Thursday, August 24, 2006

Effects Vary in Dividend Tax Change

The Toronto Star, James Daw, 24 August 2004

Say you had about $30,600 to invest in dividend-paying company shares.

The right selection of stocks would now pay about $1,000 the first year, but could pay $1,900 within five years.

Such a growth in income is not guaranteed. But it would occur if dividends continued to rise at the pace of a couple of dozen companies that Thomas Connolly of Kingston has tracked for his limited-circulation Connolly Report newsletter.

Share prices of those companies have risen as dividends went up. For example, buyers of Sun Life Financial Inc. saw their shares rise to $45.55 from $37 during the five years ended Aug. 18. Meanwhile, their annual dividends rose from 48 cents a share to $1.20. This sort of performance made Sun Life shares a better hedge against inflation than the interest paid on government bonds, Connolly argues.

A dividend investment strategy will get even better this year after enhancements to dividend tax credits announced by Ottawa and Ontario.

The changes will raise to $41,285 a year the amount of income, coming entirely from dividends, that an investor in a public Canadian company or shareholders of substantial family businesses would be able to receive tax free.

But the taxation of dividends is both bizarre and complicated. Before the newly enhanced credit is applied, the taxpayer will have to count each dollar of dividend income as $1.45. This will result in an increase in the income level used to determine eligibility for certain government assistance programs, explains Jamie Golombek, vice-president of tax and estate planning at AIM Trimark.

Many taxpayers will need more than a new tax preparation software package to figure out the net benefit from earning this particular form of income.

The enhancement to the dividend tax credit is intended to ensure that the total of taxes paid by corporations and their shareholders is not greater than what the shareholder would pay on a dollar of wages or interest.

Previously the tax credits only neutralized double-taxation at the level of corporate taxes paid by private corporations, which enjoy a preferred rate of tax on their first $300,000 of profit, or $400,000 starting next year. The enhanced credit, which will not apply to dividends paid from that first level of profits, will address the double-taxation problem for more profitable private firms and for public corporations.

This change will help to put corporations on a more equal footing with the growing number of enterprises that have rolled themselves into income trusts so that their distributable cash flow will only be taxed in the hands of investors.

This year in Ontario, no one will pay more than 25.08 cents in federal and Ontario income taxes per dollar of eligible dividend income, according to KPMG LLP. Ontario has promised changes over the next five years that would reduce the maximum tax on dividends to 24.6 per cent, 23.9, 23 and finally 22.3 per cent.

Last year, those with incomes of more than about $131,000 from dividends alone would have paid a combined tax rate of 31.3 per cent on additional dividends. The top rate by 2010 will be lower than the tax for capital gains.

Only a minority of Ontario taxpayers would pay more than zero to 7 per cent in taxes on dividend income. But, at certain levels of individual or family income, they would forfeit other income-support benefits by choosing dividend income.

When the taxpayer multiplies or grosses-up his or her actual dividend income by 45 per cent, this higher amount is recorded as net income on the tax return. It's this definition of income that affects eligibility for other government support programs, Golombek said.

The most extreme impact from grossing up dividend income would be for those poor retirees eligible to collect a tax-free, guaranteed income supplement to their Old Age Security. That supplement is reduced by 50 cents for each additional dollar of net income above a minimum threshold.

Counting each extra dollar of dividend income as $1.45 would cost these seniors no taxes but they would lose 72.5 cents of the income supplement dollar. Other families would see a much lesser impact on certain tax credits, child tax benefits and, at income levels above $62,144 for 2006, the basic Old Age Security for those older than 65.

By my calculations, a high-income senior who suddenly inherited $30,600 would have a few extra dollars to spend after taxes and the claw back of Old Age Security if he or she chooses to earn $1,000 of dividend income over $1,300 in interest from a 10-year government bond. Their extra spending power would grow if dividends continued to rise as in the past.

"I don't think the Old Age Security claw back would change my investing habits," Connolly says. "I will get both dividend growth and capital growth if my dividends go up."

Jason Safar of the accounting firm PricewaterhouseCoopers says, however, "everyone has to work out their individual situation. It's too complicated to generalize."