Non-Eligible Dividends

A Non-Eligible Dividend is a type of dividend paid to shareholders by a Canadian corporation that qualifies for a lower dividend tax credit (DTC) compared to its more glamorous cousin, the “eligible dividend.” Think of it as a dividend with slightly less tax-fighting power. This distinction is unique to the Canadian tax system and is rooted in the principle of tax integration. The core idea is to ensure that income earned through a corporation and distributed to an individual is taxed at roughly the same rate as if that individual had earned it directly. Non-eligible dividends typically come from the profits of a Canadian-controlled private corporation (CCPC) that have been taxed at a lower corporate rate, thanks to the small business deduction. Because the company paid less tax upfront, the government “claws back” some of that tax advantage from the shareholder through a less generous tax credit.

Why create two classes of dividends? It all comes down to fairness in the eyes of the taxman. Canada has two main tiers of corporate income tax: a general rate for large companies and a much lower rate for small businesses on a certain amount of their income. This lower rate is a powerful incentive to help small businesses grow. However, this creates a potential imbalance. If the dividends from both high-tax and low-tax companies received the same tax credit, investors receiving dividends from small businesses would get a huge tax break. To prevent this, the system is designed to “integrate” corporate and personal taxes.

• Eligible Dividends: Paid from corporate income that was taxed at the higher, general rate. The shareholder receives a larger dividend tax credit to compensate for the higher tax already paid by the company.
• Non-Eligible Dividends: Paid from corporate income that was taxed at the lower, small business rate. The shareholder receives a smaller dividend tax credit, reflecting the smaller tax bill the company initially paid.

It’s a balancing act designed to level the playing field between earning income directly and earning it through a corporation.

For the average investor, the key difference appears on your tax return. The process of taxing a non-eligible dividend involves a bit of financial gymnastics known as the “gross-up and credit” system.

Let's unravel this tax puzzle with a simple example. Imagine you receive a $100 non-eligible dividend.

1. Step 1: The “Gross-Up”
   • First, the dividend amount is artificially inflated, or “grossed-up,” to estimate the company's pre-tax profit that generated the dividend. For non-eligible dividends, the federal gross-up rate is 15% (note: tax rates can change).
   • Calculation: $100 x 1.15 = $115. This grossed-up amount is what you add to your taxable income.
2. Step 2: Calculate the Tax Credit
   • Next, you calculate your dividend tax credit, which directly reduces your tax bill. For non-eligible dividends, the federal DTC is 9/13ths of the gross-up amount.
   • Calculation: $115 (the gross-up amount) x (9 / 13) = $10.08 (approximately).

So, you report $115 of income, calculate the tax on it at your marginal rate, and then slash $10.08 directly off your final tax bill. Provincial dividend tax credits will reduce your tax bill even further.

As a value investor, it's easy to get bogged down in tax details, but it's crucial to see the bigger picture.

• Focus on the Business, Not the Tax Label: A dividend is a return of profit. The quality, durability, and growth potential of the underlying business are infinitely more important than the tax classification of its dividend. A fantastic small company growing its earnings and paying a non-eligible dividend is often a better investment than a mediocre large company paying an eligible one.
• Total Return is King: Your goal is to maximize your total return, which combines capital gains and dividend income. Don't let the tax tail wag the investment dog. The difference in tax rates on dividends is often marginal compared to the potential for significant capital appreciation from a well-chosen stock.
• Context for Non-Canadian Investors: If you're an American or European investor receiving dividends from a Canadian company, this distinction is largely academic for your personal tax filing. Your dividend income will typically be subject to a Canadian withholding tax (often 15%, depending on tax treaties), and you'll file according to your own country's rules for foreign dividends. However, knowing a company pays non-eligible dividends tells you it's likely a smaller, private entity, which is a valuable piece of analytical information.