half the federal credit, or
about 6.67%. (Each province's rate is different).

The effect of the gross-up and tax credit is that the shareholder initially
pays $46 of tax on the $100 of grossed-up dividends received. She then gets a
20% or $20 combined federal and provincial dividend tax credit, which puts her
net tax at $26 on an $80 dividend received, netting her after-tax cash of $54
--the same after-tax proceeds as if the $100 was earned directly. The resultant
effective marginal tax rate on dividends is therefore 32.5%. See column 1 of the
table above.

However, dividends paid by public companies face a much higher corporate tax
rate than 20%, currently averaging 36.5%. You can see (column 2) that the same
$100 earned by a public company in Canada only nets the investor about $43,
versus the $54 for personal income.

Income trusts long ago figured out a way to escape this double-taxation:
Convert to a trust and eliminate corporate tax altogether.

To address this issue, last week Finance Minister Ralph Goodale announced
changes to the dividend tax rules. Under the new proposed rules, to be effective
in 2006, the gross-up would be enhanced to 45% (from 25%) and the federal
dividend tax credit would then be increased to 19%. These rates are based on a
combined average federal-provincial corporate tax rate of 32% in 2010 -- the
year in which the 2005 budget's federal corporate tax reductions will be fully
implemented.

The feds assume that the provinces will also provide an enhanced dividend tax
credit equal to 13%, which, when combined with the federal credit, would total
about 32% -- the corporate tax rate in 2010. This would achieve full integration
and result in the top marginal tax rate for dividends dropping to 20.3% (column
3).

While this might all sound great in theory, there are two main flaws with the
proposal. The first flaw, addressed here by Jonathan Chevreau, is the adverse
effect the 45% gross-up will have on income-tested benefits, such as Old Age
Security.

The second problem is the fed's assumption that the provinces will adopt the
13% provincial dividend tax credit needed for perfect integration. As KPMG
national tax partner Paul Hickey says: "It's very dangerous to assume that the
provinces will fall into line."

Add to the mix the complexity associated with yesterday's election call and
you've got a recipe for continued uncertainty. Stay tuned ...

GRAPHIC: Table: Aim Trimark Investments, National Post; Levelling the Score:
(See print copy for complete table.)