Tax-Free Capital Dividends: Elections and Penalties

Posted on by Tax Partners
25
Dec

Introduction

Capital dividends offer a valuable means for Canadian private corporations to distribute tax-free funds to their shareholders. These dividends are distributed from a corporation’s Capital Dividend Account (CDA) and can provide significant financial advantages. However, it is crucial to understand the rules governing these distributions, as non-compliance can lead to severe penalties. This article explores the mechanics of capital dividends, the election process, and the consequences of excess or late-filed elections.

 

What Are Capital Dividends?

Capital dividends represent a return of capital to shareholders, which allows them to receive these funds tax-free. To issue a capital dividend, corporations must:

  1. Elect Under Section 83(2) of the Income Tax Act (ITA).
  2. File the necessary documents with the Canada Revenue Agency (CRA):
    • Form T2054.
    • A certified copy of the directors’ resolution authorizing the capital dividend.
    • Schedules showing the computation of the CDA immediately before the election (commonly using Schedule 89).

Key Conditions for Capital Dividend Elections:

  • The election must be made by the earlier of:
    1. The date the dividend becomes payable.
    2. The first date any part of the dividend is paid.
  • A corporation can only issue a capital dividend up to the balance in its CDA.

 

Understanding the Capital Dividend Account (CDA)

The CDA consists of the non-taxable portion of certain types of income that a corporation earns. Some key contributors to the CDA include:

  1. Non-taxable portion of capital gains (e.g., 50% of capital gains).
  2. Proceeds from life insurance policies received by the corporation.
  3. Non-taxable portions of eligible capital amounts.
  4. Certain trust distributions.
  5. Capital dividends received by the corporation.

For example:

  • If a corporation realizes a capital gain of $100,000, only $50,000 (50%) is taxable. The remaining $50,000 is added to the CDA and can be distributed as a tax-free capital dividend to shareholders.

 

Late-Filed Elections for Capital Dividends

If a corporation misses the filing deadline, it may still make a late election. To do so, the corporation must file the same forms and schedules required for an on-time election, along with the applicable late-filing penalty.

Late Filing Penalty Calculation:

The penalty is the lesser of:

  1. $41.67 per month (or part-month).
  2. 1/12 of 1% of the dividend amount per month.

For instance:

  • If the election is filed one year late:
  • Dividends over $50,000 incur a penalty of $41.67/month.
  • Dividends under $50,000 incur 1/12 of 1% of the dividend amount/month.

Special Consideration:

If the CRA issues a written request to file a late election, the corporation has 90 days to comply. Failure to meet this deadline bars the corporation from filing a late election for that specific dividend in the future.

 

Excess Capital Dividend Penalties

When a capital dividend exceeds the available balance in the CDA, the corporation faces a 60% penalty tax on the excess amount under Sections 184 and 185 of the ITA. 

Shareholders still receive the entire dividend tax-free, but the corporation bears the financial burden.

Common Reasons for Excess Dividends:

  • Errors in calculating the CDA balance.
  • Reassessments that reduce the CDA balance.
  • Timing mismatches, such as including a capital gain before the corporate year-end.

Relief Under Section 184(3):

Corporations can avoid the 60% penalty by electing to treat the excess amount as a separate taxable dividend. This election must be made within 90 days of the CRA's notice of assessment related to the excess capital dividend tax. Shareholders are deemed to have received the taxable dividend at the time of the original capital dividend declaration.

 

Key Considerations for Capital Dividend Elections

To ensure compliance and avoid penalties, corporations should:

  1. Verify the accuracy of the CDA balance before declaring a dividend.
  2. File all required documents and forms within the prescribed deadlines.
  3. Monitor reassessments and timing differences that may impact the CDA.

 

FAQs

What is a Capital Dividend?

A capital dividend is a tax-free distribution to shareholders from a corporation’s Capital Dividend Account (CDA), often derived from the non-taxable portion of capital gains and other exempt income.

What Happens if a Corporation Declares Excess Capital Dividends?

Excess dividends incur a 60% penalty tax on the overage. However, corporations may elect to treat the excess as a taxable dividend within 90 days of CRA’s notice.

 

Conclusion

Capital dividends offer a tax-efficient mechanism for Canadian corporations to reward shareholders. However, strict compliance with election rules and filing deadlines is essential to avoid penalties. Whether filing a late election or navigating excess dividend taxes, seeking guidance from a Canadian tax professional ensures optimal outcomes and adherence to the latest regulations.

 

This article is written for educational purposes.

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at [email protected], or by visiting our website at www.taxpartners.ca.

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