Unit 1 – Income Taxes
Lesson 5: Dividend Income & How it is Taxed
An important consideration when developing your investment plan is with the taxation of your assets—in particular, dividends and various distributions.
As Lesson 4 showed, investments may be subject to tax, but the tax generated is not uniform across all types of investments. Understanding the income each investment type generates, as well as the benefits or limitations each account holds, will have a significant effect on your after-tax return as well as in reaching your investment objectives.
When it comes to investing, an investor pays tax on four things:
- Interest-bearing investments
- Dividend-paying stocks
- Capital gains
- Foreign investments
This lesson will focus on dividend income and the tax implications of this type of investment income. I will explain what a dividend is, and most importantly, how it is taxed. Knowing the tax implications of either a domestic or international dividend will be important in calculating your true investment rate of return.
What is a Dividend?
Let’s say I want to open a sporting goods store--- Vittorio’s Sporting Goods. For me to open my first store, I gather money from investors and issue shares in return. My store becomes a massive success, sales skyrocket, and I begin opening other locations, and with each new location, more profits are generated. Instead of opening more new stores, and having them compete with one another, I have a decision to make—do I reinvest my profits? Or pay my profits to my existing shareholders?
Of my profits, I will hold a certain percentage for future business expenses or emergencies, but the remainder I will pay to my shareholders. This cash payment is known as a dividend. The dividend can be increased or decreased monthly, quarterly, or yearly depending on how Vittorio’s Sporting Goods performs and the dividend schedule I decide.
In publicly traded companies, i.e. Apple, Coca Cola, Royal Bank of Canada, the dividend is decided and managed by the board of directors (BOD) and paid to the class of its shareholders. The members of the board have the final say on the dividend amount paid, time of payment and whether the dividend should be paid out or suspended. The board also has the right to issue ‘special dividends’ which can be in addition or separate from the scheduled payment. Often, when companies hit a major milestone, the BOD will declare a special dividend for its shareholders.
If you own preferred shares, instead of common shares, dividends are paid at a fixed rate based on the par value of the share. It is treated like a fixed income instrument. Dividends can be issued either as cash, stock, or other property. This distinction between types of stock shares will be the subject matter of a future Lesson.
What is a Dividend Tax Credit?
If you are invested in a Canadian corporation, you potentially earn a dividend, which should be reported for tax purposes. However, eligible dividends from a Canadian business will receive preferential treatment in the form of a federal dividend tax credit. It is a non-refundable credit that minimizes the total tax you owe. The tax credit is there to avoid double taxation, which I will discuss shortly.
Dividends are paid out of a company’s after-tax profits. The amount you receive is what is left over after the government took their piece. Grossing-up a dividend means adding the percent back to the approximate amount of what the pre-tax profit would have to earn to pay the dividend.
For simplicity, let us say the dividend is $10.00, and the gross-up rate is 20.00%. Even though you earn $10.00, you must add $12.00 to your taxable income. Sound unfair? That is the double count. The dividend tax credit will reduce the gross-up amount, roughly the amount the company has already paid.
The federal dividend tax credit in 2019 is 15.00% of the grossed-up dividend. Provinces also add their own dividend tax credit. In B.C, the tax credit is 12.00% for a combined credit of 27.00% of the gross-up dividend. The dividend tax credit prevents double taxation and lowers the tax you pay overall.
I.e. if you are in the highest marginal tax rate of 33.00%. Your tax on the $12.00 dividend will be $4.00 ($12.00 * 33.00%), but it is offset by a combined $3.24 ($12 * 27.00%). The tax owed on the dividend is $0.76 or about 7.00% of your $10.00 dividend.
An important note, the dividend tax credit is only applicable in non-registered accounts. Be sure you know which accounts your investments are held in for optimal tax efficiency.
Any dividend received from an international company is not eligible for the tax credit. The dividend must
be converted to Canadian dollars and included on your income tax return. It is taxed at the same rate as your marginal tax rate. If the foreign dividend has been withheld, you must include the gross amount and claim a foreign tax credit for all the taxes withheld. The foreign tax credit will reduce the tax owed but it’s limited to 15.00% of the lesser between the foreign income and the amount of Canadian tax payable on that foreign income. In B.C, if your federal foreign tax credit on non-business income is less than the related tax you paid to a foreign country, you may be eligible to claim a provincial foreign tax credit.
As mentioned, not all dividends are paid in cash. Sometimes dividends are paid in new shares of the corporation. A stock dividend is taxed as an ordinary dividend, the new cost base of the shares is the actual amount used, not the grossed-up amount.