Treatment of taxable dividends
If 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. However, you are then entitled to a dividend tax credit, which is roughly meant to credit you for tax paid at the corporate level on the income from which the dividend was paid.
The gross-up and dividend tax credit mechanism results in taxable dividends being subject to a lower tax rate in your hands than ordinary income.
For example, the highest marginal tax rate on “eligible dividends” (combined federal and provincial) is about 21 – 38%, depending on the province. The highest marginal rate for other dividends is about 30 – 46%. In contrast, the highest marginal tax rate on regular income ranges from about 40 – 54%.
In very general terms, an eligible dividend is paid out of a corporation’s business income that was subject to the general corporate tax rate and not the lower preferential rate that applies to small business income. A non-eligible dividend includes a dividend paid out of income that was subject to the small business rate, which applies to the first $500,000 of active business income of a Canadian-controlled private corporation.
The dividend tax credit is not refundable. It can reduce your tax to zero, but not lower. (It can generate a refund of instalments or source deductions you paid, but only to get your tax for the year down to zero.) It cannot be carried forward or back to another year. In other words, you either use it or lose it.
Transfer of dividend to spouse or common-law partner
However, there may be relief where a lower-income spouse (or common-law partner) may not be able to use the dividend tax credit, or where the credit will only save a nominal amount of tax. In such case, the lower-income spouse can transfer the dividend to the higher-income spouse, who may be able to use the credit and save tax.
Basically, the spouses can elect that the dividend (and dividend tax credit) be transferred to the higher-income spouse, if the exclusion of the dividend from the lower-income spouse’s income either creates or increases the spousal tax credit for the higher-income spouse. The federal spousal credit for 2015 is:
15% of ($11,327 minus your spouse’s income for the year)
As such, the credit for a higher-income spouse is eliminated once the lower-income spouse’s reaches $11,327. Put another way, the higher-income person’s spousal tax credit can be created or increased only if the lower-income person’s income is pushed below that number. The parties must determine whether the transfer of the dividend to the higher-income spouse saves tax overall.
Example (involving federal tax only)
In 2015, Bill has ordinary income of $5,327 and he also receives a grossed-up eligible dividend of $6,000. He is in the lowest federal tax bracket of 15%.
His spouse Joanne is in the 22% federal tax bracket and the transfer of the dividend to her would keep her in the 22% bracket.
They want to know whether they should make the election to transfer the dividend to Joanne.
Result without the election: Bill would pay no tax because the personal credit amount ($11,327) would fully offset the tax otherwise payable on his income. The dividend tax credit could not be used.
Joanne would get no spousal tax credit and no dividend tax credit.
Result with the election: Bill would still pay no tax because of his personal credit amount.
Joanne would include the $6,000 grossed-up dividend in income. The initial federal tax payable on that amount would be $1,320 (22% of $6,000). She could claim a dividend tax credit equal to 15.02% of the grossed-up dividend, equal to $901. Furthermore, her spousal credit would equal 15% of ($11,327 minus $5,327), or $900. Her overall federal tax savings would be: $901 + $900 − $1,320 = $481. Therefore, the election would be advantageous in this case.