What it means
Company profits are taxed at the corporate level before anything is distributed. When a shareholder then receives a dividend and pays personal income tax on it, that same profit is taxed a second time, which is the double taxation problem the credit is designed to soften.
The mechanism usually works in two steps. The dividend is first grossed up, meaning it is increased on the tax return to approximate the pre-tax profit the company earned, and then a credit is subtracted from the tax bill to represent the corporate tax already paid.
The practical effect is that dividend income is taxed more lightly than interest income at the same marginal rate. This is why business owners and retirees pay close attention to whether income arrives as salary, interest or a dividend, since the after-tax difference on identical gross amounts can be several thousand dollars a year.
Systems differ in generosity, and most distinguish between dividends paid out of profits taxed at the full corporate rate and those paid out of profits that already enjoyed a small-business rate. The first category attracts a larger gross-up and a larger credit; the second attracts a smaller one, because less corporate tax was paid in the first place.
An important limitation is that the credit is generally non-refundable, so it can reduce tax owing to zero but does not generate a refund on its own. Dividends held inside a tax-sheltered account usually get no credit at all, because there is no tax to offset, which occasionally makes a taxable account the better home for dividend-paying shares.
In practice
Real-world examples.
Example
A retired couple restructure their portfolio so that dividend-paying shares sit in their taxable account and bonds sit in their sheltered account. The dividend tax credit only helps in the taxable account, so the switch lowers their combined tax bill without changing their overall asset mix.
Example
The owner of a small consulting company asks her accountant whether to take another $40,000 as salary or as a dividend. The accountant models both, factoring in the smaller gross-up and credit that apply to small-business-rate profits, and finds the dividend leaves more after tax at her income level.
Example
A young graduate with very little other income receives $2,000 in dividends from an inherited share portfolio. Because her tax before the credit is already close to zero, most of the credit is wasted, since it cannot be refunded or carried forward.
Formula
Calculation
Tax payable on dividend = (Cash dividend x (1 + gross-up rate) x Marginal tax rate) - (Grossed-up dividend x Credit rate).
An investor receives a $1,000 eligible dividend and faces a 33% combined marginal tax rate, with a 38% gross-up and a credit worth 15% of the grossed-up amount. The grossed-up dividend is 1,000 x 1.38 = $1,380. Tax before the credit is 1,380 x 0.33 = $455.40. The dividend tax credit is 1,380 x 0.15 = $207.00. Net tax payable is 455.40 - 207.00 = $248.40, so the effective rate on the $1,000 of cash received is 248.40 / 1,000 = 24.84%. Had the same $1,000 arrived as bank interest, tax would have been 1,000 x 0.33 = $330.00, so the credit is worth 330.00 - 248.40 = $81.60 on this single dividend.Case study
Seen in the real world.
Northbank Tooling is a fictional family-owned manufacturer used here purely as an illustrative example. Its two owner-directors had historically taken all their income as salary, largely out of habit, and the company paid corporation tax on whatever profit remained.
Their adviser ran a comparison for one year in which each director needed $90,000 of income. Taking the last $30,000 as an eligible dividend rather than salary meant the company lost a deduction and paid more corporate tax, but the directors' personal tax fell because the gross-up and credit combination taxed that slice more lightly than employment income.
The illustrative point is that the credit cannot be judged in isolation. Once payroll contributions, the loss of pension room and the company's own tax rate were added in, the net saving was real but far smaller than the headline rate difference suggested, and the answer flipped entirely at higher income levels.
Watch out
Common mistakes.
- Treating the grossed-up dividend as actual income received, when it is a notional figure used only to calculate tax and never lands in the bank account.
- Assuming every dividend attracts the same credit, when dividends paid from small-business-rate profits carry a smaller gross-up and a smaller credit.
- Holding dividend shares inside a tax-sheltered account and still expecting the credit, which is not available where the income is not taxable in the first place.
Questions
People also ask.
Why is a dividend grossed up before tax is calculated?
Because the gross-up estimates the pre-tax profit the company earned, so the credit can then be sized to match the corporate tax already paid on it.
Can an unused dividend tax credit be carried forward to a later year?
Generally no, since the credit is non-refundable and is lost if there is not enough tax payable to absorb it.
Do foreign dividends qualify for the credit?
Usually not, because the company paid tax to another government, and a separate foreign tax credit mechanism normally applies instead.
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