Capital dividends planning is an important tool for tax-savings and protecting shareholder relationships, but the process is more complex that its initial appearances. This article discusses some further considerations when drafting a strategic CDA plan.
Do negative gross capital gains always affect the ability to pay CDA dividends?
Throughout the lifetime of a corporation, the net value of its capital gains will fluctuate. Sometimes, the gross capital gains will be in the black (e.g., positive) and sometimes being in the red (e.g., negative). The capital gains and losses of a corporation do affect the balance of the corporate dividends account (CDA). If the gross capital gains are in the black, then this can prevent distributions being made from the CDA account based on the gross capital gains.
There is, however, a loophole to this effect. A corporation may still be able to declare CDA dividends by calculating CDAs separately, tracking them separately, and then accumulating them such that any negative CDAs have a net value of zero. However, there are further considerations in this process.
Let’s say a company realizes $8,000,000 of capital losses, but a life insurance policy of $800,000 has matured. Initially, the gross capital of the company would have been -$50,000 (due to the current 50% rate of 2020). However, by accumulating the $800,000 and rendering the other losses as zero, the overall CDA will be $800,000. Therefore, the company will be able to distribute $800,000 of dividends.
How are CDA dividends affected by previous pay-outs?
Tracking and aggregating CDAs is limited by previous CDA dividends, which puts a cap on the amount of future dividends that can be paid out. This is because CDA dividends can only be distributed insofar as the accumulated CDA balance exceeds the total amount of previous dividends paid out. Anything over this is the corporation’s CDA balance.
A corporation carries out a CDA strategy, selling any corporate assets with unrealized capital gains, declaring dividends, and realizing capital losses.
$10,000,000 of capital gains are realized, giving a gross capital of $400,000, which can be paid as CDA dividends where there have been no previous pay-outs. However, when the $10,000,000 are realized, the gross capital will be reduced to net zero, regardless of the timing. If the CDA dividends were already paid-out, then the CDA balance of the corporation will be zero. When the corporation receives the $800,000 life-insurance proceeds, only $400,000 will be available to be paid out in CDA dividends due to the previous pay-out of $400,000.
Without assistance from an expert accountant, strategic CDA planning can therefore still result in a limit on the amount of CDA dividends that can be paid out. This is a risk that many may be willing to take in their hour of need. Because these damages may not materialize for a considerable time, this is a downside that many are willing to take. However, there are ways that an expert accountant can be of value in creating a maximized CDA strategy that minimizes any restrictions in the future.
How does the Income Tax Act affect excess CDA dividends?
Wherever a CDA dividend exceeds a corporation’s actual CDA, the distribution is liable for Part III Tax on 3/5ths of this excess amount. However, by applying for specific elections that allow the excess to be treated as taxable distributions to the shareholder, this can be avoided. Such a process requires the timely and express consent of any shareholders, as it will directly affect their dividends.
What is the process for applying for an election on Part III Tax?
To avoid Part III Tax on excess dividends, it is necessary to acquire a T2054 election. This requires a CDA calculation to be submitted, which should generally be made by an expert accountant to avoid errors leading to a rejected election application. One way to make these calculations is to put in an application to the CRA for the official CDA balance of the corporation. However, this is also the slowest method, which may not suit time-sensitive operations, and CRA calculations should always be double-checked internally for errors.
Several other protective practices can be used to support a successful election:
- Accumulate as much evidence as possible to show that the director intended the CDA dividend to be limited to the CDA balance
- Choose a lower estimate of the CDA balance, even if this does not yield the strongest results
Key Takeaways on Strategic CDA planning
Choosing whether to maximize your CDA and how to do so without blocking your future potential to pay-out dividends is a complex process that is best handled by an experienced accountant. Additionally, the process of calculating CDA accounts to make a T2054 election can be fraught with errors and delays. Consult with an expert advisor today to navigate these issues and create a CDA plan that works for you, your business, and your shareholders.