The dividend tax credit (DTC) has been doing a progressively worse job of compensating for the dividend gross-up in recent years. This has given rise to “phantom income” for dividend investors.
The first time I filed my taxes in a year where I received a dividend in a taxable account, I was surprised to find that I had to declare more income than I actually received. This is called the dividend “gross-up”. Fortunately, I also got a deduction from the taxes I owed, called the dividend tax credit (DTC). The idea behind this tax treatment is to coordinate the taxes you pay and the taxes the company distributing the dividends pays.
Initially, the company earns some profits, but must pay taxes on these profits. Then the company can pay dividends out of the lower after-tax profit amount. Tax laws for individuals are designed to give you credit for the taxes the company paid. The idea is that you declare the larger amount (which is more than you actually received in dividends) as income, and then get a tax reduction equal to the taxes the company paid. In theory, the total taxes paid by you and the company is the same as if you had earned the larger amount as regular income. However, in practice, this hasn’t been working very well since 2006.
From the point of view of the investor, we start with the actual amount of dividends and then gross this up by some percentage to get the larger amount which is the company’s income before taxes. For exact coordination between company taxes and individual taxes, the tax reduction you receive should exactly match the amount of the gross-up.
For several years ending in 2005, the dividend tax rules had been steady. An investor who collected a $120 dividend would have to gross-up this amount by 25% to $150 and declare this larger amount as income. Then the investor would get a $20 reduction in federal tax and (in Ontario) another reduction in provincial taxes of between $7.70 and $12 depending on whether the investor’s income was high enough to pay the Ontario surtaxes. So the gross-up is $30, and the tax reduction is between $27.70 and $32. This is reasonably close to coordination of total taxes paid by the investor and the company.
However, starting in 2006, governments have been tinkering with the amount of the gross-up and the amount of the tax reduction (DTC). The following chart shows the total of the federal and Ontario DTC as a percentage of the dividend gross-up for people with high enough incomes that they pay the Ontario surtaxes.
In 2012, the DTC is 9% too low to cover the dividend gross-up. Things are even worse for people with lower incomes who don’t pay the Ontario surtaxes:
For 2012, the DTC for low incomes is too low by 22%. So, if we assume that a fair tax is one that exactly coordinates personal taxes and company taxes, we are paying too much by between 9% and 22% of the gross-up. Expressed as a percentage of actual dividends received, in 2012 we will pay between 3.5% and 8.4% too much in taxes on dividends depending on income level.
When people like Gordon Pape talk of phantom income from dividends, they are referring to the entire gross-up amount. While I don’t think it is reasonable to expect to get the tax credit without adding a gross-up, it is fair to say that a percentage of the gross-up is phantom income and that this percentage has been increasing in recent years.
Many thanks to Canadian Investor who writes Canadian Financial DIY and How To Invest Online for pointing out the DTC gap in a comment on my earlier post about the tax system and retirees. I still don’t agree that the dividend gross-up is phantom income, but a percentage of it is phantom income and this percentage has been rising.