If you look at a T5, one sees that taxable dividend amounts are greater than the actual dividend amounts. So, the government considers the actual dividends paid out to you less than what should be taxed. Why is that?
The reason is that there should be only one level of taxes. In other words, you shouldn’t tax the same loonie multiple times. When a company makes money, it pays taxes on that income. Then, when it pays out a dividend with this after-tax income the shareholder has to pay taxes on it. That means two levels of taxation on the same dollar! That’s not fair. It would also discourage Canadians from investing in Canadian companies.
In the shareholder’s hands the government considers the actual dividends (cash paid out) and then the dividends that would be paid as if they were never taxed. Using the latter, that is the shareholder’s income. And that income will be taxed. Personal taxes will be higher because ‘taxable dividends’ (i.e. pretending tax at corporate level never happened) are higher than actual dividends. This means higher income, and more tax paid.
How is that fair? Well, in addition to the above, there is a Dividend Tax Credit that credits the shareholder for the tax the company already paid. To sum up, the government pretends the taxation at the company level never happened (taxable dividends). Then the government credits for tax paid by the company. It is complex, but that complexity is how the government tries to make everything as equitable as possible.