Dividend Tax Advantages May Be An Illusion

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gaspr
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Dividend Tax Advantages May Be An Illusion

Post by gaspr »

We have all seen the articles touting the tax advantages of receiving retirement income in the form of dividends from eligible Canadian companies. Some examples here. One by Jon Heizel:

https://www.theglobeandmail.com/globe-i ... le4599950/

Another by Jonathon Chevreau:

http://business.financialpost.com/perso ... have-a-job

For a long time I bought into this argument but after reading this article by Stephanie Dietz I am rethinking my position.

http://www.advisor.ca/tax/tax-news/all- ... ion-231498

It seems to me that the fatal flaw in the earlier articles is that they ignore the fact that the companies have already paid a rather large amount of tax on your behalf before paying out your dividend... 26.5% for an Ontario based company for example. $1000 of net earnings destined for dividends would net the shareholder $735 on an after tax basis. A proper comparison is done in the third article.

When I calculate total tax paid at various income levels, and include the corporate taxes, it appears that the assumed dividend advantage totally disappears. In fact in most cases, regular income such as RRIF's would be a preferred way to fund retirement. So read the articles and see what you think. Then flame away! :)

edited to add: The above argument assumes that RRIF income is from fixed income only...IOW on income that has not been previously taxed...
Last edited by gaspr on 23 Aug 2017 16:25, edited 1 time in total.
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Re: Dividend Tax Advantages May Be An Illusion

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In principle our income tax system is supposed to be neutral as to whether the taxpayer receives income via salary, interest, or dividends. The dividend gross-up plus dividend tax credit were originally designed, and periodically updated, to compensate for corporate tax paid. In practice it doesn't quite work out that way, since changes in gross-up and DTC lag changes in corporate tax rates. But in the situations I have seen analyzed, we get pretty close to tax neutrality.

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Re: Dividend Tax Advantages May Be An Illusion

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ghariton wrote: 23 Aug 2017 15:36 In principle our income tax system is supposed to be neutral as to whether the taxpayer receives income via salary, interest, or dividends. The dividend gross-up plus dividend tax credit were originally designed, and periodically updated, to compensate for corporate tax paid. In practice it doesn't quite work out that way, since changes in gross-up and DTC lag changes in corporate tax rates. But in the situations I have seen analyzed, we get pretty close to tax neutrality.

George
Agreed. It does mean that it is much better to receive dividends in a non registered account so that the compensations apply. Dividends in registered accounts (RRSP) get taxed very heavily...once at the corporate level (on your behalf) and again as regular income when withdrawn.
Last edited by gaspr on 23 Aug 2017 17:25, edited 1 time in total.
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Re: Dividend Tax Advantages May Be An Illusion

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In addition, for high earners paying tax at the maximum marginal rate, it is quite a bit better to receive the necessary cash flow in the form of stock liquidations. Even if these are mostly capital gains the tax will be no more than half the max marg rate. 24% in Alberta and about 26.5% in Ontario. Quite likely a fair bit lower since you will be receiving some return of capital. In contrast, the max marg rate for divs is much higher-31.7% in Alberta and a whopping 39.3% in Ontario. These differences are significant, especially in Ontario(13%).
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Re: Dividend Tax Advantages May Be An Illusion

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General rule of thumb: Canadian dividend payers in non-registered accounts, U.S. dividend payers in RRSPs, fixed income in TFSAs, subject of course to the room in the RRSPs and TFSAs and your desired asset allocation. Capital gains in non-registered accounts are also very good. Not only are the tax rates competitive with dividends, as SQRT points out, you usually have flexibility as to when you crystallize the capital gains.

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Re: Dividend Tax Advantages May Be An Illusion

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gaspr wrote: 23 Aug 2017 15:22
It seems to me that the fatal flaw in the earlier articles is that they ignore the fact that the companies have already paid a rather large amount of tax on your behalf before paying out your dividend... 26.5% for an Ontario based company for example. $1000 of net earnings destined for dividends would net the shareholder $735 on an after tax basis.
I am not an accountant, but I think you have got it wrong. The company does not pay taxes on my behalf. The company pays taxes on their earnings. The earnings may, or may not, be directed to fund the dividend. The company will pay the same tax on their earnings regardless of whether it does, or does not, pay a dividend.
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Re: Dividend Tax Advantages May Be An Illusion

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If the company is owned by the shareholders, then it is indeed paying taxes on their behalf. It is the reason why the CRA compensates for this through the gross up/ dividend tax credit.
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Re: Dividend Tax Advantages May Be An Illusion

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ghariton wrote: 23 Aug 2017 21:35 General rule of thumb: ...fixed income in TFSAs,....
George
I think you would be doing a disservice to young people giving them that advice.
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Re: Dividend Tax Advantages May Be An Illusion

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Koogie wrote: 24 Aug 2017 10:21
ghariton wrote: 23 Aug 2017 21:35 General rule of thumb: ...fixed income in TFSAs,....
George
I think you would be doing a disservice to young people giving them that advice.
I was commenting where assets should be held so as to reduce taxes/receive tax credits. If your point is that young people should be more heavily into equities because they can better cope with risk, and that the ensuing capital gains are better off in a TFSA, well...

(1) I agree that young people should tilt towards equities if psychologically they can handle the volatility (many can't). But to the degree they have fixed income products, these should be in a TFSA. After all, interest is fully taxed and it is good to shelter it in a TFSA.

(2) If there is further space in a TFSA, by all means use it up with Canadian dividend payers or Canadian and foreign growth stocks. However, realize that you lose the benefit of the dividend tax credit and reduced tax rate on capital gains. Perhaps one can hope that capital gains on these equities will be very large, and so that it is good to shelter those capital gains in a TFSA. But that does not take advantage of that wonderful feature of TFSAs, sheltering interest. If you fill your TFSA with equities, you will have to hold your fixed income in a non-registered or RRSP, and pay full taxes on the interest.

But again, as I said, I was setting out rules of thumb. When making actual investing decisions, one should go well beyond rules of thumb, and consider the details of one's actual situation.

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Re: Dividend Tax Advantages May Be An Illusion

Post by twa2w »

gaspr wrote: 23 Aug 2017 23:24 If the company is owned by the shareholders, then it is indeed paying taxes on their behalf. It is the reason why the CRA compensates for this through the gross up/ dividend tax credit.
Aren't all companies owned by their shareholders? Or are you referring to one or two owner small businesses.

I always felt corps should be able to deduct dividends as an expense and have people who recieve dividends add it to their income and pay normal tax rates. This would, I know, increase the amount of taxes paid and reduce the huge benefit small business owners get from the current tax regime.
OTOH, dividends from larger corps may increase due to the Corp getting a deduction.
Essentially dividends would be no different than salary. Of course, this in theory would reduce investment in the stock market by higher income individuals.
And yes currently most of my income is from dividends.

Of course the dogma is that small businesses create most of the jobs etc and should be encouraged etc etc. But the facts do not support this. Small businesses churn jobs but it is medium and larger companies that create more permanent jobs in the econmy over the longer term. Of course it is small businesses that grow to medium etc. But most small corps were never intended to grow. They are the professionals and the one person contractors who want to write off their car, travel, etc. Things that salaried people cannot.
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Re: Dividend Tax Advantages May Be An Illusion

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twa2w wrote: 24 Aug 2017 17:01 I always felt corps should be able to deduct dividends as an expense and have people who recieve dividends add it to their income and pay normal tax rates. This would, I know, increase the amount of taxes paid and reduce the huge benefit small business owners get from the current tax regime.
OTOH, dividends from larger corps may increase due to the Corp getting a deduction.

Essentially dividends would be no different than salary.
Equivalently, dividends would be taxed no differently than interest on debt.

This has the added advantage, in my view, of eliminating the system's present bias toward debt (at least as seen by the corporation). Make the debt/equity decision subject to risk and other financial considerations, without distortions by the tax system.

Of course, my preference would be for abolition of the corporate income tax altogether, with distributions of earnings taxed only in the hands of recipients. But I know I'm dreaming on this one.
Of course the dogma is that small businesses create most of the jobs etc and should be encouraged etc etc. But the facts do not support this. Small businesses churn jobs but it is medium and larger companies that create more permanent jobs in the econmy over the longer term. Of course it is small businesses that grow to medium etc. But most small corps were never intended to grow. They are the professionals and the one person contractors who want to write off their car, travel, etc. Things that salaried people cannot.
Agree. But once you give out this kind of advantage, you build up powerful vested interest groups.

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Re: Dividend Tax Advantages May Be An Illusion

Post by IdOp »

twa2w wrote:I always felt corps should be able to deduct dividends as an expense and have people who recieve dividends add it to their income and pay normal tax rates.
+2

(Counting ghariton's post as +1)
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Re: Dividend Tax Advantages May Be An Illusion

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IdOp wrote: 24 Aug 2017 19:38
twa2w wrote:I always felt corps should be able to deduct dividends as an expense and have people who recieve dividends add it to their income and pay normal tax rates.
+2

(Counting ghariton's post as +1)
One of the problems is non-resident shareholders.
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Re: Dividend Tax Advantages May Be An Illusion

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adrian2 wrote: 24 Aug 2017 20:34 One of the problems is non-resident shareholders.
Fine. Then levy a corporate income tax and give every shareholder a tax credit equal to his or her share of the corporate tax. Cancels out for shareholders paying Canadian income tax. Effect would be subject to tax agreements for residents of other jurisdictions. Kinda like a withholding tax.

Also solves the other criticism often levied against the abolition of the corporate income tax -- that the corporate income tax acts to some extent to limit tax evasion.

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Re: Dividend Tax Advantages May Be An Illusion

Post by IdOp »

Why not a withholding tax for non-residents, much like we pay on US dividends? That would keep it simpler for Canadians.
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Re: Dividend Tax Advantages May Be An Illusion

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ghariton wrote: 24 Aug 2017 22:21
adrian2 wrote: 24 Aug 2017 20:34 One of the problems is non-resident shareholders.
Fine. Then levy a corporate income tax and give every shareholder a tax credit equal to his or her share of the corporate tax. Cancels out for shareholders paying Canadian income tax.
Isn't this pretty close to the current system of dividend tax credit?
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Re: Dividend Tax Advantages May Be An Illusion

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IdOp wrote: 24 Aug 2017 22:37 Why not a withholding tax for non-residents, much like we pay on US dividends? That would keep it simpler for Canadians.
I think that's already in place.

However, the withholding tax rate is limited by tax treaties to a relatively low percentage; if Canada wants to extract more out of corporations + non-resident shareholders, the current system achieves that.
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Re: Dividend Tax Advantages May Be An Illusion

Post by IdOp »

adrian2 wrote: 25 Aug 2017 07:46I think that's already in place.
I had been wondering if it was in place for bond interest, which isn't pre-taxed like dividends.
However, the withholding tax rate is limited by tax treaties to a relatively low percentage; if Canada wants to extract more out of corporations + non-resident shareholders, the current system achieves that.
Interesting, thank you.
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Re: Dividend Tax Advantages May Be An Illusion

Post by twa2w »

Good point Adrian,

But curious how big an issue are dividends paid out to foreign investors. The big banks, big telecoms have ownership restrictions etc so how many other big dividend payers would have a large % foreign ownership.

There surely must be a better fairer system than what we have now.
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Re: Dividend Tax Advantages May Be An Illusion

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ghariton wrote: 24 Aug 2017 13:57
Koogie wrote: 24 Aug 2017 10:21
ghariton wrote: 23 Aug 2017 21:35 General rule of thumb: ...fixed income in TFSAs,....
George
I think you would be doing a disservice to young people giving them that advice.
I was commenting where assets should be held so as to reduce taxes/receive tax credits. If your point is that young people should be more heavily into equities because they can better cope with risk, and that the ensuing capital gains are better off in a TFSA, well...

(1) I agree that young people should tilt towards equities if psychologically they can handle the volatility (many can't). But to the degree they have fixed income products, these should be in a TFSA. After all, interest is fully taxed and it is good to shelter it in a TFSA.

(2) If there is further space in a TFSA, by all means use it up with Canadian dividend payers or Canadian and foreign growth stocks. However, realize that you lose the benefit of the dividend tax credit and reduced tax rate on capital gains. Perhaps one can hope that capital gains on these equities will be very large, and so that it is good to shelter those capital gains in a TFSA. But that does not take advantage of that wonderful feature of TFSAs, sheltering interest. If you fill your TFSA with equities, you will have to hold your fixed income in a non-registered or RRSP, and pay full taxes on the interest.

But again, as I said, I was setting out rules of thumb. When making actual investing decisions, one should go well beyond rules of thumb, and consider the details of one's actual situation.

George
Another way of saying the same thing is that eligible Canadian dividends received inside of a Tax Free Savings Account are not tax free at all. The dividend amount is the after corporate tax amount. You get no credit for this inside of a TFSA, but you do if received in a non registered account.

Interest income received inside of a TFSA is completely tax free. You get the full benefit.
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Re: Dividend Tax Advantages May Be An Illusion

Post by SQRT »

gaspr wrote: 26 Aug 2017 13:40

Another way of saying the same thing is that eligible Canadian dividends received inside of a Tax Free Savings Account are not tax free at all. The dividend amount is the after corporate tax amount. You get no credit for this inside of a TFSA, but you do if received in a non registered account.

Interest income received inside of a TFSA is completely tax free. You get the full benefit.
Agree and when TFSA first were implemented everyone understood this would be a great place to shelter interest income. Problem is rates are so low you end up sheltering almost nothing. I started out with GIC's etc but after a few years switched to equities. Might switch back if rates increase to something meaningful.
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Re: Dividend Tax Advantages May Be An Illusion

Post by Shakespeare »

I started out with GIC's etc but after a few years switched to equities. Might switch back if rates increase to something meaningful.
Agreed; my TFSA is about 98% Canadian dividend growth stocks. Current IRR is 11.6%.
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Re: Dividend Tax Advantages May Be An Illusion

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Yes I understand why you choose to have equities in TFSA's. Investments with the highest expected returns are a good fit in a TFSA. But 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?

IOW does the "highest expected returns" rule of thumb, overrule the "FI tax efficiency" rule of thumb?
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Re: Dividend Tax Advantages May Be An Illusion

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gaspr wrote: 26 Aug 2017 14:38 Yes I understand why you choose to have equities in TFSA's. Investments with the highest expected returns are a good fit in a TFSA. But 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?

IOW does the "highest expected returns" rule of thumb, overrule the "FI tax efficiency" rule of thumb?
Agree. But I don't have any FI investments other than in my operating accounts.
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Re: Dividend Tax Advantages May Be An Illusion

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I bave come to the conclusion the best investments for the TFSA are relatively tax inefficient equities such as REITs. A basket of good REITs can match average equity returns of the market. I preferentially put my FI in my RRSP which will be fully taxed on withdrawal anyway. I prefer my DTC divies and cap gains in non-reg.
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