The dividend tax credit reduces the personal tax on dividends from Canadian corporations, recognising that the company already paid corporate tax on the underlying profits.
Dividends are paid from income a corporation has already been taxed on. To avoid taxing the same profit twice, Canada uses a gross-up and credit system: you report a grossed-up dividend amount, then claim the dividend tax credit to offset the corporate tax already paid. The result is that dividends are taxed at lower effective personal rates than regular income.
There are two streams. Eligible dividends (from income taxed at the general corporate rate) carry a larger gross-up and credit; non-eligible dividends (from small-business-rate income) carry a smaller one. This mechanism is the backbone of the salary-versus-dividend decision for owner-managers.
You receive a $10,000 eligible dividend. You report a grossed-up amount of $13,800, then claim the dividend tax credit, which reduces the tax so that your effective rate on the dividend is well below your rate on salary.
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