December 2006 — PRINT EDITION    
 
Table of Contents
   
 

Detax the dividends

By Jennifer Smith & Trent Henry
Illustration: Gary Clement

In an attempt to level the playing field, the feds have put forth their plan to reduce the income tax rate on certain dividends

The federal government and certain provinces have announced changes to the taxation of dividends. The federal proposal follows the former Liberal government’s announcement in late 2005 and seeks to level the playing field between income trusts and corporations. By levelling the playing field it means to reduce the total tax paid by individuals on dividends from Canadian corporations to an amount that is at least close to what an individual would pay on a distribution from an income trust. However, this can only be accomplished if the provinces and territories follow the federal initiative and reduce the provincial rate of tax on dividends. In this regard, with the exception of Nova Scotia, most provinces have announced they will make changes to harmonize with the federal proposal. However, most have not yet announced the details of how they intend to do so. It appears Nova Scotia will not harmonize and will adjust its dividend tax credit so an individual continues to pay approximately the same provincial tax on dividends he or she currently pays. Moreover, provinces such as Ontario intend to phase in the changes so it may take time before the full extent of the changes are realized by individual taxpayers.

On June 29, 2006, Finance Minister Jim Flaherty released for public comment a package of draft legislation to implement the government’s 2006 budget proposal lowering the income tax rate on certain dividends paid after 2005 to Canadian-resident individuals. The proposed changes build upon the existing gross-up and dividend tax credit provisions, but the conceptual framework of the taxation of dividends remains intact. Of course like many tax changes that attempt to achieve fairness and equity, it makes the taxation of dividends more complex in many respects. This will result in more costly compliance for certain corporate taxpayers to track and comply with the new rules. The proposals also include specific penalties for failure to comply.

The complex package, including explanatory notes, is almost 50 pages and contains some apparent anomalies. Most of the complexities, both from a planning and compliance perspective, relate to dividends paid by Canadian-controlled private corporations (CCPC), whereas the rules relevant to public corporations are relatively straightforward. Public comment was invited until September 15, 2006, with a view to introduce final legislation in Par-liament in the fall. While further changes can accordingly be expected, the package, when finalized, will apply to dividends paid after 2005.

The receipt of an eligible dividend allows a Canadian-resident individual shareholder to receive the enhanced gross-up and dividend tax credit. Such dividends will be subject to a gross-up for income inclusion of 45% of the dividend received instead of the current 25%, and be eligible for a federal tax credit equal to 11/18 of the gross-up. A dividend is an eligible dividend if the dividend-paying corporation has given the recipient written notice to that effect. The recipient can rely on that notice without inquiry into the status of the dividend. Noneligible dividends will continue to be taxed under the current gross-up and credit regime.

While an eligible dividend is any divi-dend so designated by the payor, if the amount designated exceeds the payor’s capacity (described below), the payor is liable to a special tax equal to 20% of the excess amount (or 30% of the entire amount of the dividend, if a special antiavoidance rule applies).

A corporation’s capacity to pay an eligible dividend generally depends on its tax status. There are two regimes for determining a corporation’s capacity to pay eligible dividends without incurring the special tax, one applicable to CCPCs and the second to large corporations. A CCPC can elect into the large corporation regime but will forgo access to the small business deduction (SBD). A nonelecting CCPC’s capacity is based on its General Rate Income Pool (GRIP); the capacity of other corporations is restricted by their Low Rate Income Pool (LRIP). A corporation will either have a balance of GRIP or of LRIP, depending on its status as a nonelecting CCPC or as a large corporation.

The package includes rules for creating an opening balance of GRIP for nonelecting CCPCs and of LRIP for electing CCPCs (on the other hand, public corporations do not have an opening balance of LRIP and are not required to track their GRIP). It seems many electing CCPCs may have a significant opening balance of LRIP at the beginning of their 2006 taxation year, which could impair their ability to pay eligible dividends in 2006 and subsequent years without incurring the special 20% tax. It is unclear whether this provision has been properly considered by Finance; however, unless modified, many CCPCs may opt to stay under the nonelecting regime.

Rules related to GRIP and LRIP
Nonelecting CCPCs

  • Dividends first come out of GRIP.
  • Dividends from GRIP can be designated as eligible dividends without the payor being subject to the 20% special tax; any dividends in excess of the GRIP balance will result in a 20% tax to the payor if designated as eligible dividends.
  • GRIP includes after-tax income, other than investment income, which has not benefited from the SBD.
  • Dividends received from foreign affiliates, and deducted in computing taxable income, also increase GRIP.
  • There are rules for setting up an opening balance of GRIP for the 2006 taxation year.

Large corporations (including electing CCPCs)

  • Dividends first come out of LRIP.
  • Public corporations do not have an opening balance of LRIP and are not subject to the GRIP rules.
  • Dividends out of LRIP are ineligible and, if designated as eligible dividends, will result in a 20% tax to the payor; any dividends in excess of the LRIP balance are eligible for the enhanced gross-up and credit.
  • The concept of LRIP is limited — consisting generally of taxable income, which benefited from the SBD, or dividends received by the corporation from a CCPC, which itself benefited from the SBD.
  • Dividends received from foreign affiliates do not increase LRIP.
  • Although a CCPC that elects into the large corporation regime forgoes access to the SBD, the rules related to refundable tax on investment income, and to the capital dividend account, are unchanged.
  • There are rules for establishing an opening balance of LRIP for electing CCPCs. The proposals currently under consideration, many electing CCPCs may have a significant opening balance of LRIP at the beginning of their 2006 taxation years. Unless the proposals are modified, these corporations may choose to remain under the nonelecting regime.

As mentioned, there are apparent anomalies with respect to the proposed changes. The proposals provide that a CCPC can elect large corporation status, without other related or associated CCPCs also doing so. It is unclear whether this is intentional and whether it is appropriate. Moreover, it appears there may be circumstances under which a nonelecting CCPC might pay dividends, which would both generate a refund of refundable tax and also qualify for the enhanced gross-up and credit. Again, it is not clear whether or not this was intended.

The proposals confirmed that dividends received from foreign affiliates will support the payment of eligible dividends that themselves qualify for the enhanced gross-up and tax credit. Mechanically, this is achieved by including these dividends in the GRIP of nonelecting CCPCs and excluding them from the LRIP of large corporations. In addition to dividends received from foreign affiliates, eligible dividends paid up a Canadian corporate chain, all the members of which are nonelecting CCPCs, should qualify the Can-adian-resident individual for the enhanced credit. There are also provisions impacting the GRIP and LRIP balances on certain corporate tax reorganizations, including amalgamations and windings-up.

The draft legislation introduces a new deemed taxation year-end rule. In general terms, a corporation will be treated as having a taxation year-end immediately before the time it becomes or ceases to be a CCPC. This rule will be relevant for computing a corporation’s balance of GRIP or LRIP when it becomes or ceases to be a CCPC, but will also apply generally for other purposes of the act.

Finally, the proposals add yet another specific antiavoidance rule to the act. The provision provides that, if it is reasonable to consider that an eligible dividend was paid as part of a transaction or series of transactions, one of the main purposes of which was to artificially maintain or increase the payor’s balance of GRIP (or maintain or decrease the payor’s balance of LRIP), the entire amount of the dividend is subject to a special tax of 30% to the payor.

Before paying dividends taxpayers, particularly CCPCs, should consider the planning opportunities these new proposals afford. Of course they are subject to change.

Taxpayers will also have to consider any provincial developments related to the federal proposal to ensure they can position themselves to benefit fully from the proposed regime.

Jennifer Smith, LLB, is a principal with Ernst & Young in Ottawa. Trent Henry, CA, is leader of international tax services with Ernst & Young in Toronto. He is the Technical editor for Taxation