[HaroldCrump]

Greetings all,

Can anyone pl. explain the rationale behind the dividend gross-up of 45%?
What's the point of grossing up and then giving a credit back (for eligible dividends)?
Why not just provide a flat credit?

-Harold

 

[stephenheath]

Here's the best explanation I've ever seen as to why the gross up exists:

How the “Gross Up” and Dividend Tax Credit Work
Under the current income tax system, income earned by corporations is taxed at the
corporate tax rate. If that income is paid out as dividends to individuals, it is taxed again, at
the personal tax rate. Without any other measures, this would result in double taxation.
To address this, the tax system uses two mechanisms: the “gross up” and the dividend tax
credit. Therefore, if we assume a corporation earns $100 in income, and pays out all the
after-tax amount in dividends, the corporation will pay 30.5 per cent, or $30.50, in income
tax and distribute $69.50 in dividends.
The individual receiving the $69.50 in dividends “grosses up” his or her income by 125 per
cent, and reports $86.90 in income. This is intended to approximate the before-tax income
of the corporation. Assuming a personal tax rate of 43.05 per cent, the individual is liable
for $37.40 in tax on this income.
The individual is then eligible to claim a Dividend Tax Credit of 19 1/3 per cent of the
grossed up amount, or $16.80, for a net tax liability of $20.60
The total tax paid by both the corporation and the individual is $51.10.

And the answer to your question as to why to gross up and then apply the dividend tax credit is because that keeps a "progressive" step in the mix... the personal tax rate varies depending on income, so someone with a lower tax rate will pay less tax and someone with a higher tax rate will pay more. Since people used to do this with pen and paper, it was probably easier to do the gross up and use that figure for both the income and the credit rather than using the gross up for the income part and the non-grossed up for the tax credit part.

 

[Max]

This makes sure that high income people do not just convert all their income to dividends in order to avoid taxes.

The 45% gross up accelerates the increase in tax brackets, while the credit is given at a fixed percentage.

This means that the more dividends you earn, the more likely you are to bump yourself into a higher tax bracker, and reduce the benefit of the dividend credit ultimately to the point where other forms of income are preferable.

Assuming a maximum federal/provincial income tax bracket in Ontario of 46.41% has already been reached, the marginal tax rate on dividend income (including dividend tax credit) is about 30% (46.41% marginal tax rate x 1.45 gross up - 37.65% federal/provincial credit).

Assuming a maximum federal/provincial income tax bracket in Ontario of 46.41% has already been reached, the marginal tax rate on capital gains is approx 24%.

Somewhere around 75,000 - 80,000 in taxable income (including the gross up on dividends) is where the marginal benefit of dividend income runs out.

 

[cardhu]

Assuming a maximum federal/provincial income tax bracket in Ontario of 46.41% has already been reached, the marginal tax rate on dividend income... is about 30% ...

No, its 23.05% ... the ON surtax makes the calc a little more complicated than shown ... and because the surtax comes after the application of the credit, in the sequence of provincial tax calcs, its effect is to boost the value of the provincial credit.

The correct calc (for 2009, changing each year for the next several years) is ...

Federal ... (29% * 1.45) - (18.97% * 1.45) = (29% - 18.97%) * 1.45 = 14.54%
Ontario ... ((11.16% * 1.45) - (7.4% * 1.45)) * 1.56 = (11.16% - 7.4%) * 1.45 * 1.56 = 8.51%

Combined ... 14.54% + 8.51% = 23.05%

By 2012, it will have risen to 29.54%, and the marginal rate in the lowest bracket will have risen to -1.89% ... Under current law, that is.

Somewhere around 75,000 - 80,000 in taxable income (including the gross up on dividends) is where the marginal benefit of dividend income runs out.

Can you explain what you mean by this? ... I’m not sure what you’re getting at.

 

[stephenheath]

Quote:
Somewhere around 75,000 - 80,000 in taxable income (including the gross up on dividends) is where the marginal benefit of dividend income runs out.

Can you explain what you mean by this? ... I’m not sure what you’re getting at.

While I could be wrong and this may not be his meaning, it is similar to a situation I encountered with small CCPC's ... where the one or two owners own 100% of the shares personally. Generally each year before all the profits are passed to the owners, the tax boys go at it to determine for their personal tax situation how much should be dividends and how much should be bonuses (treated as salary income). I'm guessing based on rough numbers in the past that he means if you were sending out $200,000 of profit from the company, the optimum mix would be somewhere around 75-80,000 in dividends then the balance in salary, as in this particular case, I do believe it was exactly 80 and 120 they split it.

 

[cardhu]

...this may not be his meaning, it is similar to a situation I encountered with small CCPC's

OK, that does seem consistent with Max’s opening line, but with a CCPC, the grossup would be only 25% ... Max referred to a 45% grossup so I assume he was referring to qualified (ie. investment) dividends.

 

[Max]

Carhu,

My calculations were based on the 6.25% Ontario Surtax, which you are saying will also (effectively if not actually) increase the dividend tax credit from my earlier calculations. That is the difference, nothing to do with CCPCs.

Based on the incorrect tax rate, I had calculated that at an income level of 75,000 - 80,000, it is preferable to earn capital gains rather than dividends, since the marginal tax rate would have been higher for dividends than capital gains. However, given your comments, I will have to revise those calculations.

The point was to prove that at a certain income level dividends may no longer be the preferred choice of income. Your calculation proves that incorrect. Eligible dividends appear to always be a better option than other forms of income.

 

[stephenheath]

Ahha! Well, I'm really glad that I clarified I was only guessing

Max, taxtips.ca is a great site for crunched numbers, you'd like this page:

http://www.taxtips.ca/taxrates/on.htm

 

[cardhu]

Eligible dividends appear to always be a better option than other forms of income.

For the moment, on a marginal basis ... but ...

Those were 2009 rates I showed, and as mentioned, they will be rising .... the effective marginal rate for dividends, in the highest combined bracket, for Ontario, over the next few years will be

2010 ... 26.58%
2011 ... 28.18%
2012 ... 29.54%

Also, you have to consider that while dividends actually ARE income, capital gains are not ... barring cap gain distributions from income trusts, mutual funds, and the like, capital gains only kick in when you sell something, and are a function of the difference between selling price and ACB ... its far more difficult to control a steady stream of gains to use as “living-expense-cash-flow”, than it is to control a steady stream of dividends .... also, the deferral of tax on capital gains suppresses the effective tax rate below the actual marginal rate ... makes the comparison, and therefore the cross-over point that you're referring to, a little less straightforward.

 

[stephenheath]

Cardhu, I hadn't realized the tax rates on dividends in Ontario are going up so significantly over the next few years (at the moment all of my stocks are inside the RRSP so I've completely ignored all tax issues)... why are they increasing it so significantly? I realize that Ontario is lowering the corporate tax rate at the same time, which could theoretically lead to higher dividends, but that would only be for companies based in Ontario, and Ontario taxpayers then lose an extra 3% on all the other companies who won't be increasing their dividends.

... as I write this I realize you didn't say it was the Ontario portion causing the increase, perhaps it is the federal portion to offset their corporate tax reductions... at least in that case the companies who could increase their dividends are at least a wider pool. Either way, doesn't this seem kind of drastic?

 

[OhGreatGuru]

Greetings all,


What's the point of grossing up and then giving a credit back (for eligible dividends)?

-Harold

To pointlessly complicate all our lives because of differences between corporate and personal tax rates, and fears that a handful of rich people will otherwise gain. Well, I have news for CRA - the rich know enough other tax dodges that they could care less. I object to having my "dividend income" artificially inflated by 45%, which is money I never received.

 

[cardhu]

why are they increasing it so significantly?

The changes are largely federal, and there have been changes at the provincial levels as well, in most (if not all) cases.

I object to having my "dividend income" artificially inflated by 45%, which is money I never received.

Do you also object to having your tax credit artificially inflated by 45%?

The entire setup is designed to retain some degree of "progressivity" in the tax system, while simultaneously recognizing the tax already paid by the corporation, and it seems to do that reasonably well.