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Dividend Income by David B. Perry
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The economist hopes for a tax system that is neutral—that is, a system that does not affect the way that economic decisions are made. Equally important, if the tax system is to be equitable for all, the tax burden should not change merely because of the form in which these decisions are implemented.
In most industrialized countries, however, compromises must be made. The taxation of business income often represents such a compromise. Profit earned by a corporation is taxed; then, when the after-tax profit is distributed in the form of dividends, it is taxed again in the hands of the shareholder.
Consider, for example, a small incorporated Canadian business that makes a profit of $100.00 per year. The business pays federal and provincial corporate income tax of $23.12, as shown in example 1, and has $76.88 to distribute to its shareholders as dividends. The shareholders also have to pay personal income tax on those dividends, but the cash dividend received by shareholders is increased (grossed up) by 25 percent before it is taken into taxable income. The shareholder therefore reports $96.10 as taxable income and faces a federal tax (at top marginal rates) of $27.87. That amount is reduced by $12.81 of the gross-up amount to produce a net federal tax on the dividend of $15.06. Provincial tax is $13.38 less the remainder of the gross-up, $6.15, which produces a net provincial tax of $7.23. The shareholder pays a total of $22.29 income tax on the dividend. When the $23.12 already paid in corporate income tax is added, the total tax on the original $100.00 of profit is $45.41, just slightly higher than the personal income tax of $42.92 payable on $100.00 in ordinary income, as shown in example 2. The higher federal tax rate payable by large corporations produces a total tax of $54.64, well above the benchmark shown in example 2. Payroll taxes, both federal and provincial, also apply. The federal taxes are paid by both the employee and the employer, while the provincial taxes are paid only by the employer.
Not all company profit is paid out in dividends. If the after-tax profit is retained and re-invested in the company, the value of the shares should increase by that amount. The shareholder can then sell the shares and treat the $76.88 increase in value as a capital gain, which, as shown in example 3, is taxed less heavily than any other form of income. Only one-half of the capital gains--$38.44 in this example--is included in taxable income, so that income is effectively taxed at half the rates charged on other income.
The theory behind the taxation of dividends
The federal Income Tax Act allows the deduction of expenses in calculating the taxable income from a business. Because certain expenses are not treated the same for tax purposes as they are in the accounts of the business, net income, or profit, is not necessarily the same as taxable income. Wages and salaries, and interest on borrowed money, for example, are treated the same for both tax and accounting purposes. Thus, if a business is not incorporated, the owner may take a salary that reduces the profit and bears mainly the personal income tax.
If the business is incorporated to take advantage of the benefits of incorporation, such as limited personal liability, the owner may choose to take part of the profit as salary and part as dividends, which will also be subject to personal income tax. The dividends also bear corporate income tax, as noted above, so the dividend income received by the shareholder will effectively be taxed twice. To minimize this double taxation, the Income Tax Act provides that dividends from Canadian companies are grossed up by 25 percent. The grossed-up amount—125 percent of the dividend actually received—is included in taxable income, and a credit equal to 13.33 percent of that amount is deducted as a credit from the federal tax otherwise payable. In theory, the remainder of the 25 percent gross-up is allowed as a credit against provincial income tax otherwise payable. In practice, as noted below, the provincial dividend tax credit varies considerably from province to province.When the recipient is another Canadian corporation, the dividends are not included in the taxable income of the recipient company, because that would lead to double corporate taxation of the dividend.
The end result is that individuals who receive dividends from small companies have almost all, and in some cases more than all, of the corporate income tax applied against their personal income tax, thereby eliminating double taxation. Because the gross-up-and-credit system provides for the passthrough of the equivalent of a tax of only 20 percent on corporate income, recipients of dividends from large Canadian companies have only a part of the tax credited.An approximate mechanism
Not all corporations pay full income tax rates on their book profit, but the gross-up-and-credit system assumes that they do. Prior years' losses, heavy investment in new physical assets, exploration expenses in the natural resource sector, and research and development incentives, among other things, can reduce the actual tax payable well below the nominal rate in relation to book profit. Despite this, the full gross-up-and-credit system applies. In these cases, the total tax on dividends could fall short of the amount that would have been payable under the other two alternatives examined here. Often, however, the differences between nominal and effective rates of tax on book profit even out over time, meaning that in later years the total tax burden on dividends may be significantly higher than shown here.Canadian variations
The Canadian tax system provides for fully independent provincial income tax rates. The provinces and territories set their own corporate income tax rates, personal income tax rates, and dividend tax credits, as shown in table 1. In addition, both federal and provincial governments set more than one corporate rate. Thus, the effects of the dividend tax credit vary according to the type of company and the province in which it earns profit, as well as the province that the investor calls home. Table 2 compares the effect of the tax system on income earned as wages, dividends, or capital gains from a company that pays income tax at the preferential rate available to small Canadian-owned companies. Table 3 provides comparable information for a company that pays the highest corporate rates. Companies that earn profit from manufacturing and processing activities pay tax below the top rate but well above the low rate, so the results fall below, but close to, those shown in table 3.
The full details of personal and corporate rates applicable in the provinces and territories are available in chapters 3 and 4 of Finances of The Nation:
Chapter 3: Taxes on Individuals Chapter 4: Taxes on Business. International practice
Most major industrialized countries provide some form of relief from the double taxation of dividends. Of the OECD countries, only Ireland, Switzerland, and the United States offer no relief. France and the United Kingdom have some form of credit system like Canada's to provide partial relief. Australia and Italy are among the six countries that use a credit system to eliminate double taxation altogether. The various systems vary in complexity and not all of them take into account the tax actually paid on the profits underlying the dividends. Other countries reduce the rate of tax that individuals pay on dividends, while a few exempt dividend payouts from corporate tax.
The United States has ignored the double taxation of dividends for many years. Dividends are paid out of after-tax corporate income, as in Canada, but 100 percent is taken into the individual's personal income tax. No credits or deductions are provided to offset the corporate tax. President George W. Bush recently proposed that dividends be should be tax-free in the hands of the recipient. Dividends from current profits that have borne tax would be reported as non-taxable income by recipients, and capital gains from dividends retained by the corporation would also be identified for preferential treatment in the hands of individuals. The details were spelled out in a release from the White House in January 2003:http://www.whitehouse.gov/infocus/economy/complexity.html A practical example
The variation in tax burdens on the different forms of income is not an abstract issue, but one that is faced by many small-business people. Consider three children in Prince Edward Island who have inherited an incorporated family firm worth $3 million. A cousin runs the firm and draws an annual salary of $50,000. Two sisters and one brother are not involved in the firm, but each is guaranteed a return of 5 percent—$50,000—on their share of the firm's profit before tax. One sister chooses dividends, the second chooses straight interest, and the brother sells the equivalent in shares to the cousin every year. After paying income tax, the siblings end up with the following amounts:
Dividends—$35,508 Interest—$37,179 Capital gains—$35,188
The cousin also has to contribute to employment insurance (EI) and the Canada pension plan (CPP), and ends up with $35,301 after tax. In addition, the company has to pay $2,874 as its share of EI and CPP levies on the cousin's salary. Although the cousin's total tax burden, including the firm's EI and CPP obligations, is higher than those of the three siblings, the EI and CPP programs provide additional benefits to the cousin that are not available to the others. Furthermore, the cousin is the only one who can contribute to an RRSP.
The typical owner-manager has to decide what combination of salary, dividends, and reinvestment in the firm will produce the best after-tax return on his or her efforts. The board of directors of a large firm has to choose the balance of dividends and reinvestment that will best suit the majority of their investors, both taxable and non-taxable.
