Dividend Tax Advantages May Be An Illusion

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Descartes
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Re: Dividend Tax Advantages May Be An Illusion

Post by Descartes »

gaspr wrote: 26 Aug 2017 14:38 ..if you are going to have fixed income as part of your overall asset allocation, and if TFSA's are more tax efficient for FI, does it make sense to fill the TFSA first?
I think the answer is not yes in all scenarios if you took the time to do the math.
You must also consider the value a higher rate of return has in inflating the TFSA contribution space faster ..making it more useful as a "tax-free haven" in the future.
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Re: Dividend Tax Advantages May Be An Illusion

Post by travesty »

I tried to do the math in the past (I think there is a post about it somewhere, maybe), and I concluded that allocating equities preferentially into the TFSA over fixed income could beat the other way around, but there had to be quite a gap in the relative returns for this to work out. With typical "expected" long-term returns it seemed like putting fixed income in the TFSA was somewhere between "better" and "roughly a wash".

There is a complicated part of this question that is often overlooked, however: I don't think $1 in a TFSA is the same as $1 outside in AA sense. For example, if you want a 50/50 allocation to FI/equity, I don't think having $1 in FI inside and $1 in equity outside gives you that AA.

I'm not 100% sure about that though. It is much more obvious in the RRSP case: $1 in your RRSP is not worth the same as $1 outside, especially close to retirement, since a share of the capital essentially already belongs to government (as well as a share of future returns). So when calculating AA you should discount the amounts in your RRSP with respect to those outside. Now many people don't do that, and that's fine since AA is approximate anyways: but if you are going to make spreadsheets to come up with a conclusion about the best AA, you need to account for this: otherwise your "winning scenarios" will often just be those that actually have a hidden higher AA in the highest returning component, rather than being due to any intrinsic tax efficiency. In the case of RRSP this generally means that putting equities outside looks better than it should due to this effect, which is the same direction that "tax efficiency" points anyways: so it usually doesn't affect the conclusion, only the magnitude.

The case for the TFSA is a lot more subtle, and in the opposite direction. Here the government doesn't have a claim on any funds in the TFSA, and you avoid any government take on the gains. So in some sense putting $1 of stuff in the TFSA increases your exposure to that stuff more than putting $1 in the same stuff unregistered. Your gains are more highly levered in the TFSA since you get all of the gain (losses). So it seems to me that the effect is the same in some ways as the RRSP, except in the opposite direction: $1 in the TFSA is more <i>more</i> than $1 outside, in a weighted AA sense.
Last edited by travesty on 25 Sep 2018 19:54, edited 1 time in total.
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Re: Dividend Tax Advantages May Be An Illusion

Post by longinvest »

For interested readers, there was a thread about asset location and managing asset allocation across registered and non-registered accounts in June: Asset Location Gets REALLY Complex
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Re: Dividend Tax Advantages May Be An Illusion

Post by travesty »

longinvest wrote: 24 Sep 2018 20:07 For interested readers, there was a thread about asset location and managing asset allocation across registered and non-registered accounts in June: Asset Location Gets REALLY Complex
Thanks, it was very relevant!
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Re: Dividend Tax Advantages May Be An Illusion

Post by gaspr »

Good article here

https://www.advisor.ca/tax/tax-news/tax ... dividends/

"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. paid on tIt merely credits shareholders for tax already heir 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."
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Re: Dividend Tax Advantages May Be An Illusion

Post by Eclectic12 »

Not sure why I am supposed to care where as an investor, I'm separate from the company that has already paid part of the tax bill.
It seems a bit theoretical to be worried about one company can pay $5 in interest while the other can only pay $4 in dividends.

How long a bond would I need to approach what the common stock is paying in dividend, never mind that for most long term holds - the dividends are tiny compared to the capital gains that interest does not offer?

If it's a holding or operating company that I'm connected to then I can see caring about the embedded taxes.


Just my two cents ...


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Re: Dividend Tax Advantages May Be An Illusion

Post by gaspr »

The $5 in interest and the 4$ in dividends refers to examples in the full article... I should have made that more clear.
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Re: Dividend Tax Advantages May Be An Illusion

Post by Eclectic12 »

So now that we are potentially agreeing it's a contrived example from the article, the key question remains.

As an arm's length investor choosing between eligible dividends or interest - my tax bill on the annual tax return is different. Why do embedded taxes matter to me?


Unless I'm missing something ... the situations where I might care are when it's my company paying me dividends or possibly foreign dividends that are taxed the same as interest income.

Keeping in mind that the eligible dividends are after-tax money is nice to know but not relevant to the taxes I have to pay.


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Re: Dividend Tax Advantages May Be An Illusion

Post by StuBee »

I have looked into this issue a few times over the years. It is true that ultimately interest and dividends receive an identical treatment. The DTC is simply the government recognizing the tax which was "withheld at source". The dividend itself is "grossed up" in an attempt to approximate the underlying pretax income.

Perfect integration is not possible. Hence, apparently according to the above article, dividends may be more taxed than interest. IMHO, the imperfection is very small and could go in either direction and not necessarily against the dividend.

But, I agree that at any given point in time, the article is more or less right.

However, I would argue that over time the dividend is far more rewarding (despite the risk). Dividends go up. Very few bonds (or none) do this on their interest. Also, it is fairly easy to find a relatively safe dividend yield at least equal to or in excess of interest bearing securities.

Ultimately, IMO, dividends are a disguised form of capital gains. Retained earnings leads to capital gains. Paid out earnings is dividends. Retained earnings are "in your pocket" when the security is sold. Paid out earnings are "in your pocket" when they are paid out (generally on a quarterly basis). CG's tax wise are better than dividends at higher total incomes. The reverse is true at lower incomes.

Indeed, dividends are not "favourably" treated. They are "fairly" treated. OTOH, Capital gains are "favourably" treated. Only half (currently) of any CG is subject to taxation. Here we can say that the government is "encouraging" investors or we can say that the government is "recognizing the risk".

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Re: Dividend Tax Advantages May Be An Illusion

Post by snowback96 »

StuBee wrote: 10 Mar 2019 09:09 Ultimately, IMO, dividends are a disguised form of capital gains. Retained earnings leads to capital gains. Paid out earnings is dividends. Retained earnings are "in your pocket" when the security is sold. Paid out earnings are "in your pocket" when they are paid out (generally on a quarterly basis). CG's tax wise are better than dividends at higher total incomes. The reverse is true at lower incomes.

Indeed, dividends are not "favourably" treated. They are "fairly" treated. OTOH, Capital gains are "favourably" treated. Only half (currently) of any CG is subject to taxation. Here we can say that the government is "encouraging" investors or we can say that the government is "recognizing the risk".
I have tried to think this through numerous times but never arrived at a satisfying conclusion; however, I like your explanation very much. Your logic makes sense to me. Thanks.
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Re: Dividend Tax Advantages May Be An Illusion

Post by Clason »

Yes, it is because of tax integration, but not all investors benefit. The advantage is therefore real, because foreign investors, pension plans and RRSP investors are pricing the stock on a risk/reward basis without that advantage.

Take a Canadian stock worth $100 and yielding 4%. A Canadian taxpayer in the top bracket is paying $100 for a $2.92 income stream (26.76% tax) while a US taxpayer in the top tax bracket is paying the same $100 for a $2.52 ordinary dividend (37% tax). That same dividend flowing through an RRSP or a pension plan may only yield an after tax stream of $1.84 (54% tax). As a Canadian-resident investor holding this stock in a taxable account, you get a deal because other investors are willing to pay the same amount for a lower benefit.
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Re: Dividend Tax Advantages May Be An Illusion

Post by Clason »

StuBee wrote: 10 Mar 2019 09:09 Ultimately, IMO, dividends are a disguised form of capital gains. Retained earnings leads to capital gains. Paid out earnings is dividends. Retained earnings are "in your pocket" when the security is sold. Paid out earnings are "in your pocket" when they are paid out (generally on a quarterly basis). CG's tax wise are better than dividends at higher total incomes. The reverse is true at lower incomes.

Indeed, dividends are not "favourably" treated. They are "fairly" treated. OTOH, Capital gains are "favourably" treated. Only half (currently) of any CG is subject to taxation. Here we can say that the government is "encouraging" investors or we can say that the government is "recognizing the risk".
But retained earnings have been taxed already. You can look at CG as an imperfect form of tax integration. Someone in the 54% tax bracket selling a stock as a way to crystalize the retained earnings is pretty much taxed appropriately. $100 of income may be $73 of retained earnings at the general corporate tax rate. Once CG is applied (after 1/2 x 54% x $73), we get $53 of after tax income (or 47% integrated taxation). For a low-income investor at 20% MTR, that is more like 34.3% (after 1/2 x 20% x $73), which is a disadvantage compared to dividends and regular income - though the lower inclusion allows low-income investors to avoid stepping up tax brackets.

Tax deferral benefits can be added for both groups (again, compared to regular or dividend income).

Note that CG that represents prospective growth rather than retained earnings, such as in the case of fast-growing company instead of a mature one, is taxed more advantageously. The CG represents goodwill that hasn't been taxed at the corporate level, which can mean an integrated tax rate of 10% to 27%. That can be seen as compensating investors for risk.

I find CG taxation fair enough. Don't go giving the government any ideas, but the 75% inclusion rate more closely provide/provided tax integration (~55-56%)in the higher tax bracket, but a clearly abusive taxation rate for lower income taxpayers.
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Re: Dividend Tax Advantages May Be An Illusion

Post by IdOp »

StuBee wrote: 10 Mar 2019 09:09Dividends go up. Very few bonds (or none) do this on their interest.
True when looking at a single bond, but I think one needs to look at the bigger picture. The investor owning a bond portfolio (which may be as simple as a bond fund or ETF) can choose to retain some of their (interest) earnings by reinvesting it. Then the income stream should go up too (all things being equal). That is not to suggest the growth will be as good as from equities.
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Re: Dividend Tax Advantages May Be An Illusion

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Clason wrote: 10 Mar 2019 11:27 Yes, it is because of tax integration, but not all investors benefit. The advantage is therefore real, because foreign investors, pension plans and RRSP investors are pricing the stock on a risk/reward basis without that advantage.
Interesting.

Another way of looking at it is that the RRIF owner is accepting some form of double taxation (the government probably does not mind...)
The pension plan manager does not really care since he is passing on the double taxation to the pension holder (again, the government is still quite happy).
I guess the foreign investor sort of understands because his own government has not received its fair share.

But, it certainly is a built in advantage to the Canadian non-registered account holder.
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Re: Dividend Tax Advantages May Be An Illusion

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IdOp wrote: 10 Mar 2019 14:13 True when looking at a single bond, but I think one needs to look at the bigger picture. The investor owning a bond portfolio (which may be as simple as a bond fund or ETF) can choose to retain some of their (interest) earnings by reinvesting it. Then the income stream should go up too (all things being equal). That is not to suggest the growth will be as good as from equities.
True, compounding constant interest is very powerful. However, the true comparable would be the compounding of an increasing dividend stream (also known as a "dividend reinvestment plan"). This is even more powerful.
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Re: Dividend Tax Advantages May Be An Illusion

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Clason wrote: 10 Mar 2019 12:43 Tax deferral benefits can be added for both groups (again, compared to regular or dividend income).

Note that CG that represents prospective growth rather than retained earnings, such as in the case of fast-growing company instead of a mature one, is taxed more advantageously. The CG represents goodwill that hasn't been taxed at the corporate level, which can mean an integrated tax rate of 10% to 27%. That can be seen as compensating investors for risk.
Two very good points. The second can almost be called an investment in something that is hoped for or expected but may or may not happen. Even more risk and therefore less taxation...
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Re: Dividend Tax Advantages May Be An Illusion

Post by Eclectic12 »

Clason wrote: 10 Mar 2019 11:27 Yes, it is because of tax integration, but not all investors benefit. The advantage is therefore real, because foreign investors, pension plans and RRSP investors are pricing the stock on a risk/reward basis without that advantage.

Take a Canadian stock worth $100 and yielding 4%. A Canadian taxpayer in the top bracket is paying $100 for a $2.92 income stream (26.76% tax) while a US taxpayer in the top tax bracket is paying the same $100 for a $2.52 ordinary dividend (37% tax). That same dividend flowing through an RRSP or a pension plan may only yield an after tax stream of $1.84 (54% tax). As a Canadian-resident investor holding this stock in a taxable account, you get a deal because other investors are willing to pay the same amount for a lower benefit.
If we are putting it on a scale, then IMO it is:
TFSA owners < Non-Resident owners or Non-Resident RRSP owners < taxable Canadian resident owners < RRSP owners


Regardless, the comparison is assuming that income levels will be the same when the RRSP withdrawal happens where YMMV.
In my case, I'm on track for the RRSP withdrawals to be 20% instead of the example's 54%.


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Re: Dividend Tax Advantages May Be An Illusion

Post by StuBee »

Eclectic12 wrote: 10 Mar 2019 16:43 If we are putting it on a scale, then IMO it is:
TFSA owners < Non-Resident owners or Non-Resident RRSP owners < taxable Canadian resident owners < RRSP owners


Regardless, the comparison is assuming that income levels will be the same when the RRSP withdrawal happens where YMMV.
In my case, I'm on track for the RRSP withdrawals to be 20% instead of the example's 54%.


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If you mean more tax owing by the individual to less tax owing, I think it should be:

TFSA < (i.e. less tax) Canadian non-registered account holder < foreign resident < RRSP account.

If indeed your tax bracket (MTR) will be 20%, then it may become TFSA = (or almost equals) Canadian non-registered account holder < RRSP < foreign resident.

I am limiting my argument here to the treatment of dividends.
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Re: Dividend Tax Advantages May Be An Illusion

Post by Eclectic12 »

... and if the foreign withholding tax is tax treaty reduced to 15%, would you stick to the same order?

Basically, like the RRSP ... YMMV.

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Re: Dividend Tax Advantages May Be An Illusion

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Eclectic12 wrote: 10 Mar 2019 16:43 If we are putting it on a scale, then IMO it is:
TFSA owners < Non-Resident owners or Non-Resident RRSP owners < taxable Canadian resident owners < RRSP owners
It depends. At a lower marginal tax rate, the taxable canadian resident owner (@20% integrated) < TFSA (@27% integrated). Because the corporation paid ~27% corporate tax, the individual tax payer gets a negative tax rate of approximately 7% (Ontario). We're in that situation in our semi-retirement, but we still choose to hold canadian stocks in our TFSA because it helps grow the TFSA aggregate limit and because of the capital gain advantage (of TFSA vs Taxable).
Eclectic12 wrote: 10 Mar 2019 21:07 ... and if the foreign withholding tax is tax treaty reduced to 15%, would you stick to the same order?

Basically, like the RRSP ... YMMV.
YMMV, indeed. It depends on what your country of tax residency will add to the 15%.
Eclectic12 wrote: 10 Mar 2019 16:43 Regardless, the comparison is assuming that income levels will be the same when the RRSP withdrawal happens where YMMV.
In my case, I'm on track for the RRSP withdrawals to be 20% instead of the example's 54%.
Which adds up to an integrated tax rate of 42% (27% corporate tax + 20% of the remainder) on dividends. Of course, you get compensated by the benefit of having received an original tax deduction, and having received tax deferral.
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Re: Dividend Tax Advantages May Be An Illusion

Post by ghariton »

One of the original justifications for including capital gains at less than 50 per cent was to account for the effects of inflation. In theory, capital gains should be the difference between disposition and ACB indexed for inflation since acquisition. But that was deemed much too complicated, and a reduced inclusion rate was used instead. That inclusion rate has varied over time, and has become quite detached from the experienced inflation rate. But the basic logic still holds. David Duff, one of my ex-tax-law-professors, calculates that, with inflation much lower than historically over the last few decades, the theoretically justified capital inclusion rate, on an average disposition, should be about 80 per cent. So capital gains are still getting a tax advantage of 30 per cent on average, over interest or dividends.

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Re: Dividend Tax Advantages May Be An Illusion

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ghariton wrote: 11 Mar 2019 00:21 One of the original justifications for including capital gains at less than 50 per cent was to account for the effects of inflation. In theory, capital gains should be the difference between disposition and ACB indexed for inflation since acquisition. But that was deemed much too complicated, and a reduced inclusion rate was used instead.
I remember hearing that from my professors too. If it was the reason, then it's a very imperfect way to treat inflation, given that the same rate applies to someone who held an investment for a few months or for a few decades. The Americans have it better, given the short-term and long-term capital gain tax. Still very imperfect though. Whatever the original intent, the capital gain inclusion rate now appears to be a way to deliver approximate tax integration, and with a better approximation than it does for inflation compensation.

Note that money invested for regular income (GICs, bonds, etc.) and dividends are also at the mercy of inflation, and that's without inflation protection. Inflation protection must come from the income derived from the security and it is taxed at a 100% inclusion rate. If an investor puts $1,000,000 in a 5-year bond and gets $900,000 back in inflation-adjusted capital, he/she is expected to cover this inflation loss through fully taxed interest income.

If instead of investing $1,000,000 in a bond, I buy a chunk of a corporation, then why should I then be protected against inflation through a tax incentive? It should be my responsibility to ensure that the combination of dividends and capital appreciation will cover my loss to inflation. If I buy a $1,000,000 painting that appreciates to $1,200,000, then I have the opportunity to derive income to compensate for the tax hit and the inflation. I can rent the artwork out for income, I can hope that it will appreciate faster than inflation, or I can just decide that the extra cost (taxes) is the price to pay for the enjoyment of having it on my wall. Same with a house: I can rent it out or I can get the enjoyment of living in it. We always have a choice to earn or not to earn an income with an asset to cover the inflation erosion. That's true for cash, real estate, a patent, a piece of equipment, etc.

Whatever the original intent, the capital gain inclusion rate is now a way to approximately deliver tax integration and/or a risk premium (in Canada). As a CCPC owner and an investor in Canadian stocks, I'm more concerned about avoiding double-taxation, which the 50% inclusion rate somewhat accomplishes (as per my post above).

We now have the technology to compute ACB-indexation rather easily. If there was a political will, there would be a way. That would open a can of worm though, as inflation has been a way for government to confiscate wealth for a long time. They would have to seriously cut back, or find revenues elsewhere. It would also require that we deal with other unpleasant topics, such as whether we get a capital loss on assets that fail to appreciate at the pace of inflation, whether they be stocks, bonds, artwork, real estate, patents, corporate assets, etc.
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Re: Dividend Tax Advantages May Be An Illusion

Post by gaspr »

So if I am understanding this correctly, someone who is in the top tax bracket who has at one time or another, received dividend income or CG resulting from retained earnings from a Canadian corp, inside of an RRSP or RRIF, could end up paying 54% personal tax plus 27% corporate tax (which the corp has paid on your behalf) for a total of an 81% integrated tax rate on this income...Yikes!

It is hard to believe that the tax deferred compounding could ever make up for this...
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Re: Dividend Tax Advantages May Be An Illusion

Post by Clason »

gaspr wrote: 11 Mar 2019 13:16 So if I am understanding this correctly, someone who is in the top tax bracket who has at one time or another, received dividend income or CG resulting from retained earnings from a Canadian corp, inside of an RRSP or RRIF, could end up paying 54% personal tax plus 27% corporate tax (which the corp has paid on your behalf) for a total of an 81% integrated tax rate on this income...Yikes!

It is hard to believe that the tax deferred compounding could ever make up for this...
More like 66% (27% + 54% of the remaining 73%). What makes up for it is not just the simple compounding, but also the compounding of the original tax deduction. Unless you contributed at a low effective marginal tax rate and didn't let it compound long enough, you're still winning.
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Re: Dividend Tax Advantages May Be An Illusion

Post by gaspr »

Thanks for the explanation. But isn't the opportunity cost on the corporate tax paid compounding against you?
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