Unlocking the Power of the Capital Dividend Account

The Capital Dividend Account (CDA) is a powerful mechanism that allows private Canadian corporations to distribute capital dividends to Canadian resident shareholders tax-free. Understanding how the CDA operates is crucial for optimizing tax efficiency and enhancing an investor’s wealth as it is one of the few ways to make a tax-free withdrawal of funds from a corporation. 

Understanding the Capital Dividend Account

The CDA is a notional account that tracks the non-taxable portion of specific types of income, enabling a corporation to distribute these amounts as tax-free capital dividends to its Canadian resident shareholders. It should be highlighted that the term notional account means that the CDA is not a physical account but rather a tax account used for tracking purposes. The purpose of the CDA and capital dividends is to ensure that certain tax-free amounts received by a private corporation (see below for examples) are treated similarly in the hands of the corporation and its shareholders. The balance of the corporation’s CDA is tracked on Schedule 89 Request for Capital Dividend Account Balance Verification of the T2 Corporation Income Tax Return when it is filed. However, the balance of the CDA can be calculated and paid at any point in time throughout the year. 

Caution: Non-Resident
Foreign jurisdictions might not recognize capital dividends as tax-free and instead may treat them as taxable income. Moreover, a capital dividend paid to a non-resident shareholder is subject to Canadian withholding tax. Thus, paying capital dividends to non-resident shareholders is generally not ideal since they don’t receive the same tax treatment as resident shareholders.

How the CDA balance is calculated is extremely complex, however, the primary components of the CDA include:

1.      Non-Taxable Portion of Capital Gains: When a corporation realizes a capital gain, only 50% is taxable. The remaining 50%, known as the non-taxable portion, can be credited to the CDA.¹

2.      Life Insurance Proceeds: Proceeds from a corporate-owned life insurance policy, less the policy’s adjusted cost basis, can be added to the CDA upon the insured's death.

3.      Capital Dividends Received: Capital dividends received from another corporation’s CDA can be added to the recipient corporation’s CDA.

4.      Non-Deductible Portion of Capital Losses: The 50% non-deductible portion of capital losses reduces the CDA balance proportionately. 

From an investment perspective, the key opportunity lies in strategically realizing capital gains and capital losses to maximize the CDA, enabling future tax-free capital dividends to be paid to shareholders.

As a simple example, let’s look at how the CDA operates when a capital gain is realized. Apex Enterprises Inc (“Apex”), a private Canadian corporation owned by an individual shareholder, invested $500,000 in an equity position on January 1. Prior to this investment the corporation’s tax advisor confirmed that Apex’s CDA balance was $0. The investment performed very well and by December 31 the investment had grown to $600,000. At this point, the position was sold, triggering a $100,000 capital gain. Of this $100,000 capital gain, $50,000 (50%) is taxable and $50,000 (50%) is non-taxable. The $50,000 non-taxable portion of the capital gain can be immediately credited to Apex’s CDA thereby increasing the balance of the CDA from $0 to $50,000. Following this, Apex’s shareholder can elect to pay themself a $50,000 capital dividend tax-free from the CDA whenever they so choose.

Capital Dividend Account: A strategic approach

When contemplating CDA planning, there are some key aspects to consider to maximize the opportunity.

1. Investment selection

Choosing the right investment mix is essential to maximizing capital gains. More specifically, focus on growth-oriented investments, e.g., appropriate stocks, mutual funds, exchange traded funds (ETFs) or segregated funds that aim for capital appreciation as opposed to income (i.e., interest, dividends or foreign income). Keep in mind, there is no opportunity to take advantage of the CDA when earning income inside of a corporation. By holding investments with growth potential within a corporation, investors can generate capital gains when they sell to build the CDA. 

2. Crystallizing capital gains

Selling appreciated assets during favorable market conditions not only maximizes the capital gain but also enhances the CDA balance. Further, strategic timing can help mitigate risks and align with the client’s broader investment strategy.

3. Tax loss selling

Tax loss selling involves selling investments at a loss to offset taxable capital gains. While this reduces the taxable portion of capital gains, the non-deductible portion of a capital loss reduces the balance of the CDA. Clients need to be mindful of the impact that tax loss selling has on the CDA. Simply put, the order of operations matters and paying out a capital dividend prior to realizing capital losses is generally recommended.

Strategic CDA planning example:

To demonstrate the benefits of strategic CDA planning, let’s look at Apex once again. As in the previous example, we’ll assume that Apex’s CDA balance is currently $0. Meanwhile, Apex holds a portfolio of investments, including investable assets with $500,000 in unrealized capital gains and $500,000 in unrealized capital losses.

The shareholder of Apex now requires liquidity personally to purchase a cottage and will need to sell the entire portfolio. The shareholder has two options:

1. Liquidate the entire portfolio at once, or
2. Implement a strategic CDA plan and liquidate the portfolio strategically

By choosing to liquidate the entire portfolio at once, from a CDA perspective, the non-taxable portion of capital gains of $250,000 ($500,000 x 50%) would be offset by the non-deductible portion of capital losses of $250,000 ($500,000 x 50%). Thus, the CDA balance would remain at $0. Therefore, the only way for the shareholder to extract funds from Apex would be by way of taxable dividends.

Alternatively, by implementing a strategic CDA plan, the shareholder would first sell the portion of the portfolio with the $500,000 capital gain allowing $250,000 ($500,000 x 50%) to be added to the CDA. From there, the shareholder would pay themselves a $250,000 tax-free capital dividend from the CDA bringing the CDA balance back to $0. Finally, the shareholder would liquidate the portion of the portfolio with the $500,000 capital loss resulting in a $250,000 ($500,000 x 50%) reduction to the CDA. The CDA would go into a negative balance of $250,000, however, what they have realized is true tax savings of $119,250²- the amount of tax that would otherwise be payable if the $250,000 was instead paid as an ineligible dividend at a tax rate of 47.74%. Lastly, these transactions would not result in any net tax liability to Apex given that the realized capital gains and capital losses would offset each other from an income tax perspective.

Often this type of planning is done in contemplation of a future corporate wind-up. It’s important to note that there are no adverse consequences when winding-up a corporation with a negative CDA balance. So, if Apex is wound-up before generating any future capital gains, the $119,250 of tax savings becomes a permanent tax benefit.  

This example highlights the importance of proactive tax planning and the value of leveraging the CDA to optimize liquidity and minimize tax liabilities for private company shareholders.

Other key considerations

1. Monitoring the CDA balance

Accurate tracking of the CDA balance is essential to avoid over-distributing capital dividends. If the amount of the capital dividend exceeds the balance of the CDA, the corporation may have to pay Part III tax on the excess portion of the dividend. However, if the corporation qualifies, it may file an election to treat the excess as a separate taxable dividend. Shareholders should work closely with their tax advisor to ensure precise record-keeping and compliance.

2. Election to pay capital dividends

There is a requirement for the corporation to file an election, Form T2054 Election for a Capital Dividend Under Subsection 83(2), with the Canada Revenue Agency (CRA) to designate a dividend as a capital dividend. This election must be made on or before the payment date of the capital dividend otherwise a late-filing penalty will apply. In that case, the corporation must estimate the amount of the late-filing penalty and pay that amount when it files the election.

In addition, Form T2054 must be accompanied by a certified copy of the resolution of the directors of the corporation authorizing the election. It will also be necessary to prepare and attach Schedule 89 if the corporation has never filed Form T2054 before or if the client disagrees with either the amount shown in their CDA balance on the My Business Account website or with their recently received CDA balance from the CRA.

3. Materiality matters

As a general rule, it’s practical to pay a capital dividend when the account reaches a material amount. However, given that there are compliance costs associated with paying a capital dividend clients should consider their own level of materiality.

Private company shareholders can effectively leverage the CDA to optimize tax outcomes and enhance their financial well-being. Proper planning and execution are essential to fully realize the potential benefits of the CDA.