Tax experts say ottawa’s move to lower income taxes on eligible Canadian corporate dividends may cause owner-manager clients to change the way they pay themselves.

Having traditionally paid themselves by “bonusing out” income left in their firms at the end of the year, they may choose instead to pay themselves dividends.

“Taking an eligible dividend may start to look a whole lot better,” says Heather Evans, partner and tax lawyer in the Toronto office of Deloitte & Touche LLP.

It had been widely recognized that the tax treatment of income, such as bonuses, was better than the tax treatment of dividends. As a result, the Canada Revenue Agency traditionally hasn’t questioned the “reasonableness” of bonuses to owner-managers. “This may now change,” Evans says.

Federal changes in the taxation of dividends assume that the provinces will make similar changes to lower taxes on dividends. If all provincial governments follow suit, Ottawa is projecting that full integration of the tax treatment of eligible dividends will occur in 2010, when the average combined federal/provincial tax rate is expected to be 32%, says Jamie Golombek, vice president of tax and estate planning at Toronto-based AIM Funds Management Inc. and chairman of the Investment Funds Institute of Canada‘s tax issues committee.

But changes in executive payment methods depend on whether all the provinces support integration. To date, only Manitoba and Quebec have announced their intentions to harmonize their tax treatment of eligible dividends with that of Ottawa’s.

Aurele Courcelles, manager of tax and estate planning at Investors Group Inc. in Winnipeg, points out that Manitoba has not only taken Ottawa’s lead, but has also “significantly” increased its dividend tax credit to 11% from 5%.

Depending on what other provinces do, combined with the federal promise to lower corporate taxes to 19% from 21% in 2010, he says, “The traditional approach to bonusing down will have to be reviewed on a case-by-case basis.”

Draft legislation released by the feds in June aims to make total personal and corporate income taxes on dividends comparable to taxes paid on income and interest. The proposed tax change is intended to eliminate a long-standing inequity known as “double taxation”: dividends paid out of a corporation’s after-tax income are also taxable in the hands of the individual taxpayer who receives the dividends.

To help taxpayers avoid double taxation, both Ottawa and the provinces allow taxpayers to “gross up” their income to reflect the taxes already paid by the corporation that paid the dividend. The next step is to apply federal and provincial dividend tax credits, which lower the amount of taxes to be paid.

The new tax change will apply retroactively to “eligible” dividends paid out after 2005. Eligible dividends include any dividends paid by public or Canadian-controlled private corporations from income (but not passive-investment income), unless the income is subject to the preferential treatment available for small companies — a deduction on the first $300,000 of active business income.

Under the old rules, this combined gross-up and dividend system worked well for small Canadian-controlled companies because of their preferential tax treatment. Traditionally, they could pay out a bonus to shareholders, such as an owner or manager, to reduce income in the corporation to the $300,000 threshold. But at large public firms, a certain amount of double taxation has been a reality.

In the 2006 federal budget, Ottawa announced an increase in the amount of the gross-up to 45% from 25%, and an increase in the amount of the federal dividend tax credit to 19% from 13.33%.

Meanwhile, IFIC’s tax issues committee plans to lobby for two changes in the draft legislation. The first relates to a technical oversight, Golombek says: the draft does nothing to amend the federal Income Tax Act’s trust provisions to allow eligible dividends to flow through to a trust beneficiary.

The second is central to the mutual funds industry. Most mutual funds, set up as trusts, have a Dec. 15 yearend. That means, for the 2006 tax year, dividends paid out during the last 15 days of December 2005 will not be considered “eligible” under the proposed legislation.

Ottawa has to clarify how those dividends will be treated, says Golombek. Otherwise, it could result in complex tax reporting for mutual fund trusts this year and incur the expense of educating investors when tax slips are issued.

@page_break@The federal Finance Department has requested comments on the draft legislation by Sept. 15. Legislation is expected to be introduced in the House of Commons this fall. IE