Mind Your Distributions
By Ryan Goldsman, CFP®, PAIP®
Making your first investment is exciting. Receiving your first cash inflow from that investment is even more exciting!
Following the initial euphoria, investors need to take a moment and consider the tax impact of that distribution (or dividend)… and it can get complicated.
Of course, those who invest in a registered account have the advantage of sheltering their gains (including distributions) if their investment is held inside an RSP/LIRA, RIF/LIF, TFSA, FHSA, RESP, or RDSP.
For those who invest in non-registered accounts, then it’s important to appreciate the tax consequences when receiving a distribution or a dividend.
To begin with, distributions can be comprised of a variety of returns which includes interest income, dividend income, and capital gains.
When an investor receives interest income, they must pay takes on 100% of the amount at their marginal rate of tax (MRT). It’s the least favorable type of return an investor can receive.
On the opposite side of the coin, capital gains are only 50% taxable as their inclusion rate (for tax purposes) is 50%. Half is taxable at one’s MRT, while the other half is tax-free. In the rare case that the non-taxable portion is distributed to shareholders, called a capital dividend, it is not subject to tax.
The most complicated type of return to account for is dividend income.
As dividends represent a share of the company’s net profit, the amount of tax paid by the company (on their earnings) must be taken into consideration. To account for this amount, investors who receive dividends from public companies must gross these amounts up by a factor of 1.38 for tax reporting purposes. Offsetting this gross up is the availability of a dividend tax credit (DTC). The federal DTC is computed as 15.0198% of the taxable dividend, whereas the provincial DTC varies from province to province. In theory, the DTC “backs out” the taxes paid by the company at the corporate level. The intent is for the DTC to offset the corporate tax, but this does not occur on a dollar-for-dollar basis. Since higher earners must remit a higher amount of taxes payable, as compared to lower income earners, the net tax on dividends varies according to one’s MRT. Since the DTC is a non-refundable credit, low-income taxpayers may not be able to benefit from the full DTC as there may be insufficient tax payable to use the full DTC.
Ultimately, the taxes payable on dividend income largely fall between the amount of taxes payable on interest income and on capital gains – it just depends on the MRT of the taxpayer.