For owners of Canadian-controlled private companies, understanding the mechanism of remuneration in the form of eligible or non-eligible dividends is essential. This understanding will enable you to ensure optimal tax management of your company.
In addition to the choice between salary and dividend, you need to know how to differentiate between eligible and ineligible dividends, as the tax treatment is not the same. In this article, our experts give you more details on this remuneration method and its tax implications.
What's the difference between eligible and ineligible dividends?
Understanding the differences between eligible and ineligible dividends, as well as how the RDTOH works, is crucial to optimizing your company's tax management.
These differences directly influence the amount of your taxable income and shareholders' tax liability.
What is an ineligible dividend?
Ineligible dividends come from the after-tax profits of companies paying tax at a reduced rate, often available to small businesses. These profits are already taxed at the corporate level, but at a more advantageous rate.
For shareholders, the taxable amount of these dividends is increased by 15%, reflecting their pre-tax value. The gross-up system aligns dividend income with your total income, making tax calculations easier.
What is an eligible dividend?
Unlike ineligible dividends, eligible dividends come from companies taxed at the general rate. These dividends are frequently distributed by large corporations or highly profitable businesses.
The amount of these dividends is also grossed up, but at a rate of 38%, to reflect the higher withholding tax applied to corporate profits. This higher gross-up results in a substantial tax credit, reducing shareholders' tax liability.
Designation of eligible dividends
Companies are required to explicitly designate eligible dividends at or before the time of distribution, in accordance with subsection 89(14) of the Income Tax Act. They must also inform their shareholders in writing that the dividends they receive are classified as eligible.
How the Refundable Dividend Tax on Hand (RDTOH) works
The Refundable Dividend Tax on Hand is a crucial tax mechanism for Canadian corporations. When a corporation generates investment income, it pays additional tax on that income, set aside in a notional account called the RDTOH.
In the case of eligible dividends, this mechanism allows companies to recover a portion of the tax paid when they pay dividends to their shareholders. For example, for every dollar of eligible dividends paid, the corporation can recapture $0.38 of accumulated RDTOH. This reduces the overall tax paid by the company and avoids double taxation for shareholders.
Non-eligible dividends, on the other hand, do not benefit directly from this mechanism in the same way, but it can still play a role in the company's overall tax management.
How are dividends treated for tax purposes?
To calculate your corporate and personal taxes, you need to understand the gross-up factor and tax treatment of corporate dividend income.
For more information on the taxation of dividends, you can consult the resources of the Canada Revenue Agency and Revenu Québec.
The gross-up
The gross-up is a tax adjustment based on your company's tax rate. It increases the amount of the dividend received to match a hypothetical pre-tax income. This increased amount is added to your total income for the year, on which you'll have to pay tax.
Here's how it works for each type of dividend:
- Eligible dividend: 38% gross-up;
- Non-eligible dividend: 15% increase.
Non-refundable tax credit
Once the grossed-up dividend has been added to your taxable income, you can benefit from a federal dividend tax credit and a provincial credit, depending on your province. This non-refundable credit is designed to mitigate double taxation since the company has already paid taxes on its profits to the relevant tax authorities.
The calculation of the tax credit therefore varies according to the type of dividend:
- Eligible dividend: substantial credit to compensate for the higher gross-up rate.
- Non-eligible dividend: smaller credit, adapted to the lower gross-up amount.
Sample dividend tax calculation
To illustrate in concrete terms how eligible and ineligible dividends are taxed, we'll look at some sample calculations. These examples will help you understand the tax implications of each type of dividend and better plan the distribution of profits within your company.
Example of eligible dividend calculation
Suppose you are a shareholder of a large Canadian corporation that has earned after-tax profits and decides to pay you eligible dividends. Let's say you receive a dividend of $1,000.
Gross-up calculation
- Amount of dividend received: $1,000
- Gross-up rate for eligible dividends: 38%
- Grossed-up amount: $1,000 * (1 + 0.38) = $1,380
Tax calculation
Assume you are in a 30% marginal tax bracket.
- Grossed-up income tax: $1,380 * 30% = $414
Calculation of dividend tax credit
Applicable tax credit for eligible dividends (assume 20.73% of grossed-up amount) :
- Tax credit: $1,380 * 20.73% = $286
Net tax payable
- Gross increased income tax: $414
- Tax credit: $286
- Net tax payable on dividend: $414 - $286 = $128
In this example, the $1,000 dividend results in a net tax of $128 after application of the tax credit.
Ineligible dividend calculation example
Now consider that you receive an ineligible dividend of $1,000 from a Canadian small business.
Gross-up calculation
- Amount of dividend received: $1,000
- Gross-up rate for ineligible dividends: 15%
- Grossed-up amount: $1,000 * (1 + 0.15) = $1,150
Tax calculation
Assume your marginal tax rate is 30%.
- Grossed-up income tax: $1,150 * 30% = $345
Calculation of dividend tax credit
Applicable tax credit for non-eligible dividends (assume 10.03% of grossed-up amount) :
- Tax credit: $1,150 * 10.03% = $115
Net tax payable
- Gross increased income tax: $345
- Tax credit: $115
- Net tax payable on dividend: $345 - $115 = $230
In this second example, for a $1,000 dividend, the net tax after tax credit is $230.
Optimize your dividend payments with T2inc.ca
By understanding the distinction between ordinary and eligible dividends, and by using these concepts intelligently, you can not only optimize your tax planning, but also increase your company's financial performance.
At T2inc.ca, our tax specialists can help you make the best choices regarding your compensation. We help you maximize both your corporate and personal tax returns.
Feel free to contact our team for help with your corporate taxes or any questions related to our specialty. We're here to guide you toward better tax management.
Frédéric Roy-Gobeil
CPA, M. TAX
As President of T2inc.ca and an entrepreneur at heart, I have founded many start-ups such as delve Labs and T2inc.ca. A former tax specialist at Ernst & Young, I am also a member of the Ordre des comptables professionnels agréés CPA and have a master's degree in taxation from the Université de Sherbrooke. With a passion for the world of entrepreneurship and the growth mindset, I have authored numerous articles and videos on the industry and the business world, as well as on accounting, taxation, financial statements and financial independence.
