Can You Receive Dividend Income Tax-Free?
What You Need To Know
This article provides an overview of the main different types of dividend income and their respective income tax treatments for a resident of Canada. Certain tax treatments provide opportunities for financial planning strategies that may allow you or members of your family to receive Canadian dividend income “tax-free.” The information in this article is not intended to provide legal or tax advice. To ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, you should obtain professional advice from a qualified tax advisor before acting on any of the information in this article.
Not all dividends are the same
Corporations can choose to pay dividends to shareholders. You, as the shareholder, may receive dividends from different ‘pools’ of income within the corporation. The source of the dividend determines how you will be taxed on the income. Canadian corporations can pay both “eligible” and “non-eligible” dividends.
As a Canadian resident, the tax rate that applies to dividend income depends on the type of dividend you receive. For example, eligible dividends from a Canadian corporation benefit from preferential tax treatment. In comparison, dividends you receive from a foreign corporation are taxable at your marginal income tax rate.
Dividend Income from Canadian Corporations
Eligible dividends are subject to an enhanced dividend “gross-up”. Individuals who earn eligible dividends can claim a federal dividend tax credit. There is also a provincial or territorial dividend tax credit available, which differs for each province or territory.
Non-eligible dividends are subject to a dividend gross-up that is smaller than the eligible dividends. The federal dividend tax credit for non-eligible dividends is also generally smaller. As with eligible dividends, you are also eligible for a provincial or territorial dividend tax credit.
Tax-free Dividend Income
Having little or no other income, you may be able to receive dividends from a Canadian corporation “tax-free.” Under certain circumstances, the dividend tax credit and the basic personal amount (and other tax credits you may be entitled to) reduce the taxes on dividends to zero. In this case, although you receive dividends, the payment does not trigger an income tax liability. The amount of this potentially tax-free receipt depends on whether the dividend is an eligible or non-eligible dividend, whether you have other income and the province or territory of residence. Please note this planning opportunity is only applicable for individuals, not for trusts or corporations.
The effect of receiving dividend income on income-tested credits and benefits
The more dividends you receive, the higher your taxable income. It is important to keep in mind the gross-up rate on dividends will increase your taxable income. For example, $1 of actual eligible dividend is reported as $1.38 taxable income on your tax return. The grossed-up amount is used for testing your eligibility for certain credits and benefits such as the age amount or Old Age Security.
Don’t forget the attribution rules
If you gift shares to a spouse or a minor child, or your minor child receives shares from a relative, the income might be subject to the attribution rules. If these rules apply, all of the dividends will be taxable in the hands of the individual who gifted the shares. If the individual who gifted the shares has other sources of income, the dividend income may not be tax-free for them.
Split income tax (Kiddie tax)
The split income tax rules prevent families from shifting income to minor children as a way of reducing the household tax bill. Where a minor child receives dividends paid directly or indirectly (e.g. through a family trust) from private corporations, the dividends may be taxable to the child at the highest marginal tax rate. The minor child will only be able to claim the dividend tax credit on these payments. These rules do not apply to dividends that a minor receives from stocks that are traded on a public exchange.
Foreign corporations are generally not subject to Canadian corporate tax, so dividends you receive from foreign corporations are not subject to the gross-up, nor are you eligible for the dividend tax credit. Foreign dividends you receive, such as those paid by U.S. or European companies, are fully taxable to you. This tax treatment results in higher taxes payable on a foreign dividend than on a Canadian source dividend. In addition, there may be withholding tax on the foreign dividends. In a non-registered account, you can claim a federal foreign tax credit to a maximum of 15% on your Canadian income tax return. If the withholding tax rate is more than 15%, you may not be able to avoid double tax on the income.
Capital Gains Dividends
Capital gains dividends are usually paid by regulated mutual fund corporations, investment corporations or mortgage investment corporations. They are distributions from the corporation’s pool of realized capital gains. Capital gains dividends are not eligible dividends for tax purposes, and do not qualify for the dividend tax credit.
A capital dividend is a tax-free dividend that can be paid by a private Canadian corporation. When the corporation has a positive balance in the Capital Dividend Account (CDA), a capital dividend distribution can be made. In general, the following items increase a corporation’s CDA:
the non-taxable portion of capital gains net of the non-taxable portion of capital losses;
proceeds from certain life insurance policies net of the adjusted cost base of the policy;
capital dividends received by the corporation; and non-taxable portion of any gains on the sale of eligible capital property.
Understanding how you will be taxed on the various types of dividend income you may receive will help you with tax planning and investment planning. Speak to your advisor to ensure that your current investments fit into your personal financial plan.
Susan Gottlieb is Vice President and Wealth Advisor with RBC Dominion Securities Inc. This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article.