Wednesday, June 6, 2012

Phantom Income and the Dividend Gross-Up

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.

11 comments:

  1. Let me make sure we're on the same page... When I last looked at this (which may have been before 2006) I understood that as an investor in a company, you are taxed on your dividends as though you "were" a part of the company, so you end up with the same after-tax income you'd have if you actually earned the share of the company's earnings represented by your dividend.

    There would be two ways to achieve such a thing:

    1. Don't tax corporate income. I'm sure investors everyone would love this.

    2. Tax corporate income, then make adjustments to each investor's tax returns to mimic #1. Investors everywhere seem to hate this, even though it has precisely the same effect on their bottom line as #1.

    #1 is what we used to do for income trusts, but that changed a few years ago because we were losing tons of tax revenue due to foreign ownership. Now companies and income trusts are handled by #2.

    At least, that's what I thought. So I'd like to understand your argument here. Are you saying that what I just described is unfair, or incorrect?

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  2. @Patrick: I'm saying that in the course of using your #2, the percentages in force right now don't quite work. The tax credit isn't quite large enough to cover the gross-up percentage. The taxes paid (in Ontario) end up being more than you would have if the rules were set to execute #2 properly.

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  3. Hi Michael, the system does prevent double taxation (corporate and individual) but it is also designed to impose maximum taxation. The first tax cut at dividends happens at the corporation. Any dividends that get passed to an individual then get reassessed and taxed at whatever is the individual's tax rate, which generally happens to be higher than the corporate rate. Investors pay any difference and since corporate tax rates have been falling, you and I are paying more on dividends. That is reflected in rising marginal rates on dividends.

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  4. @CanadianInvestor: The system prevented double taxation (up until 2005), but since then, part of dividends do get double-taxed because either the gross-up to too large or the DTC is too small.

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  5. In a nutshell--a 4% dividend is equivalent to about 5.5 % interest--am I correct

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  6. @Anonymous: With the current gross-up at 38%, you are right except for the fact that the DTC doesn't quite cover the gross-up as I explained in the article. So, the 5.5% interest is somewhat better from a tax standpoint. How much better depends on your income level.

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  7. Hi Michael, Think you need to include at least one other thing. In 2006 the Fed lower corporate rates and then that moves the bar over to the dividend collector by raising the bar. So in a way its the same amount just a different payer.

    Scrouge McDuck

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  8. @McDuck: If this is true, then it is the gross-up that is too high rather than the DTC being too low. No matter what the level of corporate taxes, the gross-up and DTC are out of sync.

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  9. The dividend gross-up is most unfair to people whose income falls into the brackets for "clawback" of social security payments. Those people have to pay back their OAC or child tax credits based on income they never received.

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  10. @Anonymous: The dividend tax credit mostly makes up for the taxes and clawbacks due to the gross-up, but not completely. The portion of the gross-up not covered by the DTC definitely leads to unfairness with clawbacks.

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  11. The gross-up also means applying portions of tuition and education mounts to income you didn't receive, and can push you into a higher OHIP payment, again for income you didn't receive.

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