Eligible dividends are paid from income taxed at the general corporate rate and receive a higher gross-up and personal tax credit; non-eligible dividends come from income taxed at the small business rate and are taxed more heavily in the shareholder’s hands.
The two-tier dividend system exists to integrate corporate and personal tax, so the combined rate approximates what a taxpayer would have paid if the income had been earned personally. Income taxed at the lower small business rate generates non-eligible dividends with a smaller personal tax credit. Income taxed at the general rate generates eligible dividends with a more generous gross-up and credit.
For most owner-managed businesses claiming the Small Business Deduction, dividends paid will be non-eligible. The practical implication is the personal tax rate paid on receipt. Mixing the two types without tracking the underlying pools correctly can result in dividends being misclassified, which the CRA will correct on assessment.
See also: Salary vs Dividends · Small Business Deduction (SBD) · Dividend RefundGetting dividend classification right is part of every owner compensation conversation. See how Wefinx approaches tax planning.