Normally, if you receive a dividend from a corporation, it is paid in cash. But sometimes, the corporation will issue you more shares as the dividend instead of cash. In this case, it is called a stock dividend (“stock” and “share” have the same meaning and are used interchangeably).
When you receive a stock dividend, the amount of the dividend included in your income for income tax purposes is the “paid-up capital” in respect of the shares that were issued to you as the dividend. The paid-up capital is a legal and tax concept, and sometimes the paid-up capital of the issued shares will simply equal their fair market value. However, that is not always the case. If the paid-up capital is different than the fair market value, the paid-up capital remains the amount to be included in income.
The amount included in income also becomes your cost of those shares. Since you will own other shares in the corporation (you must have owned shares to receive the stock dividend), the cost of the issued shares on the stock dividend is averaged out with your cost of the other shares. Technically, the cost is called the “adjusted cost base” for capital gains purposes.
I own 1,000 shares in XCorp, which I have owned for several years. My adjusted cost base of those shares was $100 per share, or $100,000 in total.
XCorp pays a 1% stock dividend, which means that every shareholder gets one share for every 100 that they own. So I get ten more shares as the stock dividend. The paid-up capital of the ten shares is $200 per share.
I include in income $200 x 10, or $2,000. (I will also be subject to the “gross-up” of the dividend, described below.)
The adjusted cost base of my new shares is initially $200 per share, or $2,000 in total. But I now own 1,010 shares, and the cost of the new shares must be averaged out with the cost of the old shares, which had a total cost of $100,000. So the adjusted cost base of each of my 1,010 shares becomes $102,000 / 1,010 = $101 per share (rounded off).
If the stock dividend is received from a taxable Canadian corporation, the regular gross-up and dividend tax credit rules apply. These rules are meant to prevent double taxation. That is, since the corporation was presumably subject to tax on its income, and then paid out a dividend, the recipient shareholder gets a credit which ostensibly offsets the tax paid at the corporate level. So, in the above example, the $2,000 dividend will be subject to these rules.
Applying the gross-up / dividend tax credit to the example
Let’s assume XCorp is a public corporation and the stock dividend I received was an “eligible dividend” (basically, this type of dividend is eligible for a larger credit than a “non-eligible dividend”).
I include the $2,000 dividend in income, but must “gross-up” the dividend by 38%, so I actually include $2,760 in income. I am in a 50% tax bracket, so my initial tax on that $2,760 amount is $1,380.
However, I can claim the federal dividend tax credit, which is approximately 15.02% of the grossed-up dividend. The provincial credit varies by province, but let’s assume it’s 10%. So I get a total credit of 25.02% x $2,760 = $690. So my final tax on the stock dividend is actually the initial tax of $1,380 minus the $690 credit, which equals $690. (All of these numbers are rounded off.)
Therefore, on my $2,000 stock dividend, I paid $690 in tax, which is a 34.5% tax rate, even though I am otherwise in the 50% tax bracket. The reason – as noted above – is that the dividend tax credit gives me some relief due to the fact that the corporation likely paid corporate income tax on its earnings.