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Why are dividends taxed at a different rate than interest? How does it work?

While income from employment and interest income are simply taxed at your marginal tax rate, dividend income from taxable Canadian corporations is given a preferential tax treatment that can save you money.

Dividends represent your share of a company’s after-tax profits. Since income tax has already been paid by the corporation, it would be unfair to tax them again in your hands. They aren’t completely tax-free, but using the dividend tax credit does save you money.

Here’s an example. You receive an annual dividend from Gigantic Company Ltd. of $1,000. To calculate the dividend tax credit, you “gross up” this amount by 25%, so the $1,000 income is now $1,250. This amount is taxed at your marginal tax rate. If we use a 26% tax rate for this example, then the federal tax on this income amounts to $325.00.

Now, you calculate the tax credit to apply to this amount. In this case, you would claim a credit of $166.63, which is 13.33% on the grossed-up amount of $1,250. The total calculation looks like this:

Dividend received: $1,000
Grossed-up amount $1,250
Federal tax at 26% $325

Dividend Tax Credit
13.33% x grossed up amount $166.63

Net federal tax (federal tax minus
the dividend tax credit) $158.37

Provincial taxes would be added to the Federal tax owing and would also receive a dividend tax credit.