Recently, the Conservative government announced some very controversial proposed changes to tax legislation. Most of the media attention was focused on the taxation of income trusts. Although these changes are important to investors, the taxation of income trusts will not come into affect for four years. In the announcement, here were two other tax announcements about taxation of dividends and pension splitting that are very important but lacked the same media attention. Let’s take a deeper look into these benefits

The new dividend system

In the recent proposal, the government intends to increase the dividend gross-up on eligible dividends from 25% to 45%. As a result, the dividend tax credit will be worth about 32% compared to a 20% dividend tax credit in the old system. These changes are in effect for any eligible dividend paid after 2005 which means any dividends paid in 2006 qualify for the higher dividend tax credit.

How does this affect investors in Canada? According to Sandy Cardy, Senior Vice President of Tax and Estate Planning for Mackenzie Financial Corporation, an Albertan in the highest marginal tax rate under the old system would pay 24% in tax on every dollar earned as a dividend under the old rules. Under the new proposed rule, this investor would only pay 14.6%, which is about a 40% savings in tax. Investors in Ontario will save over 37% on their dividend income.

This is great news for investors holding dividend paying stocks and dividend mutual funds. Under the old rules, the most tax efficient form of investment income was capital gains. Under the new proposed rules, dividend income attracts less tax than capital gains and interest income.

This new system is also beneficial to small business owners. In fact, Cardy says “the change to dividends is the most significant change to small business owners in the last 20 years.”

One of the biggest criticism to the new dividend system is how the dividend gross-up will affect seniors who are concerned about income tested benefits like the age credit clawback and the Old Age Security (OAS) clawback. In both cases, the clawback is based on net income. That means the 45% gross up will gross up the income used to calculate the clawback for OAS and the age credit and result in a higher likelihood that more people will have their benefits clawed back. With respect to OAS, Cardy believes that while this may appear to be a concern, there are very few people that will be affected by OAS clawback. The statistics today suggest that only 3% of seniors are affected by OAS clawback and less than 1% of seniors are fully clawed back. Cardy suggests that the tax savings should more than offset any negative consequences of clawbacks.

Another income tested benefit that will be affected is the medical expense tax credit.

Pension income splitting

Retirees will also benefit from the new changes with respect to Pension Income Splitting. Income splitting has not been a terribly easy thing to accomplish in Canada.

Prior to the announcement in October 2006, the two most common income splitting strategies for retirees was utilizing spousal RRSPs and splitting Canada Pension Plan (CPP). Business owners had some options to split income by paying spouses or family members and income from the business. Other than that, the government was pretty tough on income splitting. The government has been reluctant to allow couples to pool their income because that would lower tax revenues. For example, an individual who makes $70,000 per year would pay considerably more tax than a couple that earned $35,000 each.

Under the new rules, for those age 65 and over, eligible pension income for the purpose of splitting includes lifetime annuity payments under a registered pension plan, an RRSP or a deferred profit-sharing plan, and payments from a RRIF.

For those under 65 years of age, eligible pension income is limited to lifetime annuity payments from a registered pension plan and “certain other payments received as a result of the death of the individual’s spouse or common-law partner.

Right now, this is only great news for seniors, especially retired couples where one spouse has considerably more income than the other. That being said, The Finance Minister has commented on income splitting to all couples. In the example where a couple has one spouse making $70,000 per year and the other spouse earning no income, pension splitting would save them about 25% in taxes or over $4000 per year. Tax savings will vary from province to province.

Although there has been lots of grumbling about the taxation of income trusts, the government did introduce two new tax proposals that are very positive to Canadians.