Category: Taxation

Rob Carrick had a column in the Globe today that examines the effect of the recently announced changes in dividend taxation:

Still, there are going to be cases where investors pay more tax without the offsetting benefit of a higher dividend. Preferred shares are one example, while another is the shares of companies that maintain a steady dividend.

Since the dividend tax credit was enhanced a couple of years ago, dividends have in many cases been the most tax-efficient form of investment income (we’re talking here about so-called eligible dividends, or those typically paid by large corporations). Mr. Mida said dividend income may lose this distinction to capital gains, but not by a big margin.

The status quo will hold in dividend taxation until 2010, when a three-year phased adjustment begins.

Mr. Carrick’s source for the figures used in his report appear to be those of Price Waterhouse:

These are different from the Ernst & Young figures that I normally use. Presumably, the two accounting houses have used different assumptions regarding what constitutes a ‘base-case average taxpayer’. Not a big deal … it would be nice to know just precisely what the differences are, but we can’t have everything for free.

Enough! Let’s do some work here! Using Mr. Carrick’s published figures and assuming no change in the marginal rate charged on income:

So … the estimate is that the equivalency factor is going to revert to approximately what it was in the nineties.

Before we take the next step, let’s emphasize to ourselves that these are estimates, approximations and forecasts! In the first place, accountancy firms can’t even agree with each other on what the top marginal rates are, such is the idiotic and increasing complexity of the Income Tax Act. In the second place, a five year forecast of something political like tax rates is going to be even more subject to error than a five-year forecast of investment returns … at least when you perform the latter operation, you can assume that at least a tiny minority of the players have functioning brain cells!

So. This is an estimate. Do with it what you will.

Note on calculation: I use base case figures for 2008 of a PerpetualDiscount yield of 5.39% and a long corporate yield of 5.90%. At the 2008 equivalency factor of 1.419, the current interest-equivalent on PerpetualDiscounts (IE Spread) is 7.65%; the current spread to long corporates is therefore 175bp.

Figuring out the change in IE Spreads is easy – multiply today’s yield by tomorrow’s equivalency factor to get tomorrow’s estimated IE Yield; subtract the (constant) corporate yield to get tomorrow’s IE Spread; subtract today’s IE Spread to get the change.

To estimate the effect on price if the IE Spread is constant, I multiply the change in IE spreads by 14.82, which is the modified duration of the PerpetualDsicount index. Thus, for year 2012, the change in price (from now) is 0.63 x 14.82 = 9.34. To check this … let us assume we have a $100 pref yielding 5.39% at the moment … therefore, it pays $5.39 p.a. If the price drops by 9.34%, the new price will be $90.66; and the yield will change to (5.39 / 90.66) = 5.95%. The Interest Equivalency Factor is 1.303, so this yield will be equivalent to 7.75% interest. We were hoping to get 7.65%, but 10bp difference is due to convexity effects (the modified duration will decrease as the price decreases; modified duration is, strictly speaking, applicable only to infinitesimally small changes in price … and a 9.34% drop is not “infinitesimal”). Additionally, the extremely precise modified duration of 14.82 is calculated using HIMIPref™’s limitMaturity, which assumes a maturity at the current price in thirty years. This is not strictly accurate in itself and is not consistent with the use of Current Yield as an approximation of YieldToWorst. So a 10bp error isn’t bad!

Update, 2008-2-29: This post updates Federal Budget – Effect on Prefs

With a hat-tip to the Financial Webring, we can look at a story in the National Post:

Canadians may be wise putting dividend-paying stocks into their TFSAs. While the government announced last October it would slash corporate income tax rate to 15% by 2012 from 19.5%, individual investors will be making up some of that lost revenue.

The average rate investors will pay on dividend income at the top marginal tax rate of 46% will rise to 25.3% by 2012 from 18.5% in 2008.

Marginal rate of dividends increasing? What will that do?

To check these figures … If we receive $1.509 in interest and pay 46% tax, or $0.694, we’re left with $0.815, which is the same as the net left after tax from dividends of $1.00 under the old regime, so that’s OK.

If we receive $1.383 in interest and pay 46% tax, or $0.636, we’re left with $0.747, which is the same as the net left after tax from dividends of $1.00 under the new regime, so that’s OK.

I don’t know where the Post got their figures from. The equivalency factor in Ontario is currently 1.40, not 1.509 as per their figures; I use a marginal rate on dividends of 21.0% and 46.4% on interest.

Throughout the 1990’s, I used 48.8% on income and 32.9% on dividends, which gave an equivalency factor of 1.311.

Before opining on the effects of the change, I want to know just what the change is! I’ll wait for the accountancy firms to crunch the numbers, then pontifficate.

Update: KPMG notes:

Dividend tax credit (DTC) — For 2010 and later years, the dividend gross-up factor and DTC will be adjusted in increments to reflect the corporation tax reductions to 15% in 2012 introduced in the October 30, 2007 mini-budget (for details on the corporate tax cuts, see TaxNewsFlash-Canada 2007-28, “Highlights of the 2007 Federal Mini-Budget”).

The KPMG report on the fall 2007 mini-budget states:

The mini-budget documents also say that, in light of the corporate tax rate cuts, the federal government will consider corresponding changes to the enhanced dividend tax credit for eligible dividends. The enhanced credit is designed to ensure that the combined corporate and personal tax rate on dividends from large corporations is comparable to the rate applying to other income. The credit was established based on the total average federal-provincial corporate tax rates that were expected to apply in 2010.

Update, 2008-2-29: Follow up article, with projected rates is Dividend Taxation Changes.

According to an official news release, Saskatchewan intends to increase the dividend gross up and tax credit quite substantially.

The Government also introduced changes to the dividend tax credit (DTC). Effective for the 2006 taxation year, Saskatchewan will establish a new DTC on dividends received from larger corporations at a rate of 11 per cent. By increasing its DTC rate for larger businesses, Saskatchewan has now integrated with the changes announced in the May federal budget. Effective for the 2007 taxation year, the DTC rate on dividends received from small businesses will drop from 8 per cent to 6 per cent to reflect Saskatchewan’s lower small business corporate income tax rate.

I’ll keep an eye on the E&Y Tax Calculator and post again when they have accounted for this change. 

Hat-tip to Financial Webring Forum for bringing this to my attention. 

Update, 2006-11-18: Boy, that was fast!

Alberta announced their tax credit improvement September 12, which E&Y have analyzed to mean:

Hah! The equivalency factors aren’t as good as for BC and Ontario! It almost eases the sting of realizing just how low taxes are out West!

I’m not sure exactly how I did it, but when I was writing the BC Taxation Update, I wiped out the Ontario one from September 15, that I will now replace.

Ontario announced their tax credit improvement, which E&Y have analyzed to mean:

British Columbia announced on October 11 that the dividend tax credit would be increased; E&Y has updated its on-line Tax Calculator to October 12

So lets plug in some numbers for British Columbia:

So not only are tax rates lower in BC than in Ontario, they have a more favourable Dividend/Income conversion ratio as well! Huh!

According to an official news release, British Columbia intends to increase the dividend gross up and tax credit quite substantially.

 I’ll keep an eye on the E&Y Tax Calculator and post again when they have accounted for this change.

Hat-tip to Financial Webring Forum for bringing this to my attention.

Alberta has followed Ontario and boosted the dividend tax credit.

This will make prefs relatively more attractive to Alberta residents. I’ll keep an eye on the E&Y tax calculator and make a note of the Alberta Equivalency Factor in due course.

Hat tip to Financial WebRing Forums for bringing this to my attention.

In very good news for preferred share investors, Ontario increased the dividend tax credit from 5.13% to 6.5%. The tax credit will rise in stages over the next four years, reaching 7.7 per cent in 2010.

There is nothing in the Official Press Release that indicates the dollars-and-cents value of this increase, but doubtless the accounting firms are working it out now and I’ll post updates when I get them.

Added 2006-09-06 : Note that Ernst & Young has a very good online tax calculator but it is currently updated only to June 16, 2006