Taxation for corporations is different from taxation for individuals. Our corporate clients can take advantage of many things: tax deferral, income splitting possibilities, tax-efficient dividend payments, etc. One of the lesser understood benefits is the payment of capital dividends – it’s tax-free. Unfortunately, if you don’t have a corporate account, this tax-free dividend does not apply to you.
With marginal tax rates in British Columbia at all time highs (highest marginal tax bracket is 53.5 per cent), it’s advantageous for owners of Canadian-Controlled Private Corporations (CCPCs) to utilize their Capital Dividend Account (CDA) to distribute dividends to their shareholders tax-free.
What is the CDA?
The Capital Dividend Account (CDA) is a notional tax account. A notional tax account means that it does not have any cash balance and it is not reported on financial statements. In the CDA, various tax-free surpluses are tracked and then these amounts can be distributed to Canadian shareholders as tax-free dividends.
The various tax-free surpluses that are tracked include the following:
1) The non-taxable portion of capital gains
In Canada, capital gains are currently subject to a 50 per cent inclusion rate for income tax purposes. In other words, only half of the capital gains are taxable. The other half is not taxable and as a result, can be added to the CDA to be distributed to shareholders.
For example, Dr. Jane Smith Inc. has $100,000 in capital gains for her fiscal year ended June 30. Half of these capital gains, also known as taxable capital gains ($50,000) are subject to corporate income tax. The other $50,000 is not taxable and increases the balance in Dr. Jane Smith Inc’s CDA account.
Similarly, the CDA is also reduced by the non-deductible portion of capital losses.
2) Capital (tax-free) dividends from other corporations
When a corporation pays a capital dividend to another corporation, the amount received directly increases the balance of the Capital Dividend Account.
3) Death benefits from a life insurance policy
If the corporation is named as a beneficiary of a life insurance policy, the death benefits, less their adjusted cost base are added to the Capital Dividend Account and can be paid out tax-free.
Why is the CDA in the Income Tax Act?
The CDA was put in place for a concept called tax integration and aims to avoid double taxation. The goal of integration is that income earned by a corporation and later paid out to an individual would be subject to a similar amount of income tax had the income otherwise just been earned by a shareholder – not more and not less.
Without the concept of the CDA, dividends paid out by a CCPC would be taxed twice. For example, Dr. Smith has a corporation and is the sole shareholder of, Dr. Jane Smith Inc. The corporation pays out a dividend with after-tax dollars to its shareholder, Dr. Smith. Now that Dr. Smith has received a dividend, she includes it on her income tax return and pays tax on it at her marginal tax rate.
In contrast, with the concept of the CDA, Dr. Smith Inc. can pay out a dividend from the corporation that is not subject to taxation in Dr. Smith’s hands.
As mentioned above, the non-taxable portion of capital gains are included within the CDA. This is because they would not have been taxable to the shareholder had the shareholder realized those capital gains in their personal account, as opposed to within their CCPC. Similarly, death benefits from life insurance are non-taxable and therefore can be included.
How much is in my CDA?
A CCPC can request for its CDA balance from Canada Revenue Agency (CRA) by requesting a T2SCH89 “Request for Capital Dividend Account Balance Verification Schedule 89” once every three years, and the balance is also available on My Business Account (online platform). Positive CDA can be paid out as tax-free dividends after the proper tax elections are made.
How to declare tax-free dividends from CDA?
The CCPC must file an election with CRA on or earlier of:
- The day the dividends become payable; or
- The day it is paid.
The election form should be submitted with the following:
- A certified director’s resolution authorizing the election; and
- A schedule showing the calculation of the CDA immediately before the election.
Corporation year end date
Many corporations may choose their fiscal year end date when they first incorporate. For example, if a business is incorporated on May 9, 2021, it may choose to have its first tax period from May 9, 2021 to April 30, 2022. The second tax year would run from May 1, 2022 to April 30, 2023. Many of the medical practitioners, or clients with a professional corporation, are restricted to having a December 31st year end if they are a member of a partnership.
Preliminary realized gain loss reports
Two months prior to the corporation’s year end we run a preliminary realized gain (loss) report. The purpose of this is to determine what transactions have been realized during the year (first 10 months). There can be three outcomes: 1) realized capital losses, 2) no trades resulting in no realized gain or realized loss, or 3) realized capital gains. We then look if the company has loss carry-forwards, or if a loss may be carried back to recover taxes.
If there are no loss carry-forward numbers, and the company has realized capital gains for the first ten-month period then we can look at a couple of different options. If the company has positions in the portfolio with unrealized losses, then we could look at realizing those to offset the gains. Another situation can occur when markets are doing well, that every position in the portfolio is in a capital gain position – this is a good problem to have. When this occurs then discussing whether a capital dividend should be done with your accountant is a prudent move.
Potential change in the inclusion rate of capital gains
Over the last year I have had several conversations with accountants who feel the capital gains inclusion rate could change, which would impact all taxable accounts with unrealized capital gains. A corporation is considered a taxable account, i.e. its income is subject to taxation, including dividends, interest and realized capital gains. Unrealized capital gains mean you currently own an investment that has increased in value (market value is higher than your book value / original cost) that you have not yet sold.
Currently Canada Revenue Agency (CRA) taxes capital gains at 50 per cent (the current inclusion rate). If a corporate account has investments with a book value of $630,000, and a market value of $1,000,000 – then the unrealized gain would be $370,000. Currently if these gains were all realized (sold), then only 50 per cent would be taxable, or $185,000 ($370,000 x 50 per cent). If CRA changed the inclusion rate to 75 per cent then a greater portion of the gain would be taxable, or $277,500 ($370,000 x 75 per cent). To reduce this risk, we have discussed with accountants the option of realizing the gains when the inclusion rate is 50 per cent. Although the client is speeding up the tax liability, the actual liability may be less, if the inclusion rate is increased.
If a significant level of capital gains is realized, then the strategy of declaring a capital dividend, after these transactions is very much complimentary.
Communication is key
We are normally the ones who proactively reach out to our clients about the possibility of doing a capital dividend. We obtain consent to speak directly to our client’s accountant. As a Portfolio Manager, we are in a position to know the realized gain numbers sooner than your accountant. It is key that the Portfolio Manager communicates this information to your accountant.
Those clients who have a CCPC and wish to declare a capital dividend should have their accountants contact their Portfolio Manager. The Portfolio Manager can provide the accountant with the information they require, such as a realized gain (loss) report for their fiscal year to date to determine the amount of taxable capital gains to add to the Capital Dividend Account balance.
Timing of election
When assisting our clients’ accountants in preparing for a capital dividend election, we also discuss the timing with the accountant. It is imperative that no trades take place while this election process is being done. We can hold off on executing any transactions within the account until after the CDA election has been filed (normally a one to two-week period). Once we have received confirmation from the accountant the capital dividend election is complete, we can then resume trading within the account.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email firstname.lastname@example.org or visit greenardgroup.com/secondopinion.