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One of the benefits of incorporation is that it allows for the use of dividends, which can be taxed at lower rates through the dividend tax credit regime.
The plot twist? Not all dividends are made equal. Dividends are taxed at differing rates depending on their type, and misclassifying the kind of dividend you declare can quickly land you in hot water with the Canada Revenue Agency ("CRA").
As such, it is crucial that business owners know the differences in types of dividends and plan dividend issuance strategies accordingly.
The Benefit of Dividends – Dividend Tax Credits
Individuals must report the full amount of dividends received from a taxable Canadian corporation as per sections 82(1)(a) and (a.1) of the Income Tax Act (the "ITA"). Then, the ITA applies a "gross up" amount, which artificially inflates the dividend to approximate the corporation's pre-tax income before it was distributed. Section 121 of the ITA then applies a credit equal to the "gross up" in order to avoid double taxation on the individual. A deep dive into the dividend tax credit mechanism was previously discussed here.
There are two broad categories of taxable dividends: eligible and non-eligible dividends. The difference has a significant impact on the gross up rate. Per section 82(1)(b) of the ITA, eligible dividends receive a 38% gross up, while non-eligible dividends receive a 15% gross up.
Designating a Dividend
Whether dividends are eligible or non-eligible depends on the type of corporation paying them and whether the income was taxed at the small business deduction rate or the general corporate rate.
It is the responsibility of the corporation's directors to declare the type of dividend being paid. This declaration will inform shareholders how to report the dividend, and which gross up rate applies on their tax returns.
Non-Eligible Dividends
Any investment income earned within the corporation and any active business income earned within the small business deduction limit (which is $500,000.00 in Ontario, as of 2025) gives rise to non-eligible dividends. The latter depends on whether the corporation is a Canadian Controlled Private Corporation ("CCPC"), which is a designation given to small, privately held businesses controlled by Canadian residents.
Eligible Dividends
Any income earned over the small business deduction limit allows corporations to declare eligible dividends. For instance, CCPCs may declare eligible dividends on any business income earned over $500,000.00, since income that exceeds that small business deduction limit is taxed at the general corporate rate.
All shareholders receiving an eligible dividend must be notified in writing at the time of payment. Public corporations are required to release a general statement that their dividends are eligible; either through their corporate website, in financial reports, or in other shareholder publications. Non-public corporations, such as CCPCs, have an additional obligation in that they must notify each shareholder specifically, by letter, cheque stub, or in its minutes if all shareholders are directors.
Punitive Tax
Under section 185.1 of the ITA, if a corporation incorrectly designates a dividend as eligible, it can face a 20% tax penalty on the amount of the error. This creates a strong incentive for corporations to be precise when deciding how to classify their dividends.
LRIP and GRIP
To keep track of which income gives rise to non-eligible versus eligible dividends, corporations maintain two balances of income: the Lower Rate Income Pool ("LRIP") and the General Rate Income Pool ("GRIP"). LRIP must first be depleted by issuing non-eligible dividends before GRIP can be used for eligible dividends, otherwise there will be a penalty tax.
LRIP is a balance that is continuously adjusted throughout the year.
GRIP is determined at the end of a tax year and includes last year's dividends. As such, there is a bit more nuance because at one point in the year, a dividend may exceed the GRIP and therefore be excessive, but may no longer be excessive at the end of the year. To avoid punitive tax, it is important for CCPCs to calculate their GRIP balance, and for non-CCPCs to calculate their LRIP balance. Otherwise, there may be excessive elections.
Capital Dividends
Eligible and non-eligible dividends are taxable. Capital dividends on the other hand, are 100% tax-free when properly declared and the shareholder can receive these amount with no personal tax liability.
CCPCs are the only corporations that have the advantage of claiming capital dividends.
Capital dividends are paid out from the capital dividend account ("CDA") which tracks certain tax-free amounts such as the non-taxable portion of net capital gains, capital dividends received from other corporations, the non-taxable portion of gains on eligible capital property, and net life insurance proceeds.
The corporation must elect to treat the dividend as a capital dividend. The election must be made on time and in the prescribed form. If elections are made improperly or in excess of the amount in the CDA, a 60% penalty tax will be imposed.
Business Planning
Understanding the different types of dividends allows a corporation to strategically maximize shareholder confidence through smart tax planning. By taking advantage of capital dividends and non-eligible dividends first, then using the GRIP to pay eligible dividends, businesses can avoid penalty taxes, and individual shareholders can take advantage of dividend tax credits or tax-free income in the case of capital dividends. It is important to consult with a tax planning lawyer to learn about your options.
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.
