Capital dividend payout

Capital Dividend Payout: Definition, Formula, Example, and FAQs

A capital dividend payout refers to a specific type of distribution made by a private corporation to its shareholders, primarily within the Canadian tax system, that is generally received free of income tax. This distinct form of dividend is rooted in corporate finance and taxation principles, allowing companies to distribute certain non-taxable amounts accumulated in a special notional account known as the Capital Dividend Account (CDA). Unlike regular dividends, which are paid from a company's retained earnings and are typically taxable to shareholders, a capital dividend payout originates from the untaxed portion of capital gains and other specific tax-free receipts.⁵⁹, ⁶⁰

This mechanism ensures that certain types of income, already subject to specific tax treatment at the corporate level or deemed tax-free to the corporation, are not re-taxed when distributed to individual shareholders. The capital dividend payout is a key tool in tax planning for private Canadian corporations.⁵⁶, ⁵⁷, ⁵⁸

History and Origin

The concept of the Capital Dividend Account (CDA) and the subsequent capital dividend payout was introduced in Canada as part of the 1972 tax reforms. This reform aimed to achieve "tax integration," a principle designed to ensure that the total tax paid on corporate income distributed to shareholders is roughly equivalent to the tax that would have been paid if the income had been earned directly by an individual.⁵⁴, ⁵⁵ Before this, certain non-taxable amounts realized by a corporation, such as the non-taxable portion of capital gains, would become taxable when distributed as a regular dividend. The CDA was created to allow private corporations to flow these tax-free amounts through to their Canadian resident shareholders without incurring additional personal income tax.⁵², ⁵³ This legislative framework is detailed in the Income Tax Act.⁵⁰, ⁵¹

Key Takeaways

• A capital dividend payout allows private Canadian corporations to distribute certain non-taxable amounts to shareholders tax-free.
• These distributions are drawn from the corporation's Capital Dividend Account (CDA), a notional tax account.
• The CDA primarily accumulates the non-taxable portion of capital gains, certain life insurance proceeds, and capital dividends received from other corporations.⁴⁸, ⁴⁹
• Shareholders receiving a capital dividend payout generally do not include it in their personal income for tax purposes.⁴⁶, ⁴⁷
• To designate a dividend as a capital dividend, the corporation must file a specific election with the Canada Revenue Agency (CRA).⁴⁴, ⁴⁵

Formula and Calculation

The Capital Dividend Account (CDA) is a cumulative balance, not an actual cash account, that private Canadian corporations must track to determine the maximum amount that can be distributed as a tax-free capital dividend payout. The calculation involves various additions and deductions. The primary components influencing the CDA balance include:

• The non-taxable portion of realized Capital Gains
• Capital dividends received from other corporations
• Proceeds from life insurance policies received by the corporation, less their adjusted cost basis.
• Deduction of the non-deductible portion of Capital Losses
• Reduction for previous capital dividend payouts.⁴², ⁴³

The general simplified formula for the CDA balance can be conceptually represented as:

For instance, if a corporation realizes a capital gain, historically 50% of this gain was taxable, and the remaining 50% was non-taxable and could be added to the CDA. (Note: The capital gains inclusion rate can change; for example, it increased to 66.67% on June 25, 2024, affecting the non-taxable portion.³⁹, ⁴⁰, ⁴¹) When calculating the CDA, it's crucial for the Board of Directors to ensure accuracy to avoid penalties.³⁷, ³⁸

Interpreting the Capital Dividend Payout

Interpreting a capital dividend payout primarily involves understanding its tax-free nature for Canadian resident shareholders. When a private corporation distributes funds from its Capital Dividend Account, it signifies that these specific amounts have already been recognized as non-taxable at the corporate level, and thus, should not be subject to additional Taxation when received by the individual. This is a direct benefit for shareholders, as it allows them to receive funds without increasing their personal income tax liability.

The ability to make a capital dividend payout often reflects sound Tax Planning and effective management of a corporation's tax attributes. For investors, receiving such a dividend can be a highly efficient way to extract value from a private company, as it avoids the personal income tax that would typically apply to other forms of Dividends or salaries. It reinforces the principle of tax integration within the Canadian system.³⁴, ³⁵, ³⁶

Hypothetical Example

Consider "Maple Leaf Holdings Inc.," a private Canadian corporation. In a given year, Maple Leaf Holdings sells a commercial property that it owned for many years, realizing a substantial capital gain. Suppose the non-taxable portion of this capital gain amounts to CAD 100,000. This CAD 100,000 is added to Maple Leaf Holdings Inc.'s Capital Dividend Account (CDA).

The Shareholders of Maple Leaf Holdings Inc. decide they want to distribute this amount. The Board of Directors passes a resolution to declare a capital dividend payout of CAD 100,000. Before the payout, the corporation files Form T2054, "Election for a Capital Dividend Under Subsection 83(2)," with the Canada Revenue Agency (CRA), along with a certified copy of the directors' resolution.³¹, ³², ³³

Once the election is properly filed and processed, the CAD 100,000 is distributed to the shareholders. Because it is designated as a capital dividend, the individual shareholders receive this CAD 100,000 completely tax-free. This means they do not report it as income on their personal tax returns, making it a very efficient way for the corporation to return capital to its owners without triggering additional tax burdens for them.

Practical Applications

The capital dividend payout is a significant tool in various aspects of financial management for private Canadian corporations:

• Estate Planning: It allows for the tax-free transfer of wealth from a corporation to an individual, which can be crucial in estate planning scenarios, such as when shares are redeemed or a business is wound up.³⁰
• Succession Planning: In the context of business succession, particularly when transferring ownership or liquidating assets, a capital dividend payout can facilitate the tax-efficient distribution of accumulated surpluses to outgoing shareholders.
• Corporate Restructuring: During corporate reorganizations or share buybacks, the CDA can be utilized to distribute funds that would otherwise be subject to higher Corporate Tax or personal income tax rates.²⁹
• Maximizing Shareholder Value: By permitting tax-free distributions, the capital dividend payout directly enhances the after-tax return for shareholders, contributing to overall Shareholder Value.
• CRA Compliance: To ensure the tax-free status of a capital dividend payout, a private corporation must file Form T2054, Election for a Capital Dividend Under Subsection 83(2), with the Canada Revenue Agency (CRA). This form must be filed by the earlier of the date the dividend becomes payable and the first day any part of the dividend is paid.²⁶, ²⁷, ²⁸ For more detailed instructions and requirements, refer to the official CRA website.

Limitations and Criticisms

While beneficial, the capital dividend payout has certain limitations and potential pitfalls:

• Strict Eligibility: The capital dividend account (CDA) and its associated payouts are strictly limited to Private Corporations in Canada. If a private corporation becomes a Public Corporation, it can no longer make capital dividend payouts from its CDA.²⁴, ²⁵
• CDA Balance Accuracy: Maintaining an accurate CDA balance is crucial. The CDA is a notional account and does not appear on the company's financial statements in the same way as other accounts; it must be calculated and tracked separately.²¹, ²², ²³ Inaccuracies can lead to significant tax penalties.
• Penalty for Excessive Payouts: If a corporation declares a capital dividend payout that exceeds the available balance in its CDA, the excess amount is subject to a substantial penalty tax (60% or 75% depending on the specific tax act provision), known as Part III tax, for the corporation.¹⁸, ¹⁹, ²⁰ Shareholders, however, are not typically taxed on this excess unless an election is made to treat it as a taxable dividend.¹⁶, ¹⁷ This risk underscores the importance of careful calculation and due diligence.
• Non-Resident Shareholders: Capital dividends paid to non-resident shareholders are generally subject to Canadian non-resident withholding tax, typically at a rate of 25%, unless reduced by a tax treaty. This can lead to a less favorable tax outcome for non-residents compared to Canadian residents.¹⁴, ¹⁵

Capital Dividend Payout vs. Return of Capital

While both terms refer to distributions that may not be immediately taxable, a capital dividend payout (specifically in the Canadian context) and a Return of Capital (often used in the U.S. context) differ in their origin and tax treatment.

A capital dividend payout in Canada is a distribution from a private corporation's Capital Dividend Account (CDA), which tracks specific tax-free amounts like the non-taxable portion of capital gains. It is entirely tax-free to Canadian resident shareholders upon receipt.¹³

A return of capital (ROC), commonly encountered in the United States, is a distribution made by a company that is not considered a dividend because it exceeds the company's earnings and profits (E&P). Instead, it represents a return of the investor's original investment. ROC distributions reduce the shareholder's Adjusted Cost Basis in the stock. Only if the ROC exceeds the adjusted cost basis does it become a taxable capital gain.¹⁰, ¹¹, ¹²

In essence, a capital dividend payout is designated as tax-free due to its source from specifically untaxed corporate amounts, whereas a return of capital becomes tax-free by virtue of reducing the investor's cost basis, with tax implications deferred until the shares are sold or the basis reaches zero.

FAQs

Q: Is a capital dividend payout always tax-free for shareholders?
A: For Canadian resident shareholders of a private corporation, a properly elected capital dividend payout is indeed received free of income tax. However, for non-resident shareholders, withholding taxes may apply.⁹

Q: Can any company issue a capital dividend payout?
A: No, only private Canadian corporations are eligible to make a capital dividend payout from their Capital Dividend Account (CDA).⁷, ⁸

Q: How does a company track its Capital Dividend Account?
A: The Capital Dividend Account (CDA) is a notional tax account, meaning it's not a cash balance but a calculated figure. Companies must maintain separate records for the CDA, often reported on Schedule 89 of their corporate income tax return for CRA reference.⁵, ⁶

Q: What happens if a company pays out more than its Capital Dividend Account balance?
A: If a company pays a capital dividend that exceeds its Capital Dividend Account balance, the excess amount is subject to a significant penalty tax for the corporation under Canadian tax law. Shareholders generally are not directly taxed on the excess unless specific elections are made to reclassify it.³, ⁴

Q: Are capital dividends recorded on a company’s Financial Statements?
A: The Capital Dividend Account itself is a tax-specific concept and does not typically appear as a distinct line item on a company's main financial statements. It might be mentioned in the notes to the financial statements for informational purposes.¹, ²