In the world of investment income, understanding the nuances of dividend types is crucial for both corporations and shareholders. Eligible dividends and non-eligible dividends play a significant role in the Canadian tax system, having an impact on after-tax profits and personal tax liabilities. This distinction is particularly important to grasp as it affects how dividend income is taxed and the overall financial strategy of businesses and investors alike.
The Canadian Revenue Agency has established different tax treatments for eligible and non-eligible dividends to reflect varying levels of corporate taxation. This article aims to explore the key differences between these two types of dividends, shedding light on their implications for public and private corporations, as well as individual shareholders. We’ll delve into the specifics of eligible and non-eligible dividends, examine their tax treatment, and consider the perspectives of both corporations and shareholders to provide a comprehensive understanding of this important aspect of Canadian corporate finance and personal taxation.
What are Eligible Dividends?
Definition
Eligible dividends are a specific type of dividend payment issued by Canadian corporations to shareholders. These dividends are designated as “eligible” by the corporation paying them, indicating that they come from income that has been taxed at higher corporate rates. The Canadian Revenue Agency has established this classification to reflect varying levels of corporate taxation and to provide certain tax advantages to shareholders.
Sources of Eligible Dividends
Eligible dividends typically originate from two main sources:
- Public corporations: These are generally large companies that do not qualify for the small business tax deduction. As a result, they pay corporate tax at higher rates.
- Private corporations with high earnings: These are companies with net income exceeding the small business deduction threshold, which is currently set at CAD 694,000.08.
Both these types of corporations pay corporate tax at higher rates compared to small businesses. This higher tax rate has an impact on how the dividends are treated when distributed to shareholders.
A key concept in understanding eligible dividends is the General Rate Income Pool (GRIP). When a corporation pays tax at the higher corporate rate, a portion of its income flows into its GRIP balance and accumulates over time. The GRIP represents the after-tax amount of income that has been subject to the higher corporate tax rate. Eligible dividends are issued from a corporation up to the amount sitting in the GRIP pool.
It’s important to note that Canadian-controlled private corporations (CCPCs) can also pay eligible dividends, but only to the extent of their GRIP as calculated at the end of the tax year. This is because CCPCs generally earn income benefiting from preferential income tax rates, which cannot be distributed as an eligible dividend.
Tax Treatment
The tax treatment of eligible dividends is designed to balance out the higher corporate taxes paid by the issuing corporation. When shareholders receive eligible dividends, they are subject to a process called “gross-up” and are eligible for a dividend tax credit.
The gross-up process involves increasing the actual dividend amount received to reflect the pre-tax corporate income. As of 2024, eligible dividends are grossed up by 38%. This means that if a shareholder receives an eligible dividend of CAD 100, they would report CAD 138 as taxable dividend income on their tax return.
After the gross-up, shareholders can claim a federal dividend tax credit. For eligible dividends, this credit is currently set at 15.0198% of the grossed-up dividend amount. This credit serves to offset the additional taxes that would otherwise be payable due to the gross-up.
The purpose of this tax mechanism is to integrate personal and corporate taxes, recognizing that the corporation has already paid tax on the income used to pay the dividend. By providing a tax credit to the shareholder, the system aims to prevent double taxation and ensure fairness in the overall tax burden.
It’s worth noting that eligible dividends are taxed more favorably than non-eligible dividends. This preferential treatment reflects the fact that the issuing corporation has paid tax at higher rates, allowing the individual receiving the dividend to pay less in personal taxes.
What are Non-Eligible Dividends?
Definition
Non-eligible dividends, also known as ineligible dividends, are a type of dividend payment issued by Canadian corporations to their shareholders. These dividends typically come from income that has been taxed at lower corporate rates. The Canadian Revenue Agency has established this classification to reflect the varying levels of corporate taxation and to provide a different tax treatment compared to eligible dividends.
Sources of Non-Eligible Dividends
Non-eligible dividends generally originate from two main sources:
- Smaller private corporations: These are usually Canadian-controlled private corporations (CCPCs) that benefit from the small business tax deduction. They pay corporate tax at lower rates on their first CAD 694,000.08 of income.
- Passive income: Income generated from investments or other passive sources within a corporation is often distributed as non-eligible dividends.
Unlike eligible dividends, which come from income taxed at higher corporate rates, non-eligible dividends are paid from corporate earnings that have benefited from preferential tax treatment. This distinction has an impact on how these dividends are taxed when distributed to shareholders.
It’s important to note that a corporation must maintain proper accounting of its income sources to ensure accurate dividend classification. For CCPCs, this involves tracking income subject to the small business tax rate, which cannot be distributed as an eligible dividend. Non-CCPCs, on the other hand, must maintain a Low Rate Income Pool (LRIP) to track income that has benefited from preferential tax rates, ensuring it is paid out as non-eligible dividends before any eligible dividends can be issued.
Tax Treatment
The tax treatment of non-eligible dividends reflects the lower corporate taxes paid by the issuing corporation. When shareholders receive non-eligible dividends, they are subject to a process called “gross-up” and are eligible for a dividend tax credit, similar to eligible dividends but with different rates.
As of 2024, non-eligible dividends are grossed up by 15%. This means that if a shareholder receives a non-eligible dividend of CAD 100, they would report CAD 115 as taxable dividend income on their tax return. This gross-up percentage is lower than that of eligible dividends, which are grossed up by 38%.
After the gross-up, shareholders can claim a federal dividend tax credit. For non-eligible dividends, this credit is smaller than the one provided for eligible dividends. The purpose of this tax mechanism is to integrate personal and corporate taxes, recognizing that the corporation has already paid tax on the income used to pay the dividend, albeit at a lower rate.
The tax rates for non-eligible dividends in the hands of shareholders range from 35.98% to 47.34%, depending on the province or territory. This higher tax rate compared to eligible dividends reflects the lower corporate tax paid on the income used to distribute these dividends.
It’s worth noting that the Canadian tax system uses different types of Refundable Dividend Tax on Hand (RDTOH) accounts to track taxes paid on various income sources. The Non-Eligible Refundable Dividend Tax on Hand (NRDTOH) can only be recovered by paying a non-eligible dividend, while the Eligible Refundable Dividend Tax on Hand (ERDTOH) can be recovered by paying either an eligible or non-eligible dividend. However, corporations must recover their NRDTOH balance before recovering any ERDTOH when paying non-eligible dividends.
This complex system of dividend classification and tax treatment aims to ensure fairness in the overall tax burden between corporations and individual shareholders, while also reflecting the different levels of corporate taxation applied to various income sources.
Key Differences in Tax Treatment
The tax treatment of eligible and non-eligible dividends in Canada reflects the varying levels of corporate taxation and aims to integrate personal and corporate taxes. Understanding these differences is crucial for both corporations and shareholders to optimize their tax planning and financial strategies.
Gross-up Rates
The gross-up process is a key factor in the taxation of dividends. It involves increasing the actual dividend amount received to reflect the pre-tax corporate income. This adjustment helps align dividend income with total income for tax calculations.
For eligible dividends, the gross-up rate is 38%. This means that if a shareholder receives an eligible dividend of CAD 100, they would report CAD 138 as taxable dividend income on their tax return. This higher gross-up rate reflects the fact that eligible dividends come from income taxed at higher corporate rates.
In contrast, non-eligible dividends have a lower gross-up rate of 15%. Using the same example, a non-eligible dividend of CAD 100 would result in a taxable dividend income of CAD 115. This lower rate acknowledges that non-eligible dividends typically come from income that has benefited from preferential tax treatment at the corporate level.
Dividend Tax Credits
After the gross-up, shareholders can claim dividend tax credits to offset the increased taxable income. These credits are designed to mitigate double taxation, recognizing that the corporation has already paid taxes on the income used to pay the dividend.
For eligible dividends, the federal dividend tax credit is set at 15.0198% of the grossed-up dividend amount. This substantial credit compensates for the higher gross-up rate and reflects the higher corporate taxes paid on the income source.
Non-eligible dividends, on the other hand, qualify for a smaller federal dividend tax credit of 9.0301% of the grossed-up amount. This lower credit aligns with the reduced corporate tax rates applied to the income source of these dividends.
It’s important to note that provinces and territories also offer dividend tax credits, which vary by jurisdiction. These credits further reduce the overall tax burden on dividend income.
Overall Tax Impact
The combination of different gross-up rates and dividend tax credits results in a more favorable tax treatment for eligible dividends compared to non-eligible dividends. This difference reflects the varying levels of corporate tax paid on the income used to distribute these dividends.
For eligible dividends, the overall tax impact is generally lower. The higher gross-up rate is offset by a more substantial dividend tax credit, resulting in a lower effective tax rate for shareholders. This preferential treatment acknowledges that the issuing corporation has paid tax at higher rates.
Non-eligible dividends, while still benefiting from tax advantages compared to other forms of income, face a higher overall tax impact. The lower gross-up rate and smaller dividend tax credit result in a higher effective tax rate for shareholders. This treatment reflects the preferential tax rates applied to the corporate income source.
The actual tax rates for both types of dividends can vary significantly depending on the shareholder’s province or territory of residence and their marginal tax rate. For example, in some provinces, the combined federal and provincial tax rate on eligible dividends for individuals in lower tax brackets can be as low as 15.9%, while non-eligible dividends might be taxed at rates ranging from 35.98% to 47.34%.
This complex system of dividend taxation aims to achieve integration between corporate and personal taxes, ensuring that the overall tax burden on corporate earnings distributed as dividends is roughly equivalent to what an individual would pay if they had earned the income directly. However, due to variations in provincial tax rates and other factors, perfect integration is rarely achieved in practice.
Corporate Perspective on Dividend Types
From a corporate standpoint, the decision to issue eligible or non-eligible dividends has significant implications for both the company and its shareholders. This choice is influenced by various factors, including the corporation’s tax status, income sources, and strategic objectives.
General Rate Income Pool (GRIP)
Canadian-controlled private corporations (CCPCs) maintain a General Rate Income Pool (GRIP) to track income that has been taxed at the general corporate tax rate. This pool represents the accumulated income that can be distributed as eligible dividends. The GRIP balance is calculated at the end of each tax year and takes into account several factors:
- The previous year’s GRIP balance
- 72% of taxable income minus amounts eligible for the small business deduction and aggregate investment income
- Eligible dividends received
- Eligible dividends paid by the corporation
CCPCs can pay eligible dividends up to the amount in their GRIP balance without incurring additional taxes. This mechanism allows corporations to pass on the tax advantage of income taxed at higher rates to their shareholders.
Low Rate Income Pool (LRIP)
In contrast to CCPCs, non-CCPCs and public corporations maintain a Low Rate Income Pool (LRIP). The LRIP tracks income that has been taxed at lower rates and must be paid out as non-eligible dividends before the corporation can issue eligible dividends. The LRIP balance is determined at any particular time a dividend is paid and includes:
- Income subject to low tax rates if the corporation was previously a non-CCPC
- Non-eligible dividends received
- Non-eligible dividends paid
- Excess eligible dividend designations
Corporations must clear out their LRIP balance by paying non-eligible dividends before they can designate any dividends as eligible. This ensures that income benefiting from preferential tax rates is distributed appropriately.
Strategic Considerations for Corporations
The choice between issuing eligible and non-eligible dividends has strategic implications for corporations:
- Tax Integration: Corporations aim to achieve tax integration, ensuring that the overall tax burden on corporate earnings distributed as dividends is roughly equivalent to what an individual would pay if they had earned the income directly.
- Shareholder Value: Eligible dividends are taxed more favorably at the personal level, potentially increasing after-tax returns for shareholders. This can make a corporation’s shares more attractive to investors.
- Cash Flow Management: The decision to pay dividends affects a corporation’s cash flow. Companies must balance the desire to reward shareholders with the need to retain earnings for growth and operational needs.
- Compliance and Penalties: Corporations must carefully manage their GRIP and LRIP balances to avoid excessive eligible dividend designations, which can result in penalties. For instance, if a CCPC pays eligible dividends exceeding its GRIP balance, it may face a Part III.1 tax of 20% on the excess amount.
- Business Strategy Alignment: A corporation’s dividend policy often reflects its overall business strategy. Companies focused on growth and innovation (often called “prospectors”) may be more conservative in their dividend payout decisions, preferring to reinvest profits into research and development or new market opportunities.
- Financial Covenants: Innovative firms may face more financial covenants in their debt contracts, potentially restricting their ability to pay dividends. This can influence the type and amount of dividends issued.
By carefully considering these factors, corporations can develop dividend strategies that balance tax efficiency, shareholder expectations, and long-term business objectives. The interplay between eligible and non-eligible dividends provides a powerful tool for corporate financial management within the Canadian tax system.
Shareholder Perspective on Dividend Types
Tax Planning Implications
For shareholders, understanding the tax implications of eligible and non-eligible dividends is crucial for effective tax planning. The Canadian tax system treats these dividend types differently, which has an impact on after-tax profits for investors. Eligible dividends, typically issued by public corporations or private corporations with high earnings, receive preferential tax treatment. This is because they come from income that has already been taxed at higher corporate rates.
The tax advantage of Canadian dividends stems from federal and provincial dividend tax credits. To claim these credits, shareholders must first “gross up” the amount of dividends received. For eligible dividends, the gross-up is 38% of the amount received, while for non-eligible dividends, it’s 15%. This process helps to integrate personal and corporate taxes, ensuring that income earned through a corporation is subject to a similar total amount of tax as if earned directly by an individual.
After the gross-up, shareholders can claim a dividend tax credit. For eligible dividends, the federal dividend tax credit is 15.0198% of the grossed-up amount, while for non-eligible dividends, it’s 9.0301%. These credits work to offset the increased taxable income resulting from the gross-up, producing a more tax-efficient outcome for shareholders.
Impact on Different Income Brackets
The tax treatment of dividends varies depending on the shareholder’s marginal tax rate and provincial laws. For individuals in lower tax brackets, eligible dividends can be particularly advantageous. In some provinces, the combined federal and provincial tax rate on eligible dividends for individuals in lower tax brackets can be as low as 15.9%, compared to higher rates for ordinary income.
However, the benefits of dividend income can differ across income brackets. High-income earners may find that the tax advantages of eligible dividends are less pronounced due to their higher marginal tax rates. It’s important for investors to consider their overall income and tax situation when evaluating the potential benefits of dividend-paying stocks.
Optimizing Dividend Income
To optimize dividend income, shareholders should consider several strategies. One approach is to hold dividend-paying stocks in non-registered accounts, where the dividend tax credit can be utilized. In contrast, dividends received in registered accounts like RRSPs or TFSAs do not benefit from the dividend tax credit, as these accounts have their own tax advantages.
Another strategy involves balancing the types of dividends received. While eligible dividends offer more favorable tax treatment, a mix of eligible and non-eligible dividends may be optimal depending on the investor’s overall income and tax situation. This can help in managing taxable income and potentially keeping the investor in a lower tax bracket.
Investors should also be aware of the concept of a “dividend trap.” This occurs when a company offers an unusually high dividend yield, which may be unsustainable. While high yields can be attractive, they may indicate underlying financial issues or an imminent dividend cut. It’s crucial to assess the company’s financial health, dividend payout ratio, and growth prospects before investing solely based on dividend yield.
For those with the flexibility to structure their income, such as business owners or professionals with corporations, careful planning around dividend payments can lead to significant tax savings. By timing dividend payments and balancing them with other forms of income, individuals can optimize their overall tax position.
Conclusion
The intricate world of Canadian dividend taxation highlights the importance of understanding the nuances between eligible and non-eligible dividends. This knowledge has a significant impact on both corporations and shareholders, influencing tax planning strategies and investment decisions. The complex system of gross-ups, tax credits, and income pools aims to strike a balance between corporate and personal taxation, reflecting the varying levels of corporate tax paid on different income sources.
For investors and business owners alike, grasping these concepts is key to optimizing tax efficiency and making informed financial choices. What’s more, it’s crucial to remember that dividends from corporations typically appear on T5 slips for personal taxes, showing both the actual dividend amount and the grossed-up figures. To wrap up, understanding the difference between eligible and non-eligible dividends is essential for effective tax planning. For all your accounting and tax needs, Contact BOMCAS Canada Today.
FAQs
What distinguishes eligible dividends from non-eligible dividends?
Eligible dividends come with a significant tax credit to offset the higher gross-up rate, whereas non-eligible dividends receive a smaller credit due to their lower gross-up rate.
How do qualified dividends differ from non-qualified dividends?
Qualified dividends are taxed at the long-term capital gains rate, which could be 0%, 15%, or 20% based on the investor’s income level. Non-qualified, or ordinary dividends, are taxed according to the investor’s normal income tax rate, which ranges between 10% and 37%.
What are the requirements to qualify for receiving dividends?
To qualify for dividends, you must purchase the stock at least one day before the ex-dividend date, which falls two business days before the record date. If you intend to sell the stock but still want to receive the dividend, ensure you do not sell it before the ex-dividend date.
What happens to non-eligible dividends from a tax perspective?
Non-eligible dividends are often refunded through the Non-Eligible Refundable Dividend Tax on Hand (NERDTOH) account. This account typically includes revenues such as interest, foreign dividends, and certain types of rental income. When a corporation issues non-eligible dividends to its shareholders, it can claim a refund from its NERDTOH account at a rate of CAD 41.64 for every CAD 138.80 paid out.
View Our Location
181 Meadowview Bay, Sherwood Park, AB T8H 1P7, Canada (Online Clients Only)