In challenging economic times, business owners are increasingly responding to market pressures by cutting costs and aiming to streamline corporate holdings. In the search for financial efficiency, it is important that owners consider the potential benefits to be gained from tax-planning opportunities. In some instances, certain basic tax-planning strategies can yield substantial tax savings, and in so doing, dramatically reduce the amount of capital that must be pulled out of a family business on a yearly basis.
In this article, I review one such strategy, the utilization of Capital Dividends, as an example of the type of planning business owners must ensure they consider when reviewing their corporate structure. In short, the Capital Dividend Account (“CDA”) is a critical tool that enables private corporations to distribute special dividends to Canadian-resident shareholders on a tax-free basis in certain instances.
The CDA is designed to fulfill the principle of “integration”, one of the central principles of the Canadian income tax system. The principle of integration posits that it should not make a (material) difference if an individual earns income directly or through a corporation and subsequently flows out the income to himself or herself via dividends. To achieve this goal of tax neutrality, the CDA allows shareholders to receive tax-free dividends in a variety of instances.
Subsection 89(1) of the Income Tax Act (the “Act”) defines the CDA, setting out a fairly complicated formula for calculating this amount. Essentially, the CDA may be understood as a method to track tax-free amounts received (or accumulated) by a corporation which may be passed on to Canadian-resident shareholders. A corporation’s CDA derives from the following five key areas.
1. When a corporation realizes a capital gain, only one half of this gain is taxable. The remaining non-taxable portion of this gain is added to the CDA.
2. When a corporation receives capital dividends from another corporation, these amounts are also added to its CDA (and are subtracted from the issuing corporation’s CDA).
3. The non-taxable portion of gains from the disposition of eligible capital property, such as customer lists and goodwill, are similarly added to a corporation’s CDA.
4. Proceeds received by a corporation upon the death of a shareholder from corporately held insurance policies (less the adjusted cost base of the policy to the corporation) are also added to the corporation’s CDA.
5. Distributions made by a trust and received by the corporation in respect of non-taxable capital gains realized by the trust and capital dividends received by the trust are also added to a corporation’s CDA.
As a whole, the CDA provides corporations with a critical tool with which to flow dividends to shareholders on a tax-free basis. However, a number of technical rules and requirements exist which must be satisfied in order to correctly declare Capital Dividends and to ensure such payments are received by shareholders on a tax-free basis. In brief, a corporation electing to pay a Capital Dividend must file Form T2054 with the CRA on or before the earlier of the day the dividend becomes payable or is paid. The corporation will also have to submit additional information to the CRA, such as a certified directors’ resolution authorizing the election and a schedule outlining the CDA.
Lastly, it should be noted that a number of other events, such as a change in control of a corporation may also adversely impact its ability to pay Capital Dividends. Thus, it is imperative that professional advice be sought with regards to the calculation of the CDA, as well as to ensure that the ability to flow Capital Dividends to shareholders is not adversely impacted by corporate restructuring or other transactions.
Colin Green is an Associate at BrazeauSeller.LLP. Colin specializes in Tax & Estate Planning, but also practices in the areas of Corporate & Commercial Law and Family Business. To learn more about Colin, visit www.brazeauseller.com. Colin can be reached at email@example.com or 613-237-4000 ext. 227.