The Power of Dividends. by Douglas M. Parker CA CFP Partner Director of Taxation Wilkinson & Company LLP

Transcription

1 by Douglas M. Parker CA CFP Partner Director of Taxation

2 1. Overview 2. The role of Income Tax in investing 3. After-tax yield is the goal 4. Investing reality we face to day yields and returns 5. Income Tax on Dividends vs. Interest 6. How the Dividend Tax Credit Works 7. Tax Brackets and Progressive Tax Rates 8. Marginal Tax Rates on different types of Income 9. Example of Interest/Dividend taxes at three levels 10. Principles from tax rates 11. The Tax-factor 12. Future Tax Rates 13. Dividend income is your only income 14. Income Splitting and the 1% prescribed rate 15. Income trusts and dividends Page 2

3 I am a Chartered Accountant, specializing in income tax matters I am not a licensed broker who can sell securities I am not an economist My talk should not be interpreted in any way as giving financial advice on the purchase or sale of any security or any category of securities The focus of today s talk is the role of income tax and its effect on investment decisions Page 3

4 Tax Caveat While income tax is important in the determination of investments, it is certainly not the sole determinant The tax tail should not wag the dog Income tax legislation changes, and sometimes changes quickly Eg. Tax in income trusts, Ontario tax rates, tax on eligible dividends No two taxpayers are alike, specific results will differ between two taxpayers who have the same interest or dividend income Page 4

5 The after-tax yield is far different for dividends received by an individual than interest It is the after-tax yield that is the most important income determinant to an investor (rather than the pre-tax yield) The after-tax yield must also take into account other factors, including: Capital gains and losses on the security when sold Currency exchange risk Inflation risk Page 5

6 Theme of today s presentation: The after-tax yield on eligible dividends to Canadian resident individual shareholders is extremely attractive today compared to other forms of income, in particular, interest income Page 6

7 Eligible Dividends Predominantly dividends received in 2006 and thereafter from Canadian public companies. Sometimes, but rarely, they can also be dividends from privately held companies (see next page) Does not include foreign corporation dividends Can include Canadian corporations that pay US$ dividends Canadian resident individual shareholders You and me, but not corporations Does include personal trusts Page 7

8 Private companies (CCPC s) pay less tax on their active business income, so they do not normally pay eligible dividends. The dividends they do pay attract more tax than eligible dividends. If a private company receives eligible dividends, it can pass them on as eligible dividends to the shareholder DRIP --- eligible dividends can be automatically reinvested into shares of the paying corporation --- they are still taxed as eligible dividends but the growth in the value of the portfolio leads to compounding growth --- higher capital appreciation. Page 8

9 Current Basic Economic Reality Declining yields of interest rates over the past 10 years --- long gone are the days of 8% yields on highly rated corporate bonds and government T- Bills The stock market value has declined in the past 10 months by 49.8% to March 9 th, which most analysts concur was a market bottom The Economic analysts and backyard pundits all agree that the current uncertainty is not going to go away any time soon. This is a time of paradigm shift Page 9

10 Old adages that don t work anymore The stock market goes up when interest rates fall is gone - -- we have both low interest rates and a declined stock market Interest rates and dividend yields moved in tandem if one went up so did the other, but that has not happened Interest rates are at their all time low Dividends are at a high point, although not necessarily the highest yields on record, (but close). The markets are all knowing or perfect if that were the case, we wouldn t have these wild fluctuations Page 10

11 Why is it that dividends attract less tax to the Canadian individual investor compared to interest? Answer dividends are paid out of after-tax corporate income, interest is paid out of pre-tax corporate income. Put another way: dividends come from income that has already been taxed Attempt to level the overall playing field is called integration of the tax system between companies and individuals Comes from the Royal Commission on Taxation (Carter Commission) in 1971 Operate through the Dividend Tax Credit Mechanism ( see next page for illustration) Page 11

12 Illustration of Dividend Tax Credit Theoretical rates at top bracket Corporate Income $100 Corporate tax 31 Dividend to individual 69 Individual Dividend Grossed up (45% gross up) 100 Net personal tax 15 Total tax Corporate and Personal 46 Total tax if not incorporated 46 Difference $0 April

13 Public vs Private companies Public companies pay about 31% tax rate, private companies pay 16.5% on their active business income Resultant dividend tax credit is therefore different, and the dividend tax credit on private companies is much smaller BUT Do we really care about the underlying tax paid by a public company whether they pay tax or not is irrelevant, the dividend we receive is the relevant aspect? Page 13

14 Canadian personal income tax system Progressive tax rates The more we make, the higher the marginal tax rate The marginal tax rate is the incremental tax on an additional $100 of income Usually in investment decisions we are more interested in the marginal tax rate, rather than the average tax rate Federal and Ontario Gov t have changed the personal tax rates and have proposed to markedly drop the corporate tax rates. Page 14

15 2008 Personal Marginal Tax Rates Taxable Income Regular Eligible Capital From To Income Dividends Gains 0 36, % -7.13% 10.53% 36,020 37, % -2.63% 12.08% 37,885 63, % 7.52% 15.58% 63,432 72, % 8.14% 16.49% 72,041 74, % 11.64% 17.70% 74,722 75, % 13.81% 19.71% 75, , % 19.61% 21.71% 123,184 and up 46.41% 23.96% 23.21% April

16 2008 Personal Marginal Taxes Comparison of Dividends to Interest Income Marginal Marginal tax - Interest tax - dividend 25,000 $ $ (71.27) 50,000 $ $ ,000 (no clawback) $ $ ,000 (clawback) $ $ ,000 $ $ Note: - Marginal tax is on $1,000 of income April

17 Principles to derive from previous overhead Eligible dividends are always less taxing than interest The after-tax yield on an eligible dividend is always greater than the after-tax yield on interest, for the same pre-tax yield The difference between the two is greater at lower tax brackets than at the top tax bracket Eg. The tax on interest is over 4 times higher than a dividend at $50,000 of income compared to the top tax bracket where it is about 2 times higher At lowest tax bracket the tax is negative (see next overhead) Page 17

18 Lowest income tax bracket leveraged dividends Individual has $25,000 of other income Individual borrows $50,000 and earns 5% dividend, incurs 5% interest cost Cash flow Eligible dividend (real $) $2,500 Interest expense $2,500 Tax reduction (savings) $704 Page 18

19 At the lowest tax bracket, you actually save money by investing in eligible dividends; you pay in the case of interest At the lowest tax bracket, eligible dividends may be better than a Tax-Free Savings Account (TFSA) Capital gains are always less taxing than interest, but only better than eligible dividends at the top tax rate otherwise eligible dividends are always superior to both. Page 19

20 Combine the fact that eligible dividends attract less tax with the fact that eligible dividend yields are higher than interest yields is where dividends become POWERFUL Assume that $50,000 invested can yield 2% interest or 5% dividends. The next overhead illustrates the comparable after-tax yield on interest vs. eligible dividends for an individual who otherwise has $50,000 of income and has $50,000 to invest. Page 20

21 $50,000 invested to earn 2% interest will yield, after-tax, $689 $50,000 invested to earn 5% eligible dividend will yield, after-tax, $2,312 That is an increase of $1,623 or a factor of 3.36 times superior!! Note: for an individual who otherwise earns $50,000 I am not comparing apples to apples Page 21

22 The tax Factor What effective pre-tax interest equals an eligible dividend? At the top tax bracket A dollar of dividend equals times that as interest Eg. A 5% dividend equals a 7.095% interest rate (pre-tax) At $50,000 A dollar of dividends equals times that as interest Eg. A 5% dividend equals % interest rate (pre-tax) Page 22

23 The future of Income Tax on Dividends The federal Government is dropping the income tax payable by public companies to the year 2012 The federal government and the province of Ontario are reducing the dividend tax credit on eligible dividends correspondingly to compensate for this lower corporate tax The result is that eligible dividends will face increasing income tax in the future See next overhead for the future income tax rate at the top bracket Page 23

24 Future Income Tax Rates 2008 to 2012 Top Tax Bracket Year Interest Eligible Dividends % 23.96% % 23.06% % 26.57% % 28.19% % 29.54% April

25 Eligible dividends will face increased income taxation throughout all of the tax brackets because both the Federal and Ontario gov ts will reduce the effective dividend tax credit 2009 is the best year, with the lowest tax rate, to earn eligible dividend income There will still be a significant savings of eligible dividends over interest income Eg. Tax factor at the top rate will decline from the 2008 rate of to in Eg. A 5% dividend will equal a 6.575% interest (pre-tax) in 2012 Page 25

26 Interesting statistics If your income was solely from eligible dividends, the amount that you can earn, without any income tax consequences are: Personal tax credit only $49,600 Student with $7,000 tuition $56,600 Note: Ignores the Ontario Health premium of $600 to $750. That amount would double for a spouse, each earning eligible dividends This is for 2008 Page 26

27 Income Splitting If two spouses have disparate incomes, the ability to move income from the high income earner to the low income earner can lead to a permanent tax savings Attribution rules in the Income Tax Act ruin all the fun! Income, or capital gains, on assets transferred to a spouse attribute back to the transferor for tax purposes Page 27

28 There are two exceptions to the attribution rule: Assets are sold to the spouse at fair market value and the transferee pays for those assets, or A loan is made to the transferee spouse, the loan bears interest at the prescribed rate at the time the loan is made and the interest is paid in the year or 30 days after the year end The prescribed interest rate for the 2 nd Quarter is 1%! Page 28

29 Example The Power of Dividends Wife has top rate income, husband does not Wife lends $100,000 to husband at 1% Husband earns 2% interest on funds borrowed (or earns 5% dividends) on funds borrowed Husband has $25,000 of other income If transaction was not undertaken, wife would have paid tax on that income at the highest rate See next overhead for results Page 29

30 Attribution example Interest income Wife Husband Interest Income: Interest $ 2,000 Less paid to wife $ 1,000 $ (1,000) Personal income tax $ 464 $ 210 Decrease in income tax $ 254 Total family cash inflow $ 1,326 April

31 Attribution example Dividend income Dividend Income: Dividend $ 5,000 Less paid to wife $ 1,000 $ (1,000) Personal income tax $ 464 $ (567) Decrease in income tax $ 1,031 Total family cash inflow $ 5,103 April

32 If the wife did not split the interest income with the husband, she would have paid $928 on the $2,000 on the interest. The income splitting has reduced the tax to $674, or a savings of $254 If the wife did not split the dividend income with the husband, she would have paid $1,198 on the dividend. The income splitting has reduced the tax to a recovery of $103, or a savings of $1,301. (Plus, as an added bonus, they have made $5,000 of dividends vs $2,000 of interest --- an overall savings of $4,031) Page 32

33 Income Splitting some notes Moving income to one spouse may reduce OAS clawback, (or increase it) Moving income to a spouse that has no income may be of less benefit because of the loss of personal exemptions Some benefits, such as the age credit, are not affected by the family income, others such as the Ontario property tax credit are based upon family income Consider splitting CPP benefits and pension income Page 33

34 Halloween October 31, 2006 Taxation of Income Trusts Trust distributions of income are to be taxed as if they were corporate business income Resultant distribution is to be treated as an eligible dividend the same as if received from a corporation The result, to an individual at the top tax bracket is no change!! (see next overhead) Distribution tax does not apply to capital gains or to return of capital Page 34

35 Income trust distributions Entity: Corporation Old Trust New Trust Rules Rules Pre-tax income in entity $ 100 $ 100 $ 100 Corporate tax (distribution tax) $ 31 $ - $ 31 Net to be distributed $ 69 $ 100 $ 69 Individual: Dividend/distribution $ 69 $ 100 $ 69 Gross-up (45%) $ 31 $ - $ 31 $ 100 $ 100 $ 100 Net personal tax $ 15 $ 46 $ 15 Total tax paid by all $ 46 $ 46 $ 46 Net retained by individual $ 54 $ 54 $ 54 April

36 Income Trusts and the changes Will (for most income trusts) not start until 2011 Does not apply to REIT s Income trusts will be able to rollover into corporations tax-free before 2011 Distributions of return of capital (ROC) will not be subject to the distribution tax RRSP s and non-residents are the real losers when it comes to the change to income trust rules Page 36

37 Again ---- The Power of Dividends I am not an investment advisor --- any advice given on the selection of, or sale of, any investment or any class of investments is to be given by a licensed investment advisor or broker Tax rules change, so advice given today will not always be true in the future No two people are alike, for income tax purposes, so any advice you seek or rely upon should be from your own tax advisor who is aware of your personal situation Page 37