Using the Capital Dividend Account to Pay Tax-Free Dividends
Introduction
A private corporation with a positive capital dividend account holds something unusual. It has the ability to move money to its Canadian resident shareholders without any further tax being paid by anyone.
Most corporate distributions attract tax in the shareholder’s hands. This one does not, which makes the balance one of the more valuable assets a private corporation can hold, even though it appears nowhere on the balance sheet.
The question for a business owner is not usually how the account works. It is when to use it, how much to take, and who should receive it.
The Balance Is Not Permanent
The most important planning point is that the account is not a vault. The balance can decline without any dividend being paid.
The principal contributor for most corporations is the untaxed portion of capital gains, reduced by the non-deductible portion of capital losses. A corporation that realizes gains in one year and losses in a later year can watch the available balance shrink.
This has a direct consequence. A balance that exists today may not exist in three years, and the opportunity to distribute it without tax disappears with it.
Corporations holding investment portfolios with both unrealized gains and unrealized losses should be particularly alert to this, because the sequence in which positions are realized determines what remains available.
The Case for Paying Sooner
Given that the balance can erode, the general bias should be toward using it when it exists rather than leaving it for later.
This runs against the instinct of many owners, who prefer to leave funds in the corporation and extract only what is needed.
The distinction worth drawing is that paying a capital dividend does not require the money to leave the owner’s control. It requires the dividend to be declared and paid. What the shareholder then does with the funds is a separate decision.
Where liquidity is a constraint, the dividend can often be satisfied other than in cash, which preserves the balance without stripping the corporation.
Liquidity and How the Dividend Is Satisfied
The account is notional. It records an entitlement, not a pool of money, and a corporation can easily have a substantial balance with no cash to distribute.
Several routes exist to resolve this. The dividend can be paid in cash where funds permit. It can be satisfied by a promissory note payable to the shareholder. It can be paid in kind using corporate property.
Each route carries its own considerations, and a dividend in kind involves a disposition of the property being distributed, which may itself produce tax.
The point for planning purposes is that an absence of cash is not by itself a reason to leave the balance unused.
Who Receives the Dividend
A dividend is paid on a class of shares, and every holder of that class participates according to their holdings.
In a corporation with a single shareholder, this raises nothing. In a corporation with several shareholders, it determines who benefits from a balance that may have arisen from circumstances connected to only one of them.
Where the balance arose from a life insurance policy on one shareholder, for instance, and the shares are held equally, a dividend on that class distributes the benefit equally regardless of the source.
Share structures with separate classes held by different shareholders give flexibility here. That flexibility has to be built into the structure in advance, since it cannot be created at the moment a dividend is contemplated.
Non-Resident Shareholders
The tax free treatment applies to Canadian resident shareholders.
A capital dividend paid to a non-resident is generally subject to withholding tax, at the statutory rate or at a reduced rate where a treaty applies.
For corporations with shareholders who have emigrated, or who were always non-resident, this needs to be confirmed before the dividend is declared rather than discovered when the withholding obligation arises.
It also raises a planning question in corporations where only some shareholders are non-resident, since a dividend on a class shared by both will be treated differently in different hands.
Dividends Paid to Holding Companies
Where the recipient is another corporation rather than an individual, the amount received credits the recipient corporation’s own account.
This allows the balance to move up through a group and ultimately reach the individual shareholders without tax.
The dependency this creates is worth noting. The recipient corporation’s balance now rests partly on the validity of the election made by the paying corporation, and the supporting documentation for both steps should be retained together.
Timing Within the Year
The balance is measured at a point in time rather than at a year end, and amounts are generally added as they are realized.
This makes the sequence of events around a declaration consequential. A transaction occurring between the declaration and the filing can change what the balance supports.
The practical approach is to confirm the balance, declare, file and pay within a defined window, and avoid realizing losses or making other distributions in the interim.
Corporations that treat this as a year end compliance item rather than as a transaction with its own timing requirements tend to encounter problems.
Estate and Succession Planning
The account frequently plays its largest role at death.
Where a corporation receives a death benefit on a policy it owns, a substantial credit arises. That credit can then fund a distribution to the estate without tax, which is often the mechanism relied upon to cover the tax liability arising on the shareholder’s death.
Plans built on this should be checked against the current expected credit rather than a figure prepared when the policy was issued, since the amount available changes over time.
The steps required at that point are time sensitive, and the estate will be dealing with them under pressure. Documenting the intended sequence in advance is worth the effort.
Common Planning Mistakes
Several errors recur.
Leaving a balance unused on the assumption it will still be there later, when subsequent capital losses can reduce it.
Treating a shortage of cash as a reason not to pay, when other routes exist.
Declaring a dividend on a class shared by shareholders who were not intended to participate equally.
Overlooking withholding obligations where a shareholder is non-resident.
Paying the dividend before confirming the balance, which removes the flexibility to adjust the amount and exposes the corporation to a penalty tax on any excess.
Conclusion
A positive capital dividend account allows a private corporation to distribute funds to its Canadian resident shareholders with no further tax, which is an advantage few other corporate assets provide.
The balance is not permanent. Subsequent capital losses can reduce it, which generally argues for using it when it exists rather than preserving it indefinitely.
A shortage of cash is not a barrier, since the dividend can be satisfied by note or in kind, though each route carries its own consequences.
Because a dividend is paid on a class of shares, the share structure determines who benefits, and that structure has to be in place before the question arises. Non-resident shareholders are subject to withholding rather than receiving the amount free of tax.
The balance should be confirmed before anything is declared, and the declaration, filing and payment handled as a single sequence rather than as separate events.
Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.
This article is written for educational purposes.
Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.
Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.