Taxation of dividends
There are three types of dividends you can receive from your corporation: an “eligible” dividend, a regular dividend (also referred to as an “ineligible” dividend) or a capital dividend (capital dividends are received tax-free).
These rules apply to certain dividends paid after 2005 by corporations resident in Canada to shareholders resident in Canada.
Dividends and individuals
For 2015, dividends designated as eligible dividends are subject to a dividend gross-up of 38% and a federal dividend tax credit equal to 20.73% of the actual dividend.
Taxable dividends from Canadian resident corporations that are not designated as eligible dividends are ineligible (or regular) dividends. For 2015, these dividends are subject to an 18% dividend gross-up and a federal dividend tax credit equal to 13% of the actual dividend. The 2015 federal budget has proposed to reduce both the dividend gross-up and the federal dividend tax credit for regular dividends over a four year period, beginning in 2016. This will result in a gradual increase in the tax rate applicable to regular dividends to coincide with the decline in the corporate small business rate (see topic 24). This is intended to maintain integration of the tax system (see topic 148). The provinces all have their own dividend tax credit rates (refer to the individual tax tables for a comparison of the top marginal eligible and ineligible dividend rates by province).
As a result of the dividend gross-up and tax credit mechanism, dividends are taxed more favourably than most other types of income (except for capital gains). In a few provinces/territories (Alberta and the Yukon for 2015), eligible dividends are taxed at a lower rate than capital gains.
Dividends received from a foreign corporation are not subject to the gross-up and dividend tax credit mechanisms. Therefore, you’ll pay a higher rate of tax on dividends from a foreign corporation.
Dividends and corporations
A corporation’s ability to pay an eligible dividend depends on its status. A Canadian-controlled private corporation (CCPC) can only pay an eligible dividend to the extent that it has a balance in its “general rate income pool” (GRIP) at the end of the taxation year in which the dividend is paid. Although the actual formula is quite complex, the GRIP generally reflects taxable income that has not benefited from preferential tax rates, such as the small business rate, or from refundable dividend tax treatment afforded to investment income earned by a CCPC. There is an exception for public company dividends that have been designated as eligible dividends. Such dividends retain their status as eligible dividends when they pass through a private corporation.
A non-CCPC that is resident in Canada can pay eligible dividends without restriction, unless it has a balance in its “low rate income pool” (LRIP) at the time the dividend is paid. The LRIP is generally made up of taxable income that has benefited from the small business deduction, either in the hands of the dividend-paying non-CCPC itself (at a time when it was a CCPC) or in the hands of a CCPC that paid an ineligible dividend to the non-CCPC. Many non- CCPCs will never have an LRIP, and thus will be able to designate all of their dividends as eligible dividends. However, if a non-CCPC does have an LRIP balance, it must reduce its LRIP through the payment of ineligible dividends before it can pay an eligible dividend.
Designating a dividend as an eligible dividend
For a dividend to be an eligible dividend, it must be designated as such in writing by the corporation paying the dividend. For private corporations, the CRA has indicated that proper notice will include: (i) a letter to the shareholders; (ii) a notation on dividend cheque stubs; or (iii) in cases where all shareholders are directors, a notation in the corporate minutes. The notification procedure for public corporations is more simplified. Before or at the time the dividend is paid, the corporation only needs to make a designation stating that all dividends are eligible dividends unless indicated otherwise. This designation can generally be found on the corporation’s Web site (under Investor Services). For eligible dividends paid after March 28, 2012, the CRA will accept a late designation (i.e., after the time the dividend is paid) at its discretion in certain limited situations. An example would include a corporation making such a request because it faces circumstances beyond its control preventing it from designating dividends by the payment date. The corporation must make the designation no later than three years following the day on which the dividend was paid.
Any taxable dividend paid prior to March 29, 2012 had to be paid as either a designated eligible dividend or a non-eligible dividend. Split-dividend designations were not permitted. For taxable dividends paid after March 28, 2012, a corporation can designate any portion of a taxable dividend to be an eligible dividend.
If a corporation makes an eligible dividend designation that exceeds its capacity, the corporation will be subject to a penalty tax. However, there are special rules that may allow the corporation to retroactively undo all or part of an excessive designation by making an election to treat the excess eligible dividend as being a taxable dividend.
Tax tip: If you’re the owner-manager of a CCPC and you want to pay a dividend from the company, consult with your tax adviser to determine if all or part of the dividend should be designated as an eligible dividend.
Tax tip: If you have no other sources of income, you can receive a significant amount of Canadian dividend income and pay little or no tax. The amount will vary depending on your province of residence at the end of the year and whether the dividend is an eligible or an ineligible dividend. Note, however, that alternative minimum tax (see topic 157) may apply—in particular, on the receipt of eligible dividends.
If you receive shares of a foreign corporation from another foreign corporation as part of a “spinoff” transaction, you may have to report foreign-source dividend income.
However, if the transaction was not a taxable transaction in the US, you may be able to make a special election that will allow you to avoid being taxed on the foreign-source dividend. You can elect to take advantage of the deferral by including a letter with your tax return for the year in which the distribution occurs. Under the taxpayer relief provisions (see topic 166), a taxpayer is allowed to late-file this election.
To qualify for the deferral, shares must be distributed by an actively held and widely traded US public corporation. In addition, US tax law must provide for a tax deferral to the distributing corporation and its US resident shareholders.
If the election is made, there’s a cost-base adjustment to the original and spinoff shares based on their relative fair market values.
Tax tip: If you receive or have received shares of a foreign corporation as part of a share restructuring, you might qualify for a tax deferral or tax refund under these rules. You should contact your tax adviser to determine if you qualify and to assist you in making the special election.