This year, small business owners will be paying more tax on the dividends they draw from their corporations.

The 2013 federal budget expressed concern that taxpayers who receive these dividends are getting disproportionately more, from a tax perspective, than if that income was paid as salary. The government has since enacted changes that target corporate income, which uses the small business deduction to try to close the gap. Previous changes already addressed corporate income that had been subject to full corporate tax rates—the so-called eligible dividend regime introduced in 2006 and rolled out over the following six years.

Ineligible dividends in 2014

The income tax system identifies two types of taxpayer: individuals and corporations. But taxes levied at the corporate level are ultimately borne by individuals, so, the dividend gross-up and tax-credit procedure accounts for previously paid corporate taxes when the shareholder/individual calculates personal taxes. The eligible dividend regime was introduced in 2006 and the federal gross-up and tax-credit rates on ineligible dividends have remained unchanged until now.

Beginning in 2014, the gross-up will change from 25% to 18%, and the federal tax credit will go from 2/3 to 13/18. Provinces use the federal gross-up, so this also affects their tax-credit rates. Based on enacted and announced changes (and subject to potential change in upcoming 2014 budgets), “Top bracket rates,” this page, shows the effective tax rate shareholders face at the top bracket in each province.

These changes are designed to integrate with the actual small-business rate used in calculating the original corporate income.

In theory, an individual taxpayer should be indifferent about earning income personally or through a corporation. This should hold true whether the distribution takes the form of salary or dividends.

In practice, things had fallen out of kilter, resulting in a preference for dividends in most provinces. The new rules narrow the gap between salary and dividends, and in some cases swing the pendulum towards salary. Also, these are not the only considerations in deciding on the salary/dividend mix (see “Tax savings or cost of using dividends,”).

TOP BRACKET RATES–INELIGIBLE DIVIDENDS

(Combined federal-provincial)

Province 2013 2014
BC 33.7% 38.0%
AB 27.7% 29.4%
SK 33.3% 35.3%
MB 39.1% 40.8%
ON* 32.6% 36.5%
QC 38.5% 39.8%
NB 33.0% 36.0%
NS 36.2% 39.1%
PE 38.6% 38.7%
NL 30.0% 31.0%

Tax savings or cost of using dividends

(A positive figure favours dividends)

Province 2013 2014
BC 1.0% -0.6%
AB 1.2% -0.3%
SK 2.0% 0.3%
MB 0.6% -0.9%
ON* 3.4% 0.1%
QC -0.3% -1.3%
NB 1.6% 0.9%
NS 4.2% 2.1%
PE 1.4% 1.3%
NL 1.8% 0.9%

* Ontario is expressed at the top federal bracket rate, rather than the significantly higher Ontario rate of $500,000+.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is vice-president, Tax and Estate Planning, Invesco Canada

Originally published in Advisor's Edge Report

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