Wonderful dividend world dawns today: Here's how much more dividend income you'll retain after taxes
Welcome to the new investing landscape. With the changes announced on
Wednesday by the Department of Finance to deal with the income-trust dilemma,
Canadian dividends are poised to assume the lead in the race for tax-efficient
investment income, beginning in 2006 when the new dividend-tax-credit regime is
proposed to be effective.
When it comes to investment income, not all forms of income are taxed
equally. Interest income is the most highly taxed of all and is fully included
in your income and taxed at your full marginal tax rate. Capital gains, on the
other hand, are the most tax-efficient, being only 50% taxable. In the middle of
the current tax-efficiency spectrum, fall Canadian dividends.
Dividends from Canadian companies have always been tax attractive, due to the
dividend tax credit associated with them. Under the current rules, if you
receive $100 of dividends from a Canadian company, you "gross them up" by 25%,
meaning you actually report $125 of dividend income on your tax return.
You then are entitled to claim a federal dividend tax credit equal to 13.3%
of the grossed-up dividend, which can be used to reduce your federal tax
payable. Since each province also grants its own dividend tax credit, which, on
average, is worth about half the federal credit or about 6.7% (each province's
rate is different), Canadians dividends receive tax preferred treatment.
These current rules and rates will continue to remain in effect for dividends
received from Canadian private companies that pay tax on their active (i.e. not
investment) income that's taxed at the preferential small-business tax rate.
That's because the current rules work very nicely in most provinces to
provide individual investors with a dividend tax credit that, combined with the
gross-up described above, attempts to compensate the individual private-company
investor for the corporate tax already paid by the corporation. It eliminates
the "double-tax problem."
Until Wednesday's announcement, however, investors in public companies faced
double tax on dividends they received because the dividend tax credit did not
fully compensate them for the corporate tax paid by public companies, which are
not subject to the same preferential small-business tax rate available to
private Canadian corporations.
Under the new proposed rules to be effective in 2006, the gross-up would be
enhanced to 45% (from 25%), meaning that the shareholder includes 145% of the
actual dividends received in her income. The federal dividend tax credit would
then be increased to 19%. The feds also assume that the provinces will also
provide an enhanced dividend tax credit, which, when combined with the federal
credit, would total about 32%.
So, what's the bottom line? As the chart at right indicates, an Ontario
investor, for example, who earns $100 of investment income and who pays tax at
the top marginal tax bracket (using current 2005 rates) would currently retain
about $54 if she earned interest income. If the $100 was in the form of capital
gains, she would retain $77.
What about dividends? Under the current rules, $100 of Canadian dividends
would net only $69 after tax, but under the proposed new system, the same $100
of dividends will net about $79 on an after-tax basis. This translates to an
effective top marginal tax rate on dividends of about 21%.
As a result of these proposed new rules, dividends will became a whole lot
more attractive in 2006. Address your thank-you cards directly to Mr. Goodale.
Colour Photo: Reuters; Thank Finance Minister Ralph Goodale for the revolution
in dividends.; Table: Aim Trimark Investments, National Post; THE NEW DIVIDEND
RULES: What you'd retain on $100 of income: (See print copy for complete table.)