The CRA’s Interpretation of Capital Dividends Under General Anti-Avoidance Rule (GAAR)

The Canada Revenue Agency (CRA) offers several tax benefits to individuals, trusts, and corporations that file their returns and pay taxes. This advantage is CRA’s way of rewarding compliant taxpayers. However, tax compliance is more than just checking all the boxes of eligibility. Compliance should maintain the object, spirit, or purpose of the legislation. When this spirit is disrupted by misusing the tax advantage to perform transactions with the intent of avoiding taxes, the CRA can deny even a technically compliant tax benefit and recover the tax.

In 1988, the Canadian Income Tax Act gave CRA special powers under the General Anti-Avoidance Rule (GAAR) in section 245 to prevent such tax avoidance transactions. Significant changes have been made in GAAR since 2024. Understanding GAAR can be challenging as the CRA tests each case on specific parameters. In this article, we will interpret a capital dividend transaction under GAAR.

How Does a Capital Dividend Transaction Work?

The CRA follows the principle of integration, wherein an amount taxed once is not fully taxed again. A business pays dividends from after-tax profit. Since the business has already paid tax, that benefit is passed on to the shareholder by adding the non-taxable portion to CDA. The CDA includes capital income and gain, including:

• The non-taxable portion (50% now and 34% from January 1, 2026) of the gain/loss on sale of the company’s shares, investments, or “eligible capital property” 
• Dividend income from investments your company made in other companies
• Tax-free death benefit from life insurance after deducting the premiums paid

Gains and dividends increase the CDA balance, and capital losses reduce it. The account continues to accumulate capital gains and losses from the company’s inception to its dissolution. 

Shareholders can withdraw the amount in the CDA as tax-free dividends. However, the withdrawal is limited to the balance in the CDA. If they withdraw more than the balance amount, they could face tax penalties. Now, certain events can significantly impact the CDA balance, such as the sale of a fixed asset at a loss. Hence, companies must be careful while withdrawing the amount.

Viewing Capital Dividend from the General Anti-Avoidance Rule (GAAR) Perspective 

The 2024 GAAR rules transformed the court-developed doctrine into a statutory tool, defining thresholds, economic substance rules, financial penalties, and enhancing enforcement powers. 

Threshold: From 2024, a transaction is considered to be under GAAR if one of its primary purposes is to secure a tax benefit.

Economic substance test: A transaction is analyzed for its economic substance, such as whether there is no real economic risk for the taxpayer or a disproportionate relationship between the tax benefit and the genuine economic return. 

The corporation should elect to declare a capital dividend, submit Form T2054, and pass the required resolution, ensuring the amount does not exceed the CDA. Failure to do so will attract a 60% Part III tax penalty on the excess amount.

The courts looked at three other aspects: 

1. Was there a tax benefit?
2. Were the transactions avoidance transactions?
3. Were the avoidance transactions abusive?

In Magren Holdings Ltd v Canada, 2022 FCA 202. Mr. James Grenon controlled several Canadian-Controlled Private Corporations (CCPCs) and received capital dividends aggregating more than $110 million from them in 2006 after filing required elections. This generated a tax benefit. 

If it is proven that the excess election was not an error, it will also attract a GAAR penalty from 2024. The capital dividends exceeded the CDA, which proved to be a tax avoidance transaction and abusive, as it resulted in a negative CDA.

Contact KSSP Partners LLP in Markham to Help You with Taxes

CDA can bring significant tax benefits if used in its true spirit. A professional tax consultant can estimate future capital losses and help you withdraw sufficient cash in your normal course of business from multiple methods without abusing benefits. At KSSP Partners LLP, our accountants can provide services such as tax planning, ensuring compliance, and paying taxes as needed. To learn more about how KSSP Partners LLP can provide you with the best accounting and tax planning expertise, contact us online or by telephone at 289-554-5997.