Dividends, taxes and the investor

Value oriented investors are well aware of the positive effects dividends have had on their total returns over time.  A company’s board of directors may decide to pay a dividend to one or more of their class of shares.  They then select a date – referred to as the record date – to determine which shareholders are eligible to receive the dividend.

Dividends are usually paid quarterly and are more common among mature businesses that do not require all of their profits to fund future growth.  Growth oriented companies are less likely to pay dividends as they retain their capital to fund internal growth and in some cases make acquisitions.

Looking at Yield

Yield is often a term associated with value companies (those that pay a dividend).  As noted above, dividends are normally stated as a monetary amount, i.e. $0.50 per share.   If the company pays this quarterly then the total dividends for the year are $2.00.  If the share price is currently at $80, then the yield is 2.5 per cent (2/80).  If the price of the share increases to $100, then the yield drops to 2 per cent (2/100).   If the price of the share decreases to $60, then the yield increases to 3.3 per cent (2/60).

2006 Federal Budget

The 2006 federal budget contained a number of proposed changes to personal and corporate income tax.  One proposed change we would like to highlight is with respect to dividends.  Dividends paid by Canadian public corporations after 2005 will be subject to a 45 per cent gross-up (previously 25 per cent) and a federal dividend tax credit of 19 per cent of the grossed up amount (previously 13.33 per cent).  This change is good news for many investors.

Dividend Gross-Up

This confuses most investors who are trying to do their income tax return for the first time.   The common question asked is that if I received $100 in dividends, why am I taxed as if I received $125 (after 2005 $145).  With the “gross-up” amount you apply your marginal tax rate.  The highest marginal tax rate (combined provincial and federal) in British Columbia for 2005 was 43.7 per cent.

Dividend Tax Credit

What is a tax credit?  The most important component to note is that “credits” are better than deductions.  A credit is generally a dollar for dollar deduction from taxes payable.

Illustrations

Let’s consider an individual who receives $1,000 in dividend income and assume they are subject to highest marginal tax rate and that other income exceeds the basic exemption.

dividends

Investors who continue to receive dividends from Canadian corporations will now end up taking more income home.  Individuals with only registered accounts or hold securities that do not pay dividends will not benefit from this proposed change.

Investors 65 and Over

Individuals 65 and older may qualify for Old Age Security, Age Credit and other government benefits.  In order to qualify for these benefits the government will look at certain line numbers on the tax return to ensure your income is below certain thresholds.  If an individual’s income is too high then these benefits may be reduced or completely eliminated, this is often referred to as the “claw back.”   The increase in the gross-up amount of the dividend may have a muted effect for investors 65 and older.  Although these investors may receive more of their dividend income they may see a portion of their government benefits eliminated or clawed back.  Obtaining an understanding of the various claw back provisions is important to avoid cash going in one pocket while being taken away from another.

A Little Planning

As with every change to the taxation of investments, individuals need to structure their portfolio in a manner that creates the most efficiency.  It is what goes in your pocket at the end of the day that is most important.  Our column next week will highlight a few strategies and compare different sources of income and the related tax benefits.

Before implementing any strategies discussed in our columns we recommend that you speak with your financial and tax advisors.