The Dividend Gross-up and Tax Credit Mechanism

The following article is a guest post by Mark Goodfield at The Blunt Bean Counter.

When Echo (Robb) asked me if I would be interested in writing a guest post, I was flattered, but when he suggested my post should be about the dividend tax credit (“DTC”) and dividend gross-up, it caused me to pause.  What could I write about the DTC and dividend gross-up?  However, as I considered the topic, I realized, many people are confused about the three dividend boxes on their T3’s &T5’s and this subject although not exactly edge of your seat exciting, is relevant to many people.

Dividends 101: The notional theory

When you receive a T3 or T5, there are three boxes related to dividends on the form.  The first box is the actual amount of eligible dividends or the actual amount of dividends other than eligible (“ineligible dividends”) you received, the second box is the taxable amount of eligible or ineligible dividends and the third box is the DTC for eligible or ineligible dividends.

The actual dividends received box is self descriptive.  If you receive a dividend from Bell Canada for $100, the actual dividend is $100.

The taxable amount of dividends is a gross-up of the actual dividend.  The purpose of the gross-up is to bring the dividend amount back up to the dividend the corporation could have paid you if it had not had to pay corporate income tax.  Thus, if a corporation had income of $125 and it paid tax at a rate of 20%, it would have $100 left to pay you ($125-$25 tax).  Since you would only be paid $100 after the corporation paid its tax that is the actual dividend that goes in box 1.  The taxable amount of dividends would be $125 in box 2, since that was the corporation’s income before it paid tax.

The third box, the dividend tax credit, represents the corporate income tax paid.  Thus, in the example above, the DTC in box 3 would be $25.

The intention of the above is that you pay personal tax on the notional income the corporation could have paid you but for the corporate income tax it paid, with the final result being, as if the corporation had never paid corporate tax, but just passed its income on to you for you to pay tax on.

The above is the simple notional version, reality is always more complex.

Eligible and Ineligible Dividends

Eligible dividends are dividends paid by Canadian corporations out of income subject to high rates of corporate tax; thus, almost all dividends paid by public Canadian corporations are eligible dividends.  Where a dividend is paid out of the low income tax rate that Canadian small businesses can access, the dividend will typically be considered an ineligible dividend.  As noted above, since the dividend tax credit is supposed to notionally represent the tax a corporation paid, eligible dividends paid by public corporations will have a larger DTC to compensate you for the higher tax paid by that corporation.  On the flip side, ineligible dividends will have a smaller DTC, since the corporations paid lower income tax.

Getting technical with numbers

For ineligible dividends, the actual dividend (say $100) received is grossed-up by 25% (¹/₄) to give you the taxable dividend ($100 actual plus $25 gross-up for a total of $125).  The $125 is the taxable amount you would see in the second box on your actual T3 or T5.  The DTC for federal purposes is equal to ²/₃ of the “gross-up” amount.  This is equivalent to 13.3333% of the taxable amount of the dividend.  Thus, in the above example the DTC is equal to $16.66, which is what would be reflected on your actual T3 or T5.

The provincial DTC for grossed-up ineligible dividends in Ontario and Alberta is 4.5% and 3.5% respectively, these amounts are not reflected on your T3 or T5, but are calculations on your provincial income tax page.

For eligible dividends, the rates are as follows:

Thus, for 2011, on a $100 actual dividend, your T3 or T5 would reflect a taxable dividend of $141.

The DTC for grossed-up eligible dividends for Ontario and Alberta is 6.4% and 10.0% respectively.

For high rate taxpayers in Ontario in 2011, the marginal rate on eligible dividends received is 28.19% versus 32.57% for ineligible dividends.  In Alberta in 2011, the marginal rate of eligible dividends is 17.72% versus 27.71% for ineligible dividends.

The Gross-up grabs you

An insidious feature of the dividend tax credit is that the grossed-up dividend and not the actual dividend is used to determine your Old Age clawback, age credit, HST credit and property tax credit.

What have we learned?

I would hope you learned three things from this article:

1. Just be happy the corporations put all the numbers in the T3 and T5 boxes, since it is complicated.
2. I have my flight booked to move to Alberta, since you are far better off living and paying taxes in Alberta than Ontario.
3. Most importantly, you will prefer to receive eligible dividends rather than ineligible dividends.

About the author:

Mark writes the blog The Blunt Bean Counter.  He is taxation and managing partner of Cunningham LLP Chartered Accountants in Toronto.