On June 29, 2006, the federal Department of Finance released draft amendments to the Income Tax Act (Canada) (the Act) aimed at implementing the government’s 2006 budget proposal to lower the income tax rate on dividends paid by large corporations. Interested parties are invited to submit comments on the proposal by September 15, 2006. It is expected that legislation effective for eligible dividends paid after 2005 will be introduced this fall.
The dividend proposal is part of the government’s strategy to "level the playing field" with other investments -- particularly income trusts-- by making investments in large Canadian corporations more attractive to Canadian investors. Under the existing rules, corporate dividends paid to individual taxpayers are taxed twice: dividends paid from the corporation’s after-tax income are taxed again in the hands of individual shareholders.
Framework For Proposals
The proposals are intended to mitigate (if not eliminate) multiple taxation of corporate income at the corporate earner and shareholder levels. In effect, they are intended to implement optimal integration of the taxation of corporate income for corporations and their shareholders when dividends are paid to the shareholders. The following four critical aspects of the proposals establish the framework within which large corporations can readily determine the impact of the rules:
- Only income that has been taxed at a non-preferential tax rate is eligible for the new treatment as "eligible dividends." Broadly speaking, this is income that has not been taxed at reduced rates, such as the "Canadian controlled private corporation" (CCPC) rate, either directly (as earned by the corporation) or indirectly (in the hands of another from which tax-free inter-corporate dividends have been received). This income is categorized in a new tax account called the "General Rate Income Pool" (GRIP) to distinguish it from preferentially taxed income tracked in the "Low Rate Income Pool" (LRIP).
- Dividends that are meant to benefit from this new regime – and, therefore, to be "eligible dividends" (even if paid from one corporation to another that would include those dividends in its GRIP) – must be designated by the corporation paying them, in relation to the shares on which the dividends are paid. It is possible that dividends on only some shares could be designated. Late-filed elections to designate dividends will not be permitted. Corporations that are CCPCs (or deposit insurance corporations) are presumed to first pay dividends out of their LRIP.
- There are two new accounts (or pools) of income which Canadian corporations will need to track. Corporations receiving tax-free inter-corporate dividends will also need to identify whether dividends that they receive are designated by the payer and, therefore, eligible to be included in the recipient’s GRIP.
- A supplemental tax regime applies to recover tax lost through dividends that benefit from the new regime but which have not actually been paid out of the payer’s GRIP (i.e., where there has been an excessive election). This supplemental regime works in much the same manner as Part III of the Act, which deals with amounts distributed as capital or capital gains dividends in excess of the income eligible for such tax-advantaged dividends. Essentially, the dividend payer pays additional tax to ensure that the distributed income has, in fact, borne tax at the general rate underlying the new system. In certain cases, excessive designations can be reversed.
As a result, apart from ensuring that the designation procedure is followed, large Canadian corporations that have not earned or received preferentially-taxed income should be able to deal with these rules readily; however, in the interests of their shareholders, they will want to be vigilant about complying with designation procedures that are necessary for these rules to operate. Other corporations will face additional compliance requirements associated with tracking the character of their income.
Integrating Corporate and Shareholder Taxation
Generally, the "gross-up and credit" mechanism provides some relief against double taxation by requiring an individual who receives a taxable dividend from a Canadian-resident corporation to "gross-up" his or her income by 25% to reflect the corporation’s pre-tax income. A dividend tax credit equal to 2/3 of the gross-up (to reflect some of the tax already paid by the corporation in respect of the income underlying the dividend) is then given to reduce the tax the individual would otherwise pay on the dividend income. The combined effect of these rules is to compensate the shareholder for corporate tax paid at an approximate rate of 20%, which is the low rate paid by CCPCs on their first $300,000 of active business income.
The New Rules
Tax Rates and the Gross-Up
To extend the double taxation relief to large Canadian corporations which cannot access preferential tax rates such as the small business deduction, the proposed amendments would increase the amount of both the gross-up and the dividend tax credit applicable to dividends paid from that portion of a corporation’s income which has been taxed at a "non-preferential" (high) rate. Such dividends are defined as "eligible dividends." Under the proposed new rules, eligible dividends would be grossed up by 45% instead of 25%, and a credit of 11/18 (instead of 2/3) of the gross-up would apply. Although the rate changes appear small, the effect of the new rules would be to decrease the tax payable by an individual taxpayer on a $100 dividend by more than $10.
To attract investors, dividend-paying corporations will be able to designate any dividend they paid to shareholders as an eligible dividend (i.e., eligible for the increased gross-up and credit rates). Since the intent of the proposal is to apply these increased rates only to income on which the corporation has paid a high rate of tax, a corporation which pays eligible dividends in excess of its eligible dividend entitlement will be subject to a special rate of tax on the excess.
Eligible Dividends: Eligible Income Sources
A Canadian corporation’s eligible dividend entitlement will largely depend on its status as a CCPC (which is able to benefit from preferential tax rates on part of its income) or a non-CCPC. Under the proposed rules, a CCPC will only be able to pay eligible dividends out of income in its GRIP – taxable income which has not benefited from special reduced tax rates. Non-CCPCs, however, will generally be able to pay unlimited eligible dividends, unless they have an LRIP. An LRIP represents taxable income subject to a reduced taxation rate (i.e., if the corporation was previously a CCPC). The CCPC will have to pay non-eligible dividends to eliminate its LRIP before it can pay eligible dividends.
In addition to more attractive tax treatment for investors, the proposed new rules also offer corporations more flexibility in determining which shareholders will receive eligible versus ineligible dividends. Corporations which otherwise qualify for CCPC status will also be able to elect to forgo the small business deduction in exchange for the ability to pay unlimited eligible dividends.
As is customary in the Act for various tax accounts, the new rules anticipate the need to track and ensure continuity with respect to GRIP and LRIP when corporations undergo various reorganizations. The essence of these supporting rules is to avoid LRIP from benefiting from the treatment reserved for GRIP through transformations that might otherwise occur in their absence.
Scott Wilkie is a senior partner in Osler's Taxation Department of the firm's Toronto office. Helen Ferrigan is an associate in the Taxation Department.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.