The reason why the recipient corporation is allowed the offsetting deduction is that the dividend is normally paid out of the payer corporation’s after-tax income. If the recipient were also subject to tax on the dividend, there would be double taxation. And if there were multiple “stacked” corporations (e.g. the payer corporation was a shareholder of another corporation that itself was a shareholder of another corporation), there could be triple, quadruple or further taxation as the dividend was paid up the corporate chain.
The offsetting deduction in computing taxable income generally means that dividends can flow up through a corporate chain on a tax-free basis. (There are exceptions for dividends on certain preferred shares and other financing vehicles created to take advantage of these rules, but these are generally of limited application.) Once the dividends are paid to an individual (human) shareholder, they are included in the individual’s income.
Special Refundable Tax
However, in certain cases, a recipient private corporation will be subject to a special refundable federal tax under Part IV of the Income Tax Act (called the “Part IV tax”) . This tax is payable on dividends received from payer corporations with which the recipient is not “connected”. In general, a recipient and a payer are not “connected” if the recipient owns 10% or less of the shares in the payer corporation, counting both votes and fair market value.
The Part IV tax makes it less attractive for you to hold your share investments through a private corporation. For example, in the absence of the Part IV tax, you could put your publicly-traded shares into a private corporation, which could receive dividends on the public shares on a tax-free basis as discussed above. Although you would be subject to tax when your corporation paid you a dividend, this tax would be deferred to the extent the monies were left in your corporation. The Part IV tax takes away the potential tax deferral advantage.
The Part IV tax for the recipient corporation is 38 1/3% of the dividends received from the payer corporation (for taxation years ending before 2016, the rate was 33 1/3%). The tax forms part of the recipient corporation’s “refundable dividend tax on hand” and is refundable to the corporation when it pays a dividend to its own shareholders, at a rate of 38 1/3% of the dividend.