Every private Canadian business has a tax account that is particularly valued by shareholders: the capital dividend account. The reason why? When its balance is positive, shareholders receive a tax-free dividend. Here is how it works.
The capital dividend account (CDA) does not appear on a balance sheet. Occasionally, it is mentioned in the notes of financial statements, but nothing more. Even if this account remains discrete, shareholders have every interest in following it closely because it offers them an exceptional tax advantage: to be able to withdraw the company’s money without paying any taxes.
This is not an error or an oversight by tax authorities. On the contrary, the CDA exists precisely to enforce a major taxation principle: integration. This principle requires that every individual pays a relatively equal tax, regardless of whether their income is earned directly or through a company. It’s because of this principle that dividends are generally taxed less than wages.
As profits have already been taxed as business revenue, it would be unfair—under the principle of integration—to fully tax them a second time once these profits are transferred to shareholders as dividends. Considering that the first tax is paid by the company, the second tax—paid by the shareholder who receives the dividend—is therefore at a reduced rate.
The CDA respects the principle of integration, but follows a more complex path. It is a notional and purely fiscal account. Therefore, it does not appear in the business’s accounting books, and must be calculated separately each year.
Reserved for private Canadian companies, the CDA is a cumulative account in which the balance indicates the maximum amount that can be withdrawn without taxing shareholders.
Many elements can increase or decrease this balance, from the creation of the company up until its dissolution. The most common elements are:
capital gains and losses;
dividends received from another company;
proceeds received from a life insurance policy contracted by the business; and
gains and losses on the sale of certain fixed assets.
For a company, as for an individual, capital gains are taxable only at 50%. When a company makes a capital gain, the untaxed half of the gain will increase the CDA balance so that it can be returned to shareholders without being taxed. Conversely, when a company has a capital loss, the untaxed half of the loss will decrease the CDA balance.
This component of the CDA is particularly important for management companies, since a significant proportion of their assets may be investments that could generate capital gains and losses.
Once gains have been recorded for the year, it’s important to empty the CDA by transferring the money into the shareholders’ pockets, because you never know what the future holds. If the following year is less profitable for the business, capital losses could decrease the balance of the CDA—or even render it negative—reducing or preventing the transfer allowed to shareholders.
Whether or not they are management companies, businesses can increase the balance of their CDA in another way: by receiving a dividend from another company in which they also have shares. Through the CDA, this dividend could be paid back to the business’s shareholders who hold an interest in the company that generated the initial profit.
Businesses often take out life insurance policies to protect themselves against the risk of losing an important executive or employee, for example, or to facilitate the company’s purchase of the shares of a deceased shareholder.
When a company receives life insurance proceeds after a death, the company does not pay taxes on this death benefit. The difference between the death benefit received and the costs incurred by the company to pay insurance premiums (the base cost adjusted by the policy) represents net income. This net income adds to the CDA and can be paid to the company’s shareholders without them having to pay taxes.
This benefit can play a vital role in your estate planning. As a business person, you can use the CDA to maximize the amount—after taxes—that you will leave to your heirs.
Many other elements can change the balance of the CDA. The account increases when a company makes a profit by selling what the Canada Revenue Agency calls “eligible capital property.” These properties include intangible assets such as goodwill related to the goodwill of a business, for example. If there is a gain on a sale, the non-taxable portion of the sale proceeds is added to the balance of the CDA. Conversely, the balance decreases when a dividend is paid from the account.
Calculating the balance of a capital dividend account is complex. It requires considering several factors from the company’s beginning, and some tax regulations may have changed since then. The moment a certain event occurred or was recorded can significantly impact the calculation.
If shareholders want to maximize the CDA’s benefits, they must be careful not to pay themselves a capital dividend greater than the balance of the account. Otherwise, they face severe tax penalties.
Before paying a capital dividend, a company must exercise a tax election in accordance with the Income Tax Act and fill out a form within a specific deadline.
To avoid potentially costly errors, the methods of calculating and using a capital dividend account require the attention and expertise of a tax specialist who can help support your growth.
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