Here's how much more dividend income you'll retain after taxes.

Welcome to the new investing landscape. With the changes announced last Wednesday by the Department of Finance to deal with the income trust dilemma, Canadian dividends are poised to assume the lead in the race for tax-efficient investment income, beginning in 2006 when the new dividend tax-credit regime is proposed to be effective.

When it comes to investment income, not all forms of income are taxed equally. Interest income is the most highly taxed of all and is fully included in your income and taxed at your full marginal tax rate. Capital gains, on the other hand, are the most tax-efficient, being only 50% taxable. In the middle of the current tax-efficiency spectrum, fall Canadian dividends.

Dividends from Canadian companies have always been tax attractive, due to the dividend tax credit associated with them. Under the current rules, if you receive $100 of dividends from a Canadian company, you “gross them up” by 25%, meaning you actually report $125 of dividend income on your tax return.

You then are entitled to claim a federal dividend tax credit equal to 13.3% of the grossed-up dividend, which can be used to reduce your federal tax payable. Since each province also grants its own dividend tax credit, which, on average, is worth about half the federal credit (Saskatchewan's rate is currently 8.0%), Canadians dividends receive tax-preferred treatment.

These current rules and rates will continue to remain in effect for dividends received from Canadian private companies that pay tax on their active (i.e. not investment) income that's taxed at the preferential small-business tax rate.

That's because the current rules work very nicely in most provinces to provide individual investors with a dividend tax credit that, combined with the gross-up described above, attempts to compensate the individual private-company investor for the corporate tax already paid by the corporation. It eliminates the “double-tax problem.”

Until last Wednesday's announcement, however, investors in public companies faced double tax on dividends they received because the dividend tax credit did not fully compensate them for the corporate tax paid by public companies, which are not subject to the same preferential small business tax rate available to private Canadian corporations.

Under the new proposed rules to be effective in 2006, the gross-up would be enhanced to 45% (from 25%), meaning that the shareholder includes 145% of the actual dividends received in their income. The federal dividend tax credit would then be increased to 19%. The feds also assume that the provinces will also provide an enhanced dividend tax credit, which, when combined with the federal credit, would total about 32%.

So, what's the bottom line? As the chart below indicates, a Saskatchewan investor, for example, who earns $100 of investment income and who pays tax at the top marginal tax bracket (using current 2005 rates) would currently retain about $56 if they earned interest income. If the $100 were in the form of capital gains, they would retain $78.

What about dividends? Under the current rules, $100 of Canadian dividends would net only $72 after tax, but under the proposed new system, the same $100 of dividends will net about $79 on an after-tax basis. This translates to an effective top marginal tax rate on dividends of about 21%.

THE NEW DIVIDEND RULES
What you'd retain on $100 of income
	Interest	Capital gains	Canadian dividends current	Canadian dividends proposed
Cash received	$100	$100	$100	$100
Inclustion rate	100%	50%	125%	145%
Taxable income reported	$100	$50	$125	$145
Tax at 44.00%*	44	22	55	67
Dividend tax credit	n/a	n/a	(27)	(46)
Net tax payable	44	22	28	21
Net cash after-tax	$56	$78	$72	$79
Effective tax rate	44.00%	22.00%	28.33%	20.89%
*Saskatchewan top marginal tax rate in 2005

As a result of these proposed new rules, dividends will become a whole lot more attractive in 2006.

Yours truly,

Tactical Asset Management, Inc.
phone: (306) 757-2121
fax: (306) 347-3655
e-mail: inquiry@tacticalassetmgmt.com
website: www.tacticalassetmgmt.com