Understanding Dividends and Taxation in Canada

Dividends are payments made by corporations to their shareholders, representing a share of the company’s profits. These distributions are taxed differently than regular income in Canada. The Canadian tax system uses an integration mechanism to ensure that income earned by a corporation and subsequently paid to shareholders as dividends is not taxed excessively.

Corporate Taxation:
In Canada, corporations pay tax on their net income. Small businesses that qualify for the small business deduction (SBD) pay a lower tax rate on active business income up to a specified threshold. Larger corporations, or income above the SBD limit, are subject to higher tax rates.

Personal Taxation:
When dividends are distributed to shareholders, they are taxed at the personal level. However, shareholders receive a dividend tax credit (DTC), which reduces their personal tax burden to account for the tax already paid by the corporation.

There are two types of dividends in Canada:

1.     Eligible Dividends: Paid by corporations from income taxed at the higher general corporate tax rate. These dividends receive an enhanced dividend tax credit.

2.     Non-Eligible Dividends: Paid from income taxed at the lower small business rate. These dividends have a smaller tax credit.

By understanding how dividends are taxed, corporations can strategically distribute profits to minimize the overall tax impact.

Strategies to Minimize Corporate Tax Using Dividends

1. Leveraging the Small Business Deduction (SBD)

Small businesses in Canada enjoy a reduced tax rate on active business income up to $500,000 (depending on the province). This lower rate allows businesses to accumulate retained earnings at a minimal tax cost. Instead of reinvesting all retained earnings, corporations can distribute non-eligible dividends to shareholders. While these dividends are taxed personally, the combined corporate and personal tax rates are often lower than paying salaries or bonuses.

2. Balancing Salary and Dividends

Business owners often face the choice of paying themselves a salary, dividends, or a mix of both. Paying dividends instead of a salary can reduce payroll taxes (e.g., Canada Pension Plan contributions) and administrative costs. Additionally, dividends do not create Registered Retirement Savings Plan (RRSP) contribution room, which can be advantageous for individuals who prefer alternative investment strategies.

A balanced approach—combining salary and dividends—can optimize tax outcomes. For example:

• Use salary to reduce the corporation’s taxable income and maximize RRSP contribution room.
• Use dividends to access the dividend tax credit and reduce overall tax liability.

3. Income Splitting with Family Members

Incorporated business owners can use dividends to split income among family members who are shareholders. This is particularly beneficial if family members are in lower tax brackets. However, the Tax on Split Income (TOSI) rules introduced in 2018 limit this strategy. To avoid TOSI, family members must actively contribute to the business or meet certain criteria, such as being over the age of 25 and owning shares that provide a reasonable rate of return.

4. Deferring Personal Taxes

Corporations can retain earnings instead of immediately distributing them as dividends. Retaining earnings allows business owners to defer personal taxes until a later time when they withdraw funds. This strategy can be beneficial if shareholders expect to be in a lower tax bracket in the future (e.g., after retirement).

5. Using Holding Companies

Setting up a holding company can provide additional flexibility in managing dividend distributions. A holding company can receive dividends tax-free from an operating corporation through the intercorporate dividend rules. These retained earnings can then be invested, distributed to shareholders, or used for other purposes.

Tax Planning Considerations

While dividends can reduce overall tax liabilities, improper planning can lead to unintended consequences. Here are key considerations:

1.     Integration and Marginal Tax Rates:
Carefully calculate the combined corporate and personal tax rates. Depending on the shareholder’s income level, it may be more tax-efficient to retain earnings or pay a salary instead of dividends.

2.     Impact on Government Benefits:
Dividend income can impact eligibility for government benefits such as the Canada Child Benefit (CCB) or Old Age Security (OAS). These benefits are clawed back as income increases.

3.     Tax on Split Income (TOSI):
TOSI rules apply strict limitations on income splitting through dividends. Ensure compliance to avoid punitive tax rates.

4.     Provincial Tax Rates:
Corporate and personal tax rates vary by province. Consider regional tax differences when planning dividend distributions.

5.     Retained Earnings Limits:
Excessive retained earnings in a corporation may attract scrutiny from the Canada Revenue Agency (CRA). Ensure funds retained in the corporation are for legitimate business purposes.

Example: Dividend Tax Minimization in Action

Imagine a small business owner in Ontario earning $100,000 in active business income.

1.     Corporate Tax Rate:
The Ontario small business tax rate is approximately 12.2%. The corporation pays $12,200 in taxes, leaving $87,800 in after-tax income.

2.     Dividend Distribution:
The owner distributes $87,800 as non-eligible dividends. At a personal tax rate of 20%, the shareholder pays $17,560 in personal taxes, resulting in $70,240 in net income.

3.     Comparison with Salary:
If the owner took a $100,000 salary, the corporation would pay no corporate tax, but the shareholder would pay higher personal taxes due to income tax and CPP contributions.

By using dividends, the business owner reduces their overall tax burden.

Final Thoughts

Dividends are a powerful tool for minimizing corporate tax in Canada, but they require careful planning and a deep understanding of tax laws. By leveraging strategies such as the small business deduction, income splitting, and holding companies, corporations and shareholders can achieve significant tax savings.

Always consult a tax professional or accountant to ensure compliance with tax laws and maximize the benefits of dividend strategies. With proper planning, dividends can help businesses retain more profits and shareholders keep more income.

This article is only for the purpose of education and awareness. Please consult a professional before adopting the right strategy.

Author

Raman Nagpal

B.Com, FCA, CMA, DISA.