“Consideration should be given to paying out capital dividends before capital losses are realized.”
The capital dividend account (CDA) is an important tax planning device for private Canadian corporations and their shareholders. The amount of the CDA can be paid out tax-free to Canadian shareholders as a “capital dividend”.
The CDA is a notional account that is calculated at any point in time and is composed of various items. The principal component is the “untaxed half” of a corporation’s capital gains, net of the non-deductible half of its capital losses. Any capital dividend that the corporation pays out reduces the CDA by the amount of the dividend.
For example, suppose a corporation with no CDA sells property on December 1 for a $1,000 capital gain. Immediately after the sale, the corporation’s CDA will be $500, and this amount can be paid out tax-free to shareholders as a capital dividend.
Suppose the corporation does not pay out the above capital dividend, but sells property on December 10 for a $1,300 capital loss. The CDA will be reduced by $650 so, immediately after the sale on December 10, the CDA balance will be reduced to negative $150.
A negative CDA balance does not trigger any tax. However, it remains negative, and until the corporation realizes enough capital gains (or other items as per below) to bring the CDA balance back to a positive amount, no tax-free capital dividends can be paid out.
Capital gains are not the only way the CDA can increase. The CDA definition is extremely complex, and includes capital dividends received from other corporations, certain life insurance proceeds and certain amounts from eligible capital property dispositions (e.g. goodwill).
Consideration should be given to paying out capital dividends before capital losses are realized. Such planning will allow shareholders to access corporate funds tax-free before the CDA is reduced. For example, using the above example, the corporation can pay out $500 tax-free, after the sale on December 1 through to immediately before the sale on December 10. After the sale on December 10 it cannot pay out any capital dividend. Paying out $500 prior to the sale on December 10 would provide the shareholders with $500 tax-free and later leave the corporation with a $650 negative balance in its CDA. This is a better result than no tax-free money to the shareholders until future realized taxable capital gains exceed $300.
If, over time, capital gains exceed the capital losses, this strategy provides tax-free money earlier rather than later, but the total amount will be the same. The time value of money is reason enough to try to pay out positive CDA balances before they are ground down. However, if the corporation will not have future capital gains to offset future capital losses, there is a permanent benefit, as otherwise no capital dividend could be paid out at all.
For example, corporations are often dissolved after a shareholder dies as part of the post-mortem planning process. Selling the “winners” before liquidating the “losers”, and paying out the CDA in between, can yield substantial permanent tax savings.
Your TSG representative would be happy to discuss planning for capital dividends with you.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.