The eligible dividends regime was designated to eliminate the double taxation for the corporate tax and distributions (dividends) to individual shareholders, from corporate earnings that did not benefit from lower corporate tax rates, such as the Small Business Deduction.
Before the introduction of the eligible dividends rules, it was common tax planning to "bonus down" corporate earnings in excess of the Small Business Deduction. The reason for this was that any earnings in excess of the Small Business Deduction were taxed at higher corporate tax rates, however there was no preferential tax regime for distributions to shareholders from income taxed at higher rates. The compensation for the shareholders of a Small Business Corporation was a combination of a salary (bonus) and dividends.
Since the new eligible dividends rules were enforced, corporate income taxed at higher rates (i.e., in excess of the Small Business Deduction), is eligible for an enhanced dividend tax credit when distributed to the individual shareholders, which means lower personal tax rates.
Although the eligible dividends rules are complex, we will illustrate the concept with the following example:
Corporate income eligible for the Small Business Deduction (currently up to $500,000) is taxed in Alberta at a combined provincial and federal tax rate of 14%. The top marginal personal rate for individuals receiving dividends from income taxed at the low corporate rate is 29%, for a combined corporate and personal tax rate of 43%.
Corporate income not eligible for the Small Business Deduction is taxed in Alberta at a combined corporate rate of 25%. Dividends paid out of income taxed at the higher rate (eligible dividends) are taxed in the hands of individuals at a 19% rate. In this case, the combined corporate and personal tax rate is 44%.
Corporations have to designate dividends as eligible. Reasonable efforts must be made to notify all shareholders about designation through directors' resolution, letters to shareholders, etc.
For dividends paid after March 28, 2012, a corporation is allowed to partially designate a taxable dividend as eligible.
Where the amount of designated eligible dividends is in excess of the cumulative corporate balance eligible for such designation, the corporation is liable for a special tax equal to 20% of the excess amount. There are also special anti-avoidance rules that can increase the tax up to 30% of the entire amount of dividends paid.
Your trusted accountant provides tax assistance for understanding the eligible dividends regime and the potential pitfalls and planning opportunities.