A Walk-through of the Mechanics of Dividend Taxes
If you received dividends last year, you may have wondered while filling out your tax return why the dividends for tax purposes were considerably bumped up. Does this "grossing up" process result in higher tax on dividends?
The following table shows how the dividend tax process works for an Ontario taxpayer in the lowest bracket of taxable income (about $39,000) using 2012 rates (taken from TaxTips.ca). It show three types of dividends: eligible dividends from Canadian corporations, which is the typical type from publicly-listed companies on the TSX contained in many mutual funds and ETFs; non-eligible dividends, which come mainly from Canadian small businesses; and foreign dividends, which come from US and international companies both held individually or through mutual funds and ETFs. Naturally, the table applies, and taxes apply, only when the investor holds the shares or funds in a taxable account. It does not apply for holdings in a registered account like a TFSA, RRSP, RESP, RRIF, LRIF or LIRA while the holdings are inside. The slippery ins and outs of dividends in a registered account are discussed further on.
Myth: The dividend gross-up results in higher tax for the investor.
Reality: The tax credit that automatically goes along with the grossed-up dividend offsets the gross-up effect. The system is designed to prevent double taxation of the profits from the corporation. The gross-up reflects the amount of pre-tax profit that the corporation is presumed to have earned while the credit reflects the tax that the corporation is presumed to have paid.
In our example, the investor with eligible dividends will not pay any tax at all (since the corporation already paid). In fact, there is a small left-over credit of $1.89. Though we show the net tax as zero since it is non-refundable as cash to the investor (much like those familiar store discount coupons with no cash value though they give the right to a discount), the credit can in fact be used to reduce taxes due on any other income of the investor. Investors shouldn't get too excited as the "negative tax" on dividends only occurs in the lowest tax bracket, generally up to about $40,000 taxable income, and the percent benefit is relatively low, a few percent at best.
Reality: Non-eligible dividends do not get grossed-up as much but they also receive a lower tax credit with the net effect that investors pay more tax than on eligible dividends.
Reality: Foreign dividends do not go through the gross-up/credit process and are treated as ordinary income, which is taxed at a higher rate than dividends across all income levels in every province (see TaxTips tables).
Reality: The dividend gross-up can result in the reduction of income-tested benefits for retirees like OAS and GIS. The gross-up produces higher income and that starts eating away at OAS above individual net income of about $69,500 (2012 figure) and GIS above total income for a couple of about $21,600.
Registered vs Taxable Accounts
Registered accounts like a TFSA, RRSP, RESP, RRIF, LRIF or LIRA cause some of the trickiest and most confusing tax effects!
Myth: There is no tax levied against dividends on investments while held in registered accounts.
Reality: Though there is no Canadian tax, foreign governments can and do levy witholding taxes depending on combinations of type of account and fund structure. In a taxable account, sometimes the tax may be claimable and may thereby offset Canadian tax owing. In registered accounts like RRSPs but not in TFSAs or RESPs, sometimes it may be avoided. In all types of accounts, sometimes it is gone and lost forever, causing a net reduction to returns. See these previous posts for details - Pros and Cons of Cross-Border Shopping in the USA for ETFs and Free Tool to Compare Cross-Border ETFs.
Myth: It is not a good idea to put dividend paying securities inside an RRSP because the dividend tax credit is not available while the dividend income will eventually be taxed upon withdrawal.
Reality: The tax credit is irrelevant and there is actually no tax payable on dividends, or for that matter on any other income capital gains or interest, generated by the RRSP contribution funds. RetailInvestor.org's Nitty Gritty of the RRSP Model brilliantly decomposes the true economic reality from the illusion - see especially the section on What does the tax on withdrawal do?
Myth: When investments must be split between registered and unregistered accounts, since the tax rate on dividends is lowest, it is best to hold dividend securities in a taxable account while interest securities should go in a registered account.
Reality: RetailInvestor.org again debunks this myth on the same webpage in the section Maximize the tax-free income by showing that it is not only the tax rate that matters. What really matters is the overall amount of tax liability from multiplying the tax rate times the investment's return. The best account to hold each type of investment also depends on your province. As the example table below shows, in Ontario and Nova Scotia, an investor buying Bank of Montreal stock that currently pays a 5.08% dividend with an expected capital gain of 2% would be better in a RRSP than a Government of Canada 10-year bond with a 2.75% coupon. In Alberta it's better the other way round with the bond best placed in the RRSP per the traditional advice. The bond, if purchased today, will be bought at a premium - CanadianFixedIncome.ca shows the bond's price (as of writing date) to be 108.20 per 100 face maturity value. If the bond is held to maturity, there will be a capital loss of 8.20 that can offset capital gains in a taxable account, thus accentuating the current tax advantage for the taxable account.
Evidently, there is no one size fits all best strategy for all investments, market conditions and provinces. To figure it out for your own situation, do the same comparison we have done with your marginal tax rates for dividends and for interest in your province.
Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
