What is a Dividend Tax Credit?
The dividend tax credit generally refers to a Canadian tax program whereby Canadian residents receive a reduction in taxes owed on dividends received from Canadian corporations.
How Does a Dividend Tax Credit Work?
In Canada, dividends are considered taxable income to investors. However, they are rarely taxed at the investor’s regular income tax rate. Instead, the Canadian tax system generally requires residents to “gross up” the dividends they receive from many Canadian corporations. Then, the Canadian federal government and the provincial governments both give investors dividend tax credits equal to a percentage of the grossed-up amount, thereby reducing the amount of tax owed on the dividends.
For example, let’s assume you live in Manitoba and your income tax bracket is 20%. Let’s further assume that the tax system requires you to gross up the dividends you receive by 25%, but that the federal tax credit is 15% and the provincial tax credit is 4%. If you receive $1,000 worth of dividend checks in a year, then you would report $1,000 x 1.25 = $1,250 of dividend income. To calculate the taxes payable on those dividends, we would first calculate the income tax owed based on your income tax bracket:
$1,250 x 20% = $250
Then we would apply the dividend tax credits. The federal tax credit would be $1,250 x .15 = $187.50, and the provincial tax credit would be $1,250 x .04 = $50. Thus, the total tax payable on the dividend income is $250 - $187.50 - $50 = $12.50. This is equivalent to a 1% tax on the dividends received.
Why Does a Dividend Tax Credit Matter?
The dividend tax credit is a method to offset the double taxation problem inherent in dividend distributions (whereby the corporation pays income taxes on its profits and investors are taxed again on those profits when they are distributed in the form of dividends).
note that the calculation method above means that the effective tax rate on dividends is influenced by the investor’s existing tax bracket and where in Canada the investor lives. Also, the size of the gross up and the dividend tax credits are a matter of legislative decision and can change often. Provincial tax credits vary by province.
It is also important to note that status of the corporation as a Canadian-controlled private corporation and its taxation as a small business influences whether a corporation’s dividends are eligible for the dividend tax credit. The corporation making the dividend must inform investors whether the dividends are eligible for the tax credit.
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