When it comes to investing, not all forms of income are created equal.
Capital gains are the most tax-efficient, being only 50% taxable. Interest
income, on the other hand, is the most highly taxed of all: It's fully included
in your income and taxed at your full marginal tax rate.
Dividends from Canadian companies fall in the middle. They're attractive
because of the dividend tax credit associated with them. However, the multi-step
process of calculating your savings is so complicated you might just want to
forget about the whole thing.
This column will endeavour to untangle the web.
Here's how the credit works: if you receive $100 in dividends from a Canadian
company, the first step is to "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.
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).
So, why all this gross-up and tax credit nonsense? The history goes back to
the theoretical 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.
Let's take a simple example to illustrate how integration is supposed to
work. Assume that you are a consultant and you are in the highest marginal tax
bracket, about 45% (on average) in Canada. You are trying to decide whether to
incorporate your consulting practice.
Say you earn $1,000 personally. In the top 45% bracket, you would pay $450 of
combined federal and provincial tax and be left with after-tax cash to spend of
$550.
Alternatively, you decide to incorporate and now it's your corporation that
earns the $1,000. Assuming a combined federal and provincial small business tax
rate of 20%, the company would be left with $800 after it paid its $200 of
corporate tax.
To get the money into your hands personally, however, you are going to have
to pay the $800 out to yourself as a dividend. Going back to rules described
above, you would first "gross-up" this dividend by 25% and report $1,000 of
dividend income on your personal tax return. You would pay tax of $450 at your
top marginal tax rate of 45% on this income before taking into account the
dividend tax credit.
This credit would be worth 13.3% of the grossed-up amount federally or $133
and an additional 6.7% provincially or $67 for a total credit against taxes
payable of $200. Deducting this $200 combined federal and provincial dividend
tax credit from the $450 of tax otherwise owing will result in a net personal
tax payable of only $250.
Thus, perfect integration would be achieved since the corporation paid $200
of corporate tax, you paid $250 of personal tax, netting you $550 of after-tax
cash - the same amount of after-tax cash that you would have had if you had not
incorporated in the first place.
Canada's integration system, while not perfect, works pretty well in most
provinces when it comes to private corporations that can take advantage of the
small business tax rate on the first $300,000 of "active income" (as opposed to
passive or investment income).
It fails miserably, however, when it comes to integration of income earned by
public corporations, which is currently the source of the tax dilemma facing
Ottawa as it struggles with the tax policy issues facing income trusts.
Income trusts have figured out a way to escape the double tax problem
experienced by Canadians on public company dividends. To illustrate, assume that
a public company earns $1,000 of income. Instead of paying tax at a 20% small
business rate, a public company would pay corporate tax at a combined federal
and provincial rate of about 35% (or higher in some provinces). This would leave
$650 after corporate tax to be paid out as a dividend to investors.
Following the gross-up ($813), the personal tax at 45% ($366) and the
combined 20% federal and provincial dividend tax credit ($163), the investor is
left with just $447 after-tax (i.e. $650 - $366 + $163). This is essentially
double-tax as the investor is not getting a full credit for the taxes paid by
the public company.
If Ottawa really wants to fix the income trust "problem", it should begin by
repairing the integration system, perhaps by lowering the corporate tax rate and
increasing the dividend tax credit.