The dividend tax credit is a useful tool to reduce the tax burden on investors, but it only applies to dividends from Canadian companies and is most effective at certain tax levels. While it’s worth taking advantage of, this tax strategy should also be looked at in conjunction with all of an investor’s holdings, to make sure it’s being used in the most effective way.
The dividend tax credit can be a useful tool for investors looking to reduce the taxes they pay on their investments, especially at lower tax brackets. But it only applies to dividends from Canadian companies, and may interact with your other holdings in ways that minimize some of its benefits. John Horwood, director of wealth management at Richardson GMP in Toronto, sat down with The Financial Pipeline to discuss what investors need to consider when it comes to the dividend tax credit.
FP: What’s the dividend tax credit and how does it work?
JH: If we think of a company being a traditional business, they earn income, they pay taxes, and their shareholders are looking for a return on their investment. That return comes in the form of either capital gains or appreciation of the value of the company in the stock or in the form of dividends. When it’s dividends, it has a special tax regime because the income has effectively already been taxed in the hands of the company, so there shouldn’t be a double taxation. The government has made provisions for special rules around corporate dividends, and they’re particularly effective in the hands of Canadians with lower taxable income.
The process of eligible dividends is quite complex (but) the net effect for Canadians with a relatively low taxable income is that you can get to a situation where dividends are basically tax-free. That’s a useful tool. It’s not the only one, but it’s certainly one that we like to exercise at every available opportunity.
FP: How does your tax bracket impact how much you can benefit from the dividend tax credit?
JH: It’s a little bit like a jigsaw puzzle because investors have many sources of income and the combination of these can change the outcome. In the purest form, if your only taxable income showed up as eligible dividends, you can earn well into the $40,000 range of dividend income and basically pay little or no income tax. But when we talk about low taxable income, that doesn’t mean that these people have small investment portfolios or small cash flows. Quite often you can drive tremendous cash flow but still show a relatively low taxable income, so it can still work for high net worth Canadians.
FP: What’s the difference between eligible and non-eligible dividends?
JH: The eligible dividend is the one that we’re talking about, where investors can qualify for the dividend tax credit. These are dividends from the traditional sources – from the public companies we all know, from the banks, the utilities. The other ones that are quite interesting are the dividends from preferred shares. Preferred shares are very close to corporate bonds in terms of their risk profile. They generally are lower risk profile but the still have the dividend tax credit available. Ineligible dividends are coming from a different stream of income, usually from private companies and they don’t have the same tax advantages available.
FP: Why is the dividend tax credit something people should be taking advantage of?
JH: From an investment point of view, many of the companies that are paying a dividend are attractive investments anyway. The second thing is that income is critical for Canadians today. We live in a very, very low interest rate world, a very low income world and when you look at the relative yields of offer from bonds, from common shares and dividends on preferred shares, you can often see four, five, six per cent dividend yields, so the cash flow to fund retirement, to fund projects is much higher. If that cash flow is net to you and isn’t being split up with the tax authorities, then five or six per cent back to the client is a very favorable result in today’s economy.
FP: Why is this tax credit offered?
JH: It’s been around as long as I’ve been an investment advisor, which is 30-plus years. They’ve tinkered with it a few times, but I think it stays because it’s fair. It’s income that’s already been taxed in the hand of the company the first time around, and so it makes sense to continue it.
FP: Are there any disadvantages or challenges associated with the dividend tax credit?
JH: The main one is that it is limited to Canadian companies, so the dividend tax credit isn’t available if investing in U.S. or overseas companies. Dividends received from companies outside of Canada are actually penalized, and the taxes are quite nasty. Otherwise, the main issue around dividends and the dividend tax credit is the interaction with the other investments that you have. They may be very attractive at a relatively low taxable income level, but the moment you pile on income from a retirement income fund or other investment income or interest income, then the benefits can soon diminish. Once you get into the higher tax brackets the real benefit disappears, and then it starts to make a lot more sense to go into return of capital structures or capital gains structures, where there’s no limit on the income.