All types of companies pay out dividends. These dividends are a portion of after-tax profits from the business or investment income distributed to shareholders.
This dividend is usually reported on a T5 slip and included in your personal taxes.
In Canada, there are broadly three types of dividends that a company can issue to its shareholders:
- Eligible dividends
- Ineligible dividends
- Capital account (find the correct name)
The various dividend types are subject to different tax treatments.
We are going to focus on the difference between eligible and ineligible dividends.
Whether doing some tax planning for your corporation or optimizing your individual taxes, understanding the difference between eligible and ineligible dividends can help you develop tax planning strategies that work to your advantage.
Different types of dividend income are taxed differently in Canada. The primary rationale is that a dollar of income earned by a corporation should be taxed the same as a dollar earned by the shareholder directly – also known as tax integration.
Corporations issue dividends only after they have paid taxes on their profits. As a result, the company has already paid some taxes on that profit. The income should not be double taxed, and shareholders should only have to pay the remaining portion.
When Canadian corporations issue dividends, shareholders receive a dividend tax credit to help offset the taxes the corporation has paid. The dividend tax credit estimates how much the corporation has already paid in income taxes. The shareholder is only liable for the rest of the taxes.
However, Canadian corporations often pay different tax rates; some can qualify for deductions, such as small business deductions. In addition, to tax each dollar of income equally, Canadian corporations issue either an “eligible” dividend or a “non-eligible” dividend to shareholders.
Eligible dividends get preferential tax treatment at the shareholder level. Shareholders get a more significant tax credit and pay less tax on income from qualified dividends.
An eligible dividend is a form of dividend income that has not received preferential treatment at the corporate level, and shareholders will receive a more considerable dividend tax credit. Corporations that pay higher tax rates on corporate profits issue eligible dividends to shareholders.
Generally, publicly traded and large private companies pay out eligible dividends to shareholders. These companies do not receive a small business deduction and pay a higher tax rate on their corporate earnings.
Since their income is taxed at a higher amount when the corporation earns it, it is taxed at a lower rate when a shareholder receives it.
Corporations and Eligible Dividends
Corporations that issue eligible dividends must have the amount available in their General Rate Income Pool (GRIP) and have a zero balance in their Low Rate Income Pool (LRIP).
The balance in the GRIP is the income that was taxed at a higher corporate rate. The income in this pool did not receive any preferential treatment. As a result, the corporation can issue an eligible dividend to the shareholder, who will receive a more significant tax credit.
The balance in the LRIP is corporate income that did receive preferential treatment (such as tax deductions). As such, these dividends will not get preferential treatment over eligible dividends.
If you are a corporation that issues eligible dividends, you must know your GRIP or LRIP balances before you issue the dividends.
When corporations issue eligible dividends, they should also notify shareholders that the dividends they receive are qualified dividends. This way, the shareholders can apply the correct “gross up” amounts and dividend tax credits.
Individuals and Eligible Dividends
Eligible dividends qualify for a higher dividend tax credit for the shareholder.
When you receive eligible dividends, the dividends are “grossed-up.” The gross-up amount reflects the income earned by the corporation. Then you deduct a higher dividend tax credit which offsets the taxes paid by the corporation.
Individual shareholders pay less tax on eligible dividends as compared to non-eligible dividends.
A non-eligible dividend is a type of dividend typically paid by companies taxed at lower corporate tax rates. As a result, shareholders get a minor dividend tax credit.
Typically, smaller private corporations or Canadian Controlled Private Companies (CCPC) pay non-eligible dividends to their shareholders. As a result, these corporations have paid a lower tax rate on their first $500,000 income.
The dividends shareholders receive do not get preferential treatment. As a result, the individual shareholder receives a minor tax credit compared to eligible dividends.
Corporations and Non-Eligible Dividends
Smaller corporations earning under $500,000 typically issue non-eligible dividends.
Individuals and Eligible Dividends
When shareholders receive these dividends, non-eligible dividends are also “grossed-up” to reflect corporate income earned. However, these dividends only grossed up 15% (rather than 38% if they were eligible dividends).
The dividend tax credit is also smaller than when eligible dividends are taxed.
An individual shareholder will pay more tax on non-eligible dividends than eligible ones.
Eligible Dividends vs. Non-Eligible Dividends
When Canadian corporations issue dividends, it can affect the corporation and the shareholder. Understanding how dividends impact your business and personal taxes can help you make better long-term decisions.
Dividend payments are only one part of an optimal tax planning strategy. A qualified and experienced tax accountant can help you navigate dividend and other tax planning strategies for your company and personal taxes.
Contact KSSP Partners LLP in Markham for all your Tax Planning Needs
Talk to a skilled Canadian tax professional to optimize your tax situation. At KSSP Partners LLP, our business planning experts can provide personalized tax planning advice for your personal and business taxes. To learn more about how KSSP Partners LLP can provide you with the best tax planning expertise, contact us online or by telephone at 289-554-5997.