Jean Turcotte, B.B.A., LL.B., D.Fisc, Fin.Pl., TEP – Director, Tax, Wealth and Insurance Planning Group with Sun Life Financial, looks at the capital dividend account and why it’s an essential tax and estate planning tool for your business clients.
Why the capital dividend account exists
Finding tax-saving opportunities in your client’s financial plan is a key part of your value as an advisor. The capital dividend account (CDA) is one of the few ways income can transfer tax-free from a corporation to an individual. And it has the potential to offer business clients a strategic advantage.
Canada’s Income Tax Act (ITA) is built on a system of integration. The system isn’t perfect, but the objective is to ensure income is taxed the same whether it’s earned directly by an individual, or by a corporation and then distributed to an individual. The CDA1, along with other mechanisms like the dividend tax credit, is a central part of this system.
The CDA allows certain amounts that are non-taxable, such as life insurance death benefits, received by private corporations in Canada to be credited to this account and then distributed tax-free to their shareholders.2 Another example of income qualifying for CDA credit is the excess of the non-taxable portion of capital gains over the non-deductible portion of capital losses.
How the CDA works
Certain tax-free amounts, when received by a corporation, are added to its CDA. A CDA is not a bank account; it’s a notional account that’s only relevant for tax purposes. It isn’t included on the balance sheet of the company, although it may be included in a footnote to the financial statements. The balance in this account, subject to an election being filed with the appropriate tax authorities, can be used to provide a tax-free dividend to shareholders of the corporation.
Canada’s 2016 Federal Budget includes changes to practices that may have been intended to maximize the CDA credit available to the corporation when an insured owner dies.
Sun Life Global Investments (SLGI) provides more information about the impact of these changes, plus a number of other key financial proposals to be aware of.
Who can pay tax-free capital dividends?
For a tax-free capital dividend to be paid by a private corporation to its shareholders, an election must be made under the ITA. Subsection 89(1) ITA defines a private corporation as a corporation that’s resident in Canada and isn’t a public corporation or a corporation controlled by one or more public corporations. And generally, this election is made by shareholders who are Canadian residents. A private corporation controlled by a non-resident could make an election under subsection 83(2) ITA, but with a withholding tax3 of 25% on the dividends, they won’t find this to be of any particular benefit.
How is the CDA calculated?
Additions and subtractions from the CDA are applicable only for a certain period. This period starts on the first day of the first corporate taxation year ending after April 1, 1971 (and at which time the corporation was private) and ends immediately before the balance in the CDA is to be determined.
To calculate the CDA during this period, it is the total of:
- the excess of the non-taxable portion of capital gains over the non-allowable portion of capital losses (including business investment losses) incurred by the corporation;
- the total capital dividends received by the corporation;
- the non-taxable portion of gains resulting from the disposition, in the period, of eligible capital property of the corporation;
- in simplified terms, the net proceeds of a life insurance policy received by the corporation as a beneficiary under the policy, less the adjusted cost basis (ACB) of that policy,
- the total of all capital dividends that became payable by the corporation in the period.
How do corporations declare a capital dividend?
First, a capital dividend is declared by the directors of the corporation and is made payable to the shareholders. A resolution of the directors declaring the dividend is recorded in the corporation’s minute book.
To convert an actual or deemed dividend into a capital dividend, the corporation files an election with tax authorities no later than the earliest time the dividend is paid or becomes payable. The election is filed using Form T20544, “Election for a Capital Dividend Under Subsection 83(2).”
Properly tracking CDA credits and declaring tax-free capital dividends can be complicated, and there are penalties for overstating the amounts. Clients need to work closely with their tax and legal advisors throughout this process.
Discuss the CDA with your clients who are shareholders of private corporations, especially those with holding companies and a life insurance need, to ensure they’re maximizing their tax strategy. The CDA is another potential benefit of corporate-owned life insurance, allowing the death benefit, less the ACB of the policy, to flow tax-free from the corporation to the shareholders.
Connect your client with a professional tax advisor, if they aren’t already working with one, so they can understand the potential benefits of the CDA and ensure they’re using it effectively.
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1 Subsection 89(1) of the Income Tax Act (ITA) defines what is included in the capital dividend account. CRA Interpretation Bulletin IT-66R6 (archived) reviews the inclusions in the CDA and the CDA mechanism.
2 The amount of the death benefit of a life insurance policy credited to the CDA must be reduced by the policy’s adjusted cost basis (ACB).
3 Paragraph 212(2)(b) ITA. The tax rate may be lower if specified by a tax treaty.
4 Section 502 of the Taxation Act (Quebec). Form CO-502 in Quebec.