Dividend Investing Part 3: Investment Dividends in a Corporation

Many professionals or small business owners invest through a corporation. Nuances of tax integration can magnify the tax effects of dividend income, for better or worse. So, the incorporated dividend investor faces another layer of complexity. Further, I have commonly seen investors and their advisors focus on one aspect of corporate dividend taxation, to the detriment of their overall portfolio. That said, some attention to this could allow incorporated dividend investors to improve the tax efficiency of their cash flow. Or opt not to because the effort and risks outweigh the benefits in their specific situation. Learn more to consider how it applies to yours.

Dividends & Corporate Tax Deferral

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Corporate Tax Deferral Advantage

The main advantage of investing self-employed income via a corporation is that you have more initial capital to invest than you would personally. For example, if I had $10K of income in the top personal tax bracket, I may only have $4600 left after income tax to invest. In contrast, a corporation pays a lower tax rate on business income (~9-31% depending on province and size). So, if earned through a corporation, there could be $7-9K left to invest.

You pay the rest of the tax when the corporation pays out a dividend personally in the future. However, during those intervening years, that larger amount invested can grow and produce more passive income. This is the so-called corporate tax-deferral advantage. Still, there are also a couple of mechanisms used to discourage corporations from building massive piles of passive investments.

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Refundable Dividend Tax on Hand

One is the refundable dividend tax on hand (RDTOH) mechanism. Basically, a corporation pays tax on interest, dividends, or the taxable half of a capital gain at approximately the highest personal tax rate. That is ~50% for most income and ~38% for eligible dividends. Top personal rates are now so high in Canada that those may now be slightly lower than the top marginal tax rates. Still, it is a big tax bite up front. All or part of that tax gets refunded to the corporation when it pays a dividend out personally (and personal tax is paid).

When you add up the corporate tax (net of the refund) and personal tax paid (net of dividend tax credits), the total tax paid may be similar or higher. This is in comparison to having earned the passive income directly. With dividend investment income, whether it is Canadian eligible dividends or foreign dividends makes a major difference.

The impact of the RDTOH mechanism is that a corporation that just receives dividend income and sits on it, pays high taxes. If it keeps the passive income flowing by paying it out to owners, the corporation stays relatively tax efficient. However, the owner pays tax instead. So, how much you need to live on becomes important.

If you require enough dividends to live on anyway, then the RDTOH is refunded to the corporation, and you pay personal tax that you would have regardless. It is as efficient as it can be. If you do not need those dividends to live on, then you face a dilemma. Either the corporation pays more tax now (without the refund until later) or you personally pay more tax now on dividends you didn’t really need. A loss of tax deferral either way.

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Passive Income Limits

Even if you pay out dividends to release RDTOH to the corporation, too much corporate passive income can be problematic. Focusing on dividend investment income could accelerate that. Passive income over $50K in a year shrinks the small business deduction (SBD) eligibility for the following year. The SBD is why businesses with less than $500K of net active income pay tax at 9-12%. Income above that is taxed at 23-31% (depending on province). One dollar of passive income shrinks the $500K threshold by $5 so that there is no SBD by $150K/yr of passive income.

That translates into a corporate tax bump regardless. However, you can attenuate that by paying out more eligible instead of non-eligible dividends from the corporation. Again, that causes a dilemma if you don’t need the money and effectively forces you to lose tax deferral. Even with some attenuation by paying personal tax, the net effect is more total tax. Except possibly in Ontario and New Brunswick where you may have less total tax, but still lose some tax deferral.

Once in retirement, when there is no active business, the passive income limits are no longer relevant.

Foreign Dividend Tax Penalty

Foreign dividends are taxed as regular income. In a corporation, that is at about 50% up front. Some of that is refunded to the corporation as RDTOH when a non-eligible dividend is paid out (and personal tax paid). Unfortunately, a wrinkle with foreign withholding tax makes the situation worse for corporations.

When the corporation files its Canadian taxes, it gets a credit for the foreign withholding tax paid. However, the amount of RDTOH available for refund to the corporation is also decreased. The net effect is 10-15% more tax on dividend flow-through. In these cases, for top marginal tax rates, in the 60-65% range depending on province and tax bracket. For those who want to see the details of how this happens, I will run through an example.

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US Dividend Income Taxation Through a Corporation

The United States collects a 15% foreign withholding tax when a US-listed stock or fund pays out a dividend. When the recipient files their Canadian taxes, they get a credit for that. However, the pre-FWT amount is used to calculate the Canadian tax owing on the dividend. In a corporation, that is ~50%. Personally, it is at your marginal tax rates.

Part of the tax on passive in a corporation is tracked as RDTOH, a described in the previous section. Usually, that is 30.67% of the original income. However, with a foreign dividend, the foreign non-business income credit is factored into the nRDTOH generation. It is the FWT rate times 75/29. That credit amount is subtracted from the dividend, and that lower amount is used to apply the 30.67%.

For the American 15% FWT that translates into an nRDTOH available for refund of 18.77% instead of 30.67%. When the corporation pays out a non-eligible dividend to release the nRDTOH, there is more tax that is unrecoverable. When added to the personal tax, it results in a total tax rate of approximately 65% (depending on province). That is punitive compared to having earned the dividend personally.

I go through the above process for different markets, provinces, and tax brackets in my dynamic tax integration tables. The impact of FWT depends on both the RDTOH inefficiency and how big of a dividend it applies to. For example, the US broad markets have historically had a lower yield (~2%) compared to non-North American developed markets (>3%). Those non-NA markets have lower foreign withholding taxes. So, less inefficiency per dollar, but more dollars of dividends paid.

Eligible Dividend Investment Income

Canadian stocks and the investment funds holding them pay out eligible dividends. The Canadian market as a whole tends to have a higher dividend yield than the US. Still, dividend investors may target the highest dividend payers in the Canadian market. From a tax standpoint, that may be an advantage or a disadvantage when investing through a Canadian corporation.

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Eligible Dividends to Boost Corporate Tax Deferral

Eligible dividends have good tax integration when they flow through a corporation. If the corporation pays out the amount of eligible dividends received, there is no net corporate tax. Plus, those eligible dividends received give the corporation GRIP on a dollar for dollar basis. GRIP allows the corporation to pay out eligible dividends with a lower personal tax rate than regular non-eligible dividends or salary. So, the corporation can pay out fewer dividends to fund the same amount of personal after-tax spending. That leaves more money retained in the corporation to invest.

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Is It Really an Advantage?

The above tax mechanism may cause some investors and their advisors to recommend Canadian dividend-payers for corporate investing. I have even seen that to the exclusion of other investments. However, that creates concentration risk that manifests if something bad happens to Canadian businesses. If Canada’s market trails other markets, that could have a larger impact than a tax nuance. Plus, this is tax deferral. The initial earnings from active business income taxed at the SBD rate eventually have to come out as non-eligible dividends. Still, tax deferral generally allows for more growth between now and then.

Another problem is that if you are dividend investing, targeting those dividends comes at the expense of capital gains. A company chooses to keep profits to reinvest or buy-back shares (captured as a capital gain) or pay that money out as a dividend (reducing the capital value of the company by that amount). The irrelevance of dividends. That assumes dividend-payers have the same total return as other companies (we’ll explore that next week).

If the comparator is investing in foreign dividend-payers, eligible dividends have a clear tax-deferral advantage. Eligible dividends have a perfectly efficient RDTOH mechanism while foreign dividends have an RDTOH inefficiency. However, capital gains are don’t have that penalty. In fact, they are tax-deferred until realized. Plus, when that are realized, they also can boost corporate tax deferral using a capital dividend. More so than eligible dividends.

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Eligible Dividends Can Be Inefficient

The efficiency of eligible dividend investment income in a corporation is contingent upon a few factors. First, if the eligible dividend investment income pushes you over the passive income limit, it could bump corporate income to the higher general corporate tax rate. That may not be a bad thing in Ontario and New Brunswick. But in most provinces , it increases the current corporate tax and the overall tax to get the money into personal hands.

The second issue arises if you do not require more income to fund your lifestyle. Eligible dividend income received by a corporation is taxed at 38% up front. The corporation does not get that refunded until you pay out those dividends and pay personal tax. That can be a drag. The other impact is that it may force you to either accept that tax drag or reduce the salary paid by your corporation. That could be undesirable if it reduces the tax-advantaged RRSP contribution room. Alternatively, it could impact your ability to use corporate pension options.

Summary

The main advantage of a corporation is tax deferral and having a larger amount of initial money to invest. That could mean more dividend income than if you were investing personal after-tax dollars. A 2% yield on $1MM invested is double a 2% yield on $500K invested. However, mechanisms to discourage passive income in a corporation can make it undesirable.

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Canadian Eligible Dividends

Canadian eligible dividends can flow through a corporation efficiently. That may boost corporate tax deferral because the corporation can pay out eligible dividends. Those are tax more lightly, so less needs to be paid out of the corporation to fund a given level of personal spending. However, if you do not need that money to live on, then the upfront tax on eligible dividends is 38%, until you do pay the money out and pay personal tax. Further, if the eligible dividend income exceeds $50K per year, that could shrink the SBD threshold and increase current corporate tax plus the overall taxes to get the money into personal hands.

If you are giving up some capital gains to get the eligible dividend, then that is also sub-optimal. Capital gains have both tax-deferral and using capital dividends can flow out of a corporation efficiently. Perhaps, boosting corporate tax deferral even more than eligible dividend usage. That assumes that Canadian dividend-payers have the same total return as non-payers. We will explore that aspect further next week.

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Foreign Dividends

Due to how the foreign withholding tax and credit works in a corporation, there is less RDTOH available to the corporation when it receives foreign dividends. That translates into high upfront and total tax rates. This makes targeting foreign dividend income unattractive.

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Opportunity Costs

By its nature, dividend investing creates concentration risk. For example, if you targeted Canadian eligible dividends to the exclusion of US markets, you would have underperformed over the last 15 years. Below is a chart illustrating how much that would have cost using a couple of Canadian dividend ETFs and excluding a US market ETF. Sure, the ETFs will have some small fees. However, the difference in compounded annual growth rate is huge.

The opportunity cost of ignoring the US was also huge compared to dividend tax nuances. Canadian markets will have their days in the sun – they have for 2025 YTD. However, even with those periods, watching your portfolio trail the broader world markets for a decade or more would be tough to stomach. You will also notice that different dividend strategies had different return rates. We will explore that in the next post.

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Bottom Line

Canadian eligible dividends can flow tax-efficiently through a corporation. If you need that income to spend personally and are below the passive income limits, the increased capital invested through a corporation makes that an advantage compared to personal dividend investing.

However, if dividend income is at the expense of capital gains, a dividend focused strategy is less attractive. Capital gains can also be moved out of a corporation tax-efficiently and benefit from tax deferral on top of that. You can choose when to take the money to tax plan for personal spending.

Sacrificing exposure to global markets to focus on Canadian dividends can also be costly. You are betting on Canada keeping up or outperforming. Chasing foreign dividends is very tax inefficient using a corporation.