The Capital Dividend Account

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(Thursday, January 21, 2010)

Summary

The Canadian income tax system is designed to integrate corporate and personal income taxation, so that individuals who make investments using Canadian Controlled Private Corporations (CCPCs) do not face a higher (or lower) income tax burden than individuals who invest directly. If a corporation has made capital gains, or received life insurance proceeds, it has received funds that are partially or wholly exempt from tax. The mechanism used to flow these tax free amounts through to the shareholders is the Capital Dividend Account (CDA). A corporation can pay a Capital Dividend from the Capital Dividend Account tax free to shareholders.

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The computation of the balance in that Capital Dividend Account is very complex, and subject to many special rules. Please consult your tax accountant before paying out a capital dividend.

The basic calculation of the balance in the Capital Dividend Account is:

Additions	Subtractions
The non taxable portion of capital gains at the appropriate fraction for the year (50% currently, has been 25% and 33.33%)	The non deductible portion of capital losses at the appropriate fraction for the year (50% currently)
Capital Dividends received from other corporations.	The non deductible portion of Business Investment losses.
The non-taxable portion of gains on the sale of eligible capital property	Capital Dividends paid out
Life insurance proceeds received by the corporation, net of the Adjusted Cost Base of the policy.

The balance of the Capital Dividend Account is the cumulative total of all of the above items since 1972 (when Capital Gains started to be taxed). However, only private corporations are entitled to have a Capital Dividend Account, so that a corporation that existed as a non-private corporation only starts to accumulate a CDA after the date it became a private corporation.

There are several important points to consider when planning a capital dividend:

· An election to pay a capital dividend should be made on form T2054 and sent to Canada Revenue Agency on or before the date the dividend is paid out. Late filed elections may be accepted, but are subject to a penalty.

· If the dividend exceeds the balance of the Capital Dividend Account, a tax equal to 60% of the excess of the dividend over the balance in the Capital Dividend Account is payable by the corporation.

· Capital dividends can be declared and paid at any time in the corporation’s fiscal year – thus, as soon as a significant balance builds up in the capital dividend account, it can be paid out.

· If a capital dividend is paid out, reducing the capital dividend account to zero, then later on a capital loss or business investment loss occurs, there is no effect on the dividend paid out. (However, the account balance must become positive due to additions in order to pay out another dividend.)

· If a capital dividend is paid out, and it is determined that the main purpose of buying the shares was to receive the dividend, the dividend may become a taxable dividend.

The major tax planning consideration for capital dividends is to pay out a dividend as soon as it becomes available, particularly if there is a possibility of incurring losses in the future. A running account balance should be kept in the accounting records, so that an opportunity to pay a capital dividend is not missed.