When applying for a mortgage, to put the applicant in the best light with a lender to get the best rate possible, the question arises, “Can you gross up T4 and dividend income from a corporation?”
In Canada, when completing a mortgage application for a client who owns a corporation, the treatment of T4 (employment income) and dividend income for mortgage qualification purposes can vary depending on the lender’s policies and the specific circumstances of the borrower.
T4 Income
T4 income, which represents employment income, is generally considered stable and can be used in its entirety for mortgage qualification purposes. If the client is an employee of their own corporation and receives a T4, this income is usually considered as regular employment income. However, the lender will likely look at the stability and continuity of this income, just as they would for any other employment income.
Dividend Income
Dividend income can be trickier because it is often seen as less stable than employment income. Some lenders may allow you to gross up dividend income, but the allowable percentage can vary. A common practice is to allow a gross-up of non-eligible dividends by a certain percentage (e.g., 15-25%) to account for the lower tax rate on this income compared to regular employment income. The rationale behind grossing up non-eligible dividends is to put the borrower on a more equal footing with salaried employees, as dividends are taxed at a lower rate. For eligible dividends, which are taxed at a higher rate, the gross-up percentage might be different or not applicable, depending on the lender’s policies.
Eligible and Ineligible Dividends
In Canada, the main differences between eligible and ineligible dividends revolve around their tax treatment and the underlying corporate income from which they are paid. Here’s a breakdown:
Eligible Dividends
Canadian corporations pay eligible dividends out of income that has been subject to the standard corporate tax rate. These dividends are generally from public companies or large private corporations. Not usually the type of corporations that go looking for a mortgage for a home.
Eligible dividends benefit from a higher dividend tax credit, which reduces the amount of personal tax payable by the shareholder.
The gross up rate for eligible dividends is 38%.
The dividend tax credit for eligible dividends is higher, reflecting the higher gross-up rate.
The overall tax rate on eligible dividends is typically lower for the recipient because the higher dividend tax credit offsets the higher gross-up.
Ineligible Dividends
Canadian corporations pay ineligible dividends, also referred to as non-eligible or ordinary dividends, from income that has been subject to the lower small business rate of tax. These businesses, also referred to as Canadian Controlled Private Corporations (CCPC), are the ones that the gross up used in mortgage underwriting affects.
Ineligible dividends receive a lower dividend tax credit, which provides less reduction in personal tax payable.
The gross-up rate for ineligible dividends is 15%.
The dividend tax credit for ineligible dividends is correspondingly lower.
The overall tax rate on ineligible dividends is higher for the recipient because the lower dividend tax credit does not offset the tax as effectively as for eligible dividends.
Summary
The distinction between eligible dividends and ineligible dividends helps integrate corporate and personal tax systems, ensuring that income is taxed fairly, whether it’s earned directly by an individual or through a corporation. The higher gross-up and tax credit for eligible dividends reflect the higher corporate tax already paid on that income.
Example
Let’s walk through an example of how $100 of dividend income is taxed differently between eligible and ineligible dividends in Canada. We’ll use simplified numbers for illustration purposes.
Eligible Dividends
- Dividend Received: $100
- Gross-Up: 38%
- Grossed-up Dividend = $100 × 1.38 = $138
- Personal Tax (Assume 30% rate):
- Tax on Grossed-up Amount = $138 × 0.30 = $41.40
- Dividend Tax Credit:
- Federal Dividend Tax Credit = $138 × 15.0198% = $20.73
- Provincial Tax Credit (Assume Ontario, 10.98%) = $138 × 10.98% = $15.16
- Total Dividend Tax Credit = $20.73 + $15.16 = $35.89
- Net Tax Payable:
- Net Tax = $41.40 – $35.89 = $5.51
Ineligible Dividends
- Dividend Received: $100
- Gross-Up: 15%
- Grossed-up Dividend = $100 × 1.15 = $115
- Personal Tax (Assume 30% rate):
- Tax on Grossed-up Amount = $115 × 0.30 = $34.50
- Dividend Tax Credit:
- Federal Dividend Tax Credit = $115 × 9.0301% = $10.38
- Provincial Tax Credit (Assume Ontario, 3.12%) = $115 × 3.12% = $3.59
- Total Dividend Tax Credit = $10.38 + $3.59 = $13.97
- Net Tax Payable:
- Net Tax = $34.50 – $13.97 = $20.53
This simplified example illustrates that eligible dividends are taxed at a lower effective rate compared to ineligible dividends due to the higher gross-up and larger dividend tax credits.
Corporate Income
Beyond T4 and dividend income, if the client is retaining earnings within the corporation (i.e., not distributing all profits as salary or dividends), some lenders may consider additional methods to assess the borrower’s ability to service the mortgage. This could involve looking at the corporation’s financial statements to assess its health and the sustainability of the income being drawn. However, this is more complex and not all lenders will consider retained earnings in the corporation as part of the borrower’s income.
It’s important to note that lending policies can vary significantly between different financial institutions. Some may have more flexible guidelines when it comes to self-employed individuals and business owners, while others may be more conservative. It’s also worth considering that the mortgage qualification process may involve a more in-depth review of the borrower’s financial situation, including the health of the corporation, the consistency of income over several years, and other factors.
What is “Grossing Up Income?”
To “gross up” T4 or dividend income from a corporation means to increase the income amount on paper for mortgage qualification purposes. This adjustment is done to account for the lower tax rates that apply to certain types of income, making the income appear higher to better reflect its true purchasing power or to align it more closely with gross employment income.
Here’s a breakdown of how grossing up works for both types of income:
T4 Income Gross-Up
T4 income, which reflects employment income, is typically not grossed up because it is already considered gross income before taxes. However, in some contexts, if referring to grossing up, it might involve adjusting income calculations for other purposes, but this is less common in the context of mortgage applications.
Dividend Income Gross-Up
Dividend income is often subject to a gross-up in the context of mortgage applications. Since dividends (especially non-eligible dividends) are taxed at a lower rate than regular employment income, grossing up involves increasing the dividend income by a certain percentage. This adjustment is made to reflect the income’s purchasing power more accurately compared to regular employment income taxed at a higher rate. For example, if a lender allows a 15% gross-up on non-eligible dividends, and the borrower receives $10,000 in dividends, for mortgage qualification purposes, this income could be considered as $11,500 ($10,000 + 15% of $10,000).
Full Example
When applying for a mortgage in Canada, lenders often gross up dividend income to account for the fact that the income has already been taxed at the corporate level. The gross-up rate for ineligible dividends is 15%. Here’s an example of how $100,000 of income from ineligible dividends is grossed up:
Ineligible Dividends Gross-Up Calculation
- Dividend Income: $100,000
- Gross-Up Rate: 15%
- Grossed-Up Income Calculation:
- Grossed-Up Income = $100,000 × 1.15 = $115,000
How Lenders Use Grossed-Up Income
Lenders will use the grossed-up income to calculate the applicant’s total income for mortgage qualification purposes. This increased income can help improve the applicant’s debt service ratios, which are critical metrics in determining mortgage affordability.
Example in Mortgage Application
Let’s consider how this grossed-up income affects the applicant’s mortgage application:
- Base Dividend Income: $100,000
- Grossed-Up Dividend Income: $115,000
Lenders may add the grossed-up income to any other sources of income the applicant has, such as employment income, rental income, etc., to determine the total income for mortgage qualification.
Impact on Debt Service Ratios
- Gross Debt Service (GDS) Ratio: This ratio measures the percentage of the applicant’s income that goes towards housing costs (mortgage payments, property taxes, heating costs, etc.).
- Total Debt Service (TDS) Ratio: This ratio measures the percentage of the applicant’s income that goes towards all debt obligations (including housing costs, car loans, credit card payments, etc.).
By grossing up the dividend income, the applicant’s total income is increased, which can improve both the GDS and TDS ratios, potentially qualifying them for a larger mortgage or better terms.
- Original Ineligible Dividend Income: $100,000
- Grossed-Up Income (15% gross-up): $115,000
Using grossed-up income helps present a more favourable financial picture to lenders, improving the applicant’s chances of securing a mortgage.
Reasonableness
Many mortgage lenders apply a reasonable test to deductions applied in calculating corporate income to support the gross-up of ineligible dividends in income calculations for mortgage applications. These deductions include things such as business use of one’s home, motor vehicle expense, capital cost allowance and so on. As every lender has a different or nuanced application of the test of reasonableness, contact Allen Ehlert to learn how it can be applied in your circumstances.
Conclusion
The purpose of grossing up income in mortgage applications is to provide a more accurate picture of a borrower’s income, especially for those with non-traditional income sources like dividends. It helps in levelling the playing field between applicants with different types of income, ensuring that those with lower-taxed income sources are not disadvantaged in the mortgage qualification process.
Lenders use the gross-up method to more fairly assess a borrower’s ability to service a mortgage, taking into consideration the actual spending power of their income after taxes. However, the specific percentages and policies for grossing up income can vary significantly between lenders, so it’s important to check with individual financial institutions or consult with a mortgage professional for the most relevant and current practices.
For the most accurate and up-to-date information, it’s best to consult Allen Ehlert to understand lenders and their specific policies regarding grossing up T4 or dividend income from a corporation. Additionally, working with Allen Ehlert can help navigate these complexities and find a lender that best suits your situation.
