What is the difference between actual and taxable dividends? In this article we provide some insight on common questions that small business owners often have about T5s, without getting overly technical.
In this article the goal is to provide some insight on common questions that small business owners often have about T5s, without getting overly technical.
Hopefully you learn something new!
What Are T5 Slips?
As accountants we are often tasked with preparing annual Returns of Investment Income also known as T5s. These are used to report (to CRA) “investment income” such as interest or dividends that have been distributed by a Canadian corporation to an individual or to a corporate taxpayer.
As a firm specializing in small businesses, we typically prepare and file T5s when our corporate clients declare and pay dividends as a form of compensation or return on investment to corporate shareholders.
T5 Slip Box Types for Dividends
If you look at a T5 slip you may notice that there are several coded boxes with amounts.
These include:
- Box 24 - Actual amount of eligible dividends
- Box 25 - Taxable amount of eligible dividends
- Box 26 - Dividend tax credit for eligible dividends
- Box 10 - Actual amount of dividends other than eligible dividends
- Box 11 - Taxable amount of dividends other than eligible dividends
- Box 12 - Dividend tax credit for other than eligible dividends
Why Are “Taxable Dividends” More Than “Actual Dividends?”
Often, our T5 clients who’ve received dividends as individual taxpayers, upon reviewing the T5 returns/slips, ask us why the “taxable” amount differs from the “actual” amount.
The taxable amount is always a larger number, which may seem counterintuitive or the result of an error. If you’re not familiar with the Canadian income tax system this is a fair question!
The Concept of Integration
The key to understanding these details is the Canadian tax concept of “integration”, where taxation of corporate and personal taxpayers is well… integrated together!
The current iteration of the Canadian tax system was designed with the objective that a stream of income should result in equal income tax regardless if earned and taxed as an individual or a corporation.
Tax Rates, Taxable Amounts and Tax Credits
This is achieved by a combination of coordinated tax rates, taxable amounts, and tax credits that work together when they end up on a corporate and personal tax return.
Income is subject first to corporate income tax when it is earned in a corporation. Then when that income is distributed to shareholders as dividend income, it is subject to personal tax for the individual taxpayer.
Integration Helps Avoid DoubleTaxation
The income is effectively taxed twice, but “integration” means that an incorporated business owner will pay similar tax whether he’s compensated via salary or dividends.
You may have heard that corporations have lower income tax rates than individuals, and this is true. But it doesn’t mean that simply going through the legal process of incorporating a business offers a way to avoid taxes.
Then Why Incorporate a Business?
Incorporating a small business offers tangible benefits in the form of income tax deferral and limited liability for shareholders but doesn’t circumvent tax.
This topic is more than we’re looking at in this article, but you can check out this post on when you should incorporate for more info.
Compensated by Salary or Dividends
A common way to demonstrate integration is to show the difference between paying yourself via wages compared to paying yourself through dividends.
Paid by Salary
In a scenario where an owner is compensated via wages earned as an employee of the corporation, said wages are a deduction in arriving at taxable income - which is then subject to the reduced corporate income tax rate.
The result is that most of the income tax is paid by the employee, and the corporation pays relatively little due to decreased income, and a lower income tax rate.
Paid by Dividends
In a scenario where an owner is compensated via dividends rather than wages, the corporation pays most of the income tax - as dividends are not deductible against the corporation’s taxable income.
This is because dividends are viewed as a distribution of the equity of a business rather than a cost incurred by the business to run its operations (like employing an individual to work in the business).
These dividend distributions come from after-tax dollars of the corporation, meaning corporate tax has already been paid on this money. Integration accounts for this via a couple of tax mechanisms.
Dividend Gross-up Creates the “Taxable Dividends” Amount
Firstly, the actual amount of dividends is “grossed up” to arrive at a larger “taxable” amount that is to be reported on the individual taxpayer’s personal tax return.
The “grossed up” amount approximates the equivalent before-tax amount in the corporation.
This is why the “taxable” amount of dividends paid on your T5 slip is higher than the actual amount of dividends paid, and why it’s important that it’s included on the slip.
Dividend Tax Credit
The other important amount on the T5 slip (in addition to the actual dividends paid, and taxable amount of dividends paid) is the dividend tax credit.
This amount reduces tax on an individual’s personal tax return to offset the double taxation of income that would otherwise occur.
Example of Integration at Work
Here's a simple example to illustrate the mechanisms in action:
If you earned $100 in wages you'd pay about $38 in tax on your personal tax return.
If you paid yourself $100 in dividends from your corporation the corporation would have paid about $11 in corporate tax on that money. You would be left to pay the remaining $27 on your personal tax return, resulting in a total of $38 in total tax paid.
Eligible Dividends vs. Other Than Eligible Dividends
Another common question from clients is “what’s the difference between ‘other than eligible’ dividends and ‘eligible’ dividends”?
Other than Eligible Dividends
“Other than eligible dividends” are a common type of dividends paid from Canadian controlled private corporations. These are sometimes also referred to as “Non-eligible” or “Ineligible” dividends.
Small Business Tax Rate
Other than eligible dividends arise due to the fact that Canadian controlled private corporations are subject to a lower corporate income tax rate on the first $500,000 of income.
This lower income tax rate creates “other than eligible dividends” which provide a smaller dividend tax credit when paid out to individuals. It’s integration at work by compensating for the corporate tax already paid.
This tax measure incentivizes companies to reinvest earnings back into a business which can help small businesses grow. It is also the main reason why it often makes sense to incorporate a small business that is operating as a sole proprietorship or partnership.
Self-employed individuals operating a sole proprietorship must calculate income tax on their profits using progressive tax rates (see more info on tax brackets here).
On the other hand, a corporation can pay income tax at a reduced rate. Then if it doesn’t pay out all of its earnings to the owners, it can use the tax savings to invest in income generating assets or hire additional employees.
Eligible Dividends
When these private Canadian corporations begin paying income tax on profits exceeding $500,000, the tax rate on income over the $500k threshold increases.
Corporations in this situation can start paying what are referred to as “eligible” dividends.
These eligible dividends use the same type of gross up and dividend tax credit mechanism to further reduce personal taxes owing on the dividends.
Personal Tax on Eligible vs. Other Than Eligible Dividends
You can see the difference if you go to the Wealthsimple tax calculator and compare taxes owing on eligible dividends vs. other than eligible dividends.
$80,000 of Eligible Dividends Paid in British Columbia
$80,000 of eligible dividends creates $1,680 in total tax to be paid by the individual on their personal tax return.
$80,000 of Other Than Eligible DIvidends Paid in British Columbia
$80,000 of other than eligible dividends creates $9,368 in total tax to be paid by the individual on their personal tax return.
The reason that eligible dividends create less personal tax is because they have to compensate more for the higher corporate tax that’s already been paid.
This again is integration at work creating a similar total tax result whether corporations pay wages, eligible dividends or other than eligible dividends.
We’ve successfully avoided double taxation!
