It’s important for investors to realize that there are differences between qualified and unqualified dividend distribution when it comes to the Canadian tax code.
This becomes apparent come tax time. Knowing the details will help you make better decisions when deciding how to properly allocate your investments and which account you should use. For examples, investments such as REITs require thoughtful considerations when selecting the investment account. While a return of capital is the most tax-efficient distribution, your ability to manage the accounting will come into play.
Dividends vs Distribution
Let’s explore the characteristics of these two types of dividend payments. Normal stocks tend to pay dividends whereas REITs and income trusts tend to pay a distribution. You can see the usage of the different words from their communication and website.
1) Dividends from Common Shares. Most regular dividend payments from Canadian corporations are qualified. This includes the monthly, quarterly or annual dividends paid out by most Canadian corporations.
2) Dividends from Preferred Shares. Most preferred shares dividends are qualified as well.
3) Dividends from US Corporations in RRSP/RRIF account. The dividend paid by US companies in a RRSP account are tax exempt from both Canadian and US governments as part of a tax treaty between the two countries. For the purpose of income taxes, we can consider them qualified. Please note that MLPs are not a US corporation, they are a Master Limited Partnership and the structure differs from a corporation and as such, other tax implications are to be considered (see point 6 in Unqualified Distributions).
Related: Common Stock or Preferred Shares
1) Dividends from Non-Canadian Corporations. If the dividend is paid by a non-Canadian company, the dividend does not qualify for the preferred dividend tax rate. In fact, there will be a tax withheld at source when you hold a US company and you will need to claim it back for a taxable account. You unfortunately have no way to claim it back if held in a RRSP/RRIF or TFSA account (point 3 above is the exception).
See the tax table below to understand all the nuances of holding US companies as investments. With respect to the Canadian tax code, non-Canadian dividend are not qualified dividends when it comes to applying the preferred tax rate in a taxable account.
This type of distribution is taxed at your normal income tax rate. So in general, the taxes on these unqualified distributions are higher. Here’s a list of some investments that may potentially pay out unqualified dividend distributions:
1) Non-Canadian Dividends. Dividends from foreign companies are not qualified for the dividend tax credit. In fact, not all tax sheltered account can be used to avoid paying taxes on foreign dividends. Dividends from American corporation should only be held in a RRSP account to avoid paying taxes on the dividends.
2) Real Estate Investment Trusts (REITS). These unique assets provide investors with a way to diversify their portfolios by investing in real estate. Many investors use REITs to complement their stock and fixed income assets. Dividend investors like them as well…one of the main benefits is the regular income. REITs are different from other investments because they pay income in the form of rent. But distributions from REITs can be unqualified.
It’s important you look at what the company includes in their distribution. In some cases, you are receiving a return of capital which affects the ACB of your stock. This is why you often hear the rule that you should hold REITs in a registered account such as a TFSA or RRSP (Traditional or a Roth IRA for Americans) to avoid the burden of accounting for income tax purposes. REIT taxation should be understood before you add REITs in an non-registered account.
3) Income Trust. They are not always distributing qualified dividends. They can sometimes have return of capitals along with dividends. Just like REITs, make sure you know if you are receiving a return of capital as it will adjust your capital gains at the time of disposition. You basically need to reduce your purchase cost which could increase your capital gains.
4) Bonds. Bonds do not pay dividends. They pay interest and the payments are considered as such which falls under the marginal tax rate calculation for income. This can include bond ETF’s and bond mutual funds.
5) Mutual Funds or ETFs. These products now have a mixture of dividend and distribution. In many cases, you cannot declare the entire amount as qualified dividends since it may have interest, return of capital, capital gains, or covered calls premiums. Many dividend ETFs or monthly income fund such as BMO Monthly Income Funds will fit this category.
6) US MLP. The distribution is not subject to any preferential tax treatment. It will be taxed at the marginal tax rate and treated as income when in a taxable account. Foreign tax withholding applies which impacts the yield on the investment.
Tax Efficient Summary
Be careful, the US withholding tax exemption, which is part of the Canada-U.S. tax treaty, does not apply to tax-free savings accounts (TFSAs) or registered education savings plans (RESPs). Also, with TFSAs and RESPs, you’re not able to claim a foreign tax credit for the tax withheld.
It might seem like a hassle to keep track of all the differences between qualified and unqualified distributions. In general, just remember that investments paying unqualified distributions are better to hold in tax-sheltered accounts. For the most part, it’s best to hold REITs and Income Trusts in tax-sheltered accounts like a TFSA or RRSP. That way you don’t have to deal with the complexity of the taxes.
Use the table below as a reference on where to hold some of your investments. It can save you money and simplify your accounting.
If the distributions is in taxable accounts, your brokerage firm will provide year-end statements. Those will break down the cash and dividend payments. Bring the statements to your accountant when you do your taxes.
As you can see from the table, taxes are complicated when it comes to generating income from companies, REITs, Income Trusts, or MLPs. Tracking all the information becomes critical and you need a process to track your transactions and income.
Readers: Are you careful about what you hold in your specific accounts?
Image courtesy of cooldesign – FreeDigitalPhotos.net