Much effort is put toward discussing and implementing tax efficient strategies. Well, it doesn’t get any more tax efficient than tax free money. Enter the capital dividend account. Something every owner of a private corporation should know about.
What is it?
The capital dividend account is a notional account and not a literal account. In much the same way that your RRSP room keeps track of your unused RRSP contribution room, your CDA keeps track of the amount of money your private corporation can pay out as a tax-free capital dividend.
What goes in the CDA account?
The CDA allows certain amounts that are non-taxable, such as life insurance death benefits (more specifically, insurance proceeds in excess of the adjusted cost basis of the policy), received by private corporations in Canada to be credited to this account and then distributed tax-free to shareholders.
Another example of income that qualifies for CDA is the non-taxable portion of capital gains over the non-deductible portion of capital losses. The latter will be the focus of this article.
Ask your tax accountant to verify your current CDA balance. You may be surprised – the ability for your corporation to pay you tax-free money could be into the tens of thousands.
Regarding the latter, the CDA balance is essentially made up of:
- Capital dividends received from other corporations
- Plus, the non-taxable portion of capital gains
- Minus allowable capital losses
- Minus capital dividends paid out.
How does the CDA work?
As discussed, the CDA is a notional account that’s only relevant for tax purposes. You won’t see it generally 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 CRA, can be used to provide a tax-free dividend to shareholders of the corporation.
What should you know?
Your CDA can be reduced by capital losses. Remember we said that what goes into the CDA is the non- taxable portion of capital gains over the non-deductible portion of capital losses.
To be a little more specific, if gains are triggered during a fiscal corporate year, it is possible to pay out CDA and then trigger losses in the same year to offset the income tax that would otherwise result. CDA is a point-in-time calculation, so as long as it’s paid out before the losses are triggered, this would work.
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In future years, you’d still have to consider both the gains and losses in determining the current CDA. So, for example, if you triggered $100,000 in gains, you add $50,000 to CDA. Let’s say you pay out $50,000 in capital dividends at that moment. CDA is now $nil. Later in the same year you trigger $100,000 of capital losses. Net capital gains for the year are $nil, but essentially your CDA balance is -$50,000. So, to pay out more capital dividends in the future, you’d first have to trigger $100K in capital gains to get the CDA back to $nil.
So, triggering capital losses may put the CDA into a negative balance.
If you are considering triggering capital losses inside a corporation, you should consider paying out any available capital dividends first.
Something to be aware of is that where marketable securities are donated in-kind, the inclusion rate on the resulting capital gain is 0 per cent, meaning 100 per cent of the gain is added to CDA in this case.
Who can pay out CDA
For a tax-free capital dividend to be paid by a private corporation to its shareholders, an election must be made under the Income Tax Act. Subsection 89(1) ITA defines a private corporation as a corporation that is resident in Canada and is not a public corporation or a corporation controlled by one or more public corporations. And generally, this election is made by director(s) of the corporation who are Canadian residents. A capital dividend paid to a non-resident shareholder is subject to a federal withholding tax of 25 per cent (or a lower rate if specified by tax treaty).
How to pay out your CDA
For a tax-free capital dividend to be paid by a private corporation to its shareholders, the following steps must be taken:
- Your accountant needs to prepare a CDA continuity schedule up to a current date.
- Your accountant then needs to prepare form T2054, “Election For a Capital Dividend Under Subsection 83(2)” to elect to have the dividend treated as a capital dividend.
- Your lawyer prepares a certified copy of a directors’ resolution authorizing the capital dividend.
These three items are filed with CRA in advance of paying out the capital dividend (or else a late-filing penalty applies).
On the dividend payment date, the corporation could pay out cash accordingly. For small private companies, however, rather than paying out cash, the corporation often credits the shareholder loan account(s) of the recipient(s) and, to document that the dividend was actually “paid,” it issues notes receivable to the shareholders for the amount of the capital dividend.
What should you do with this information? Ask your tax accountant to verify your current CDA balance. You may be surprised – the ability for your corporation to pay you tax-free money could be into the tens of thousands. Next, you should either have it paid to you, or else declare the dividend on a certain class or classes of shares and pay it out by crediting the shareholder loan account and issuing a note payable to the shareholder. Use it or lose it. You could lose the opportunity to use your existing CDA balance if capital losses are triggered.
On an ongoing basis, I recommend discussing with your tax accountant how to avail yourself of annual tax-free withdrawals as desired. Many fee-only, advice-only financial planners who specialize in corporate planning are also happy to liaise between your investment advisor and tax accountant to co-ordinate tax-free withdrawals in harmony with your planning needs.
Nancy Grouni, a Certified Financial Planner with Objective Financial Partners Inc., specializes in financial, tax and estate planning for business owners and professionals. She is based in Markham, Ont.
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