The Best of The Blunt Bean Counter - Capital Dividends - A Tax-Free Withdrawal from your Company

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game (which is not going well by the way, as my handicap has gone up 3 strokes since the beginning of the year). Notwithstanding my handicap increase, I just came back from an awesome trip to Cabot Links. The picture below of the 16th hole at Cabot Cliffs is a bit deceiving since the tee is actually to the left and further up, but it is a blind shot to a two tier green so no day in the park. Plus, when the wind blows it is crazy. The first day with no wind I actually hit to within 15 feet of the pin, the next day with huge winds I aimed ten yards out to the ocean and the ball still blew left of the green, pretty crazy.

Anyways, back to the topic at hand. Next week I start a three-part series on cottages, but today, I am re-posting a March 2015 post that discussed how small corporate business owners can take advantage of the Capital Dividend Account ("CDA"). Given I had over 80 comments, it was of definite interest.

As per my post last week, Tax Planning Using Private Corporations - The New Liberal Proposals there may be future tax changes that impact the CDA. However, at this time, I cannot state with any certainty how those changes may impact the CDA account. 

Capital Dividends - A Tax-Free Withdrawal from your Company

If you are a private corporate business owner, you may be sitting on a treasure trove of tax-free money. Yes, I said tax-free money. The source of these “free” funds is the CDA, which I discuss in greater detail below. Although a CDA account is most often found in holding/investment companies, the largest accounts are often generated in active companies who have sold all or part of their business.

Private business owners often discuss with their professional advisors whether they should take salary and/or dividends, which are both taxable to the owner when paid. However, surprisingly, the possibility of paying a tax-free dividend is often overlooked, which is possible if the dividend is paid from the Capital Dividend Account (“CDA”) of a private corporation to a Canadian resident individual.

The Capital Dividend Account

The CDA tracks certain amounts that are not taxable to the Company and may be distributed to shareholders with no personal tax. For example:

(i) if the company earns a capital gain which is 50% taxable, the half that is not taxable is added to the CDA.

(ii) if the company was paid a capital dividend from another company it invested in, that amount is not taxable and is added to the CDA.

(iii) if the company sells a particular eligible capital property (“ECP”) in the year, the portion of the gain that is not taxable is added to the CDA. Please note that the addition to the CDA occurs at the end of the year in which the sale of the ECP took place. As a result, the CDA cannot be paid out tax-free until the first moment of the following taxation year (there have been significant changes to the ECP rules since I wrote this post, please speak to your accountant. For reference, I wrote this blog post on the changes).

(iv) if the company receives proceeds from a life insurance policy which are considered to be non-taxable, this is added to the CDA.

(v) if the company incurs a capital loss, 50% of such amount that will not be deductible in the current or future years against capital gains and will reduce the CDA.

Filing and Declaring a Capital Dividend

The following are the filing procedures and considerations as to the timing of declaring a capital dividend:

i) For the dividend to be tax-free, the company needs to make an election on Form T2054 - Election for a Capital Dividend Under Subsection 83(2), which is due to be filed with the Canada Revenue Agency on or before the earlier of the day that the dividend is paid or becomes payable.

A certified copy of the Director(s) resolution authorizing the capital dividend and a detailed calculation of the CDA at the earlier of the date the capital dividend is paid or becomes payable must accompany the Form T2054.

If the Form T2054 and attachments are filed late, a penalty will arise.

ii) If the Canada Revenue Agency reviews the election and determines that the capital dividend paid (or declared) was too high, then a penalty, equal to 3/5 of the excess of dividend over the CDA balance available, will arise.

It is possible to avoid such penalty if an election is made to treat the excess portion as a taxable dividend at the time it is paid, and such election is filed within 90 days after the date of the notice of assessment in respect of the tax on the excess, noted above.

To avoid these negative consequences, it is important to properly calculate the CDA.

iii) The CDA is a cumulative account from the date of incorporation (assuming it has always been a private corporation). If the company has not previously filed a Form T2054, it will be necessary to review the historical capital gains and losses and corporate activities from the date of incorporation to the date of the dividend in order to determine the correct CDA balance.

iiii) The CDA is paid at a moment in time. If you have a CDA balance but incur a loss the next day, your CDA balance is reduced. Thus, in general, it is prudent to pay a CDA dividend when the account reaches a material amount (this amount is different to each person) so that you do not take the risk of a capital loss reducing the balance in the account. If you pay a capital dividend and then incur a capital loss, the account can go negative.

Further analysis may be required for any non-resident shareholders, since a payment from the CDA to a non-resident of Canada is subject to non-resident withholding tax and the dividend may be taxable in their country of residence.

Journal Entries

Some companies reflect capital dividends by adjusting journal entry (“AJE”), rather than paying the actual dividend. Where the dividend is paid by AJE, the shareholder loan is credited. This creates a tax-free loan owing from the company to the shareholder. The CRA has stated that an AJE on its own does not constitute payment of the funds and that a demand promissory note accepted by the recipient as absolute payment together with an indication of such an intention in the resolutions is at a minimum required to have the dividend considered paid and received.

Balance Determination

Where a company has had more than one accountant and/or has amalgamated with other corporations in the past, the determination of the CDA can be problematic. The CRA now allows you to file Schedule 89 to help your verify the account. Note, they may only verify part of the years, so for older companies, this may still be problematic.

Speak with your accountant to see if your private company has a CDA balance. If so, paying out a capital dividend should be considered as part of your Company’s overall remuneration strategy.

 

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Capital Dividends - A Tax-Free Withdrawal from your Company

If you are a private corporate business owner, you may be sitting on a treasure trove of tax-free money. Yes, I said tax-free money. The source of these “free” funds is the Capital Dividend Account (“CDA”), which I discuss in greater detail below. Although a CDA account is most often found in holding/investment companies, the largest accounts are often generated in active companies who have sold all or part of their business.

Private business owners often discuss with their professional advisors whether they should take salary and/or dividends, which are both taxable to the owner when paid. However, surprisingly, the possibility of paying a tax-free dividend is often overlooked, which is possible if the dividend is paid from the Capital Dividend Account (“CDA”) of a private corporation to a Canadian resident individual.

The Capital Dividend Account

The CDA tracks certain amounts that are not taxable to the Company and may be distributed to shareholders with no personal tax. For example:

(i) if the company earns a capital gain which is 50% taxable, the half that is not taxable is added to the CDA.

(ii) if the company was paid a capital dividend from another company it invested in, that amount is not taxable and is added to the CDA.

(iii) if the company sells a particular eligible capital property (“ECP”) in the year, the portion of the gain that is not taxable is added to the CDA. Please note that the addition to the CDA occurs at the end of the year in which the sale of the ECP took place. As a result, the CDA cannot be paid out tax-free until the first moment of the following taxation year.

(iv) if the company receives proceeds from a life insurance policy which are considered to be non-taxable, this is added to the CDA.

(v) if the company incurs a capital loss, 50% of such amount that will not be deductible in the current or future years against capital gains and will reduce the CDA.

Filing and Declaring a Capital Dividend

The following are the filing procedures and considerations as to the timing of declaring a capital dividend:

i) For the dividend to be tax-free, the company needs to make an election on Form T2054 - Election for a Capital Dividend Under Subsection 83(2), which is due to be filed with the Canada Revenue Agency on or before the earlier of the day that the dividend is paid or becomes payable.

A certified copy of the Director(s) resolution authorizing the capital dividend and a detailed calculation of the CDA at the earlier of the date the capital dividend is paid or becomes payable must accompany the Form T2054.

If the Form T2054 and attachments are filed late, a penalty will arise.

ii) If the Canada Revenue Agency reviews the election and determines that the capital dividend paid (or declared) was too high, then a penalty, equal to 3/5 of the excess of dividend over the CDA balance available, will arise.

It is possible to avoid such penalty if an election is made to treat the excess portion as a taxable dividend at the time it is paid, and such election is filed within 90 days after the date of the notice of assessment in respect of the tax on the excess, noted above.

To avoid these negative consequences, it is important to properly calculate the CDA.

iii) The CDA is a cumulative account from the date of incorporation (assuming it has always been a private corporation). If the company has not previously filed a Form T2054, it will be necessary to review the historical capital gains and losses and corporate activities from the date of incorporation to the date of the dividend in order to determine the correct CDA balance.

iiii) The CDA is paid at a moment in time. If you have a CDA balance but incur a loss the next day, your CDA balance is reduced. Thus, in general, it is prudent to pay a CDA dividend when the account reaches a material amount (this amount is different to each person) so that you do not take the risk of a capital loss reducing the balance in the account. If you pay a capital dividend and then incur a capital loss, the account can go negative.

Further analysis may be required for any non-resident shareholders, since a payment from the CDA to a non-resident of Canada is subject to non-resident withholding tax and the dividend may be taxable in their country of residence.

Journal Entries

Some companies reflect capital dividends by adjusting journal entry (“AJE”), rather than paying the actual dividend. Where the dividend is paid by AJE, the shareholder loan is credited. This creates a tax-free loan owing from the company to the shareholder. The CRA has stated that an AJE on its own does not constitute payment of the funds and that a demand promissory note accepted by the recipient as absolute payment together with an indication of such an intention in the resolutions is at a minimum required to have the dividend considered paid and received.

Balance Determination

Where a company has had more than one accountant and/or has amalgamated with other corporations in the past, the determination of the CDA can be problematic. The CRA recently announced that as of April, 2015, a CDA balance request form will be available to hopefully alleviate this tracking issue.

Speak with your accountant to see if your private company has a CDA balance. If so, paying out a capital dividend should be considered as part of your Company’s overall remuneration strategy.

 

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.Please note the material is time sensitive and subject to changes in legislation or law.

The Two Certainties in Life: Death and Taxes - The Impact on Small Business Owners

In my two prior blog posts in this series on death and taxes, I discussed with you the general income tax rules as they relate to the death of an individual. Today, I am going to discuss the income tax issues that arise on death, where you own shares in a private Canadian corporation (“CCPC”).

Note:You may own shares in a private corporation (typically a Canadian company controlled by non-residents) as opposed to a CCPC  or shares in a private foreign corporation. Although the general deemed disposition rule will apply upon death, for purposes of this blog post, I am not considering any issues related to these type entities. Please seek specific advice if you own such shares.

It has been my experience that some owner-managers of CCPC’s are surprised to find out that their shares are subject to the general deemed disposition rules upon death. The rule being: that upon your death, the shares of your CCPC (assuming the shares are not transferred to your spouse) are deemed to have been disposed of for proceeds equal to the fair market value (“FMV”) of those shares and a capital gain results to the extent that FMV (which is often difficult to determine for a CCPC) exceeds the adjusted cost base (“ACB”) of those shares.

There are two reasons I typically hear as to why the private company owner-manager does not think their shares are subject to the deemed disposition rules:

(1) They thought the corporate taxes they paid each year took care of that issue.

(2) They thought if they left the company to their children, their kids would be the ones who pay the tax (as per my blog on estate freezes, this tax can be mitigated, but not eliminated by undertaking an estate freeze).

The owner-manager may also be surprised to hear that their shares are potentially subject to double taxation if proper steps are not undertaken to alleviate this liability. Double taxation can occur where the estate pays tax on the deemed disposition reported on the owner-manager’s terminal tax return, and then the estate pays further tax when it removes the assets from the corporation in the form of dividends to the estate.

There are two tax planning strategies that can generally eliminate any double tax; however, both techniques have some potential restrictions:

(1) The first is known as a subsection 164(6) loss carryback. In simple terms a loss is created on a share redemption by the estate that reduces or eliminates the capital gain that arose as result of the deemed disposition on death. It should be noted that new legislation related to the changes to “graduated rate estates” could impact this planning in the future, as the loss carryback may be restricted.

(2) The second, known as the pipeline strategy allows the estate to remove the corporate funds tax-free by in very simple terms, transferring the deceased owner-manager’s shares to a new corporation and using redemptions and a netting of promissory notes to remove those funds tax-free.

However, a pipeline strategy can be problematic in certain circumstances.

Capital Gains Exemption

In many cases the owner-manager can avail themselves to the $800,000 capital gains exemption ("CGE") to utilize against any deemed capital gain. However, as discussed in this post, it can be problematic to access the exemption where the corporation has excess cash or the owner-manager dies suddenly without implementing the proper planning.

In summary, as morose as this sounds, if you own shares of a private corporation, you and your tax advisor should be proactively planning for your death, which includes monitoring on an ongoing basis, whether your shares will qualify for the CGE.

The planning process would in general start with a determination of your potential income tax liability on death, including an estimate of the liability related to your private company shares. This will lead to a discussion of whether or not your estate will have enough liquidity to cover that anticipated liability or if you need to consider purchasing life insurance to cover any taxes potentially owing upon your death. The discussion should then morph into a succession planning discussion, and whether or not an estate freeze/sale to family member would make sense in your situation, or what plans you have in regard to an exit strategy.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.