The reason is that tax authorities have their eye on the big picture. “It’s all about tax integration,” says McShane, the financial planner. Think of it this way: the money you receive as dividends starts off as a company’s earnings, and the company pays corporate taxes on those earnings. After paying those taxes, the company takes a portion of the money that is left and passes it directly to you as a dividend, and you pay tax on it again.
The government recognizes that it’s unfair to tax the same income twice. So they give you a break on dividend taxes to offset the taxes the corporation already paid. As a result, you should pay roughly the same tax as if the income had come straight to you in the first place, without passing through corporate hands.
Now that you know what the tax authorities are trying to do, have another look at the three-step calculation. Step one, where you apply the gross-up, brings your income back to the starting point, as if the corporation had never touched it. Step two applies your marginal tax rate to this income, again as if it had never gone through corporate hands. Then step three applies the dividend tax credit to give you back the taxes the corporation actually paid. In general, if your marginal tax rate is higher than the corporate tax rate, you’ll still pay some tax: roughly the difference between the two rates. If your marginal tax rate is lower than the corporate tax rate, you’ll typically get some money back. However, you won’t ever get a cheque from the Canada Revenue Agency: the dividend tax credit is “non-refundable,” which means it can only be used to offset tax otherwise payable on other income.
Before you count on the dividend tax break too much, you should realize that it has been gradually shrinking. That’s because the federal government has been phasing in reduced corporate income tax rates from 2007 to 2012. Since the dividend taxes you pay are based on the difference between your personal tax rate and the corporate tax rate, this means your share of the taxes paid is getting larger. The consolation prize, as Lento points out, is that (in theory) the reduction in corporate taxes should allow companies to increase their dividends.
The dreaded clawback
For affluent seniors, the real unsavoury morsel is the OAS clawback. Remember our first step in the calculation, which inflates a dollar of dividends to $1.41? Well, it’s that grossed-up income that’s used when determining the clawback. Thanks to this seemingly twisted math, dividends can appear less desirable than interest income in this situation.
As you can see in our table, for the senior with an income of $85,000, an extra $1,000 in interest income reduces OAS by $150, but the same amount of additional dividend income reduces OAS by $212.
The tax authorities use a similar approach to calculate other clawbacks on income-related seniors’ benefits, including the Age Credit, which is shown in the examples laid out in our table. The same principle also works against lower-income seniors who are potentially eligible for the Guaranteed Income Supplement (GIS). The GIS is reduced in proportion to your other income, and it too uses grossed-up dividends when making the calculation.