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 Kid in the Candy Store: Human Nature, RRSPs, Free Cash and the Holy Grail

Several weeks ago I read a column by Rob Carrick titled “Why TFSAs Trump RRSPs for the young and lower paid.”. The column was premised on a paper by Jamie Golombek of CIBC on why TFSAs beat RRSPs as a better retirement savings for some Canadians. This topic has subsequently been beaten to death, but in this blog I want to concentrate on the exchange I had with Jamie in regard to human nature and its impact on investing.

The Globe and Mail had an online discussion about the above article and I sent in the following comment: “The problem with technically correct solutions is that they ignore human nature. As a Chartered Accountant I can tell you people consider their RRSPs holy and try their best to never withdraw from them. A TFSA or any accessible account is like candy, you stare and stare and then indulge.”

Jamie responded "you may be surprised to learn that that 80% of all RRSP withdrawals are made by individuals under age 60, generally pre-retirement! Not much of a holy grail!" Jamie's paper also reports that recent data shows 1.9 million Canadians withdrew $9.3 billion from their RRSPs in 2008 and taken in conjunction with the 80% withdrawal statistic noted above, suggests RRSP funds are being used well before retirement age to supplement income.

Jamie clearly considered the human nature aspect of investing in his report (see Accessibility of Funds on page 5) and provides statistics to develop or support the thesis of his paper. I have no issue with his statistics or his assertion RRSPs are being used to supplement retirement income by those under the age of 60. I do object however, to his contention that RRSPs are not considered the Holy Grail.

In my practice, I have observed that RRSPs are the Holy Grail for most of my clients. More importantly, RRSPs seem to act like those invisible fences for dogs and form an invisible barrier to prevent my clients from "grabbing" at their RRSPs; although I think Jamie would suggest the barrier may have some holes in it based on his statistics.

I asked Rob Carrick his thoughts on the matter and he responded, "I'm stunned every time I read stats on how many people take money out of their RRSPs, never mind TFSAs. The harder it is to withdraw from a retirement savings vehicle, the better."

On the surface, it is difficult to refute Jamie's assertion without my own statistics. Numbers are numbers. But, if we could dig a little deeper the same numbers may tell a different story. Here is where human nature and its impact on investing come into play. Human nature, like physical nature, takes the path of least resistance. At the end of the day, my professional observation of human nature takes me down the same road as Rob: the greater the barrier, the better - even if some ignore the barrier. Anyway, I will leave this for the psychologists to study and will return to my laboratory, being my office, and provide some personal experiences on human nature and free cash.

RRSPs, The Holy Grail Or Just Full of Holes

In my accounting practice, it has been my experience based on discussions with my clients, that they withdraw RRSPs almost exclusively for financial need only and not for discretionary purposes. I will concede that my client’s incomes are well above the national average and thus they may not be a representative sample. If we could somehow ask each person who withdraws funds from their RRSP in Canada, “why are you doing such and what is the intended use of the funds?", I am convinced that the vast majority would answer we are taking out the funds due to financial need and not for discretionary purchases. Most people take a certain pride and comfort in their RRSP savings. There is a peculiar permanency in investing in an RRSP that is not nearly as tangible in a TFSA or other savings account. Non-RRSP savings accounts seem to represent “leftover money”. RRSPs represent security from old age impoverishment. That is the Holy Grail. Most people cash out RRSP’s only under financial duress. Financial duress is not the same as supplementing income.

So what about those alarmingly counter-intuitive statistics that would suggest we have become an unholy nation desecrating their RRSPs? It is highly probable in my humble opinion, that many Canadians are convinced that they have to contribute to a RRSP by the various advertisements they are bombarded with in January and February each year by financial institutions and at the urging of financial commentators and in fact, many were really not in a position to contribute to their RRSP in the first place, thus dooming their RRSP from inception and inflating the withdrawal statistics.

I See It, I Want It

Now, assuming we are not compelled to withdraw our savings (or perhaps more aptly borrowings), restricted savings accounts are like invisible fences, or the glass in front of the candy counter. Withdrawing cash from an accessible savings account like a TFSA is relatively easy. Especially when we see that cash as “leftover earnings”, or as a well-deserved reward for how much we’ve earned or how hard we’ve worked. If we move away from restricted accounts such as RRSPs, the invisible fence seems to turn off. Now the buying is easy. Self-restraint is hard. Accessible cash quickly winds its way along the path of least resistance and a cash register.

I often observe the sweet lure of accessible cash in the actions of many self-employed individuals and professionals in respect of their quarterly personal income tax installments. Some make significant sums of money, but you would not believe how many don't have the funds to make their quarterly income tax installments. This results in huge income tax liabilities around April 30th and installment interest and penalties for failure to make these required installments. Why don’t they have this cash you ask? In some cases they have not collected their accounts receivable or received allocations from their partnerships, but in many cases, they have spent the free cash that should have been allocated to their income tax installments on discretionary items only because it is was easily accessible and winking at them.

A hot topic that has been widely debated recently is whether it is better for small business owners to eschew salary and RRSPs in favour of leaving the funds in their holding company. Technically leaving the money in the corporation is correct (although I have some reservations with this strategy because you stop RRSP contributions, lose eligibility for CPP income in the future if no salary is taken, and potentially forgo the deductibility of child care expenses if no salary is taken) but in my opinion, the candy (ie: available cash) will prove too tempting for most people and some of those corporate funds will find their way to cover that vacation they wanted in Europe or that new car or boat they have their eye on; whereas if those funds were contributed to a RRSP, the invisible fence effect would come into play. I have observed this first hand with the typical current holding company structure where excess profits from a operating company are moved to the holding company; this new twist would only create more accessible cash to potentially be withdrawn.

Intuitively Rationally Irrational

Although not directly related to free cash, an example of personal behavior superseding fundamental financial common sense is in relation to income tax refunds. Individuals can file a form T1213 to obtain waivers to reduce income tax withholdings in certain circumstances, but almost no one does. Ignoring the administrative issue of obtaining the income tax withholding reduction, which may contribute in part, individuals just love their lump-sum tax refunds (usually as result of their RRSP contributions) and they intuitively know they would not save an amount equal to the same lump-sum income tax refund if they had their income tax withholding reduced on a bi-weekly or semi-monthly basis.

I have only anecdotal evidence to prove people consider their RRSPs the Holy Grail. But really, is it unreasonable to accept that TFSAs or other non registered accounts are merely shelves displaying the cash candy to which our sweet tooth cash cravings will inevitably succumb? The path of least resistance generally ends at the cash register in the candy store. The high road is easier to follow when the candy case is locked. A financial vehicle that people feel is “locked in” will help stymie our natural inclination to self-indulge and spend and will only be accessed under financial duress and not necessarily as a supplement to retirement income. Now that is a Holy Grail indeed.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Introducing a Family Trust as a Shareholder in a Private Corporation

Two weeks ago I discussed using a holding company as a simple method to creditor proof excess corporate funds or other assets in a private corporation. In this blog I will discuss a “fancier” and far more complex transaction that can not only achieve creditor proofing, but potentially provides a means to income split with family members, potentially provides multiple access to the $750,000 capital gains exemption and finally, may provide a means to crystallize or "freeze" the income tax liability related to your company's shares at death.

For the purpose of this blog, I will  use the example of Starlet Yohansen who owns all the common shares of Movie Star Limited ("MSL"). The shares initially cost Starlet $1 and are now worth $3,000,000.

For Starlet to concurrently achieve all the objectives noted above, she would typically “freeze” the value of her  common shares in MSL. At the date of the “freeze”, Starlet would exchange her common shares for special preferred shares with a value equal to the value of the common shares exchanged, that being $3,000,000. Thus, at this point in time, there are no common shares and Starlet owns special shares worth $3,000,000. These special shares cannot increase in value, hence the term "freeze".

Any future growth in the value of MSL over the current value of $3,000,000 will accrue only to the new common shares that are issued as part of this reorganization. That growth will accrue directly, or indirectly through a family trust, to potentially Starlet's family members and/or a Holding company by having them subscribe for the new common shares issued in MSL (Starlet can also maintain some of the future growth if she subscribes for the new common shares or is included in the family trust). Often we see this strategy being used in succession planning when the owner-manager wishes to transfer ownership of their operating company to the next generation, but this strategy can be used without succession being the objective.

The beauty of the freeze is that Starlet's maximum income tax liability on her MSL shares has been established (unless she subscribes for more common shares). At Starlet's death, her income tax liability on her MSL shares will be equal to $3,000,000 times the applicable income tax rate at that time, likely around 23%. As Starlet knows the maximum income tax liability on her special shares she can plan to pay this liability by putting aside funds or by purchasing life insurance.

In addition, we often further reduce Starlet's  income tax liability by redeeming her frozen shares over time, which typically creates a current taxable dividend to Starlet, but also serves to reduce the value of the frozen shares by essentially the value of the dividend reported [ie: if Starlet redeems 500,000 shares that have a paid up capital and adjusted cost base of $1, she will have a deemed dividend of approximately $500,000 to report on her personal income tax return and her special shares are now only worth $2,500,000 ($3,000,000-$500,000 redeemed)]. Thus, if Starlet lives long enough, much if not all of her income tax liability can be eliminated prior to her death by redeeming her shares slowly over time.

If Starlet uses the Yohansen Family Trust to subscribe for the new common shares of MSL, the beneficiaries of the family trust would typically include Starlet, her spouse (although given Starlet's past history, we may want to leave her spouse out of the trust), her children and a Holding company. The inclusion of these beneficiaries can provide tax-effective income splitting on dividends received from MSL when the children are 18 years of age or older or when a spouse is in a lower income tax bracket (Starlet may have a trophy husband who does not have much income). The trust can also provide tax-effective income splitting on the sale of a business irregardless of the beneficiary’s age.

Generally, a family trust is discretionary. The trustees can tax effectively allocate the income received by the trust (i.e. dividends from MSL) to any or all of the beneficiaries including Starlet, so long as they are 18 years of age or older. A beneficiary who is 18 years of age or older and has no other sources of income can receive up to $37,500 in dividends tax-free. This strategy is a great way to help fund a child’s post-secondary school education (in addition to an RESP) or other expenses, while also lessening the family’s overall income tax liability.

If the shares of MSL are sold in the future, any sale proceeds in excess of the value of Starlet's original  frozen special preferred shares ($3,000,000 maximum) can be allocated to the beneficiaries of the trust. This may permit the utilization of the $750,000 capital gains exemption by each of these beneficiaries. A word to the wise though, any sales proceeds allocated to a beneficiary of the trust, including a minor child, will result in the money legally belonging to the child.

Finally, back to the original creditor proofing issue. The inclusion of a Holdco as a beneficiary of the trust would provide a means to transfer any excess funds in MSL as a tax-free via a dividend from MSL to Holdco thus creditor proofing the excess cash in MSL by moving it to Holdco.

I am sure there are very few readers still awake or with eyes not glazed over; but believe it or not, this type of reorganization has been simplified greatly for discussion purposes. There are several pitfalls along the way and in the future that must be avoided in order to successfully achieve the objectives noted at the beginning of this blog. If you are contemplating undertaking such a transaction, you must consult your accountant and lawyer to ensure that the transaction makes sense given your personal situation and that no details are missed in carrying out the finer points of the reorganization.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the material is time sensitive and subject to changes in legislation or law.