|How Dividends are Taxed in Canada|
How are dividends taxed in Canada? I see this question almost everyday from our blog readers. They want to know the tax implications of owning a company's shares in Canada.
This article will break down the answer to the question in a way that even a novice in the finance industry will understand how dividends are taxed in Canada. The truth is that the answer to the question is more simple than people thought.
I don't want to confuse you, so we will look at only the federal tax. The federal tax system works in the same way as the provincial system. However, the only difference between them is the tax rates.
Furthermore, I want to state categorically that this article is for general information, and does not substitute your personal research. It doesn't make you an expert in corporate taxes. Please consult with an accountant near you in Canada or an online accountant for any issues with your tax.
What is a Dividend?
For people who don't know the meaning, a dividend is the part of the profits of a corporation that are paid out to the owners (shareholders). Shareholders decide the Board of Directors. The Board of Directors agrees on the amount of tax-free dividend income in Canada through a Board Resolution.
Normally, the Board Resolution specifies the amount of money to be paid for each share as a dividend. For instance, a Board of Directors could agree to pay $2.50 per share to Class A Common Shareholders.
Dividend Tax Rate in Canada
Investopedia revealed that, in the 2019 tax year, Canadian investors might have to pay up to 29% in income tax on their dividends if they are in the highest tax bracket.
Small Business Tax Deductions in Canada
You might not see its importance now, but trust me, it will matter in the next part. In Canada, companies that are called a Canadian Controlled Private Corporation (CCPC) can get a special tax deduction known as the small business deduction.
This is a big tax deduction for CCPCs on their initial $500,000 in active business earnings. We won't go into more detail here, but keep in mind that the small business deduction greatly lowers the taxes a company has to pay.
Eligible vs. non-eligible dividends
There are two dividend types: eligible and non-eligible. Usually, the tax rates on eligible dividends are lower than those on non-eligible dividends for individuals. Let me explain why.
Eligible dividends are profits given to shareholders who didn't get the small business deduction or any other special tax rate benefit. Because the Corporation paid higher taxes on the profits before distributing dividends, the tax system is designed so that people pay less tax on eligible dividends than on non-eligible dividends.
Conversely, non-eligible Canadian dividends are profits paid to shareholders who received benefits from small business tax deductions or other special taxes.
Because the Canadian Corporation pays lower taxes on its profits, the income tax system is designed so that individuals pay more tax on non-eligible dividends than on eligible dividends.
There are a few other words that you might hear when discussing dividend taxes in Canada. But unless you're an accountant actively handling corporate income tax returns, all you need is a simple grasp of these terms.
Dividend gross-up is a term used in Canada to refer to the process of increasing the amount of dividends received by an individual to account for taxes that have already been paid by the corporation distributing the dividends.
Dividend gross-up is like the tax authority (CRA) saying, "We see you got $1,000 in non-eligible dividends, but let's pretend it's $1,160 and tax you on that amount."
The dividend gross-up basically means that the CRA looks at the dividends you received and goes “yeah… I get that you received a non-eligible dividend of $1,000 but let’s just pretend it’s $1,160 and then tax you on that, okay?
Oh, hold on! Those dividends are eligible for taxation? They say, "Let's pretend it's $1,380!" Yes, that's really how it works – might sound bad, but it's balanced by something great called a dividend tax credit.
Federal Dividend Tax Credit
Taxes can be needlessly confusing. You know when the CRA made us increase the taxable dividend amount in the gross-up? Well, the CRA can change its mind sometimes.
As you go through your tax return, they realize they were a bit "strict," so they give you some of that back as the dividend tax credit. You actually receive both a Provincial and Federal dividend tax credit.
General Rate Income Pool (GRIP)
The General Rate Income Pool is a record that keeps track of the profits made by a CCPC, which are taxed at regular corporate income tax rates. The money in the GRIP can be distributed by the CCPC in the form of eligible dividends.
Low Rate Income Pool (LRIP)
The Low Rate Income Pool (LRIP) refers to a pool of income that a non Canadian-controlled private corporation (CCPC) can use to access a lower tax rate on certain types of income. It's an account that keeps track of the profits a non-CCPC makes, and these profits were taxed at lower rates.
A non-CCPC needs to use up all its Low Rate Income Pool (LRIP) by giving out non-eligible dividends before it can distribute eligible dividends.
Integration is important to the tax system. In simple terms, integration means that regardless of how taxable income moves from companies to individuals, the tax rate on that income will stay consistent. That's why we have things like eligible and non-eligible dividends, the dividend gross-up, and the dividend tax credit.
This doesn't mean tax planning is useless. Tax deferral can create opportunities. Here's a different way to think about it: You'll have to pay taxes, but tax deferral lets you decide when you pay them. Tax planning can be helpful, and it can make sure you don't pay more taxes than you should.
How is the Canadian Capital Gains Tax Structured?
In Canada, you pay tax on 50% of your capital gains, and you need to add this amount to your taxable income. This is because the investments in the ETF portfolio are sold at a higher price than what they were bought for.
While just half of the capital gains count as taxable income, the capital gains tax rate is 12.50%, which is half of the normal income tax rate. Due to the dividend tax credit, the marginal tax rate for eligible dividends is only 2.57%.
Are Dividends Added to Taxable Income in Canada?
If you get a dividend as a shareholder, you need to report it on your tax return. Dividends are subject to both provincial and federal taxes. The tax on qualified dividends is 15.0198%, and for non-eligible dividends, it's 9.031%.
Are Dividends Taxed Twice in Canada?
No, dividends are not taxed twice in Canada. The laws governing taxable income are straightforward. Shareholders who received dividends from companies in Canada are entitled to Canadian Dividend Tax Credit, since the companies already paid taxes on their profit. This law is important to avoid double taxation.
Dividends from Real Estate Investment Trusts (REIT)
Anyone who wants to invest in a Real Estate Investment Trust (REIT) should do it in a registered account. It is important to note that the Payment from a Real Estate Investment Trust (REIT) is called DISTRIBUTION, not dividend.
A distribution is different from dividend because distribution may include capital gains, dividends, interests, capital return or any other income. Having a REIT in a registered account makes handling taxes easier since different kinds of payments could be taxed at different rates.
Can you Apply a Dividend Tax Credit to Foreign Dividends?
As mentioned before, you can't get the Canadian dividend tax credit for stocks that aren't Canadian-based. Most foreign earnings are taxed with a withholding tax, and the rate varies from country to country. Please ensure to contact an experienced accountant in Canada before investing in shares outside the country.
Conclusion: How Dividends are Taxed in Canada
I hope you now understand how dividends are taxed in Canada. With this understanding of how dividends work, you can now consult with a tax professional to help you check your taxes.
If you need professional accounting services for you start-up, you should hire an online accounting firm in Canada or visit an accounting firm near you to discuss your problems and how they can help you solve them.
FAQs on How Dividends are Taxed in Canada
Here are some frequently asked questions (FAQs) on how dividends are taxed in Canada:
1. What are eligible and non-eligible dividends in Canada?
Eligible dividends are typically paid by public corporations and receive a more favorable tax treatment. Non-eligible dividends are usually paid by private corporations and are subject to higher tax rates for most individuals.
2. How are eligible dividends taxed in Canada?
Eligible dividends are grossed-up by a specific factor and then taxed at a lower rate for most individuals due to the dividend tax credit.
3. How are non-eligible dividends taxed in Canada?
Non-eligible dividends are grossed-up by a different factor and are subject to higher tax rates for most individuals compared to eligible dividends.
4. Do I receive a tax credit for dividend income in Canada?
Yes, Canada offers a federal dividend tax credit to reduce the tax payable on eligible dividends.
5. Are there any provincial variations in dividend taxation?
Yes, provincial governments have their own tax rates and rules regarding dividend income, so the taxation of dividends can vary by province.
6. Is there a dividend tax credit for non-eligible dividends?
Some provinces may offer a dividend tax credit for non-eligible dividends, but the rates and rules differ by province.
7. Are there any tax advantages to holding shares in a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP)?
Income earned on investments within a TFSA is tax-free, while income within an RRSP is tax-deferred until withdrawal. This can provide tax advantages for dividend income.
8. Do dividend tax rules apply to foreign dividends received by Canadian residents?
Yes, foreign dividends are also subject to taxation in Canada, and the tax treatment can vary depending on tax treaties and other factors.
9. What is the gross-up factor for eligible and non-eligible dividends?
The gross-up factor for eligible dividends and non-eligible dividends is determined by the federal government and can change from year to year.
10. Are there any tax planning strategies for minimizing dividend tax in Canada?
Tax planning strategies can include income splitting, using tax-efficient accounts like TFSAs and RRSPs, and carefully managing your investment portfolio to optimize tax outcomes.