The Minister of Finance released for public comment on 29 June 2006 draft legislative changes to lower the income tax rate on dividends paid by large Canadian corporations to Canadian individual shareholders. The impetus behind the legislative amendments is the need to improve tax neutrality, and to achieve a more balanced tax treatment of corporations and publicly listed flow-through entities (such as income trusts).

Current system

The current dividend tax credit (DTC) system only partially offsets the double taxation that arises from the fact that dividends are paid out of a corporation's after-tax income, and are also taxable in the hands of the shareholders who receive them. Resident individual shareholders who receive dividends are required to "gross-up" the amount included in their income in respect of the dividend (to reflect the pre-tax income of the corporation). When computing tax payable, however, the shareholder deducts a DTC in recognition of the corporate tax.

Double taxation is generally eliminated for dividends paid out of income benefiting from preferential tax rates, such as the small business rate, but not for dividends paid by large corporations that do not benefit from preferential rates.

Proposed system

The proposed system will generally eliminate the double taxation of dividends paid by large corporations that do not benefit from preferential rates at the federal level.

The draft legislation requires an individual taxpayer who receives an "eligible dividend" from a corporation resident in Canada to include in its income a gross-up of 45% of the dividend. The draft legislation then provides for a tax credit equal to eleven-eighteenths of the amount of the gross-up. A dividend is an eligible dividend if the dividend-paying corporation has given the dividend recipient written notice to that effect.

From the dividend-paying corporation's perspective, an eligible dividend is any dividend the corporation designates to be one. However, some corporations will have a limited capacity to pay eligible dividends. If their designations exceed that capacity, they are liable to a special tax. That tax applies to the excess amount or, if the corporation can reasonably be considered to have attempted artificially to increase its capacity to pay eligible dividends, to the full amount of the eligible dividend.

A corporation's capacity to pay eligible dividends depends mostly on its status. If a corporation is a Canadian-controlled private corporation (CCPC) or a deposit insurance corporation, it can pay eligible dividends only to the extent of its "general rate income pool" (GRIP) – a balance generally reflecting taxable income that has not benefited from the Sec. 125 small business deduction or any of certain other special tax rates.