Eligible Dividend Designations – Let’s Change the Default Rule for Public Corporations and their Subsidiaries


Some of the annoying complexity of our tax system stems from how we integrate corporate taxes and personal taxes when a corporation pays a dividend to an individual shareholder.  Our integration system grosses up the dividend (to reflect the assumed amount of income earned by the corporation before its corporate taxes), applies the personal tax rate to the grossed up dividend, and then allows the individual to claim a dividend tax credit for the amount of corporate tax assumed to have already been paid in respect of the corporate income that funded the dividend.

But corporate tax is paid at different rates depending on the nature of the income and the type of corporation.  The general rate (currently 26.5% combined federal/Ontario) applies to all public corporations and their subsidiaries, and in many other situations.  However, Canadian-controlled private corporations (CCPCs) can benefit from the small business deduction which taxes active business income at a lower rate (currently 12.2% combined federal/Ontario).  CCPCs are also subject to special refundable taxes on their investment income; some of these taxes are refunded when they pay a dividend, resulting in a non-refunded corporate tax rate less than the general rate.

To reflect these lower corporate tax rates applicable to CCPCs, since 2006 our system has had two rates of dividend tax credit, depending on whether the dividend is designated by the corporation as an “eligible dividend”.  An eligible dividend is assumed to have been paid out of corporate income subject to the higher general rate of corporate tax, and is consequently eligible for the more generous dividend tax credit.  In contrast, a non-eligible dividend is assumed to have been paid out of corporate income subject to a lower rate of corporate tax (i.e., a CCPC’s investment income or business income eligible for the small business deduction), and consequently benefits from a less generous dividend tax credit.

So how do we prevent corporations from designating all their dividends as eligible dividends, as would be preferred by their individual shareholders to get a more generous dividend tax credit?  We impose a hefty penalty tax on corporations that make an “excessive eligible dividend designation”.  In effect, we require CCPCs to keep track of their accumulated after-tax earnings subject to the higher general rate of tax (their “general rate income pool”, or GRIP).  And we require non-CCPCs (including public corporations and their subsidiaries) to keep track of any after-tax earnings that have been subject to a lower rate of tax (their “low rate income pool”, or LRIP), which would be unusual but could arise if the non-CCPC received non-eligible dividends from another corporation.   The penalty tax forces corporations to self-police.  CCPCs are supposed to track their GRIP and only designate dividends as eligible to the extent of their GRIP, and they will suffer penalty tax if their eligible dividends exceed their GRIP; and non-CCPCs are supposed to keep track of their LRIP and will pay penalty tax if they designate an eligible dividend while they have any positive LRIP.

The requirements to make a valid designation of an eligible dividend are strictly set out in ITA s. 89(14).  A corporation must notify the shareholder in writing, on or before the time the dividend is paid, that the dividend is an eligible dividend.  Thus it takes a positive action on the corporation’s part to provide the required notice, and this must be done before the dividend is paid, otherwise the dividend is non-eligible.  Helpfully, the CRA has a longstanding administrative policy accepting that a public corporation can validly make an eligible dividend designation by providing notice to shareholders on its website.  In practice, most if not all public corporations make an effectively permanent eligible dividend designation in this manner for all their dividends.  But this policy is limited to public corporations – subsidiaries of public corporations, and private corporations, must still actively provide notice to their shareholders in some timely way in order to make a valid eligible dividend designation.

Which finally brings me to my point.  The default rule is that all dividends paid by all corporations are non-eligible, unless the corporation has made a valid eligible dividend designation.  I can see the sense of this default rule for CCPCs, where in many cases the income is subject to a low corporate tax rate.  But I do not think this is the best default rule for public corporations and their subsidiaries, where generation of LRIP is typically “exceptional”.

Consider the common situation of a public corporation with a group of controlled subsidiaries.  Every time a subsidiary pays a dividend up the chain, it must be actively and timely designated as an eligible dividend, otherwise it would be a non-eligible dividend and add to the LRIP of the parent corporation, even if the income from which the dividend was paid bore the higher general rate of tax.  LRIP is a big problem for a public corporation, because of the practical commercial necessity to designate all of its dividends to the public shareholders as eligible dividends. Imagine the analyst reaction and stock price hit if a large Canadian public company were to retract its blanket eligible dividend designation by saying “sorry, we have some LRIP – so you shareholders are going to have to pay a higher tax rate on your next dividend.”  The reality is that in the rare circumstances where a public corporation has any LRIP, it will invariably continue to pay eligible dividends to its shareholders, and will consequently suffer the penalty tax for making an excessive eligible dividend designation.

Why don’t we change the default rule for dividends paid by public corporations and their subsidiaries, so that all such dividends are automatically treated as eligible dividends unless designated otherwise.  This would legislate the helpful CRA administrative concession under which nearly all public companies have made blanket eligible dividend designations on their websites for dividends paid to their public shareholders.  And it would eliminate the potential for a public company to undeservingly generate LRIP as a result of an inadvertent failure to designate a subsidiary dividend as eligible.

What really frustrates me about the current rule is that it creates a severe and unnecessary “tax trap”.  Why should it be necessary for routine dividends paid from a subsidiary up the chain to a parent public corporation to each be designated as eligible dividends, with a  separate notice given to each shareholder recipient along the way, simply to preserve tax treatment (avoidance of LRIP, and ability of the ultimate shareholders to get the more generous dividend tax credit) that should apply by default, without unnecessary extra paperwork?  Routine intercorporate dividends are already more complex, given the recently expanded scope of ITA s. 55(2) and the need to consider safe income and the purpose of the dividend.  I have seen unfortunate situations where a junior employee tasked with papering dividend payments up the chain to a parent corporation failed through inadvertence to prepare a timely eligible dividend designation – and since the designation isn’t filed with CRA (it’s usually just put into the company’s minute book or internal records), what’s to stop someone from later backdating a designation and slipping it into the file?  I’d much prefer a tax system that doesn’t create these corrosive temptations in the first place especially when it could easily be avoided with a simple change of the rule.

So let’s re-assess the eligible dividend designation procedure.  It’s a small, simple thing, but for so long as we retain our current integration system, we could easily reduce the compliance burden for a large number of Canadian corporations by changing the default dividend treatment for public company groups to eligible dividends, unless designated otherwise.

- Professor Geoffrey Turner