A Guide To Canadian Corporate Dividend Tax Strategy

For Canadian small business owners, determining the most tax-efficient method to draw income from a corporation is a key strategic challenge. Corporate income is generally subject to two layers of taxation: once at the corporate level and again when distributed to shareholders as a dividend. This creates a "double taxation" problem where a shareholder who receives the dividend is taxed twice, at the corporate level and again at the individual level.

The Canadian tax system addresses this through the Dividend Tax Credit (DTC) regime, which uses different dividend classifications to ensure an equitable total tax burden between a shareholder who receives the dividend from a corporation and someone who earns the income directly without a corporation.

Understanding and correctly applying the rules governing eligible, non-eligible, and capital dividends is crucial for tax compliance and minimizing overall tax liability. Misclassifying a dividend can lead to penalties from the Canada Revenue Agency (CRA).

The Mechanism to Prevent Double Taxation

To reconcile the tax paid by the corporation with the tax paid by the individual shareholder, the gross-up and dividend tax credit mechanisms are provided in sections 82(1) and 121 of the Income Tax Act (ITA).

1. Gross-up: The actual dividend amount received by the shareholder is artificially "grossed up" (inflated) and included in his or her taxable income. This grossed-up amount is intended to approximate the corporation's pre-tax income that generated the dividend.

Dividend tax credit (DTC): The shareholder is then entitled to claim a non-refundable tax credit on his or her personal return. The dividend tax credit is designed to give the shareholder credit for the tax already paid at the corporate level, effectively reducing his or her net personal tax payable on the dividend income. The rate of the gross-up and the corresponding dividend tax credit vary significantly based on the type of dividend, which in turn is determined by the corporate tax rate applied to the underlying income.

The Three Types of Dividends

1. Eligible Dividends

Eligible dividends are paid from corporate income that has been subjected to the general corporate tax rate, which is the income that did not qualify for the small business deduction (SBD).

The income pool to pay eligible dividends is tracked by a Canadian-controlled private corporation (CCPC) in the General Rate Income Pool (GRIP). GRIP tracks corporate income already taxed at the general rate; income subject to the small business deduction and therefore taxed at a lower rate at the corporate level is not included. A non-CCPC, on the other hand, does not track GRIP.

For the receiving shareholder, eligible dividends are taxed at a lower personal tax rate to compensate for the higher tax rate applied at the corporate level. First, a grossed-up amount of 38% of the actual dividend received is calculated; then a dividend tax credit of 6/11 of the grossed-up amount is applied to reduce the taxable dividend, to account for the tax already applied to income at the corporate level.

A corporation paying an eligible dividend must formally notify its shareholders in writing at the time of payment. Public corporations meet this requirement by releasing a general statement (e.g., on their website or in financial reports) declaring the dividends as eligible. Non-public corporations (such as CCPCs) face a stricter rule, requiring them to specifically notify each shareholder, typically via letter, cheque stub, or entry in the corporate minutes (if all shareholders are directors). The appropriate corporate resolutions are typically prepared by a knowledgeable Canadian tax lawyer based on dividend details from the corporate accountant. The corporation misclassifying a non-eligible dividend as eligible will incur a 20% penalty on the misclassified amount.

2. Non-Eligible Dividends

Non-eligible dividends are paid from corporate income that has benefited from a lower rate of corporate tax, which is the income that qualified for the reduced rate available under the small business deduction (SBD).

The income pool to pay non-eligible dividends is tracked by a non-CCPC in the Low Rate Income Pool (LRIP). The LRIP account tracks corporate income benefited from preferential (lower) tax rates and therefore receives a lower dividend tax credit. A non-CCPC must pay non-eligible dividends out of LRIP first before it pays eligible dividends. A CCPC, on the other hand, does not track LRIP.

For the receiving shareholder, non-eligible dividends are taxed at a higher personal tax rate to compensate for the lower tax rate applied at the corporate level. First, a grossed-up amount of 15% of the actual dividend received is calculated; then a dividend tax credit of 9/13 of the grossed-up amount is applied to reduce the taxable dividend, to account for the tax already applied to income at the corporate level.

3. Capital Dividends

Capital dividends are a unique and highly advantageous type of distribution available only to private corporations.

Capital dividends are paid from the Capital Dividend Account (CDA). The CDA tracks specific non-taxable amounts within the corporation, such as the non-taxable portion of net capital gains, disposition of eligible capital property, capital dividends received from other corporations, and net life insurance proceeds.

Capital dividends can be received by the shareholder completely tax-free. The corporation must declare a capital dividend through specific director resolution and then formally elect to treat the dividend as a capital dividend on a prescribed form T2054. An improper election or an amount paid in excess of the CDA balance is subject to a severe 60% penalty tax.

Pro Tax Tip – Strategic Planning and Compliance

For effective tax planning, a corporation must strategically manage its dividend pools and issuance:

• CCPCs must calculate and track their GRIP balance (using Schedule 53) to ensure that any eligible dividends designated do not exceed the amount available, which would otherwise trigger the Part III.1 penalty tax for an Excessive Eligible Dividend Designation (EEDD).
• Non-CCPCs must calculate and track their LRIP balance (using Schedule 54) at the time any dividend is paid.
• Prioritize Distributions: A common strategy for small private corporations is to first take advantage of the most tax-efficient pools: utilizing Capital Dividends for tax-free withdrawals, then using the GRIP to pay Eligible Dividends.

Consulting with an experienced Canadian tax lawyer is essential to navigate these corporate tax planning rules, ensure proper record-keeping, and maximize the tax efficiency of shareholder distributions.

FAQ

Q: What is the purpose of the "gross-up" amount in the Canadian dividend tax system?

The gross-up is an artificial increase in the amount of dividend that must be included in the shareholder's taxable income. The purpose is to approximate the corporation's pre-tax income that was used to fund the dividend payment. By reporting this higher, "grossed-up" amount, the shareholder is theoretically taxed as if they had earned the pre-tax income directly. A corresponding Dividend Tax Credit (DTC) is then applied to the shareholder's personal tax to reconcile the tax already paid at the corporate level, thereby avoiding double taxation.

Q: As a Canadian-Controlled Private Corporation (CCPC), what is the most strategic order for paying dividends from the various tax pools?

For a CCPC, strategic management of dividend distributions is essential to maximize shareholder after-tax income and avoid punitive taxes. The most tax-efficient payment order is to utilize the pools in the following sequence:

1. Capital Dividends (from CDA): Pay dividends from the Capital Dividend Account (CDA) first, as these are received by the shareholder 100% tax-free.
2. Eligible Dividends (from GRIP): use the General Rate Income Pool (GRIP) to pay Eligible Dividends. This income was taxed at the general corporate rate, which entitles the shareholder to a higher dividend tax credit and a lower overall personal tax rate compared to non-eligible dividends.

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.