Have you ever wondered why the dividend gross-up rates are what they are? Allow me to do some basic high school math to show you.
Integration and its Purpose
Understanding the math requires an appreciation of the purpose of dividend income “integration.” The purpose of integrating dividend income (disregarding capital dividends) is to ensure that this type of income is not subject to double taxation. Dividends are paid out of income that has already been taxed at the corporate level. To subject that income to full personal level tax would penalize someone for choosing the corporate form. Neutrality in this regard is effected by a “gross-up and tax credit” mechanism. In Canada, a corporation pays two types of dividends – eligible or non-eligible. The difference between the two is in the size of the gross-up/tax credit each attracts. An eligible dividend is eligible for a greater gross-up/tax credit, whereas a non-eligible dividend is only entitled to a smaller one. Why should an eligible dividend be given an enhanced gross-up/credit? It reflects that the eligible dividend has been sourced from corporate income which bore a higher level of corporate tax (ex. the 26.5% general rate vs. the 12.2% small business deduction rate, in Ontario). Provision of a greater gross-up/credit at the personal level means less personal tax is payable. The reverse is true for non-eligible dividends. Effectively, as between eligible and non-eligible, different gross-up rates represent an effort to accurately apportion the incidence of tax between the corporation and its individual shareholder.
The Long and Mechanical Derivation (Equality of Tax Payable)
(a) What Gross-Up Rate Perfectly Integrates the General Corporate Rate (26.5%)?
Income which is taxed at the 26.5% general corporate rate is paid out as an eligible dividend. What gross-up rate (“GU Rate”) would perfectly integrate an eligible dividend? The starting point is an equation which expresses in formulaic terms the “fiscal unity” that our integration system aims to achieve.
- Fiscal Unity Equation
- Corporate Taxes on Income + Personal Taxes on Dividends (via Gross-Up/Credit) = Personal Taxes if Income Earned Directly
- Components of the Equation
- Corporate Taxes on Income
- = (1)(Corporate Tax Rate)
- = (1)(0.265)
- = 0.265
- Personal Taxes on Dividends (via Gross-Up/Credit)
- = [(Dividend Income) + (GU)][Personal Tax Rate] – (DTC)
- Where
- Dividend Income = After-Tax Corporate Income = 1 – 0.265 = 0.735
- GU = (Dividend Income)(GU Rate) = (0.735)(GU Rate)
- Personal Tax Rate = 0.5353
- DTC = GU = (0.735)(GU Rate); though this does not hold in practice due to different provincial gross up rates.
- = [0.735 + (0.735)(GU Rate)][0.5353] – (0.735)(GU Rate)
- = 0.3934 + 0.3934(GU Rate) – 0.735(GU Rate)
- = 0.3934 – 0.3416(GU Rate)
- Personal Taxes if Income Earned Directly
- = (1)(Personal Tax Rate)
- = (1)(0.5353)
- = 0.5353
- Substitute into Equation and Solve for “GU Rate”
- Corporate Taxes on Income + Personal Taxes on Dividends (via Gross-Up/Credit) = Personal Taxes if Income Earned Directly
- 265 + 0.3934 – 0.3416(GU Rate) = 0.5353
- GU Rate = (0.5353 – 0.265 – 0.3934)/(– 0.3416)
- GU Rate = (– 0.1231)/(– 0.3416)
- GU Rate = 36.04%
- Corporate Taxes on Income
Hence, eligible dividends sourced out of corporate income taxed at 26.5% are perfectly integrated if shareholders get to apply a gross-up rate (GU Rate) of 36.04%.
(b) What Corporate Tax Rate is Assumed by a 38% Gross-Up?
The current and actual gross-up rate applicable to eligible dividends is 38%, not 36.04%. This means that the Income Tax Act perceives the income from which eligible dividends are sourced to have been taxed at a rate different from 26.5%. What is that rate? The answer is easy enough to obtain by using the above equation in reverse – by plugging in 38% for “GU Rate” and solving for “Corporate Tax Rate.” You will find that the answer is 27.54%. This discrepancy can be attributed somewhat to differences in provincial corporate tax rates; 26.5% is an Ontario rate.
The Short Derivation (Equality of Income)
There is a much quicker way to derive the gross-up rates (“GU Rate”). It is more subtle and requires an understanding that the gross-up (“GU”) adds to dividend income (“Dividend Income”) in order to bring the total up to pre-tax corporate income. If the foregoing method focused on equality of tax payable, this short method focuses on equality of income (between corporation and shareholder):
- Dividend Income + GU = Corporate Income
- Dividend Income
- = After-Tax Corporate Income
- = Corporate Income – Corporate Taxes
- = 1 – (1)(Corporate Tax Rate)
- = 1 – (1)(0.265) = 0.735
- GU
- = (Dividend Income)(GU Rate)
- = (0.735)(GU Rate)
- Corporate Income = 1
- Dividend Income
- Substitute In and Solve for “GU Rate”
- Dividend Income + GU = Corporate Income
- (0.735) + (0.735)(GU Rate) = 1
- GU Rate = (1 - 0.735)/0.735
- GU Rate = 36.05%
Just as above, the true gross-up applicable to eligible dividends (38%) can be plugged in to solve for the assumed Corporate Tax Rate.
Imperfect Integration
As previously mentioned, there are two types of dividends and each has its own gross-up rate. The rate for eligible dividends is 38% and for non-eligible dividends it is 15%. Each rate reflects a different assumption about the Corporate Tax Rate applied to the income from which the dividend is sourced. However, there are roughly five different types of corporate tax rates in the Act. In Ontario these work out to:
- The rate of 12.2% – applicable to CCPC active business income below the business limit,
- The general rate of 26.5% – applicable to the income of a non-CCPC’s and the active business income of a CCPC in excess of the business limit,
- The rate of 20% - applicable to the aggregate investment income of CCPC’s (post-RDTOH refund),
- The rate of 39.5% - applicable to the aggregate investment income of a non-CCPC (no refundable taxes),
- The personal service business rate of 44.5%.
Given there are only two types of dividends and two gross-up rates, the Act assumes only two corporate tax rates. Thus, the five foregoing rates are blended into two assumed corporate rates. This leads to over and under-integration. For example, investment income of a CCPC is taxed at a post-refund rate of 20%. This refund is only realized once a non-eligible dividend is paid. The non-eligible dividend gross-up rate is 15%. If you plug-in 15% for “GU Rate” into the formula above, you will find the assumed “Corporate Tax Rate” to be 13.04%, not 20%. Hence, the system under-integrates investment income of a CCPC. In plain English this means that the shareholder is not being given adequate credit for tax paid at the corporate level. Perhaps simplicity militates in favour of disregarding these types of discrepancies. What are your thoughts?