The Dividend Tax Rate in Canada: What You Need to Know Now

The dividend tax rate in Canada is something that benefits the average Canadian investor. That is because dividend stocks in Canada share the tax burden with the company. You benefit from the company’s financial performance due to money you invested, you keep the stock and its potential future dividend returns, and you pay less tax on the dividend income.

Is there a catch? It sounds simple. We simply share the wealth?

There is no catch but the entire process is not straightforward. That is because Canadian companies often qualify for a dividend tax credit and not a dividend tax rate per se when they pay out dividends. So, the company gets a tax credit from the Canada Revenue Agency (CRA) for paying dividends. 

What do you need to know about dividend stocks and taxes? If you are a self-directed investor, you need to understand how the CRA looks at your dividend income and why it might, or might not, be good for you. Let’s start from the beginning.

What is a dividend tax credit?

A dividend tax credit represents an amount that is applied toward the tax liability on the gross-up component of the dividends a Canadian company pays. You cannot apply this credit for investing in U.S. or overseas stocks. The tax credit can only be used for Canadian stock accounts, which you can get through an online broker or retail broker. The dividend gross-up and related dividend tax credit account for the percentage of tax that a firm pays on income before paying a dividend.

Therefore, the dividend gross-up and the dividend tax-credit are used to avoid double taxation on dividends. Dividends are paid by the corporation from after-tax profits. This is done because taxing your dividends at the full rate is unjust.

Why go through all these hoops? The purpose of a dividend gross-up is to restore a dividend amount to the amount a firm would have paid if it did not pay taxes. This is due to the fact that dividends are paid to shareholders from the after-tax earnings a company lists on its tax return. That sounds, well, kind of nice; thanks for the gift, CRA!

Dividends that are eligible and non-eligible are both grossed-up, but at a different rate. The Canadian Income Tax Act requires Canadian companies to inform shareholders if their payout is eligible before paying a dividend. Thank you for the transparency! 

Therefore, a corporation determines the eligibility of a stock’s dividend based on their overall earnings. The earnings do not have to be in the millions of dollars and the company doesn’t have to be a private company.

Generally speaking, eligible dividends are received from either a public or private corporation who has not received the small business deduction, and who has high earnings of a net income over 500,000 CAD.   Because a firm pays less tax on non-eligible dividends, the recipient is entitled to a lower tax credit.

For the tax year, 2021, the gross-up percentages for eligible dividends is 38% while the non-eligible percentage is 15%. That makes sense. Let’s look at some examples.

Eligible federal dividend tax credits

To get a better grasp of how taxation works, let’s review the following scenario.

• Jane Bell received $1,000 in dividend payments for her stocks in 2021. 
• Eligible dividends made up $800 of that amount while non-eligible dividends comprised $200 of the total. 
• Because Ms. Bell makes more money and is in a higher tax bracket, her nominal tax rate is 30%.

To figure the taxable income, we need to first gross-up each amount at the applicable tax rate.

Federal dividend tax rate calculation 

For example, you would multiply the eligible dividends of  $800 x 1.38 first. Remember that eligible dividends are taxed at 38%, hence we get the multiplier of 1.38. This gives you a grossed up amount of $1,104. 

You would then multiply the non-eligible dividends of $200 by 1.15 leading to a balance of $230. Remember that the non-eligible dividend is taxed at 15%, giving us the multiplier of 1.15. Therefore, when you add $1,104 + $230, your total taxable income equals $1,334. 

Because Jane has to pay the 30% nominal tax rate on her grossed-up dividend income, she will pay a little over $400. How did we get it? $1,334 x 0.30 = $400.2

Wait! The federal dividend tax credits have not been applied. The rate for eligible dividends in this case is 15.0198% and the rate for non-eligible dividends is 9.031%. Therefore, the tax credit is applied to the grossed-up tax amount, not to the total taxed income.

In this case, the calculated tax credit is $96.25, which is subtracted from the amount due of $400.20, making the tax payment $303.94 on dividend earnings of $1,000. You didn’t have to pay nearly $100 in taxes!

Canadian taxpayers incorrectly assume that they should apply the tax credit to the total taxable income of $1334 before figuring the tax payment. However, you need to apply the tax credit to the $400.2 in taxes that are due on the taxable dividends.

If the dividends earned are the same but Ms. Bell falls into a lower tax bracket with a nominal tax rate of 18%, she will owe 18% on $1,334, or a tax of $240.12 on her dividend earnings. Because the dividend credit does not change, Ms. Bell would subtract the $96.25 from the dividend tax owed of $240.12. In turn, she would only pay $143.87 in taxes on total dividends of $1,000. Whether you make more or less money in income, you can see how the dividend credit can save you money.

Keep in mind that the above example does not cover the tax credits received on the provincial level, which reduces the amount you owe in tax further. Each province has its own dividend tax treatment. TurboTax has a really great explanation and the CRA website has links to the Canadian tax forms you need. If you’d rather use the H&R Block software, it also explains how to claim this credit.

Applying a dividend tax credit to foreign dividends

As noted, you cannot apply the Canadian dividend credit to stocks that originate outside of Canada. Most foreign dividends are assessed withholding tax, which varies, depending on the country. To invest in stocks outside of Canada, you should speak to an accountant first.

Taxable dividends vs interest income

From a tax perspective, the income derived from interest is less beneficial than income originating from capital gains or stock dividends. An interest-paying investment would include such items as a certificate of deposit (CD), a high-interest savings account, bonds, and rental properties. The interest income on these investments is fully taxable. For instance, if you receive $1,000 in interest income, you are taxed on the full amount. Therefore, at the 30% tax rate, you will have to pay $300 in taxes.

Dividends received from real estate investment trusts 

If you invest in a real estate investment trust (REIT), it usually is better to hold the investment in a registered account. The payment from a REIT is actually not considered a dividend but is called a distribution. A distribution is different from a dividend, as it may include dividends, capital gains, a return of capital, interest, or other income. Holding a REIT in a registered account will make it easier to deal with taxation, as these forms of payments can be taxed at varying rates.

While it is nice to know you receive a dividend tax credit, you may still wonder if it still is fair to pay a tax on unearned income. Let’s put the idea of fairness to the side for a minute. We cannot get out of paying taxes in some form. At least a tax credit offers a reprieve.

Dividend stock yields vs capital gains

Sophisticated investors frequently focus on dividend yields.  A dividend yield is a business’s total annual dividends per share divided by the current stock price. Some companies have paid dividends consistently for years. Stock dividends are not the same as capital gains from selling a stock. 

In Canada, capital gains from stocks also provide Canadians with tax advantages. For example, if you make a $1,000 capital gain, you are taxed on only 50% of the gain, and that is with your regular tax rate. For example, If you are taxed at 30% and you made $1000 in capital gains, you pay 30% tax on $500. In the end, you pay $150.00 in taxes. However, you don’t hold the asset anymore.

Again, in Canada, capital gains get a better tax treatment and are taxed at a lower rate than both dividends and interest. Capital gains tax is paid on the profit made from an asset, whether it takes the form of a security, such as a bond or share of stock, or a fixed asset, such as equipment, buildings, land, or another possession. A capital gains inclusion rate is used to calculate the size of the portion of what you make. That is, if you make a profit at all. With a dividend yield, you get to keep the asset and make future income.

Defining a dividend

A dividend is a payment a company makes to share its profits with shareholders. A dividend is paid monthly, quarterly every 3 months, twice annually, or annually so investors can earn money as a return on investment.

Dividends are paid out according to the number of shares a shareholder owns. A dividend is usually paid when a business has additional cash that it is not reinvesting into the company. The additional cash is divided among the shareholders for payment.

Declaring a dividend

A company declares or announces its dividend per share to qualified shareholders of record through a press release, which features the following:

●  The date the dividend is declared, known as the Declaration Date.

●  The list that a company reviews to see which shareholders are eligible to receive an upcoming dividend payment, known as the Record Date.

●  The date shareholders receive their dividend payment, called the Payment Date.

●  The date the shares no longer trade with a dividend, called the Ex-Dividend Date. Shareholders who trade on or after this date are not entitled to the upcoming dividend payment.

Most dividends on shares are paid quarterly, but as indicated, are paid at other times too. In some cases, one payment may be made for special dividends. Again, what you receive in dividends depends on the total shares owned in a company. For instance, if you own 100 shares, and receive 50 cents per share, you would get $12.50 each quarter, or $50.00 for the year.

Shareholders who receive dividends are listed as a Shareholder of Record with the company where they own stock. When a dividend is paid, it relates to a company’s financial health and the share price.

If a share has a higher value dividend yield, it may mean the company is healthy financially or making money. However, it may also mean that a company is using its extra cash to pay its investors versus using the money for reinvestment.

Dividend payouts

So, what does it mean if a company suddenly reduces its per dividend payout after regularly paying out dividends? In this case, this change may signal a deterioration in a company’s financial health or may reveal a company’s plan for reinvestment and growth. Therefore, before you invest in a dividend stock, you should carefully consider the investment.

Ask questions. What does the company do? What are its projections for future growth? Does the company have a balance sheet that looks good? What is a stock’s price-to-earnings (P/E ratio)? The P/E ratio allows an investor to figure a stock’s market value compared to a company’s earnings.

Stock valuations: what they mean to you

If you notice a reduction in share dividends or the elimination of dividends, you may need to move your money to another stock. In some instances, the company may be directing the money it normally pays out to dividends for expansion and growth. That is why you need to learn about a company’s operations and future plans when you begin dividend investing.  Keeping current on this information will give you a financial edge.

Reasons for dividend investing

An investor may consider investing in dividend stocks for one of two main reasons. These reasons may include the following:

●  Dividend stocks offer a continuous income stream – income that can be reinvested in future shares, known as DRIPs, or Dividend Reinvestment Plans. Therefore, the investor can use dividend investing for saving for emergencies and retirement.

●  Canadian investors receive tax credits on the dividend income they make from dividend-paying stocks

Learning more about DRIPs

For people who are dividend reinvestment plan (DRIP) investors, investing in dividend stocks becomes a habit. A DRIP allows you to take the dividends you make from stocks and turn the amount into additional shares. Instead of taking cash for the stock, you use the money to buy future shares. If you want to avoid paying a commission, this type of plan saves you money.

Most companies that pay dividends usually have good cash balances. Therefore, they frequently are considered stronger businesses. Buying these shares are preferred by investors who have low-risk preferences.

What to consider when choosing dividend stocks

If you wish to add dividend stocks to your investment portfolio, make sure you invest your money in companies that are reputable, or which have a solid record of paying out dividends. Keep in mind that a good historical track record does not necessarily mean a company will continue to pay future dividends.

To make a better investment choice, look at the yield or annual dividend per annual share price. This will give you more information about what you may receive in dividends for every dollar you invest. However, don’t focus primarily on the yield, as you also have to review the fluctuations in a stock’s price. The fluctuations in share price have a direct link to a company’s performance.

Remember, when a stock’s value grows, the dividend’s value normally increases. If the demand rises, so does a stock’s price. However, because a dividend, technically, is not directly associated with the stock price, the dividend yield may fall if the price per share rises. This is because the dividend yield is determined by dividing the annual dividends paid per share by a stock’s share price.

The payout ratio

The dividend payout ratio figures the dividend paid in relation to a company’s earnings. If payouts are high, or from 55% to 75%, more than half a company’s earnings are directed toward dividends. If the ratio ranges from 10% to 30%, the dividend is modest, meaning, possibly, that a company is channeling its earnings toward growth.

The component of the P/E ratio is defined as an increasing function of the payout ratio and a company’s growth rate or a decreasing function of a company’s payout risk. Therefore, a P/E ratio increases if the payout ratio increases for a given growth rate. For instance, if a stock with a P/E of 15 shows a dividend yield of 5%, its earning’s yield is figured at 6.67%, making the payout ratio around 75%.

Past trends

When researching dividend stocks, it helps to review a company’s prior dividend payouts. Has the dividend per share made gains in the past few years? Maybe the dividends have been slowly declining. How much, if any, of the dividend share price has fluctuated? By reviewing a company’s annual report, you can learn more about a company’s plan for growth and what it means for you, the investor.

Again, dividends are not set in stone. Even if a company displays a strong balance sheet, a sudden shift in the economy can cause it to slash its dividends to save money.

The dividend yield

The dividend yield is an important calculation. It represents the percentage of the return a business pays out annually in dividends relative to the price per share. Not all companies that sell shares pay out dividends, so if you see the dividend yield on a stock quote, it is positive. 

The dividend yield on a stock is figured by taking the annual dividend per share and dividing it by a stock’s current price.

Therefore, the formula is expressed as dividend yield = annual dividend divided by stock price x 100. For example, if a company pays an annual dividend of $1.44 and the stock’s price is $53.00, you would calculate the dividend yield as follows: dividend yield = $1.44 divided by $53 x 100 = 2.7%.

The dividend yield is not guaranteed, as it can go up or down, depending on fluctuations in the market. Companies may or may not choose to pay out the money.

As you can see, dividends make up one element of a stock’s total return. The other element is the change in a share’s price over time. For example, if a stock price increases 4% in the year and it pays a 2% dividend yield, your total return is 6%, provided you hold the stock for the year.

Alternatively, if you hold a dividend-paying stock and the price declines 3% but you receive 1% in dividends, your total decline only goes down 2% for the total return.

If you plan to invest for the long term, it pays, literally, to keep both parts of a stock’s total return in mind. The basic formula is Return = Dividend yield + Price change.

Tax-Free Savings Accounts and registered retirement savings plans

A brief word: a dividend tax credit applies to stocks owned outside a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP). The credit is not applicable for these accounts, as the dividends are not taxed on these types of investments.

RRSPs, in and of themselves, are tax deductible. This means any contributions you make reduce the tax payable on your yearly income. TFSAs, on the other hand, do offer this advantage. The withdrawals made from a TFSA are not taxed while the withdrawals from an RRSP are taxed at the yearly margin tax rate.

Dividend paying stocks offer many benefits, especially for long-term investors. Whether you realize capital gains or receive payouts in dividends, you can save on taxes as well. If you want your money to work for you, dividend stock investing can give you the leverage you need to see significant returns and ultimately accumulate wealth.