In your recent Investor Clinic video, you mentioned that for some people the tax rate on dividends can actually be negative. How is this possible?
It sounds bizarre, but it's true: In many provinces, if your income level is low enough the marginal tax rate on dividends is indeed negative.
How negative depends on the province. For example, if you live in Ontario and had 2012 taxable income of $39,020 or less, your dividends would be taxed at negative 1.89 per cent (subject to the dividends not affecting the Ontario Health Premium or the Ontario Tax Reduction).
In British Columbia, dividends in the lowest income bracket are taxed at negative 6.84 per cent (again, subject to certain conditions). You'll also find negative rates for the lowest income brackets in Alberta, Saskatchewan, New Brunswick, Nova Scotia, Prince Edward Island and Newfoundland.
Now, before you get too excited, I should point out that the government won't write you a cheque for the negative amount. That's because sub-zero tax rates result from the dividend tax credit, which is non-refundable. The good news is that negative taxes on dividends can reduce other taxes payable.
Let's walk through an example that illustrates how the dividend tax credit (DTC) works, and how it can create a negative tax on dividends. The following example is for illustrative purposes only. We recommend you consult a tax professional regarding your own situation.
Say you receive a dividend of $100 from XYZ Corp., a public company whose dividends qualify for the DTC. You put $100 in your pocket, but on your tax slip, you may have noticed that dividends are "grossed up" by 1.38, so you actually report taxable income of $138.
Why the gross up? Well, dividends are paid out of a company's after-tax profits. The purpose of the gross up is to take that $100 dividend and estimate what the company would have had to earn in pre-tax profits to generate it. In this case, the assumption is that the company earned about $138, on which it paid corporate tax.
Now, we need to ask a question: If you, the shareholder, had received the entire pre-tax profit of $138, how much tax would you (theoretically) pay on it? If you're in the lowest tax bracket in Ontario, your combined federal and provincial tax rate is 20.05 per cent. So you would pay $27.67 in tax – at least in theory.
Clearly, it would not be fair to make you pay that much. Remember, the company has already paid corporate tax on that $138, so taxing it again would amount to double-dipping. What Ottawa and the provinces do is give you a credit – the dividend tax credit – for what the company has presumably already paid. In Ontario the combined federal and provincial DTC is 21.42 per cent of the grossed-up dividend. Calculated on $138, that's $29.56.
Are you still awake? Because this is where it gets exciting.
If you subtract the DTC of $29.56 from the theoretical tax owing of $27.67, you get negative $1.89. So, in this case, your actual tax on the dividend is negative. In fact, it will be negative whenever a person's marginal tax rate is lower than the DTC rate.
This gives rise to some unusual scenarios. Consider Jane, who lives in B.C. and earns $31,000 from a part-time job. Her income tax would be $4,268 (including $798 for B.C.'s Medical Services Plan).
Now consider Steve, who has a similar job paying $31,000, but who gets an additional $5,000 from eligible dividends. Amazingly, although Steve's income is higher than Jane's, his tax bill would be $319 lower, at $3,949 (we used the tax calculator at taxtips.ca to generate these results).
Admittedly, most people collecting dividends probably aren't in the lowest tax bracket. But even at higher income levels, dividends are still taxed at favourable rates compared to interest and other income. (To see a comparison, go to taxtips.ca and click on your province, then select "tax brackets and marginal rates.") In fact, as I've written before (tgam.ca/Didq), in some provinces you can earn close to $50,000 in dividends without paying any tax, as long as you have no other sources of income.
Dividends do have a downside, in that the gross-up can sometimes increase the clawback on Old Age Security and other income-tested government benefits. But for a lot of people, generating a portion of their income from lightly taxed – or even negatively taxed – dividends makes a lot of sense.