Accounting

How a Capital Dividend Account Works?

October 10, 2024

An image of an accountant reviewing their clients capital dividend options.

As a small business owner, you can withdraw money from the business either as salary or dividends; both are taxable income. But what if there was a way to withdraw money tax-free while complying with the Canada Revenue Agency (CRA) rules? The Capital Dividend Account (CDA) is a special account that does not appear in your financial statement. The calculation and treatment of this account are different and hence need extra care.

What is a Capital Dividend?

A company pays dividends to shareholders from retained earnings after deducting all expenses and payments to other stakeholders. These are regular dividends paid from business income and are taxable in the hands of the shareholders. Do not confuse them with capital dividends, which are paid from capital gain.

Capital is the money invested to make more money. And any returns, gains, or income from this capital becomes a capital gain.

There are three primary sources of capital gain for a company:

  • Capital gains from owning or selling shares of other companies: For instance, company A invests in shares of company B. Company A gets dividends from company B. The former decides to sell the shares of company B and realizes a gain of $50,000. Dividends and proceeds from the sale of shares are capital income for company A.
  • Life insurance policies: Many businesses buy life insurance policies to buy back shares of the business owner after their demise. The money received from the policy is tax-free. If you deduct the policy premium from the claim amount, the balance amount is capital income.
  • Sale of eligible capital properties: Businesses sell their fixed assets for a profit or a loss. The proceeds from the sale are categorized as capital income.

The Tax Treatment of Capital Income in Canada

In Canada, capital income is taxed differently. The capital losses are deducted from capital gains to arrive at net capital gains. A company or trust must include 66.67% of any capital gain in its taxable income. The remaining 33.33% of the capital gain is exempt from tax. This exempt amount is added to the Capital Dividend Account.

For instance, company A sold stock investments for a gain of $10,000 and lost $1,000 on selling a company car. The net capital gain is $9,000, of which $3,000 is exempt from capital gain tax and becomes the CDA balance.

Since this amount is tax-exempt for companies, the CDA is not included in the Balance Sheet. Instead, it is reported separately in the Notes to Financial Statements. Only the exempted capital gain is included in the CDA so the company can disburse it to shareholders tax-free.

How Capital Dividend Works in Various Scenarios

The company records its capital gain or loss in the CDA. It reports the CDA balance on Schedule 89 of the corporate income tax return for CRA’s reference. The CDA balance is the highest tax-free dividend a company can give its shareholders.

Excess Dividend Paid: If the company pays more dividends to shareholders, they could face a penalty of 60% on the excess dividends paid. One solution is for the company to declare the dividend up to the CDA limit as a tax-free capital dividend and the remaining amount as a taxable regular dividend.

Company Goes Public: The CDA benefit is only available to private corporations in Canada. If the company plans to go public, the CDA balance will remain intact. The company cannot distribute the dividends to shareholders. If it is acquired or merged into a private company, the new owner can access the CDA balance. Hence, you could distribute the entire CDA balance to shareholders before going public.

Dividends To Foreign Shareholders: If a private company pays capital dividends to foreign shareholders, it must deduct a 25% withholding tax unless the shareholder is from a country that has a special tax treaty with Canada (like the United States). Canadian private companies are suggested to issue a separate share class to foreign investors.

Steps a Company Should Follow to Pay Capital Dividends

Now that you understand the benefits of a CDA, how can you pay them to shareholders?

  • Determine the amount of capital dividends by calculating the CDA balance.
  • Pass a resolution declaring dividends. 
  • Before paying the capital dividend, file Form T2054 with the CRA, a copy of Schedule 89, and a certified copy of a special resolution of the directors authorizing it. Failure to file the form with the CRA could result in a penalty.

Shareholders won’t get a T5 dividend slip as capital dividend is not taxable. 

Contact KSSP Partners LLP in Markham to Help You Report and Maintain Capital Dividend Account

The calculation and filing of Capital Dividends are complex. You have to keep a tab of the changes in tax rules and adjust the CDA accordingly. A professional accountant is well-versed in the accounting procedures and CRA reporting requirements and can help you manage CDA efficiently. To learn more about how KSSP Partners LLP can provide you with the best accounting and taxation expertise, contact us online or by telephone at 289-554-5997.

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