Monday, December 10, 2018

How Beneficial is the Dividend Tax Credit?

Many investors love Canadian dividends because they come with a tax break called the Dividend Tax Credit (DTC). Others look a little deeper and say that the DTC just prevents double taxation because the companies paying dividends already had to pay tax on their profits. They conclude that dividend income is no better than interest income, at least from a tax perspective. However, comparing the DTC to capital gains taxes gets more complex.

Dividend Taxation in Canada

The DTC is intended to prevent Canadian company profits paid to Canadian shareholders from getting taxed twice. Here’s an example to illustrate the idea:

Suppose a company earns one dollar in profit per share, pays 27 cents in income taxes, and pays the remaining 73 cents in dividends to each shareholder. Canadian shareholders actually declare the full dollar as income (called the dividend gross-up), but they get to deduct the 27 cents from the taxes they owe. The idea is that the total tax paid by the company and the shareholder is the same as if the shareholder had received a dollar of regular income.

In truth, the numbers don’t work out quite this perfectly. But the DTC does give Canadian shareholders a tax break that mostly covers the corporate income taxes.

Most investors don’t think about the corporate taxes paid and just focus on the tax they pay on the dividends they received. Ontarians in the 53.53% tax bracket pay 39.34% on their eligible dividends. Those in the 20.05% tax bracket actually pay a negative tax rate on their eligible dividends (-6.86%).

Comparing Dividends to Interest

Critics of dividend cheerleaders point out that dividends aren’t taxed any less than interest income once you properly account for corporate taxes. These critics are right. Thanks to reader Garth who pointed me to more detailed explanation of dividend and corporate taxes than I gave above.

This doesn’t mean that dividend-paying stocks are no better than fixed-income products. Taxes aren’t the only consideration. A company’s shares may appreciate even if it doesn’t retain any of its earnings. So, future dividends may be larger than interest payments on a fixed-income product even if neither type of income has a tax advantage. Of course, a company’s share price and dividends can go down as well.

Comparing Dividends to Capital Gains

Dividend cheerleaders look foolish when we compare dividend taxes to interest taxes, but what happens when we compare dividends to capital gains? To me, this is the more relevant comparison. Those who prefer dividend stocks to fixed income products can point to dividend growth as an advantage even if there is no taxation advantage. But when we compare stocks with different levels of dividends and capital gains, the tax difference is important in taxable accounts.

Suppose we are choosing between two baskets of stocks, both expected to earn a compound average return of 5% per year. We expect the dividend stock basket to pay 4% dividends and earn 1% capital gains. We expect the other basket to pay 2.5% dividends and earn 2.5% capital gains. So, the only difference is that with the dividend stocks we trade some capital gains for more dividends.

For both baskets of stocks, the companies have to pay corporate taxes, so we can just leave them out of the comparison. Now dividend cheerleaders don’t look so foolish for ignoring corporate taxes. For any money we withdraw to live on each year, we can just compare dividend tax rates to capital gains tax rates. In Ontario, dividend tax rates look better when our total income is under about $95,000.

But this ignores capital gains deferral. Suppose we spend less than 4% of our savings each year. With dividend stocks, we’d have to reinvest some dividends that we’ve already paid taxes on. With the other basket of stocks, we’d get the advantage of deferring some capital gains taxes to the future when we sell the stocks. Depending on how long we defer the taxes, this can give the capital gains the advantage over dividends down to total incomes as low as $48,000 in Ontario. Note that with the dividend gross-up, our actual received income can be even lower than this.

If we’re expecting our total income (including CPP and OAS) to be lower than $48,000 in retirement, it may seem like we should opt for dividend stocks. But keep in mind that all of this analysis assumes we have a taxable account. It only makes sense to have a taxable account if your RRSP and TFSA are completely full. This tends to be true only if we have large RRSPs that lead to high income in retirement. So, in most cases, capital gains taxes are lower than dividend taxes.

Conclusion

Those who like Canada’s lower tax rate on dividend income appear misguided when we compare dividends to interest income and properly account for corporate taxes. But when we compare dividend taxes to capital gains taxes, it makes sense to ignore corporate taxes and focus on the favourable tax rates for both dividends and capital gains.

8 comments:

  1. Thanks for taking on this challenging topic. However, you seem to be saying that capital gains come from earnings just like dividends. That is obviously not true in the case of startup tech companies that can burn through cash for years, paying no corporate taxes, and yet the stock value soars as future earnings look promising. Tax on this gain is deferred until realized and then only at the 50% inclusion rate no matter what tax bracket you are in. Seems far more tax-efficient than dividends...

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    1. @Garth: Actually, I'm saying that neither capital gains nor dividends come entirely from earnings. This year's dividends are paid out of this year's earnings, but future higher dividends come in part from past goodwill growth.

      Whether or not capital gains taxes get realized depends on the shareholder's income needs. As I said in the article, if the shareholder can defer capital gains, then we need to compare this case to another shareholder of dividend-paying companies who reinvests dividends. In this comparison, the shareholders' total income level determines which of these two shareholders pays less in taxes. My conclusion is that "in most cases, capital gains taxes are lower than dividend taxes."

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    2. What I am trying to say is that dividends always include corporate taxes which have been paid on the shareholder's behalf. Capital gains may not include any tax at the corporate level. Therefore total tax (your share of corporate tax plus your personal tax) paid is almost always lower on cap gains, sometimes significantly

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    3. @Garth: Dividend-paying stocks experience goodwill growth too. This means that some of their growth is not directly related to this year's earnings. So dividend stocks grow some capital gains without associated tax at the corporate level. And some non-dividend-paying stocks flame out and produce capital losses.

      I'm convinced that these other factors are mostly a wash and that we can just compare dividend tax rates to capital gains tax rates (with or without dividend reinvestment and capital gains deferral, depending on the shareholder's needs).

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  2. Aren,t the corporate-level taxes paid on income before it is distributed to shareholders analogous to an employee who has taxes withheld at source? Does the employee think (s)he paid no taxes and earned tax free income just because they didnt remit a cheque to the receiver general in April?
    The claims about earning tax free dividend income seem disingenuous at best, downright deceptive or mischevious in the worst case.

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    1. @Eric: I doubt many people are actually trying to be deceptive. Some are misguided. It's normal to ignore some factors in a given context. If I say my first $11k or so of income each year is tax-free, I'm ignoring the HST I paid when I spent that money. I wasn't trying to deceive -- it's just normal to ignore certain factors in a given context. When people with low enough income say they get dividends tax-free, they just mean they don't pay any income taxes directly themselves. Whether they are misguided depends on the type of comparison they're making, as I explained in the article.

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  3. You are really poking the Dividend Bear here... let me just get my popcorn and wait for the contrary arguments.

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    1. @Alan: So far, I've just had comments from people who aren't dividend cheerleaders. Maybe the other side will show up too.

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