Dividend Tax Considerations Every Canadian Should Know
Tax Facts: Dividend Tax Tips Every Canadian Should Know!
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But first, I want to share with you some important information to be aware of when it comes to paying tax on your investments.
So, without further ado…
A Taxing Issue
The old saying goes there are two things certain in life – death and taxes.
Since you’re reading this, we presume you’re alive and breathing. But since you’re alive and breathing, the taxman will also have his beady eye on you, looking to get his fair share of your investment related income and capital gains.
Now, I’m willing to wager that not one of you likes to pay taxes. When it comes to investing though, taxes mean you’ve very likely made some money, which is a good thing. After all, this should be a bedrock goal for every investor – make money.
However, it’s also natural to want to optimize your portfolio’s after-tax returns. For that reason, you should have a basic understanding of how the stocks you own will be taxed. And when it comes to dividend-paying stocks, there are more than a few considerations to keep in mind.
(As everyone’s tax situation differs, please consider this a broad overview only. We’re not tax experts here at the Fool and as ever, if you are unsure about anything tax related, seek advice from your friendly accountant.)
The Joy Of Dividends
We Fools love dividend payments. To long-term investors, dividends from high quality companies are the gifts that just keep on giving.
On the flip side, in non-registered accounts (does not apply to RRSP or TFSA accounts), individual taxpayers must pay tax on their dividend receipts. Trust the taxman to spoil the party!
But there is some good news. Unlike many other countries, dividends from Canadian-based companies are eligible for a somewhat convoluted set of calculations that can fondly be described as “the dividend gross-up and tax credit system”.
The basic rationale behind this system is that dividends are paid by corporations after the taxman has already taken his cut. Therefore, if dividend payments were fully taxed in the hands of the investor as well, it would equate to a double taxation.
(Warning: math ahead)
To illustrate this double tax situation, assume that Canadian based company Gnarley Tuques earned $100 in its fiscal year and was taxed at a rate of 30%. Gnarley’s after tax profits would be $70. If you’re keeping score at home, this means $30 went to the taxman.
Now assume the company decides to pay all of this $70 out to shareholders as a dividend. Also assume all of the company’s shareholders are taxed at a rate of 40%. In theory, this means, collectively, Gnarley’s shareholders would pay an additional $28 in tax on that dividend. Therefore, of Gnarley’s $100 in profits, $58 would find its way into the coffers of the Canadian government. Not a very incentivizing system for the company, or the investors.
Thanks to the dividend gross-up and tax credit system, this is not the way it works. The gross up is meant to convert the value of the dividend, $70 in the case of Gnarley Tuques, into an amount that approximates the company’s pre-tax earnings. The current (2016) gross-up rate for eligible dividends is 38%. Applying this to the $70 dividend brings us to $96.60.
First we need to calculate how much tax the investor theoretically needs to pay on this grossed up amount. Assuming a 40% tax rate, this would amount to $38.64.
Here comes the slightly tricky part. Each province has their own dividend tax credit rate which goes on top of the Federal dividend tax credit rate of 15.02%. To make our lives a little easier here, we’re going to assume that the combination of the Federal and Provincial dividend tax credits amount to 25% (to be clear, this is fictional and for demonstration purposes only). We apply this 25% to our grossed up dividend and arrive at a dividend tax credit of $24.15.
Still with me?
This tax credit is then subtracted from the $38.64 calculated earlier. We are left with taxes being owed by Gnarley’s shareholders on that $70 dividend of $14.49 – basically half of the tax that would have been owed had this system not been in place.
Where this system really shines is when we compare it to other income producing securities, namely fixed income instruments like bonds and GICs. These securities pay interest, which is classified as income for tax purposes. Income is taxed fool.ca The Motley Fool 3 at the individual’s tax rate. End of story. No gross up, no credit. If your personal tax rate is 40% and you receive interest from a Government of Canada bond of $70, you’re going to be sending $28 of that interest receipt right back to the GoC at tax time.
When it comes to generating income from your portfolio, there’s little doubt that dividend-paying stocks are among the most tax efficient options available.
A Few Wrinkles
Again, the scenario outlined above largely applies to treatment given to dividends gleaned from Canadian-based companies and held within a nonregistered account.
One wrinkle to consider is that dividends that are collected in registered accounts, such as a TFSA, RRSP, or RESP are not taxed upon their receipt. End of story. Skip the math and enjoy the dividends that the companies you own in these accounts generate. However, this same dynamic applies to fixed income securities as well.
Another wrinkle involves the treatment of foreign dividends.
When it comes to foreign dividends, there is somewhat of a laundry list to keep in mind. A collection of these considerations is provided below:
- Foreign source dividends will usually be subject to “gross withholding taxes” in the source jurisdiction.
- If there is a tax treaty (and there almost always will be) between Canada and the other country, the gross withholding tax rate is usually reduced according to the terms of the treaty. (See, for example, the Canada-U.S. treaty and the long list of in-force tax treaties for Canada here: https://www.fin.gc.ca/ treaties-conventions/in_force–eng.asp.)
- You can generally claim a foreign tax credit (FTC) for the amount of the gross withholding tax that you pay to the other country’s government. This means that you get to reduce the Canadian tax you have to pay by the amount of foreign tax already collected.
- Dividends from U.S. stocks flow into an RRSP without being subject to the withholding tax (not all foreign jurisdictions qualify). This is not the case, however, in other registered accounts like a TFSA or RESP. U.S. stocks held within these accounts are still subject to withholding tax on dividends paid (again, other jurisdictions may be different).
- If you’re investing in real estate investment trusts (REITs) or other instruments (like a master limited partnership, or MLP) that are not true “corporate shares” but rather “trust units,” there may be a different withholding tax rate that applies under the tax treaty. You’ll need to read the individual treaties (it’s fun!) to know what this tax treatment is.
In our mind, the point to highlight is the one that pertains to the treatment of U.S. dividends inside and outside of an RRSP account. Again, U.S. dividends that flow into an RRSP are exempt from withholding tax. In virtually every other kind of account, this is not the case. With this in mind, from a tax efficiency perspective, it tends to make sense to hold dividend-paying U.S. companies within an RRSP account.
Foolish Bottom Line
These are very general points and many intricacies exist when it comes to dividends and taxation. Especially when we start considering dividends from beyond our borders. We’ll emphasize again that we’re not tax experts and have provided these considerations for informational purposes only. Personal and security specific situations may vary. With that said, we expect that these high level thoughts will come in handy as you’re determining how best to allocate dividend paying stocks across your portfolio.
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Disclosure: David Gardner owns shares of MercadoLibre. Tom Gardner owns shares of Shopify and Tucows. Iain Butler owns shares of Shopify. The Motley Fool owns shares of Cognex, MercadoLibre, Shopify, Veeva Systems, and Tucows. Returns as of July 19, 2019.
The information regarding tax treatment in this piece is informational only and not intended as tax advice. For information on your individual tax situation and how it could be affected by dividends, please consult your tax advisor. Disclosure: All figures as of January 5, 2017. All dollar amounts are represented in Canadian Dollars, unless otherwise noted. This report is: (a) for general information purposes only and not intended as investing advice; and (b) not to be used or construed as an offer to sell, a solicitation of an offer to buy, or an endorsement, recommendation, or sponsorship of any entity or security by The Motley Fool Canada, ULC, its employees and affiliates (collectively, “TMF”). This report represents the opinion of the individual author and does not attempt to give you professional financial advice or advice that relates to your personal circumstances. © Copyright: 2017 The Motley Fool Canada, ULC. All rights reserved. The Motley Fool, Fool and the Jester logo are registered trademarks of The Motley Fool Holdings, Inc. Published by: THE MOTLEY FOOL CANADA, ULC 1959 UPPER WATER STREET P.O. BOX 997 HALIFAX , NOVA SCOTIA B3J 3N2 This publication is for general information purposes only. The studies in this report are not complete analyses of every material fact regarding any company, industry, or investment and they are not “buy” or “sell” recommendations. This publication is provided with the understanding that the authors and publisher are not engaged in the rendering of personalized investment advice. It also should not be used or construed as an offer to sell, a solicitation of an offer to buy, or an endorsement, or sponsorship of any entity or security by The Motley Fool and its affiliates.