Reader alert: This is part 2 of a five-part series.
• Part 1: Tackling tax-efficient investing
• Part 2: Capital gains mean tax-efficient investing
• Part 3: Tax-efficient investing and dividends
• Part 4: Magic of tax-efficient bond investing
• Part 5: Tax-efficient investor behaviour
Tax-efficient investing, as it relates to dividends, revolves around these questions:
• What are the relevant considerations when deciding whether to invest in the stocks of dividend-paying or non-dividend-paying companies? We discussed this question in an earlier article.
• Is it preferable to invest in dividend-paying stocks rather than bonds, on the grounds that dividends are more lightly taxed than interest? We will address this question here.
Companies pay dividends to their shareholders out of their after-tax income. First, the company pays tax on its income. Then, it pays dividends to its shareholders out of after-tax income. Shareholders, finally, pay tax on the dividends. In the absence of special measures, the same income would be taxed twice — once in the hands of the company and again in the hands of the shareholders.
Taxing the same income two or more times would be unfair. It would also have the undesirable result of discouraging savings and investment. The Income Tax Act (Canada) includes a number of mechanisms, known as flow-through mechanisms, to avoid multiple taxation of the same income. A flow-through mechanism taxes the income of a business entity as if it had been earned directly by the investor.
Consequently, the business entity and the investor pay the same amount of tax overall, as though the investor had earned the underlying income directly.
The flow-through mechanism used to avoid the double taxation of dividends is known as the imputation system.
Why dividends aren’t taxed twice
The objective of the imputation system is to integrate the personal and corporate tax systems such that dividends are taxed only once. The mechanics of the system are as follows: Calculate the corporate income out of which the dividend was paid. This is achieved by grossing up the actual amount of the dividend received by the shareholder. The gross-up percentage depends on the rate of tax paid by the company.
Shareholders are taxed on the grossed-up amount. This is their notional share of the company’s before-tax income corresponding to the dividend received. Shareholders pay tax on the taxable amount of the dividend at their marginal rate.
The system recognizes the company has already paid tax on its income. This tax is considered to be a prepayment of tax by the company on behalf of its shareholders.
The latter may deduct their share of this tax in the form of a dividend tax credit calculated as a percentage of the grossed-up dividend.
Let’s illustrate these mechanics with a hypothetical, scaled-down example.
A company’s income before taxes amounts to $100 and it pays tax at the rate of 20%. Its tax expense is therefore $20 and its after-tax net income is $80. The company pays the $80 to its shareholders by way of a dividend.
If we didn’t know the company’s before-tax income, we could calculate it by grossing up the dividend by (20/80) or 25%.
Actual amount of dividend = $80
Gross-up (25% * $80) = $20
Company’s income before taxes = $100
Note the amount of the gross-up is equal to the amount of tax paid by the company.
In an ideal system, the dividend tax credit would be equal to 20% of the grossed-up dividend. The rate of the dividend tax credit would thus be equal to the corporate tax rate and the amount of the dividend tax credit would be equal to the amount of the gross-up, which would itself be equal to the amount of tax paid by the company.
Let us now consider the case of a shareholder who receives a dividend in the amount of $4.00 and whose marginal rate of tax is 45%.
We first calculate the taxable amount of the dividend as follows:
Actual amount of dividend = $4.00
Gross-up (25% * $4) = $1.00
Taxable amount of dividend = $5.00
The gross-up of $1.00 corresponds to the tax paid by the company on behalf of the shareholder. The taxable amount of the dividend ($5.00) corresponds to the corporate before-tax income underlying the dividend.
Next, we calculate the income tax payable by the shareholder on the dividend.
Taxable amount of dividend = $5.00
Shareholder’s marginal tax rate = 45%
Income tax on taxable amount of dividend = $2.25
Finally, we calculate the dividend tax credit and deduct it from the income tax otherwise payable.
Income tax on taxable amount of dividend = $2.25
Deduct: Dividend tax credit (20% * $5) = $1.00
Net tax payable by the shareholder = $1.25
How does the imputation system integrate the personal and corporate tax systems? Note the overall tax paid by the company and the shareholder:
Tax paid by the company on behalf of the shareholder = $1.00
Tax paid by the shareholder = $1.25
Overall tax paid = $2.25
Had the investor owned the business directly rather than through a company, the business would have earned a before-tax income of $5.00, on which the investor would have paid tax of $2.25 ($5.00 times the marginal tax rate of 45%). This is exactly the same as the overall tax paid under the imputation system.
This example depicts a rather idealized world where the personal and corporate tax systems are perfectly integrated: there is no double taxation of dividends. This is achieved by setting the appropriate rates for the gross-up and the dividend tax credit.
In real life, the rates are such that the integration of the two systems is imperfect, leaving an element of double taxation.
Dividends versus interest
It is commonly believed dividends are taxed more favourably than interest income. In the example above, the shareholder received $4.00 of dividends and paid tax of $1.25. The implied tax rate is 31.25% ($1.25/$4.00). If the shareholder had instead received interest of $4.00, the tax would have been $1.80 ($4.00 times the marginal tax rate of 45%), instead of $1.25. Therefore, the argument goes, dividend income is taxed more favourably than interest income.
While true, it’s not the whole truth. Comparing $1 of dividends received with $1 of interest is like comparing apples with oranges, because dividends are paid out of after-tax income whereas interest is paid out of before-tax income.
Consider two companies which are identical in all respects, except for their capital structure. They generate the same income before interest and tax. Company A is financed entirely by share capital and therefore has no interest expense. It pays out the whole of its net income after tax to its shareholders by way of dividends.
Company B has nominal share capital and is mostly financed by bonds. Are the investors who receive dividends from Company A better off after tax than those who receive interest from Company B?
Let’s see what happens to each company’s income.
|Company A||Company B|
|Income before interest and tax||$5||$5|
|Less: Interest expense||$0||$5|
|Income before tax||$5||$0|
|Less: Income tax (20%)||$1||$0|
Assume, as above, that the investors pay tax at the marginal rate of 45%. We showed in the previous example that the overall tax paid by Company A and its shareholders is $2.25.
Company B paid $5 of interest to its bondholders. This amount of interest is deductible for tax purposes and reduces its taxable income to nil, such that there is no corporate tax to pay. However, the bondholders must pay tax of $2.25 ($5 * 45%) on their interest income. This is identical to the overall tax paid by Company A and its shareholders.
Clearly, the overall tax burden is the same for the two companies and their investors.
Another way to look at the picture is as follows. The shareholders of Company A receive $4 of dividends on which they pay tax of $1.25, leaving them with $2.75. The bondholders of Company B receive interest of $5 on which they pay tax of $2.25. The net result is they are in pocket by $2.75, just like the shareholders of Company A.
The key points to remember
- It is inappropriate to compare $1 of dividends received with $1 of interest income. This is because dividends are paid out of after-tax income, while interest is paid out of before-tax income. The corporate tax reduces the amount available for distribution by way of dividends. In our example, Company B could afford to pay $5 of interest but Company A could only afford to pay $4 of dividends.
- Dividends appear to be more lightly taxed than interest because of the dividend tax credit. In actual fact, the dividend tax credit does not constitute a gift from a benevolent government intent on encouraging Canadians to invest in the shares of companies. It merely credits shareholders for tax already paid on their behalf by the company. The dividend tax credit does not constitute an additional benefit to investors — all it does is prevent double taxation.
- Look beyond visible taxes. In particular, be wary of embedded taxes. These taxes may be relatively painless because the investor may not even be aware of them. However, they are just as harmful to the investor’s financial situation. A company belongs to its shareholders and corporate taxes are effectively paid out of shareholders’ pockets.
In practice, the imputation system does not fully integrate the personal and corporate tax systems, resulting in a residual amount of double taxation of dividends. This means the overall tax rate is actually higher on dividends than on interest.
In a previous article, I pointed out tax considerations are only part of the story. Suitability to the client is paramount and involves a proper analysis of his or her investment needs and the relevant investment considerations:
- The payment of interest on the due dates is a contractual obligation of the company. Dividends are discretionary.
- Interest is paid at a known, fixed rate. Dividends may rise or fall, depending on the fortunes of the company, and may drop all the way to zero.
- Bonds have a known maturity date on which they will be worth a known amount (the principal amount), subject to the solvency of the company. Stocks do not have a maturity date and their future value could be higher or lower than today’s value.
- Stocks have a greater potential for capital gains or losses than bonds.
- In a bankruptcy, bondholders rank ahead of shareholders.
Bondholders benefit from greater certainty and priority over shareholders but are denied direct participation in the upside. When they are suitable to the client, it is entirely proper to recommend dividend-paying stocks. Just don’t do it under the delusion that the client pays less tax when receiving dividends instead of interest.
Foreign dividends are taxed twice
The imputation system applies only to Canadian dividends. It does not apply to dividends from foreign companies. Those dividends are indeed taxed twice. First, the foreign company pays tax to the foreign government. It then pays dividends to its shareholders, including Canadian shareholders, out of its net after-tax income.
The dividends are taxed as ordinary income in the hands of Canadian shareholders at their marginal rate of tax. There is no gross-up or dividend tax credit.
This is not to say you should not invest in foreign stocks. Foreign stocks are desirable because they improve the diversification of a portfolio. However, you should be aware that when you invest in foreign stocks, you are paying income tax twice on the same profits.
Withholding tax is usually deducted from foreign dividends before they are paid to Canadian shareholders. The withholding tax is not an expense to the Canadian taxpayer because it may be claimed on the personal tax return as a foreign tax credit. However, there is a cash flow disadvantage. The withholding tax is deducted when the dividends are paid, whereas the foreign tax credit is only received much later, after the tax return is filed the following year.
Note the foreign tax credit relates only to the withholding tax deducted from foreign dividends. It does not relate to income taxes paid by the foreign company on its income. There is no way for Canadian taxpayers to get credit for those taxes.
ANDRÉ FOK KAM, CA, MBA is a consultant to the financial services industry. He authored the Tax-efficient Fund Investing Course offered by the IFSE Institute. He is a member of the Independent Review Committee of the Standard Life Mutual Funds.