The Canada Revenue Agency’s policy for the designation of eligible dividends, released in late December, is a soothing antidote to last June’s draft legislation, say mutual fund companies and tax practitioners.

In the recently released policy, the CRA clearly noted that it will accept the designation of eligible dividends on the appropriate tax slips for the 2006 taxation year. The draft legislation, which set out the rules for designating eligible dividends, was dubbed by tax experts as “hopelessly complicated.”

“We were worried that we would have to designate each dividend as eligible. It would be a laborious task,” says Jamie Golombek, vice president of taxation and estate planning at Toronto-based AIM Funds Management Inc. and chairman of the Investment Funds Institute of Canada’s tax issues committee.

“Here’s the CRA trying to make the rules work. It’s a practical response. Hallelujah,” says Robin MacKnight, partner and tax lawyer with Wilson Vukelich LLP in Markham, Ont., as well as chairman of the technical committee of the Society of Trust and Estate Practitioners (Canada).

“If only all our compliance was this simple,” MacKnight adds.

Ottawa’s intentions behind reforming the taxation of Canadian dividends seemed simple enough — stemming the tide of corporate conversions to income trusts and lessening the impact of double taxation on dividends that Canadian corporations pay out. But the actual mechanics involved in diminishing the effect of double taxation raised alarm bells among dividend issuers and tax practitioners.

Dividends paid out of a corporation’s after-tax income are also taxable in the hands of the individual taxpayers who receive the dividends. Although dividends paid by foreign corporations are taxed as ordinary income, Ottawa and the provinces provide tax breaks for investing in Canadian companies.

To reduce double taxation on dividends, Ottawa and the provinces have given investors in Canadian companies a “gross up” of their dividend income that reflects the taxes that have already been paid by the corporation that issued the dividend.

The next step is applying federal and provincial dividend tax credits, which lowers the amount of tax the individual pays on dividend income.

In the 2006 federal budget, Ottawa announced an increase in the amount of the gross-up for “eligible” Canadian dividends — which include any dividends paid by public or Canadian-controlled private corporations from active income, not from passive investment income — to 45% from 25% and an increase in the amount of the federal dividend tax credit to 19% from 13.33%. The June draft legislation confirmed these changes.

Canadian-controlled private corporations get a lower small-business tax rate on the first $300,000 of active business income. Any dividends paid from that income will not be eligible dividends.

Under the old gross-up and dividend tax credit rules, the system worked better for investors in CCPCs because they got the dual benefit of the dividend tax credit and the small business tax rate. Meanwhile, investors in large public corporations generally faced a larger amount of double taxation.

In the draft June legislation, the rules for keeping track of the income that could result in eligible dividends presented significant challenges. CCPC income accumulated beyond $300,000 had to be placed in a general-rate income pool. Eligible dividends could be paid out of the GRIP.

For a publicly traded company, eligible dividends could be paid out of net income, unless the company was a CCPC during the tax year. In that instance, it would probably have a low-rate income pool that had been taxed at the small-business rate. LRIP dividends would be ineligible.

As the legislation puts the onus on each corporation for properly deeming which of its dividends are eligible — and threatened punitive taxes for dividends that the CRA subsequently finds to be ineligible — keeping track of dividend eligibility presented an administrative nightmare, says MacKnight.

However, the CRA has provided a practical solution for 2007 and subsequent tax years. It will accept that a public corporation has notified its shareholders of eligible dividends by posting a notice on the corporation’s Web site, or placing a notice in an annual or quarterly report. Alternatively, a press release declaring a dividend and stating that the dividend is eligible will suffice.

IFIC had two significant concerns about the draft legislation, says Golombek. The first concern is that mutual fund trusts are flow-through vehicles that invest in underlying companies. They are, therefore, dependent on receiving notice from the underlying corporations regarding dividend eligibility before they can then notify their fund investors. And since mutual fund trusts generally invest in public companies, it’s likely that all their dividends would be eligible. However, tax practitioners cautioned that such an assumption could not be technically made under the legislation as written.

@page_break@The CRA’s policy has provided mutual funds with administrative relief. When a trust has received dividends from a corporation but has not designated whether they are eligible before the trust’s deadline for issuing T3 slips, the trust will be able make a “reasonable assumption” that the dividends are eligible. If that assumption turns out to be incorrect, however, the trust must re-issue T3 slips for dividend amounts greater than $100.

IFIC’s other concern, says Golombek, was that many mutual fund trusts have a Dec. 15 year-end. Dividends paid between Dec. 15 and Dec. 31 are reported on trust tax returns for the following tax year. But under the legislation, dividends falling into this period in 2005 do not qualify as eligible dividends for the 2006 tax year. The CRA, though, has provided administrative relief for calculating the amount of ineligible dividends that fall into that period.

The federal government projects the combined federal/provincial top marginal tax on dividends will be as low as 14.6% on eligible dividends, down from the current 24%-37%, depending on the taxpayer’s province of residence.

This will require co-operation from the provinces, says Heather Evans, partner and tax lawyer with Deloitte & Touche LLP in Toronto. To date, Alberta, British Columbia, Newfoundland and Labrador, Saskatchewan, Manitoba, Ontario and Quebec have announced legislation to mirror the federal proposals. IE