In Canada, dividend income can provide a significant source of income for many investors. One of the advantages of investing in dividend-paying stocks is that some of the income received from these investments can be tax-free. However, it’s important to understand the rules and regulations surrounding tax-free dividend income in Canada.
Dividends are payments made by corporations to their shareholders out of the company’s profits. In Canada, dividends are subject to different tax rates based on the type of dividend received and the taxpayer’s income level. The Canadian government introduced the concept of taxable dividends and eligible dividends to determine the tax treatment of dividend income.
Taxable dividends are dividends paid by Canadian corporations that are subject to the regular tax rates. These dividends are included in the taxpayer’s taxable income and are taxed at the individual’s applicable tax rate. The amount of taxes owed on taxable dividends will depend on the individual’s total income and their tax bracket.
On the other hand, eligible dividends are dividends paid by Canadian public companies that have been designated as eligible for the dividend tax credit. The dividend tax credit helps to reduce the overall tax liability on eligible dividends. The purpose of the tax credit is to eliminate the double taxation of dividends, as the income earned by the corporation is already subject to corporate taxes.
The dividend tax credit is a non-refundable tax credit that can be applied to the tax payable on eligible dividends. The credit is calculated on the grossed-up amount of the dividend received. The gross-up amount is determined by multiplying the actual dividend received by a specific factor set by the Canadian government. For example, in 2021, the gross-up factor for eligible dividends is 1.3829.
To determine how much dividend income is tax-free in Canada, individuals need to understand their marginal tax rate and the dividend tax credit. The dividend tax credit effectively reduces the tax rate applied to eligible dividends. The amount of tax credit available depends on the province of residence, as each province has its own tax rates and dividend tax credit rates.
For example, in Ontario, the tax credit for eligible dividends is 10.03% of the grossed-up eligible dividends received. This means that if an individual receives $1,000 in eligible dividends, the grossed-up amount would be $1,382.90. The tax credit would be $138.41, effectively reducing the tax liability on the dividend income.
It’s important to note that while the dividend tax credit can reduce the amount of taxes owed on eligible dividends, it does not make the income completely tax-free. The tax credit simply helps to lower the tax liability, making dividend income more tax-efficient compared to other types of investment income.
Additionally, there are some specific situations where certain dividend income can be received tax-free in Canada. For example, individuals can benefit from the lifetime capital gains exemption (LCGE) on certain dividends received from qualified small business corporations. The LCGE allows individuals to claim a tax-free amount on the capital gains realized from the sale of qualified small business corporation shares.
The LCGE is a lifetime limit, and the tax-free amount available changes every year based on inflation. For 2021, the LCGE limit is $892,218. This means that if an individual sold qualified small business corporation shares and realized a capital gain of $892,218 or less, they could claim the entire amount as tax-free income.
In conclusion, while not all dividend income is tax-free in Canada, there are opportunities to benefit from tax-efficient dividend income. Understanding the difference between taxable and eligible dividends, as well as the dividend tax credit, can help investors maximize the tax advantages of their dividend investments. Additionally, certain situations, such as qualified small business corporation shares, can provide tax-free dividend income through the lifetime capital gains exemption. It’s important to consult with a tax professional or financial advisor to fully understand and optimize the tax treatment of dividend income in Canada.