Hit isn't as hard as it first seems

National Post


Last week's federal budget proposed an adjustment to the taxation of dividends beginning in 2010. Many experts have commented that the tax rate on eligible Canadian dividends, which includes most dividends received from public companies as well as dividends from some private companies, will be increasing as a result.

The top federal marginal tax rate on eligible dividends for 2008 is currently 14.55%. It's scheduled to remain the same in 2009, rise to 15.88% in 2010, 17.72% in 2011 and settle at 19.29% in 2012.

At first glance, this is a preposterous 30% hike in dividend tax for investors. But when you look at the math behind it, the hit isn't as hard.

Essentially, in the 2008 budget, the feds announced adjustments to the "gross-up" factor and the dividend tax credit rates to parallel reductions in the general corporate tax rates (announced as part of the 2007 Economic Statement). The reductions for corporations bring federal tax rates down from a high of 19.5% currently to 15% by 2012.

To understand the true interaction between corporate tax rates, the gross-up and the dividend tax credit, a quick review of the concept of integration is in order. In theory, an investor earning income directly will have the same after-tax amount had that income been earned in a corporation, taxed there and then distributed as a taxable dividend to that investor.

If you are in the top tax bracket and earn $100 of income personally and pay tax at the top average tax rate of 45%, you would have $55 cash left to spend.

If the same $100 was earned by a corporation, after applying the corporate tax rate, paying a dividend and "grossing up" that dividend to its pre-corporate tax equivalent, the shareholder should also be left with $55 after paying his or her dividend tax.

In both cases, the total taxes paid would be identical -- $45. The difference is who bears the burden of the tax.

The chart above shows how the 2008 budget proposals are designed to keep the total net cash received by shareholders constant, at approximately $55. This example assumes a constant 12% provincial corporate tax rate and a constant 16% provincial personal tax rate.

The example is premised on two important assumptions -- the most basic one being that the corporation will increase its dividend payout to shareholders by the amount of corporate tax saved.

The second assumption inherent in the new gross-up factors and federal dividend tax credit rates is that the provinces will similarly adjust their dividend tax credits proportionately so that the total after-tax cash received by the investor remains constant.

Whether the provinces actually follow through on this is another story.