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Update on reduced taxation of dividends

November 2006 special edition of TaxBreaks and Executive TaxBreaks


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In July 2006, we published a special edition of Executive TaxBreaks on draft legislation released by the federal government proposing to reduce the tax rate on certain dividends received after 2005 by individuals and trusts. Since then, a number of developments have occurred.

  • First, on October 16, 2006, the federal government released a Notice of Ways and Means Motion clarifying certain technical provisions of the earlier draft legislation. These provisions were included in Bill C-28, which received second reading October 30, 2006. It is anticipated that the dividend tax proposals will be enacted into law by the end of the year.
  • Second, the provinces of Alberta, British Columbia, Saskatchewan, Newfoundland and the Northwest Territories, joining Manitoba, Ontario and Quebec, announced they will be amending their legislation to mirror the federal proposals.
  • Third, on October 31, 2006, the federal government announced its intention to impose income tax on flow-through entities (for the most part income trusts) in respect of certain distributions made to investors.  Under the proposal, investors in these entities will be taxed as though the distributions were dividends.

As discussed in the July special edition, the proposed changes will reduce the effective personal tax rate on “eligible dividends” (explained below). Currently, the combined top marginal rate paid by individuals on taxable dividends received from Canadian corporations ranges from 24% to 37%, depending on the province of residence. Assuming the provinces make similar changes to their regimes, the proposed changes will reduce the tax rate significantly, to as low as 14.6% on eligible dividends in 2009. The reduced tax rate will be achieved through an increase to the dividend gross-up and the dividend tax credit on eligible dividends. Dividends that are not eligible will continue to be taxed at the current rates.

Background
Eligible dividends
Under the draft legislation, only eligible dividends qualify for the reduced tax rate. The draft legislation sets out rules for determining whether a corporation’s dividends are eligible. The rules differ depending upon the status of the corporation. For example, a Canadian-controlled private corporation (CCPC) may pay eligible dividends to the extent that its taxable income is not subject to the small business tax rate (excluding investment income). Such income would accumulate in the general rate income pool (GRIP), representing the balance that may be designated as eligible dividends. Dividends not paid from the GRIP would be considered ineligible and taxed at the existing higher rate.

For public corporations and other non-CCPCs resident in Canada, the new rules generally allow eligible dividends to be paid out of net income, unless the corporation has a balance in its low rate income pool (LRIP) at the time the dividend is paid. The LRIP, in short, represents the accumulation of net income that has benefited from the small business tax rate and therefore may not be paid out as eligible dividends. A non-CCPC could have an LRIP at any point in a taxation year if it was formerly a CCPC or has received ineligible dividends paid by another corporation.

Based on the draft legislation, the responsibility of determining whether a dividend is an eligible dividend rests on the payer corporation. The corporation will be required to designate, in writing, a dividend as an eligible dividend.

The draft legislation also places punitive measures on corporations that designate eligible dividends in excess of their capacity to pay such amounts. A special tax will be levied on a corporation that does so, on the amount of the excess. Consequently, it will be critical for a corporation to track income pools to ensure that the balances are accurate.

Impact of the draft legislation
Overall, the impact of the draft legislation will be significant and far-reaching, affecting both individual taxpayers and corporations.  Some of the decisions and tax planning that will be impacted are:

  • Income splitting
  • Estate planning
  • Shareholder compensation and the decision to “bonus” down
  • Acquisition planning (impact on GRIPs/LRIPs)
  • Becoming or ceasing to be a CCPC

Now is the time to start thinking about what impact these changes will have on your personal and corporate tax planning.  For dividends paid before the draft legislation is enacted, a designation will be deemed to have been made in a timely manner if it is made within 90 days of the date on which the legislation is passed.  Further, there are special transition rules for CCPCs. Consequently, there is a discrete time period for tax planning with respect to the dividend taxation rules. Your local Deloitte professionals are here to assist you along the way.

Heather Evans, Marsha Reid and John Chou

Top personal tax rate on ordinary and dividend income – 2006
(based on information available as of October 31, 2006)  

 

Province

Ordinary
income

Current rate/
ineligible dividend

Proposed rate on
eligible dividends 1

British Columbia

43.70%

31.58%

18.47%

Alberta 2

39.00%

24.58%

18.18%

Saskatchewan

44.00%

28.33% 3

20.35%

Manitoba

46.40%

35.25% 4

23.83%

Ontario

46.41%

31.34%

25.09% 5

Quebec

48.22%

36.35% 6

29.69% 7

New Brunswick

46.84%

37.26%

32.09%

Nova Scotia

48.25%

33.06%

23.41%

Prince Edward Island

47.37%

31.96%

22.13%

Newfoundland and Labrador

48.64%

37.32%

32.52%

Yukon

42.40%

28.64%

20.13%

Northwest Territories

43.05%

29.65%

18.25%

Nunavut

40.50%

 28.96%

22.23%

1 The combined federal and provincial tax rate on eligible dividends is based on the proposed federal rate reduction and the current provincial dividend tax credit rates. For Newfoundland, Quebec, Ontario, Manitoba, Saskatchewan, Alberta, British Columbia, and Northwest Territories, the dividend tax credit rates contained in the respective provincial proposals have been used.
2 The combined Alberta tax rate on ineligible dividends will be gradually increased to 27.71% by 2009; for eligible dividends, the combined rate will be gradually reduced to 14.55% by 2009.
3 The combined Saskatchewan tax rate on ineligible dividends will be increased to 30.83% in 2007.
4 The combined Manitoba tax rate on ineligible dividends will be increased to 36.75% in 2007.
5 The combined Ontario tax rate on eligible dividends will be gradually decreased to 22.38% in 2010.
6 The combined Quebec tax rate on ineligible dividends received between January 1, 2006, and March 23, 2006, is 32.81%. 
7 The combined Quebec tax rate on eligible dividends received between January 1, 2006, and March 23, 2006, is 28.61%.

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