tax-free

The Capital Dividend Account (CDA) is a powerful tax-planning tool for people who own shares in private businesses. This notional tax account (see “Why the CDA exists,” below) allows taxpayers to access tax-free amounts from private businesses.

But accidentally misusing the account could lead to steep penalties. Corporations paying dividends beyond the amount available in the CDA are subject to a 60% tax.

The CDA includes:

  • the cumulative excess of non-taxable gains over the non-deductible portion of capital losses;
  • capital dividends from other corporations;
  • the non-taxable portion of gains relating to the disposal of eligible capital property;
  • life insurance proceeds received in excess of the adjusted cost basis (ACB) of the policy; and
  • certain distributions made by a trust to a corporation.

From that amount, you’d subtract capital dividends paid. If the CDA balance is positive, a capital dividend can be declared for that amount by filing a T2054 form with supporting documents. The form must be filed on or before the date when the dividend becomes payable, or any part of the dividend is paid—whichever is earlier.

Warning

Life insurance owned by a trust (other than a bare trust) does not increase the CDA for corporate beneficiaries.

10 traps to watch for

  1. A negative CDA can affect future payouts if you’ve previously paid out the CDA and subsequently experienced capital losses.
  2. Life insurance proceeds received in excess of a policy’s ACB are a component of the CDA. Multi-life policies have only one ACB, so when each person under the policy dies, the policy’s ACB will reduce the credit to the CDA account at the time of each death.
  3. CRA may disagree with the characterization of a disposition of property as a capital gain.
  4. If corporations use different currencies to report taxable income to CRA, their CDAs also must be in those denominations.
  5. Capital dividends received by corporate trust beneficiaries are added to the corporation’s CDA at the end of the trust’s taxation year.
  6. For a trust dividend to be considered a capital dividend, the trust must reside in Canada the entire year.
  7. No matter when members of a partnership sell eligible capital property, the CDA credit happens at the end of the partnership’s fiscal year.
  8. The non-taxable portion of a gain on eligible capital property isn’t added to the CDA until the end of the tax year.
  9. The CDA will not increase for a death benefit payable after 2013 if it’s associated with borrowing under a 10/8 arrangement.
  10. The government has introduced draft legislation for tax years ending after March 20, 2013 that would prohibit death benefits of certain leveraged life insurance arrangements from increasing the CDA.

It’s not all bad news. The CDA now increases if proceeds of a key-person life insurance policy were paid directly to a creditor to reduce corporate debt. In this case, the proceeds (in excess of the policy’s ACB) will be added to the CDA, even though the creditor is the irrevocable beneficiary of the policy.

Why the CDA exists

The Capital Dividend Account 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’d earned it directly, especially if the business has received certain life insurance proceeds, or if the business or its assets have been sold.

Stella Gasparro, CPA, CA, is a tax and assurance partner at MNP LLP.

Originally published in Advisor's Edge

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