Hidden Treasure: Is There Tax-Free Money Buried in Your Corporate Tax Return?
Owner managers of small to medium-sized private corporations know that there are basically three ways to extract money from their corporations. They can return funds invested, either through shareholder loan repayments or return of capital, they can pay a wage, or they can pay a dividend. For the most part, obtaining this money tax-free requires either shareholder loans or the return of other tax-free capital.
There is, however, another type of dividend that is often overlooked. CDA dividends -- those paid from the corporation's Capital Dividend Account -- are completely tax-free to the shareholder. They are an effective, but often forgotten or under-used, source of funds from corporations.
What is a CDA and how are CDA dividends obtained?
Capital gains in Canada are taxed at a lower rate than most other forms of income. This is so because only half of capital gains are subject to tax. This is a fairly simple concept at the personal level, but it becomes a bit more complicated at the corporate level.
There are two key factors relating to CDAs. First, though corporations technically are taxpayers, the non-incorporated shareholders are the ultimate taxpayers in the Canadian tax system. Secondly, the system is designed so that, in theory, there should be no advantage or disadvantage to earning income inside or outside a corporation.
When a private corporation earns a capital gain, it too pays tax on only half of the gain. In order to maintain the "non-taxable" status of the other half of the gain, the Canada Revenue Agency (CRA) created the CDA mechanism.
A corporation's CDA (with some exceptions) includes the following amounts:
- The excess of the non-taxable portion of capital gains over the non-deductible portion of capital losses (including business investment losses) incurred by the corporation;
- the accumulated capital dividends received by the corporation from other corporations;
- the non-taxable portion of gains resulting from the disposition of eligible capital property; and
- the net proceeds of life insurance policies of which the corporation was the beneficiary.
In the majority of cases, the CDA comes from the non-taxable portion of a capital gain. However, it is common for life insurance policies to be part of estate/succession planning arrangements for small business corporations.
Once a capital dividend amount has been determined, the corporation can file an election with the CRA to declare a non-taxable CDA dividend to its shareholders. If holding companies are involved in the corporate structure, multiple elections may be required.
The election is due on or before the earlier of the day the dividend becomes payable and the first day on which any part of the dividend was paid. Penalties will apply for late filing.
There are also penalties for electing to pay more CDA dividends than are in the CDA pool. Amounts paid in excess of the CDA pool can be taxed at a 75% rate. (Proposed legislation, if enacted, could reduce the rate to 60%.) Thus, for every $100 of excess dividend, the corporation would pay a tax of $75.
More and more, private corporations are investing funds in the stock market. While this may be an effective use of the corporation's excess funds, it can present some difficulties in filing the election. As discussed above, the non-taxable portion of capital gains is netted with the non-deductible portion of capital losses. This is done on a cumulative basis, and therefore capital losses can cause significant problems when trying to determine the CDA pool at a particular point in time.
Once a CDA balance is calculated, the corporation generally should avoid any loss transactions prior to filing the election. Unfortunately, the stock market typically does not wait for Canada Post to deliver elections. Sometimes, in order to preserve capital, investments must be sold at a loss. In such situations, however, the CRA provides a mechanism whereby a corporation, with the consent of its affected shareholders, can elect to treat the amount of a CDA dividend that was paid in excess of the CDA amount available as a regular taxable dividend. While this election will make part of the "tax-free" dividend taxable, it will also avoid a corporate tax of 75%.
So, is there tax-free money buried in your corporate tax return? While most corporations do not regularly sell assets at a gain, it is possible that yours did at some point. It may very well be that all you need to do is file an election to get the tax-free money that is owing to you. Your Collins Barrow advisor can help you find out.
Michael Pestowka, B.Acc., CA, CFP, is a Tax Partner in the Chatham office of Collins Barrow.
Information is current to April 19, 2012. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.