General rule
A Canadian corporation (“recipient”) that receives a dividend from another Canadian corporation (“payer”) must include the dividend in income. However, an offsetting deduction is allowed in computing the recipient corporation’s taxable income, so that the dividend is normally not subject to tax for the recipient (subject to the comments below regarding Part IV tax).
The reason why the recipient corporation is allowed the offsetting deduction is that the dividend is normally paid out of the payer corporation’s after-tax income. If the recipient were also subject to tax on the dividend, there would be double taxation. And if there were multiple “stacked” corporations (e.g. the payer corporation was a shareholder of another corporation that itself was a shareholder of another corporation), there could be triple, quadruple or further taxation as the dividend was paid up the corporate chain.
The offsetting deduction in computing taxable income generally means that dividends can flow up through a corporate chain on a tax-free basis. (There are exceptions for dividends on certain preferred shares and other financing vehicles created to take advantage of these rules, but these are generally of limited application.) Once the dividends are paid to an individual (human) shareholder, they are included in the individual’s income.
Special Refundable Tax
However, in certain cases, a recipient private corporation will be subject to a special refundable federal tax under Part IV of the Income Tax Act (called the “Part IV tax”) . This tax is payable on dividends received from payer corporations with which the recipient is not “connected”. In general, a recipient and a payer are not “connected” if the recipient owns 10% or less of the shares in the payer corporation, counting both votes and fair market value.
The Part IV tax makes it less attractive for you to hold your share investments through a private corporation. For example, in the absence of the Part IV tax, you could put your publicly-traded shares into a private corporation, which could receive dividends on the public shares on a tax-free basis as discussed above. Although you would be subject to tax when your corporation paid you a dividend, this tax would be deferred to the extent the monies were left in your corporation. The Part IV tax takes away the potential tax deferral advantage.
The Part IV tax for the recipient corporation is 38 1/3% of the dividends received from the payer corporation (for taxation years ending before 2016, the rate was 33 1/3%). The tax forms part of the recipient corporation’s “refundable dividend tax on hand” and is refundable to the corporation when it pays a dividend to its own shareholders, at a rate of 38 1/3% of the dividend.
Example
In year 1, a recipient private corporation receives a $100,000 dividend from a non-connected payer corporation (e.g. from an investment in a widely-held public corporation. The recipient corporation is subject to Part IV tax of $38,333. However, if it pays out a $100,000 dividend to its shareholders, it will receive a refund of $38,333, meaning that it will have zero net Part IV tax payable for the year.
If the recipient paid no dividend in year 1, there would be no refund in that year. However, the $38,333 would carry over to the next year as part of the recipient’s “refundable dividend tax on hand”. So if the recipient corporation paid a dividend in year 2, it would receive a refund of 38 1/3% of the dividend in year 2, to a maximum refund of $38,333 (assuming no other transactions).
Usually, a recipient corporation that receives dividends from a payer corporation with which it is connected will not be subject to the Part IV tax. The corporations will be connected if the recipient controls the payer corporation or it owns more than 10% of the shares in the payer corporation on a votes and fair market value basis.
However, if the payer corporation itself gets a refund of Part IV tax when it pays the dividend to the recipient corporation, the tax is regenerated in the hands of the recipient corporation, in a proportion equal to the dividends it receives to the total dividends paid by the payer.
Example
A private recipient corporation receives a $100,000 dividend from a connected payer corporation. The payer paid a total of $200,000 dividends in the year. As a result of the payment of the dividends, the payer claimed a Part IV refund of $40,000.
One-half of that refund, or $20,000, will be subject to Part IV tax for the recipient corporation (since the recipient received half of the $200,000 dividends paid out). However, that tax will in turn be refundable to the recipient, at a rate of 38 1/3% of dividends it pays to its shareholders (as above).
Lastly, instead of claiming a refund of the Part IV tax, the recipient can reduce its Part IV tax payable for a year by 38 1/3% of its non-capital losses for the year, or by 38 1/3% of its non-capital losses carried over from up to 20 years preceding or 3 years following the year.