Tax on Dividends Simplified 

The Income Tax Act in Canada encompasses more than just income tax. While Part I deals with income tax, other parts impose specific taxes under certain conditions. These taxes supplement income tax and prevent avoidance or unintended benefits. Corporations typically enjoy lower tax rates than individuals, and the Canadian Government has implemented measures in the Income Tax Act to restrict this lower rate to active business income, not passive income. 

Part IV of the Act, focusing on “Tax on Taxable Dividends Received by Private Corporations,” is one such measure. It applies a 38 1/3% tax on “assessable dividends” received by private corporations. This provision is complex, with various definitions and exceptions influencing its application. 

Key points about Part IV Tax include: 

• Applicability to Private Corporations: Part IV tax concerns only private corporations. Public corporations, trusts, individuals, or partnerships are not subject to this tax. 

• Taxable Dividends: The tax applies only to taxable dividends. Tax-free dividends, like capital dividends, are exempt. 

• Connected Corporations Exception: Dividends from connected corporations (controlled by the recipient or where the recipient owns significant shares) are not subject to this tax. It primarily targets dividends from investment shares. 

• Assessable Dividends: Not all taxable dividends are assessable. Assessable dividends are specific types that are eligible for deduction under certain sections of the Income Tax Act. 

If Part IV tax is applicable, the corporation must pay the tax and maintain a Refundable Dividends Tax On Hand (RDTOH) account. This account tracks RDTOH paid on dividends received. Corporations can receive a refund from the government when they pay dividends to individuals, at a rate of $1 for every $3 of dividends paid, provided there’s sufficient RDTOH in the account. 

The rationale behind this system is to pre-pay tax on investment dividends, removing the deferral advantage of earning such income through a private corporation. It’s designed to be equal to or higher than the highest individual marginal tax rate, discouraging investment income through corporations. 

Additionally, Part IV tax complements the tax on Aggregate Investment Income, which is taxed at over 49% for Canadian Controlled Private Corporations. This high rate discourages earning investment income through corporations. Aggregate Investment Income includes taxable capital gains exceeding allowable capital losses and income from property (rent, interest, royalties), but not dividend income. 

In summary, when planning investment and wealth strategies, it’s crucial to consider the impact of the tax on Aggregate Investment Income and Part IV tax, as they are designed to deter shareholders from using corporations for non-active business income purposes.