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Capital Dividend Account

Stipulated by subsection 83(2) of the Income Tax Act Where at any particular time after 1971 a dividend becomes payable by a private corporation to shareholders of any class of shares of its capital stock and the corporation so elects in respect of the full amount of the dividend, in prescribed manner and prescribed form and at or before the particular time or the first day on which any part of the dividend was paid if that day is earlier than the particular time, the following rules apply:

1. the dividend shall be deemed to be a capital dividend to the extent of the corporation’s capital dividend account immediately before the particular time; and
2. no part of the dividend shall be included in computing the income of any shareholder of the corporation.
(the “Act”), Capital Dividend Account (CDA) is a special corporate tax account which keeps track of various tax-free surpluses accumulated by a private corporation resident in Canada. There is no requirement that corporations in question must be Canadian controlled. At the discretion of the board of directors, these surpluses may be distributed as tax-free capital dividends to the corporation’s Canadian-resident shareholders. Public corporations do not qualify for a CDA, even if they had previously been private corporations and had a balance in their CDA immediately before they became public corporations.

The CDA is a notional tax account to track these tax-free amounts for income tax purposes and passing these amounts through to shareholders by way of a tax-free capital dividend. It is a cumulative account from the date of incorporation and is not recorded in the corporation's taxable accounting entries or financial statements. The balance of CDA may be reported in the notes to financial statements to comply with full disclosure requirement. CDA balance previously recorded on file with the Canada Revenue Agency (CRA) can be found on-line in My Business Account under "View Return Balances" of the corporate income tax section. Primarily, it is used for tax and estate planning purposes. Of course, a surplus balance in the CDA is attractive to investors who are contemplating to buy shares of qualified corporations.

Overview of the CDA

Pursuant to subsection 89(1) of the Act, CDA balance is calculated as follows. The sum of the following:

summation
  1. The non-taxable portion of the company's capital gains net of capital losses, which is currently 50% (capital gains inclusion rate) of the net capital gains. Capital gains from foreign accrual property income of a foreign affiliate of a corporation cannot be added to the corporation’s CDA.
  2. Any capital dividends the company receives from other companies.
  3. The non-taxable portion of any gains on the sale of eligible capital property1 (added after the end of the tax year in which the gain is realized).
  4. Proceeds of life insurance policies
    If the whole life insurance policy has been assigned as collateral for securing indebtedness (as opposed to an absolute assignment of the policy) or is the subject of a hypothecary claim by the creditor, and the debtor remains entitled to the proceeds as beneficiary or policyholder, the net proceeds of the policy would be included in the debtor’s CDA. In such cases, the proceeds of the insurance policy would be constructively received by the debtor in its capacity as beneficiary or policyholder even if paid directly to the creditor in accordance with the assignment or hypothec. The creditor is neither the beneficiary of the policy nor the policyholder and would not be entitled to include the proceeds in its CDA because the amount it receives would not be considered to be proceeds of a life insurance policy.

    Effective 27 October 2010, life insurance proceeds paid directly to a creditor financial institution may be added to the debtor’s CDA, if:

    1. the life insurance proceeds are paid directly to the financial institution as either
        a. policyholder of a creditor’s group life insurance policy; or
        b. beneficiary of a life insurance policy owned by the debtor as policyholder; and
    2. pursuant to a contractual obligation, the life insurance proceeds are required to be applied (and are applied) in reduction of the debt of the debtor to the financial institution with any monies in excess of such debt being paid to the debtor.
    on death of the insured payable to the corporation less outstanding policy loan (if any) minus the adjusted cost base
    The Adjusted Cost Base on a life insurance policy is the sum of the premiums minus the net cost of pure insurance. When life insurance death benefits are paid to the corporation and therefore create a credit in the CDA that credit is the face value of the life insurance policy minus the ACB.
    of the policy immediately before death.
  5. Distributions a trust may make to the company by paying out capital gains the trust has realized, or capitals dividends it has received.

Minus the total of all capital dividends the company itself pays out.

Certain changes in a corporation’s status 1. If a private corporation that, at any time, had been controlled directly or indirectly in any manner whatever [subsection 256(5.1)] by one or more non-resident persons becomes a Canadian controlled private corporation (CCPC) at a particular time after 31 March 1977, otherwise than because of a change in the residence of one or more of the corporation’s shareholders, the CDA balance of the corporation will be reduced to nil immediately before the particular time [subsection 89(1.1)].

2. If at any time after 26 November 1987, a corporation that was exempt from tax under Part I of the Act ceases to be exempt from tax, the CDA balance of the corporation will be reduced to nil immediately after that time [subsection 89(1.2)].
will cause the corporation to lose its entire CDA balance.

Filing and Declaring a Capital Dividend

Qualified corporations have the sole discretion to designate any eligible income available to be a capital dividend accrued by filing the election form T2054 Election for a Capital Dividend Under Subsection 83(2) (be mindful that this form may change yearly) with the CRA. The due date of filing this stand-alone election form is on or before the earlier of the day that the dividend is paid or becomes payable. If the election is not filed before or at the same time the dividend is paid, the CRA will impose a late-filing penalty of approximately $42 per month.

A certified copy of the Director(s) resolution authorizing the capital dividend and a detailed calculation of the CDA at the earlier of the date the capital dividend is paid or becomes payable must accompany the Form T2054 to support the election.

Corporations paying dividends beyond the amount available in the CDA are subject to a 60% tax.

How CDA works

How capital gains from private corporation is paid out via CDA

The CDA is often used in estate planning. It allows Canadian resident shareholders to receive tax-free dividends in situations where they would not have been subject to tax on the amount if they had earned it directly, especially if the business has received certain life insurance proceeds, or if the business or its assets have been sold.

A common strategy is for private corporations to pay the premium of life insurance policies on key-person life insurance policies with the corporations named as beneficiaries. Death benefits of any company-owned insurance policy on the deceased will be added to the CDA, rendering such proceeds eligible for tax-free distribution. Shareholders may receive the resultant capital dividends tax-free in the future (not necessarily in the immediate future upon death of the insured).

This has significant estate planning advantages. Death benefits of insurance policies on the life of an insured will circumvent probate fees as benefits are paid directly to the named beneficiaries. By designating beneficiaries (other than one's estate) in life insurance policies, death benefits fall outside of estate and avoid disclosure as public records (since probated wills are public records accessible at a nominal court fee).

Astute people would realize that death benefits of life insurance policies are tax-free and not subject to probate even if received personally. Then, why bother? By buying life insurance with qualified corporations named as beneficiaries, retained earnings in the corporations are used to pay the premium and hence transferred to shareholders tax-free. This avoids being treated by CRA as a taxable benefit in the hands of the insured if the individual shareholders are policy-owner's beneficiaries. Furthermore, premiums paid are deductible. In the alternative, drawing retained earnings from a corporation by way of dividends or wages will be taxed personally and could incur applicable payroll expenses.

Be mindful that CDA created by capital gains could be eroded by capital losses. A wise strategy is to realize the capital gains, pay out the CDA and then realize any capital losses to maximize tax-free capital dividends. As a rule of thumb, CDA should be paid out as it accumulates to maximize its tax benefits.

Limitations of CDA in estate planning

To most incorporated companies, using corporate funds to invest and earn capital gains2 will generate passive income Passive income refers to income generated outside the main business activities of the corporation. It includes aggregate investment income such as rents, royalties, interest.. The 2017 corporate federal and provincial (B.C.) tax rate combined on the taxable passive income is about 49.67%. This high non-progressive corporate tax rate on passive income offsets some tax benefits of CDA.

Death benefits from life insurance policies payable to qualified corporations generate CDA when the insured dies. Since few people know when one will die, this creates uncertainty and restricts when capital dividends are available for tax-free distribution to qualified shareholders.

Furthermore, written consent from the board of directors by way of a certified true copy resolution is required to authorize distribution of capital dividends. If there are more than one director in the corporation, complications could arise if there is no prior written arrangement on when capital dividends should be distributed and to whom. Wills of the insured should be written to include distribution of capital dividends from corporations in which the insured has an interest.

Remarks

If used properly, CDA is a helpful tool in estate planning and corporate transition when a key-person dies. Like many tax planning schemes, using the CDA may not create immediate benefits and will require careful planning and meticulous implementation. Information presented herein is not professional advice. Professional advice from accountants and lawyers is strongly recommended.

References



1 Goodwill is not eligible for an election under subsection 14(1.01) or (1.02) of the Act.  ↩
2 Unless the capitals gains derive from the sale of capital assets that produce active income.  ↩

[This page was added on 16 October 2017, last revised 22 October 2017.]