Gross up makes no sense
Canadian dividends are taxed favourably but the road to such beneficial treatment is circuitous, involving both a "grossup" and dividend tax credit along the way. The gross-up, which is 38% in 2012, is meant to bring the actual level of eligible dividends received by a shareholder in a public company back up to the level of pre-tax corporate income earned. The dividend tax credit is then meant to compensate the individual for the corporate taxes paid by the corporation in attempt to avoid, or at least reduce, the double taxation inherently associated with corporately-earned income.
But the gross-up itself is not without unintended - or if you take a more cynical approach to tax policy, intended - consequences. For example, for the vocal 3% of retired Canadian seniors whose income is more than about $70,000 in 2012, the gross-up of dividends further increases the amount of Old Age Security benefits lost to the dreaded clawback.
But it gets worse. As a recent tax case demonstrates, the gross-up of dividends can also add insult to injury by artificially inflating income which is used in the calculation of various penalties assessed for tax filing errors.
The case involved a taxpayer who was assessed a penalty for failure to include an amount on her 2008 tax return, following a previous failure to include an amount in income in filing her 2007 tax return. The penalty is 10% of the amount not reported and is only assessed if you failed to include an amount in income in the current year and in any one of the three preceding years.
In 2007, the taxpayer failed to include $1,156 in her income and in 2008, the amount of unreported income on which the penalty was based was $5,226, which included $2,075 of taxable dividends.
For 2008, the gross-up factor was 45% of the amount of dividends actually received. Since the penalty is based on 10% of the amount that is required to be included in income and since you must gross-up dividends before including them in your income, the penalty is inflated by the amount of the gross-up.
As the judge wrote, "This result appears to be counterintuitive." He went on to give an example of an individual who received a $10,000 eligible dividend in 2008 and had to include $14,500 in income. The penalty for failure to report this amount would be $1,450. If that same individual, however, failed to report $10,000 of interest income on his 2008 return, the penalty would be only $1,000.
What's even more bizarre is that, owing to the dividend tax credit, the tax liability arising from a $10,000 eligible dividend would be less than the tax liability arising from interest income of $10,000, yet the penalty for failure to include the dividend is larger than that for failure to include the same amount of interest income.
Does this make sense? I suggest not and it provides yet another reason that our current system for grossing up dividends, while perhaps theoretically logical, may be due for an overhaul.