The devil in the details

They say the devil is in the details and there were several of them in Finance Minister Ralph Goodale’s pre-election announcement on income trusts and reduced taxes on dividends.

For instance, it has yet to dawn on many people that the dividend tax cut that starts in 2006 does not extend to small businesses. Only payments made by large corporations qualify and they account for less than 40 per cent of all dividends paid in Canada.

Another devil lurks in the suggestion that the Goodale plan will create tax parity between income trusts and corporations. It will — but only once the corporate tax rate falls to 19 per cent which is not due to happen until 2010.

But the devil that really concerns me relates to the method used to calculate the dividend tax credit. The Goodale formula will compound an already-existing injustice in the tax system and could have an adverse effect on thousands of unsuspecting taxpayers.

Under the current rules, dividends must be “grossed-up” by 25 per cent and this higher amount is declared as income on your tax return. So if you receive $10,000 in dividends, you have to declare $12,500. The tax credit of 13.33 per cent, which is lculated later, then compensates for that.

The problem arises because the grossed-up amount is used in the calculation of net income. That figure, in turn, is used to determine eligibility for a several types of income-tested benefits, such as the child tax credit. Of special concern to seniors is the fact it is also used to ascertain whether an individual is subject to the 15 per cent Old Age Security clawback tax.

Every year people are being penalized on the basis of phantom income — money that never passed through their hands and which only exists because of an artificial tax calculation. Mr. Goodale’s plan will raise the gross-up to 45 per cent, which would mean that for every $10,000 actually received a taxpayer would have to declare income of $14,500! That could lead to even more serious inequities.

I have been concerned for some time about the gross-up formula for calculating the dividend tax credit and have received numerous complaints about it over the years, mainly from older Canadians who have been hit by the OAS clawback. Now that the problem is going to get worse, I contacted the Finance Department and requested a rationale for using the gross-up as opposed to simply declaring dividends actually received and applying a higher credit.

For example, under the existing formula $10,000 in dividends is grossed-up to $12,500 which is then multiplied by 13.33 per cent to produce a tax credit of $1,666. You would get exactly the same credit by multiplying $10,000 by 16.66 per cent. So why the convoluted process?

Finance replied to me as follows: “Basing income-tested benefits on grossed-up dividend income reflects the fact that a greater proportion of dividend income is available after-tax to meet personal consumption needs than for other sources of income.”

In other words, Finance seems to believe that a certain category of Canadians should be penalized financially if some of the income they receive is tax-advantaged. That logic is questionable to begin with but when we look more closely we discover that, if this is what Finance truly believes is right, it is only applying the principle selectively.

I replied to Finance as follows: “Why doesn’t the same principle apply to capital gains? A greater proportion of income from that source is also available after-tax to meet consumption needs. But in fact only 50 per cent of actual capital gains is included in the total income calculation at line 127 of the tax return. This seems to be at odds with the logic given for including grossed-up dividends at line 120.”

They didn’t have an answer to that one. The response I received said simply: “We are aware of certain issues surrounding the income used to establish income-tested benefits and are looking into it.” (Although I dealt with real people, the ground rules are that their comments can only be attributed to a “spokesman”)

That’s well and good, but what has taken so long? This problem has been around for many years. Perhaps it took Mr. Goodale’s 45 per cent gross-up plan to convince officials that it finally needs to be addressed. Whatever the cause, let’s hope we will finally see an end to this basic inequity in the tax system.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder subscriber: