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Explainer: What is the corporate dividend tax credit loophole?

22 February 2022 By John Anderson

Photo: Don Agnello

Photo: Don Agnello

SUMMARY

The corporate dividend tax credit provides a tax break to shareholders who receive corporate dividends. [1] (It is only available for individuals, not corporations. [2]) The intended purpose of this tax credit is to compensate shareholders for the corporate taxes that businesses pay.

However, this tax credit is an unfair loophole because:

  • The beneficiaries save more money as tax credits than they supposedly lost through taxes on their share of corporate profits.
  • Corporate tax rates in Canada are already extremely low, so we shouldn’t be compensating people for paying them.
  • Almost all the people saving money via this tax credit are already very wealthy. (Over 90% of its value goes to the top 10%, and almost half goes to the top 1%.) [3]
  • This loophole costs the federal government over $5 billion annually, depriving the economy of investments, and depriving Canadians of public services.

The corporate dividend tax credit should be abolished.

 

WHY DOES THIS LOOPHOLE EXIST?

The original purpose of the corporate dividend tax credit was to prevent double taxing: corporations paying taxes on income, issuing dividends to shareholders based on income, then shareholders paying taxes on those dividends.

However, the real reason that exists today is that it helps very rich people avoid paying taxes, and our politicians won’t take it off the books because most people don’t know it exists, or how much it’s costing our government.

 

HOW DOES THIS LOOPHOLE  WORK?

Most corporations distribute their dividends, depending on their income, after they’ve paid their corporate taxes. So the amount of money that can be paid out to shareholders is reduced by taxes before those payouts can happen. When corporations pay more taxes, dividend payouts to shareholders are smaller, and vice versa. 

Therefore, if you as an investor own stocks in a company, you’ll be paid less than you would have otherwise received because of the company’s tax bill. So at tax time, your accountant will know to file for the federal dividend tax credit, and get some of that money back.

 

WHY IS THE CORPORATE DIVIDEND TAX CREDIT UNFAIR?

This loophole is unfair in principle, for taxpayers in general, for small businesses, and for everyone who isn’t rich enough to avoid taxes this way.

Unfair in principle: Firstly, we know that corporations already reduce the tax they pay significantly by using loopholes, tax havens, and aggressive accounting. Because corporations  are paying significantly reduced taxes, they are consequently paying out higher dividends. In other words, shareholders are still receiving the same tax break to prevent double taxation, while that initial taxation isn’t really happening. So why should shareholders benefit from corporate tax dodging, and then benefit from taxes that help alleviate the effect of corporate tax dodging on our tax base?

Unfair to most of us: Also, most of the benefit of this tax break goes to very wealthy people. Over 90% of its value goes to the top 10%, and almost half goes to the top 1%. Remember: 9 out of 10 stocks are already owned by the rich or the super-rich. And we know that the richest Canadians already pay a lower share of their income and wealth in tax than the rest of us. So why should the super-rich have yet another means of not paying their fair share? This is simply a loophole that provides a tax break for wealthy individuals, while corporations are busy avoiding their own tax bills. And the government shouldn’t keep giving a tax credit to shareholders for money that is not being paid by corporations.

Unfair to taxpayers: This loophole is also unfair to taxpayers in general because the government is losing out on tax revenue. The corporate dividend tax credit costs the federal government over $5 billion annually. [4] Who do you think will be asked to cover the cost that these rich corporations and investors are avoiding?

Unfair to small businesses: It is unfair to small businesses because of the difference between the types of dividends provided by small businesses and public companies (See Example 3 below). Essentially, investors are de-incentivised from investing in small businesses because the type of dividend they receive carries more of a tax burden than the type of dividend they would receive from investing in a large corporation. [5]

 

CAN WE MAKE THIS LOOPHOLE FAIR?

If tax policies are not having the intended effects, they should be updated and adapted, or eliminated.

This loophole was formerly in place as a deduction in 1985, when the average combined federal/provincial corporate tax rate was 40%. You could make a case to leave this tax loophole in place if we raise corporate taxes back to more reasonable levels. In that case, this loophole then wouldn’t be so egregious, but it would still be unfair to taxpayers, small businesses, everyone but the super-rich, and as a matter of principle.

Alternatively, we could reduce the amount of the corporate dividend tax credit to offset the lost revenue from corporate tax avoidance. But it would still be unfair to small businesses and everyone who isn’t a rich shareholder, and it would still perpetuate wealth inequality.

It’s clear that this tax credit loophole can’t be fixed.

The corporate dividend credit should be abolished.

 

 

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HOW DO I CALCULATE A DIVIDEND TAX CREDIT?

For those interested in how the dividend tax credit is calculated, the below examples show step by step how it works.

It is important to note that there are two kinds of dividends in Canada that have specific tax policies: eligible and non-eligible.

  • Eligible dividends are dividends often given to shareholders by larger corporations with profits over $500,000.
  • Non-eligible dividends are dividends given by smaller corporations and businesses with profits less than $500,000. Non-eligible dividends are taxed differently because those companies can claim the small business deduction on their corporate tax returns. 

 

EXAMPLE 1: GROSS UP

If an investor named Ms. Grossup receives a dividend from a company, this is how it would be reported on her income tax return:

- She would include the dividend in her taxable income… but just the amount that she received from the company. 

- Since her dividend is a reflection of the company’s income after tax, she needs to account for the tax that has already been paid by the company before including it in her taxable income. This is called a gross up. 

It is an odd and complex idea, but the intention of the gross up is to acknowledge that her dividend would have been larger had the company not paid any tax on the income they used to give her the dividend.

The gross up on an eligible dividend is an additional 38% of her dividend. So if she received a $100 dividend, the gross up would make it $138 that would be included in her taxable income.

 

EXAMPLE 2: CREDIT CALCULATION

Now that we understand the gross up, let’s look at a full calculation of the dividend tax credit:

 

1. Mr. Stockwell receives an eligible dividend of $500 from a large corporation. To include it in his taxable income, he applies the gross up.

Taxable Income = Dividend + Gross up 

Taxable Income = $500 + 38% of $500 = $690

The amount of taxable income Mr. Stockwell would report for his dividend is $690.

 

2. Now, he can calculate the tax he would pay on that $690 of taxable income. For the sake of this example, let’s say his marginal tax rate on this income is 25%.

Tax Liability (before credits) = Taxable Income x Tax Rate 

Tax Liability = $690 x 25% = $173

Mr. Stockwell’s tax liability before the credit is applied would be $173

 

3. Next, he can calculate his dividend tax credit. In 2022, the credit for eligible dividends is 15.0198% of his gross up amount, $690

Dividend Tax Credit = Taxable Income x 15.0198%

Dividend Tax Credit = $690 x 15.0198% = $104

Mr. Stockwell’s dividend tax credit would be $104.

 

4. Finally, he can calculate his total tax liability by subtracting his tax credit from his original tax liability.

Final Tax Liability = Tax Liability (before credits) - Dividend Tax Credit

Final Tax Liability = $173 - $104 = $69

The amount of tax I would have to pay on my $500 dividend is $69.

That is an effective tax rate of 13.8%. [6]

Generally, these dividend policies reduce an individual’s marginal tax rate on dividends to be lower than that of employment income

 

EXAMPLE 3: ELIGIBLE VS NON-ELIGIBLE DIVIDENDS

Using the same principle as above, we can see the difference between eligible and non-eligible dividends and their respective credits. This example demonstrates how the credit favours large corporations over small businesses.

 

Eligible (38%)

Non-eligible (15%)

Dividend Income 

100,000

100,000

Gross Up 

138,000

115,000

Tax Liability (federal tax rates for individuals) [7]

27,597

21,618

Dividend Tax Credit (15.0198% and 9.0301% of gross up, respectively) [8]

20,727

10,385

Final Tax Payable 

6,870

11,233

Effective Tax Rate

6.87%

11.23%

 

ENDNOTES

[1] A dividend is money paid to shareholders by a company for investing in that company. It is essentially a distribution of corporate profits to shareholders whose investment helped the corporation to achieve those profits. Governments offer a tax credit on dividend income. 

[2] The credit can only be applied to domestic dividends, not foreign.

[3]https://www.policyalternatives.ca/sites/default/files/uploads/publications/National%20Office/2016/11/Out_of_the_Shadows.pdf, pg 18-25.

[4]https://munkschool.utoronto.ca/mowatcentre/wp-content/uploads/publications/143_tax_exemptions_for_investment_income.pdf

[5] The example in question uses dividends of $100,000. The effect is the same for dividends of $1,000,000:

Eligible Dividend

1,000,000

Non-eligible Dividend

1,000,000

Gross up (38%)

1,380,000

Gross up (15%)

1,150,000

Tax Liability (federal marginal tax brackets)

433,580

Tax Liability (federal marginal tax brackets)

357,680

Dividend Tax Credit (15.0198% of gross up)

207,273

Dividend Tax Credit (9.0301% of gross up)

103,846

Final Tax Payable

226,307

Final Tax Payable

253,834

[6] This is less than the lowest federal individual marginal tax bracket (15%) on employment income. 

[7] This calculation only includes the federal marginal income tax brackets. There are also provincial dividend credits that can be applied to dividend income to reduce the tax liability even further. 

[8] https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/deductions-credits-expenses/line-40425-federal-dividend-tax-credit.html

 

 

Photo: Don Agnello