Do you own a private corporation? Then you should know about the capital dividend account (CDA), a special corporate tax account that enables shareholders to earn tax-free capital dividends. The Canada Revenue Agency (CRA) created this tax exemption to balance the capital gains of individuals and corporations.
What is a capital dividend?
In Canada, when an individual earns capital gain from the sale of an asset, 50% of that gain is charged as a capital gain tax. The CDA gives a similar benefit to private corporations. When a corporation makes a capital gain, 50% of that amount is taxed, and the remaining 50% is tax-free. The corporation distributes the tax-free capital dividend to its shareholders through the CDA, so it is not taxed in the hands of shareholders. Do not confuse capital dividend with regular dividend, which is taxable.
A small business gives dividends to its shareholders from its retained earnings. But when the company sells an asset, like a property or equipment, the capital gain is considered a capital dividend. The CRA considers this type of dividend as returning the capital that investors put into the business and therefore exempts it from taxation. Hence, CDA is a crucial part of Canadian corporation shareholders’ estate and tax planning.
There can be various types of capital gains. The three most common capital gains and losses that fall under the CDA are:
- Capital gains or losses on the sale of assets
- Proceeds on certain life insurance policies a company receives
- Dividends from investments in other corporations
How does the capital dividend account work?
Every year, when a company makes some form of capital gain or loss, it reflects in the Capital Dividend Account. As CDA is a special account, the corporation does not record the capital dividend in taxable financial statements but in the notes to financial statements for information purposes. The CRA tracks the CDA balance annually on Schedule 89 of your corporate income tax return. It keeps accumulating capital gains and deducting all capital losses and any capital dividends paid to shareholders.
Please note the CDA benefit is exclusive to Canada’s private companies. Hence, if your company is not privately incorporated in Canada, you can not avail of the CDA benefit. Moreover, if you disburse capital dividends to non-resident shareholders, a 25% withholding tax applies unless the other country has a special tax treaty with Canada (like the United States). Therefore, it is recommended to allot a separate share class to foreign investors. If your company goes public, your CDA balance will remain intact, but you cannot distribute tax-free dividends from that account. If the company is merged, the new corporation becomes the owner of the combined CDA of both companies.
Things to consider before paying capital dividend
The CDA may look easy on the face of it, but there are many elements you need to consider before paying a capital dividend.
First, check the balance in your CDA. If you accidentally declare higher capital dividends than the CDA balance, the CRA will impose a 60% penalty on excess dividends. If the total dividend is higher than the CDA amount, the corporation has to declare two separate dividends; the tax-free capital dividend up to the CDA limit and taxable dividends of the remaining amount. Second, pass a resolution declaring dividends.
Third, file a special election with the CRA (Form T2054, Election for a Capital Dividend Under Subsection 83(2) along with a copy of the capital dividend verification amount (Schedule 89)) on or before the capital dividend is payable or is paid, whichever is early. Also, attach a certified copy of a special resolution of the directors authorizing the election. A failure to file the election would result in a penalty.
Apart from the procedural steps, time your capital dividend properly. As stated, various corporate events impact CDA, like a company going public, selling the property at a loss, or a merger and acquisition. Such events don’t happen overnight. If any corporate event could negatively impact CDA, you may consider distributing capital dividends ahead of that event. As capital dividend is not taxable, shareholders won’t get a T5 dividend slip.
The things discussed in this article are just the tip of the iceberg. The capital dividend account is critical for small business owners in estate and tax planning. But the complexity of its working could trigger hefty penalties.
Contact KSSP Partners LLP in Markham to discuss how a capital dividend account would work for your business.
Take assistance from tax experts, who can help you make the most of CDA and other estate planning tools, so you don’t give most of your estate in taxes. At KSSP Partners LLP, our tax consultants can help you plan your estate and save on taxes. Contact us online or by telephone at 289-554-5997.