March is flow-through share season: the time of year when Canadian resource and exploration companies are most likely to be out raising funds. Charitable-giving strategies using flow-through shares are relatively well known, but strategies using a corporate client’s capital dividend account, or CDA, are underutilized.
People say the CDA is a valuable tool, but don’t elaborate on why or how it can be used in different tax-planning strategies or quantify its value. Consider: A shareholder of a company can have the company purchase flow-through shares, utilize the tax deductions and donate the shares in-kind.
Depending on the tax attributes of the company, a $100,000 donation to a charity may result in a net cost to the shareholder of only $5,000 (depending on the province of residence). The power of this strategy is the ability to increase the amount inside the company available for tax-free distribution.
About flow-through shares
To encourage exploration and resource development by Canadian oil and gas, mining or renewable energy companies, the government allows companies to issue flow-through common shares.
These companies use the proceeds for exploration and development and renounce or flow through its tax deductions (many of which can’t be used by these yet-to-be-profitable companies) to shareholders for use on their own personal and corporate tax returns. Investors generally are able to deduct the entire cost of the flow-through shares from their net income.
By doing so, the investment’s adjusted cost base becomes zero, meaning the entire value of the investment will be taxed as a capital gain when it is sold — a good deal, when you consider only 50% of all capital gains are taxable. Most people like to think of flow-through shares as an investment and a tax tool in one. However, as with most tax analysis, you must consider the investment in conjunction with the tax attributes.
To help investors diversify their holdings, many choose to invest in flow-through limited partnerships, which in turn invest in a number of exploration and development companies. These partnerships are then typically rolled over into a mutual fund. This can spread the risk among a number of different companies.
For tax purposes, a gift of securities is normally treated as a disposition at its fair market value. However, when you donate publicly listed securities directly to a registered charity, you are not required to pay tax on capital gains realized on the disposition. Shares, bonds and other rights listed on a Canadian or foreign-prescribed stock exchange, as well as Canadian mutual fund units and segregated fund units, qualify for this incentive.
Advantage of the CDA
The CDA is a notional account that tracks the amount of a company’s tax-free income that can be distributed tax-free to shareholders. The CDA typically consists of the tax-free portion of capital gains (currently 50% of the gain) as well as life insurance proceeds. Where eligible shares are donated to charities, the full amount of the gain (not just the 50% portion) goes into the CDA.
The amount tracked in this account can then be distributed to shareholders tax-free as a capital dividend. In certain provinces, the tax rate to pay out a dividend can be in excess of 40%, so you can see the value of converting this otherwise-taxable dividend into a tax-free capital dividend.
It’s worth noting the importance of working with a company’s accountants when selling corporate assets or investments at a loss. If you’ve sold assets at a loss, this reduces the tax-free amount available for distributions. Inadvertently paying out a capital dividend in excess of the CDA balance can result in heavy tax penalties.
Personal or corporate?
Should a philanthropically inclined shareholder donate as an individual or donate assets from their corporation? As with most questions of this nature, it depends. For example, if the individual investor is expecting to receive a large lump sum of taxable income (stock option benefits or gain on the sale of a business are two examples), investing in a flow-through limited partnership can offset the gain and defer taxes to another year when the shares are sold. In addition, seniors who are receiving OAS payments might also find it more efficient to invest as an individual in order to lower their net income in certain years, making them eligible for full or partial OAS payments.
In addition to creating an opportunity to extract funds, the small business that chooses to invest in a flow-through share can utilize the tax deductions to reduce company income to the small business limit — generally between $400,000 and $500,000, depending on the province — thereby reducing taxes payable.
When determining whether it makes more sense to invest and take deductions personally or in a private company, it is necessary to weigh these scenarios along with the different personal and corporate tax rates and donation tax credits, as well as the long-term plans for winding up the company.