The Canadian tax system is sometimes used in textbooks around the globe as an example of what a tax system shouldn’t be – it is complicated, labor intensive, there are too many loopholes and it feeds a huge army of accountants and lawyers which is not a productive sector of economy. One of the examples illustrating this complexity is the way dividend income is taxed.

First, the income is “grossed-up” by 45% (for Canadian public corporations) and the person pays income tax on this larger amount at whatever their marginal tax rate is at the moment. But after that the taxpayer receives a tax credit which will be different in each province. As a result of this complicated transaction, the highest personal marginal tax rate for dividend income is only 31.58% as compared to 43.7% for regular income. The idea behind this preferential treatment of dividend income is that dividends are paid out of corporate profits which have already been taxed and nobody likes double taxation.

Taxation of dividends paid out by Canadian Controlled Private Corporation (CCPS) is even more complex. The rates will depend on the nature of the income (active vs. passive) and whether it is below or above the small business income threshold which is currently at $500 at the federal level and $400 at the provincial level in BC. This results in four different levels of taxation for dividends paid by private companies. In addition, private corporations can pay their shareholders so-called capital dividends, which are tax free. In order to be able to do it, a corporation must have a positive balance in its Capital Dividend Account (CDA). This notional account derives its value from life insurance proceeds, non-taxable portion of capital gains and capital dividends paid to the corporation from other corporations. This opens the door for creative tax planning with private companies.

Leaving the taxation of CCPC dividends aside and going back to public corporations, the most important conclusion for a regular investor is that dividend income enjoys better tax treatment than interest income. Therefore, choosing dividend generating investments over investments producing interest income at the same rate is advantageous from the net income standpoint in a non-registered portfolio.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.