A theory on dividends
Canadian dividends are more attractive than ever before. In at least half the provinces, they now outpace capital gains as the least-taxed form of investment income in Canada.
The big issue, however, is to what degree the dividend advantage will continue in future years given the changes to the dividend rates announced in this year's federal budget, which have now become law.
The changes will affect the taxation of "eligible" Canadian dividends, which includes most dividends received from public companies as well as dividends from some private companies.
What's changing in the years ahead are the "gross-up" factors and the dividend tax credit rates. These changes are meant to parallel reductions in the general corporate tax rates, which will bring the federal corporate rate down from 19.5% currently to 15% by 2012.
Corporate tax rates, the gross-up factor and the dividend tax credit are all intricately linked through the theory of integration. This basic tax principle states that an investor earning income personally (as opposed to inside a corporation) should be left with the same after-tax cash at the end of the day as the shareholder who earns income through a Canadian corporation (which has paid corporate tax), and receives the after-tax amount personally as a taxable dividend.
Consistent with the theory, when corporate tax rates fall, both the gross up and dividend tax credit rates should drop as well. And that's exactly what's happening from 2010 to 2012.
Of course, the obvious question is: If the federal changes are supposed to be neutral, why do dividend rates, as shown below, appear to be rising across the board?
The answer is that the theoretical integration model is based on two assumptions: The first is that the corporations will simply increase their cash dividends by the amount of corporate tax saved. The second is that the provinces will fully adjust their own tax rates in a corresponding manner.
Both assumptions are far from a sure thing, which means that the tax efficiency of dividends may soon reach its peak.