Ottawa’s plan to boost the dividend tax credit will leave more after-tax dividend income in the hands of taxpayers, but the windfall may erode seniors’ benefits.

Under the old system, the dividends an individual received from Canadian corporations were “grossed up” by 25% and the grossed-up amount was entered as taxable income on the income tax form. Then, because dividends are paid out of a company’s after-tax profits, the shareholder was compensated with a combined federal and provincial tax credit of approximately 25%.

Under the federal government’s new regime to reduce the tax rate on dividends in order to restore full integration to the corporate tax system, eligible dividends paid in 2006 will be grossed up by 45%, and the investor will receive a federal tax credit of 19%, up from 13.33%.

Ottawa is assuming a combined federal/provincial dividend tax credit of 32%, says Jamie Golombek, vice president of taxation and es-tate planning at AIM Funds Management Inc. in Toronto.

The big question is whether all the provinces will follow Ottawa’s lead to make the system work. To date, only Manitoba, Ontario, Quebec and Alberta have announced plans to adjust their tax systems in response to the federal proposal.

Manitoba has cut its top marginal tax rate on eligible dividends to 23.83% from 35.08%; Ontario plans to match the federal gross-up and introduce a tax credit starting at 5.13% in 2006, growing to 7.7% by 2010; Quebec is making changes that will result in a decreased combined federal/provincial tax rate on dividends to 29.65% from 32.82%. Alberta will parallel the federal changes and eliminate double taxation on eligible dividends by 2009 by increasing its tax credit. (See page B4.)

“In some provinces, dividends may even be taxed at a lower rate than capital gains, making dividend-bearing investments more attractive than ever,” says Golombek.

Seniors, however, are concerned that benefits based on their net income will be clawed back because of their extra dividend income.

Carol Libman, a Toronto consultant who works with Canada’s Association for Retired Persons, applauds the increase in the dividend tax credit. “The problem,” she says, “is where the gross-up goes on the income tax form. It comes in before taxable income — on which clawbacks to the old-age security benefit, the guaranteed income supplement, the age credit and medical benefits are based. We’re losing benefits on income we never had, and that irks seniors.”

Golombek says there is little need for concern. He says most recipients of the GIS probably have little investment income. This supplement to the OAS pays $597.53 a month to Canada’s lowest-income seniors. It is gradually is clawed back to zero as net income rises to $19,487.

According to AIM’s research using income statistics from the Canada Revenue Agency, 97% of eligible Canadian seniors receive the OAS with no clawbacks, and less than 1% is clawed back entirely. Clawbacks to the OAS 2006 pension of $487.55 begin when annual net income exceeds $62,144; for every $1 above this threshold, the OAS is reduced by 15¢, until it becomes zero at $101,031.

Although the higher dividend gross-up will result in affected seniors losing more of the OAS, Golombek says, net taxes payable on dividends by seniors may be less under the new regime because of the enhanced dividend tax credit.

He cites the example of a senior with taxable income of $75,000, including $1,000 of dividend income. Under the old system, this person had $1,250 of taxable dividends. With federal taxes of 26% ($325) and a federal dividend tax credit of $166.66, net federal taxes were $158.34. Under the new regime — with a gross-up of $1,450, federal taxes of $377 and a federal dividend tax credit of $275.07 — net federal taxes would be $101.94.

But, for lower-income seniors, the tax savings may be undermined by the loss of other benefits. “I don’t feel too sorry for the person with an annual income of more than $90,000 who loses the OAS,” says Wayne Taylor, president of the Canadian Association of Pre-Retirement Planners and president of Taylor Financial Inc. in Edmonton. “But there is a problem when this extra income results in tax-bracket creep, and loss of some or all of the federal age credit and the medical tax credit.”

Sharon Paterson, a chartered accountant with Deloitte & Touche LLP in Toronto, knows low-income seniors who worked for corporations and bought their companies’ shares, or who inherited dividend-bearing stocks and live off their dividend income.

@page_break@Seniors in the lowest tax bracket, with its income ceiling of around $36,000 and a marginal federal tax rate of 15.25%, will be most affected by extra dividend income, she says: “It could push them up into the next tax bracket, boosting their tax rate way up to 22%.”

The creep between the higher brackets is not as dramatic: the marginal tax rate for the third bracket, with its ceiling of around $118,000, is 26%; it is about 29% for income of more than $118,000.

The clawback for the 2006 age credit, $3,979, available to everyone over 65, affects considerably more seniors than the OAS clawback. The age credit kicks in at $29,619 and disappears entirely at $56,000, a much lower income level than the OAS clawback.

The federal medical expenses credit can be claimed if medical expenses exceed the lesser of 3% of taxable income or $1,885. This affects people earning less than $63,000. “For the lower-income person, higher dividend income will raise the threshold at which he or she could claim this credit,” Paterson notes.

All these clawbacks can add up for lower-income individuals, she says: “When you have less than $35,000 coming in, every dollar counts. The new dividend tax credit will have a domino effect, and I’m not sure the federal government considered the impact of all these elements when it brought out the tax credit to help Canadian corporations compete with income trusts.”

“CARP has a right to be concerned,” says Dave Cesmystruk, senior tax manager with Meyers Norris Penny LLP in Abbotsford, B.C. “The feds have given taxpayers a benefit, then mitigated that benefit for seniors.”

This won’t be an easy problem to address, Paterson says.

Ottawa would have to change how the gross-up mechanism works by removing the gross-up from the calculation of net income, then adding it back into the calculation of taxable income. To do this, it would have to change how the legislation is currently written.

“An easier way,” she says, “would be to increase the minimum clawback threshold of all government-assisted programs. But that would also increase the clawback threshold of people earning income from sources other than dividends.” IE