An eligible dividend is a type of dividend that is paid by a Canadian corporation that meets certain criteria and is eligible for the enhanced dividend tax credit. The dividend tax credit reduces the amount of tax payable on dividends by providing a credit against the tax liability. An eligible dividend has a higher gross-up rate and a higher dividend tax credit rate than a non-eligible dividend, which means that it results in a lower effective tax rate. A capital dividend is a type of dividend that is paid from the capital gains realized by a corporation and is tax-free to the shareholder. However, a tactical asset allocation fund is unlikely to pay capital dividends, as they are usually reserved for private corporations. A capital gain is the profit from selling an asset at a higher price than its purchase price. Only 50% of the capital gain is taxable, which means that it has a lower effective tax rate than interest income, which is fully taxable. However, a capital gain distribution from a mutual fund is not the same as a capital gain from selling the mutual fund units. A capital gain distribution is paid when the fund realizes a capital gain from selling its underlying assets, and it is taxable in the year it is received, regardless of whether the shareholder sells the fund units or not. Therefore, it does not benefit from the deferral of tax that occurs when the shareholder sells the fund units at a later date. An interest distribution is paid when the fund earns interest income from its underlying assets, such as bonds or money market instruments. Interest income is fully taxable at the marginal tax rate, which means that it has the highest effective tax rate among the four types of distributions.
To compare the amount of tax payable for each type of distribution, we can use the following formula:
Tax=(Distribution×Gross−up)×MarginalTaxRate−(Distribution×Gross−up)×DividendTaxCreditRate
For simplicity, we assume that Davis receives $100 of each type of distribution and that he does not have any other income or deductions. We also ignore any provincial taxes or credits. Using the formula, we can calculate the tax payable for each type of distribution as follows:
Capital Dividend: Tax=(100×0)×0.26−(100×0)×0=0
Capital Gain: Tax=(100×0.5)×0.26−(100×0.5)×0=13
Eligible Dividend: Tax=(100×1.38)×0.26−(100×1.38)×0.15=10.14
Interest: Tax=(100×1)×0.26−(100×1)×0=26
Therefore, an eligible dividend would result in the lowest amount of tax payable, followed by a capital gain, a capital dividend, and an interest distribution.
References:
Canadian Investment Funds Course (CIFC) Study Guide, Chapter 7: Taxation, Section 7.2: Taxation of Investment Income, page 7-41
Eligible Dividends Definition - Investopedia2
Capital Dividend Definition - Investopedia3
Capital Gain Distribution Definition - Investopedia4
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