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Last week you wrote about the dividend "gross-up." Can you explain why dividends are grossed up and why I have to pay tax on more than I've earned?

The dividend gross-up leaves a lot of investors scratching their heads. Even those who know how the math works don't necessarily understand the theory behind it.

So today, I'll break it down using a simple example.

Let's assume you received $100 in eligible Canadian dividends in 2014 and that you hold your shares in a non-registered account. (The gross-up doesn't apply to registered accounts.)

On your T5 tax slip, you'll see three amounts related to the dividend: the actual amount of eligible dividends, which is $100; the taxable amount of dividends, which is $138 ($100 plus a gross-up of 38 per cent); and the federal dividend tax credit, which is $20.73 ($138 times 15.02 per cent).

To understand what's going on here, the first thing you need to know is that dividends are paid out of a company's after-tax profits. That $100 dividend you receive is essentially what's left after the taxman has already taken a cut. The purpose of grossing up the dividend by 38 per cent is to approximate how much pretax profit the company would have had to earn – in this case it's $138 – in order to pay the tax and send you a cheque for $100.

Here's what irks some people: Even though you receive only $100, you have to add the $138 to your taxable income. Seems unfair, right? But this is where the dividend tax credit (DTC) comes in: The DTC gives you "credit" for roughly the amount of tax the company has already paid. The federal DTC is 15.02 per cent of the grossed-up dividend. Provinces also kick in their own DTCs. In Ontario, for example, the DTC is 10 per cent of the grossed-up dividend, for a combined federal and provincial DTC of 25.02 per cent.

The DTC prevents double taxation and dramatically lowers the tax you actually have to pay. Continuing with the example, assume you live in Ontario and your marginal tax rate is about 33 per cent. Your tax on the grossed-up dividend of $138 would be $45.54, but this would be offset by a combined DTC of $34.53. Your net tax owing would therefore be $11.01, or about 11 per cent of the actual dividend of $100.

Thanks to the DTC, dividends are taxed at a lower rate than interest regardless of your tax bracket. In some cases, it's even possible to have a negative tax rate on dividends. How? Well, at low income levels, the combined DTC rate can be higher than a person's marginal tax rate. Unfortunately, because the dividend tax credit is non-refundable, the government won't send you a cheque for the negative amount of tax. But you can use it to offset other taxes owing.

The gross-up and tax-credit system is based on a concept called tax integration, which holds that an individual should pay roughly the same amount of tax whether money is earned from a company directly (as a salary, for example) or indirectly (as a dividend).

Returning to the example, the gross-up in effect converts the $100 dividend into $138 of "salary," on which you must pay tax at your marginal rate (less the credit for the corporate tax already paid). In theory, you should end up with the same amount of after-tax money in your pocket whether you receive income in the form of dividends or salary, although the numbers won't be identical because integration isn't perfect.

The gross-up isn't without problems. Some seniors complain the phantom income created by the gross-up results in an increased clawback of their Old Age Security (OAS) payments and other credits. It's not fair to make them report income they never actually receive, they say.

While their frustration is certainly understandable, as my column last week demonstrated, dividends can still be a good choice – even taking the OAS clawback into account – thanks to the benefits of the gross-up and dividend tax credit system.