Kevin Greenard: Understanding Tax-Free Capital Dividends
Corporate taxation is different from personal taxation. Our corporate clients can take advantage of several advantages: tax deferral, income splitting possibilities, payment of tax-efficient dividends, etc. One of the less well understood benefits is the payment of capital dividends – it’s tax free. Unfortunately, if you don’t have a business account, this tax-free dividend doesn’t apply to you.
With marginal tax rates in British Columbia at record highs (the highest marginal tax bracket is 53.5%), it is beneficial for owners of Canadian-controlled private corporations (CCPCs) to use their Capital Dividend Account (CDC) to distribute dividends to their shareholders tax-free.
What is CDA?
The capital dividend account (CDA) is a notional tax account. A notional tax account means that it has no cash balance and is not reported in the financial statements. In the CDC, various non-taxable surpluses are tracked and these amounts can then be distributed to Canadian shareholders as non-taxable dividends.
The various non-taxable surpluses which are monitored are as follows:
1) The non-taxable portion of capital gains
In Canada, capital gains are currently subject to a 50 percent inclusion rate for income tax purposes. In other words, only half of the capital gains are taxable. The other half is not taxable and, therefore, can be added to CDC for distribution to shareholders.
For example, Dr. Jane Smith Inc. has $ 100,000 in capital gains for its fiscal year ended June 30. Half of these capital gains, also called 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.
Likewise, the CDA is also reduced by the non-deductible portion of capital losses.
2) Capital dividends (not taxable) from other companies
When a company pays a capital dividend to another company, the amount received directly increases the balance of the capital dividend account.
3) Death benefits of a life insurance policy
If the corporation is named as the beneficiary of a life insurance policy, the death benefits, less their adjusted cost base, are added to the capital dividend account and may be paid tax free.
Why is the CDC in the Income Tax Act?
CDA was set up for a concept called fiscal integration and aims to avoid double taxation. The purpose of integration is that income earned by a corporation and later paid to an individual would be subject to a similar amount of income tax if the income had otherwise been earned by a shareholder – no more and no less.
Without the CDC concept, dividends paid 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 an after-tax dividend to its shareholder, Dr. Smith. Now that Dr. Smith has received a dividend, she includes it on her tax return and pays tax on it at her marginal tax rate.
In contrast, with the concept of CDC, Dr. Smith Inc. can pay a dividend to the corporation that is not subject to tax in the hands of Dr. Smith.
As mentioned above, the non-taxable portion of capital gains is included in the CDA. Indeed, they would not have been taxable for the shareholder if the latter had realized these capital gains in his personal account, rather than in his CCPC. Likewise, death benefits from life insurance are not taxable and can therefore be included.
How much does my CDA cost?
A CCPC can request its CDA balance from the Canada Revenue Agency (CRA) by requesting a T2SCH89 “Schedule 89 Capital Dividend Account Balance Verification Request” once every three years, and the balance is also available on My Business Account (online platform). Positive CDCs can be paid out as tax-free dividends once the appropriate tax choices have been made.
How to declare CDA tax-free dividends?
The CCPC must file an election with the CRA no later than:
– the day on which the dividends become payable; or
– The day he gets paid.
The election form must be submitted with the following:
– A certified director’s resolution authorizing the election; and
– A schedule indicating the calculation of the CDA immediately before the election.
Company’s fiscal year end
Many companies can choose their fiscal year end when they are first incorporated. For example, if a business is incorporated on May 9, 2021, it can 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 physicians, or clients of a professional corporation, are limited to a December 31 year-end if they are members of a partnership.
Preliminary reports of loss of realized earnings
Two months before the end of the company’s fiscal year, we publish a preliminary report on realized gains (losses). The goal is to determine which transactions were made during the year (the first 10 months). There can be three outcomes: 1) realized capital losses, 2) no transaction resulting in no realized gain or loss, or 3) realized capital gains. We then look to see if the business has losses carried forward, or if a loss can be carried back to recover taxes.
If there are no loss carryforwards figures and the business has realized capital gains for the first ten month period, we can consider different options. If the company has positions in the portfolio with unrealized losses, then we might consider realizing them to offset the gains. Another situation can arise when the markets are doing well, every position in the portfolio is in a capital gain position – that’s a good problem to have. When this happens, it is prudent to discuss the desirability of a capital dividend with your accountant.
Potential change in the capital gains inclusion rate
Over the past year, I have had several conversations with accountants who believe the capital gains inclusion rate may change, which would affect all taxable accounts with unrealized capital gains. A company is considered a taxable account, that is, its income is taxable, including dividends, interest and realized capital gains. Unrealized capital gains mean that you currently own an investment that has increased in value (the market value is greater than your original book value / cost) that you have not yet sold.
Currently, the Canada Revenue Agency (CRA) taxes capital gains at 50 percent (the current inclusion rate). If a business account contains 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 percent would be taxable, or $ 185,000 ($ 370,000 x 50 percent). If the CRA changed the inclusion rate to 75 percent, then more of the gain would be taxable – $ 277,500 ($ 370,000 x 75 percent). To reduce this risk, we spoke with the accountants about the possibility of realizing the gains when the inclusion rate is 50%. Although the client speeds up tax liability, the actual tax liability may be lower 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 operations, is very complementary.
Communication is the key
We are normally the ones who proactively contact our clients about the possibility of paying a capital dividend. We obtain consent to speak directly to our client’s accountant. As a portfolio manager, we are able to know the earnings numbers sooner than your accountant. It is essential that the portfolio manager communicate this information to your accountant.
Clients who have a CCPC and wish to declare a capital dividend should ask their accountants to contact their portfolio manager. The portfolio manager can provide the accountant with the information he needs, such as a report of realized gains (losses) for his fiscal year to date to determine the amount of taxable capital gains to be added to the dividend account balance in capital.
Time of election
When we assist our clients’ accountants in preparing a capital dividend election, we also discuss the timing with the accountant. It is imperative that no transactions take place during this electoral process. We may delay the execution of any trade in the Account until the CDC election has been deposited (normally a period of one to two weeks). Once we have received confirmation from the accountant that the capital dividend election is complete, we can then resume trading in the account.
Kevin Greenard CPA CA FMA CFP CIM is Portfolio Manager and Director, Wealth Management within the Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250.389.2138, email [email protected] or visit greenardgroup.com/secondopinion