The ability to pay capital dividends is a great benefit of private corporations. Capital dividends are tax-free distributions paid to Canadian resident shareholders. These distributions are paid from the Capital Dividend Account (CDA) of the corporation by filing an election in a timely manner.
The purpose of the CDA is to track tax-free surplus received by the corporation. There are three common components to this account: non-taxable portion of capital gains less the non-deductible portion of capital losses, life insurance proceeds received on certain policies and capital dividends received from other corporations.
Based on current tax law, 50% of capital gains are subject to tax and 50% of capital losses may be deducted from taxable capital gains in the determination of taxable income. Therefore, the other 50% of the gains or losses is included in the calculation of the CDA. It is important to note that the CDA is a running balance that is calculated at a point in time. Therefore, 50% of capital gains may be added to the account and paid out as a capital dividend reducing the balance to zero. If capital losses are subsequently incurred, it is possible for the account to become negative.
It is common for corporations to be named as the beneficiary of life insurance policies for certain shareholders, directors or key employees. Depending on the terms of these policies, the premiums paid are often non-deductible to the corporation. As a result, the net proceeds (proceeds less adjusted cost base) received upon the death of the individual are non-taxable to the corporation and added to the CDA. This is a high level overview and there are many added complexities in determining whether life insurance proceeds will be added to the CDA and the amount to add.
The capital dividend account may also be adjusted when corporations are combined by an amalgamation, merger or winding-up. The CDA balances of the predecessor corporations may be carried over to the surviving corporation subject to certain adjustments.
Once the CDA has been calculated, an election must be filed to pay a capital dividend. This election is done in prescribed form and submitted to Canada Revenue Agency for approval. This form is required to be filed on the earlier of the date the dividend becomes payable and the first day on which any part of the dividend is paid. Late-filed elections may be accepted but will be subject to a penalty in the amount of the lesser of $41.67 or 1/12 of 1% of the amount of the dividend, multiplied by the number of months or part months that the election is late. Payment of the penalty must be submitted with the late-filed election form.
Excessive elections will be subject to a penalty. The penalty is calculated as 60% of the excess amount. If an excess amount is paid, you may be able to file an election to treat the excess amount as a taxable dividend paid on the same date as the capital dividend. This election must be made within 90 days of the assessment of the penalty and no later than 30 months after the dividend originally became payable.
Capital dividends should only be paid to residents of Canada to achieve the tax-free benefits. Capital dividends paid to non-residents are subject to a withholding tax of 25%. This withholding tax may be reduced depending on the terms of any applicable tax treaties. It is critical to properly structure your corporation to ensure that resident and non-resident shareholders do not own the same class of shares if you plan to elect to pay a capital dividend on that class.
Capital dividends offer the rare opportunity for business owners to receive large, tax-free sums of money personally. There are many nuances to calculating the CDA balance and ensuring you are in compliance with your obligations when making payments from this account.
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