The combination of budget surpluses and the federal election led to a variety of tax announcements designed both to garner votes and address serious issues of economic policy. However, the interconnectedness of the various parts of the income tax system has led to unintended consequences for the giving of charitable donations.

(We are assuming here that there is no change in government or policy as of January 23, as there may well be.)

In the mini-budget of 2005, the then-government proposed that the lowest income tax rate (on income up to $35,595) be reduced from 16% to 15% (retroactive to January 1, 2005). The charitable donation tax credit on the first $200 of income is equal to the donation multiplied by the lowest income tax rate. Hence, the reduction from 16% to 15% effectively reduces the value of the tax credit on the first $200 donated to a charity in Canada. 

While the amount is not significant in dollar values (on a $200 donation the difference is $2), the reduction in value is a direct blow to efforts by charity sector groups to erase the distinction between the rate applicable on the first $200 and that over $200. There may also be a psychological effect to those in the lower income tax brackets, who may see a reduced tax benefit to their charitable donations.

Of greater impact was the decision with respect to the treatment of dividends from public corporations and certain private corporations. The Department of Finance announced this decision in late November with much fanfare. The policy decision arose from the controversy regarding the different tax treatment of distributions from income trusts versus dividends from publicly listed corporations. To understand the government’s decision, one must first understand how dividends are taxed.

The system is designed so that in whatever way an individual earns income through a corporation, the same amount of tax is paid. Since corporations pay tax at a lower rate than individuals, when an individual receives a dividend from a corporation, s/he pays the difference in tax between what the corporation pays and what the individual would have paid if s/he earned the income directly. 

Until November, this was accomplished through a mechanism whereby the individual was taxed on 125% of the dividend but received a tax credit equal to 16.67% of the dividend. Under the new rules, an individual will be taxable on 145% of the dividend received, but this will be offset by an enhanced dividend tax credit equal to 19% of the amount received.

Although the mechanism is complicated, the net effect on the maximum amount for a charitable donation tax credit is simple to calculate. The charitable donation tax credit is limited to 75% of income (certain types of donations, including those of appreciated securities, have different rules). With respect to dividends, this is 75% of the grossed-up amount. Until November, this meant that the limit was 75% of 125% of the dividend; now this will be 75% of 145% (or 108.75%) of eligible dividends. 

Example 1: Naomi receives $100,000 in dividend income from a public corporation; she also has $300,000 in cash savings. The charitable donation tax credit limit would be $93,750 before the November announcement, $108,750 after the policy change.

Example 2: Isaac has employment income of $200,000 and dividend income of $100,000. The charitable donation tax credit limit would be $243,750 before the November announcement, $258,750 after it.

While the net effect of these changes does not necessarily mean an increase in charitable giving, it certainly helps donors with high dividend income to offset their taxes by donating the dividends received rather than the capital from which the dividends arose. For younger donors, this may prove attractive as the capital can still provide security and many years of dividend income when employment income drops.