What Is a Capital Dividend and How Does It Benefit Your Corporation

When an individual sells some property, investments or other assets (perhaps you have a Picasso lying around that's appreciated in value), only 50% of the gain is subject to tax. For example if you sell a rental property and realize a gain, after brokerage and expenses, of $100,000, only $50,000 will be taxable. (The actual tax that you pay will depend on your marginal tax rate at the time). The other 50% of the capital gain is a non taxable gain. For a corporation, however, this distinction is a little more complex. In order to allow corporations the same benefit as individuals with respect to capital gains and losses, the 50% non taxable portion of the gain on a corporate capital transaction is allocated to what is referred to as a Capital Dividend Account or CDA. The balance in the CDA, which is a cumulative balance over the lifetime of a corporation, is then available to the shareholders on a tax free basis.

Note that shareholders who receive capital dividends do not receive a T5 dividend slip since the dividend is effectively tax free. Instead the corporation is required to complete an election detailed below:

Components of the Capital Dividend Account:

The three most common transactions that increase the balance in the Capital Dividend Account are:

• Capital gains realized by corporation on the sale of assets

• Life insurance proceeds that accrue to the corporation on certain policies

• Capital dividends received from other corporations (when the corporation is an investor in another corporation)

The CDA account is reduced by:

• Cumulative capital losses

• Amounts paid out of the CDA as a capital gain dividend

How to Pay a Capital Dividend

Unfortunately, shareholders cannot simply withdraw the funds from the capital dividend account and be done with it. They must file an election on the date on which the dividend is paid or becomes payable, whichever is earlier. Note that this date is chosen by the taxpayer. Failure to file by the due date will result in a penalty so it is best to submit the forms by or before the due date. Forms to file the election are:

For Revenue Canada (CRA) file Form T2054, Election for a Capital Dividend Under Subsection 83(2) along with a copy of the capital dividend verification amount (Schedule 89)

The form is fairly straightforward,however, it is very important that the CDA balance should be correctly calculated otherwise the difference will be subject to a Part III tax at 60% of the excess amount (this can also be avoided with an additional election for which approval is required from all shareholders which allows the excess amount to be reflected as an ordinary dividend). The CDA balance, if not paid out annually, is usually an accumulation of several years. Your accountant or tax software should be able to provide the correct amounts. Another way to determine the CDA balance is to file schedule 89 (capital dividend verification balance) prior to declaring the dividend to ensure that excessive amounts are not inadvertently disbursed to the shareholders. Note that it might take some time for Revenue Canada to get back to you so best to file it as soon as you determine that you will be paying a capital dividend.

For Revenue Quebec the Capital Dividend Form CO-502 V must be filed along with a copy of the T2054 and Schedule 89 capital dividend verification balance, per above.

Other Points of Note:

• Shareholders who receive capital dividends do not receive a T5 slip since the dividend is effectively tax free.

• Capital dividends may only be paid by a private corporation. Public corporations are not allowed to pay capital dividends

• CDA balances can be combined in the event of an amalgamation or a wind up of a subsidiary

• Capital dividends to non residents are subject to Part XIII 25% withholding which must be submitted to CRA at the time of payment. See details on withholding and paying non resident remittances from Revenue Canada

• From an accounting perspective, the payment of a capital dividend is essentially reflected and grouped as a dividend in the shareholder's equity section. The journal entry for a capital dividend is:

  Debit: Dividends Paid

  Credit: Bank/Cash or Shareholder Loan (if a loan was made to the shareholder and the capital dividend is being paid to effectively clear out the shareholder loan account)

Having a capital dividend balance that may be parked in the company from previous years can be a great bonus to shareholders looking to withdraw funds tax free. Given the administration involved it might make sense to do this when enough funds have accumulated in the CDA, although the decision may be affected by the possibility of losses in a future year, potential sale of a company or the decision to take a company public.