General Taxation of Dividends
Dividends are taxed preferentially relative to most other sources of income. While the highest marginal federal rate of tax is 33%, the highest rate is 24.81% for “eligible dividends” and 27.57% for “non-eligible dividends”. When provincial taxes are added, a similar discrepancy exists: the combined Federal and provincial rate of tax on ordinary income is higher than that for eligible dividends.
(In general terms, an “eligible dividend” is paid out of a corporation’s business income that is subject to the general (approximately 25%) corporate tax rate. A “non-eligible dividend” is paid out of income that was subject to the small business tax rate for Canadian-controlled private corporations, or investment income that was eligible for a corporate tax refund.)
The way in which you are taxed lower on dividends relative to other income is that you receive a dividend tax credit, which is meant to offset the corporate tax that was paid on the corporation’s income from which the dividend was paid. In other words, the intent of the dividend tax credit is to prevent double taxation.
The way it works: When you receive a taxable dividend from a Canadian corporation, you must “gross up” the dividend by a percentage and include that grossed up amount in your income. (Including the gross-up, you add to your income roughly the amount of income the corporation earned before paying corporate tax and then paying you the dividend.) However, you are then entitled to the dividend tax credit, which is roughly meant to credit you for the tax that was paid at the corporate level.
As a result, the gross-up and dividend tax credit mechanism means that taxable dividends are subject to an overall tax rate that is lower than the rate which applies to ordinary income. Eligible and non-eligible dividends have different dividend tax credit amounts, reflecting the fact they come from corporate income subject to different rates of tax.
The dividend tax credit is not refundable. It can reduce your tax to zero but cannot be used beyond that point. It cannot be carried forward or back to another year. In other words, you generally either use it or lose it. However, in such cases, a “transfer” of the dividend to your spouse or common-law partner may be allowed so that they can use the credit.
Transfer of Dividend to Spouse or Common-law Partner
The transfer of the dividend works as follows. Where a lower-income spouse receives a dividend and cannot fully use the dividend tax credit, the spouses can make an election to have the dividend included in the other (higher-income) spouse’s income. However, the election can be made only if including the dividend in the other spouse’s income either creates or increases the spousal tax credit that the other spouse may claim.
The regular federal spousal credit for 2019 equals 15% of X, where X is $12,069 minus the lower-income spouse’s income for the year. (The dollar amount is increased annually for inflation.)
As such, the higher-income spouse’s credit is reduced if the lower-income spouse has any income and is eliminated once the lower-income spouse’s reaches $12,069. If the transfer of the dividend from the lower-income spouse creates or increases the credit (since it reduces the lower-income spouse’s income), the election can be made. Of course, the election should be made only if it reduces tax overall.
Simple Example (federal income tax only)
In 2019, Evan has $6,069 of interest income and a grossed-up eligible dividend of $6,000, for total income of $12,069. He is therefore in the lowest federal tax bracket of 15%.
His spouse Lisa has taxable income of $85,000 and is therefore in the 20.5% tax bracket.
They want to know whether they should make the election to transfer the dividend to Lisa.
Result without the election: Evan will pay no tax because his personal credit (15% of $12,069) will fully offset the tax otherwise payable on his income. He cannot use the dividend tax credit.
Lisa will get no spousal tax credit and no dividend tax credit.
Result with the election: Evan will still pay no tax because of his personal credit.
Lisa will include the $6,000 grossed-up dividend in her taxable income, bringing her total taxable income to $91,000. This keeps her in the 20.5% marginal tax bracket.
Her initial federal tax on the dividend will be $1,230 (20.5% of $6,000). But she will claim the dividend tax credit, which is 15.02% of the $6,000 grossed-up dividend. That equals $901. So the net tax payable on the dividend will equal $329 ($1,230 minus $901).
Since Evan’s income is now below the $12,069 threshold, Lisa can also claim the spousal credit of 15% of ($12,069 minus Evan’s $6,069 income), or $900.
As a result, she will save tax of $900 − $329 = $571. Therefore, the election makes sense in this example.