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Today being Canada Day, what better way to celebrate than with an uplifting discussion about taxes?

If there's one thing Canadians agree on, it's that they hate paying tax. What many folks may not realize is that Ottawa's much-maligned tax system has some special goodies for investors.

One of the juiciest is the dividend tax credit - a perk that can dramatically reduce your income tax bill.

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"It's a big deal," says Dorothy Kelt, a retired accountant who, with her husband, runs "I don't think most people are very aware of it. Even a lot of people who know a fair amount about investing aren't really that up on it."

Certainly, most people have better things to do than learn about tax credits, gross-ups and marginal tax rates. That's what accountants are for. But having a basic understanding of how the dividend tax credit works, and how it can benefit you, can only make you a better investor.

So let's look at an example.

Suppose you own 100 shares of Slate Rock and Gravel Co. that pay an annual dividend of 50 cents each, for a total of $50. Let's further assume that you live in Ontario and you make $60,000 a year, putting you in the 31.15-per-cent tax bracket.

Now, let's watch what happens to that $50 as it winds through the tax system. There's some math here, but you'll like the end result, I promise.

The first step is that the $50 dividend is "grossed-up." That's just a fancy way of saying you have to multiply it by 1.45, which is the current gross-up rate set by Ottawa. So your $50 would grow to $72.50, which is the amount you'd report as income on your tax return.

So far, this looks pretty bad, right? Thanks to this strange gross-up thingy, you're reporting more income than you actually made. At your marginal tax rate, you'd owe $22.58 on your grossed-up dividends.

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But we're not done yet. Because it's dividend income from a publicly traded company, you're entitled to a federal dividend tax credit of about 19 per cent of the grossed-up amount, plus an Ontario dividend tax credit of 7.4 per cent, for a combined credit of 26.4 per cent of the $72.50, or $19.14.

Now here's the best part: Subtract that $19.14 credit from the original tax owing of $22.58, and your tax bill drops to $3.44. So on that $50 in dividends from Slate Rock and Gravel, you'd be paying a puny tax rate of 6.9 per cent.

In other words, yabba dabba doo.

The tax rate on dividends varies, depending on your income and province of residence.

In the top tax bracket in Ontario, for instance, dividends are taxed at 23 per cent, which is still about half the rate for regular income.

If you have very low income, it's even possible to have negative tax on dividends, which means you can use the credit to offset other tax.

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Remember, you only get the dividend tax credit for shares held outside registered accounts. So, although every situation is different, it generally makes sense to keep higher-taxed, interest-paying investments inside your RRSP and - if you have no contribution room left - leave your dividend stocks outside because the income is taxed at a lower rate.

If you do have contribution room left, you can certainly put dividend stocks inside your RRSP; you won't get the tax credit, but you won't be paying any tax on your dividends anyway.

The dividend tax credit formula isn't without drawbacks. In particular, the gross-up - the rationale for which is beyond the scope of this article - results in a phantom increase in one's income. That can hurt people who qualify for income-tested benefits such as the Old Age Security Pension, notes Brian Quinlan, partner at Campbell Lawless Professional Corp. chartered accountants.

"Depending on what your income is, you could have your Old Age Security clawed back and lose part of your age credit," he says.

The good news is that the gross-up rate is set to fall over the next few years, dropping to 1.38 in 2012. The bad news is that the tax rate on dividends will rise by a few percentage points over the same period. But dividends will still be taxed at much more favourable rates than other income.

So the next time someone starts complaining about taxes, tell them about the money they can save with the dividend tax credit.

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