How proposed changes to Canada’s dividend rules could affect certain tax refunds

Proposed changes to Canada’s dividend rules could determine whether related tax refunds are delayed—or potentially lost—for corporate groups with mismatched year-ends.

When a private business is carried on through a corporate structure with holding companies, subsidiaries or trusts, it is common for money to move between those entities in the form of dividends. Canada's tax system generally allows a corporation to recover certain taxes when it pays a dividend so that those same amounts are not taxed multiple times as they move through these entities.

The federal government proposed new rules that could delay access to those tax refunds when a dividend is paid to a related corporation whose taxation year ends after that of the corporation paying the dividend. These dividends would be known as suspended dividends.

How the Part IV tax system works

The recovery of certain taxes when dividends are paid between entities is accomplished through the Part IV tax system.

It implements the tax principle of integration— which says that income earned through a corporation and later distributed to an individual should generally bear approximately the same overall tax as if the income had been earned directly by the individual.

Part IV tax is paid on taxable dividends received by a corporation to the extent the dividend is deductible from the recipient’s income. This rule applies when the corporation receiving the dividend is a private corporation or certain closely held public corporations resident in Canada.

The tax is payable with the corporation’s year-end tax liability, but is refundable when taxable dividends are subsequently paid to shareholders.

If dividends move through several corporations before being paid to ultimate shareholders, Part IV tax effectively follows the dividends through the corporate chain. The tax is paid when a corporation receives the dividend and is generally refunded when that corporation pays taxable dividends onward.

The tax will ultimately be paid by the individual shareholder upon receipt of the dividend.

The mismatched year-end problem

For corporations with the same year-end, the refund and Part IV tax will be remitted in the same year.

But for entities with mismatched year-ends, the refund and Part IV tax can be payable in different years—as illustrated below.

Sources: DLA Piper; RSM Canada

As outlined, the first payor corporation receives a dividend refund in Year One. In that example, Year Three is the earliest point where Part IV tax may be remitted to the Canada Revenue Agency (CRA).

If this trend continues with further corporations in the corporate chain, the payment of Part IV tax or tax payable by the individual shareholders could be further delayed.

The newly proposed rules are intended to prevent this multi-year deferral.

Understanding the proposed changes

Under the proposed rules, no dividend refund will be issued on suspended dividends.

A dividend is considered suspended when it is paid to an affiliated private corporation and the recipient corporation's taxation year ends after the payor corporation's taxation year in which the dividend was paid.

This suspension rule does not apply if: 

• Dividends with the same eligible or ineligible character as the dividend being paid were already distributed outside the affiliated group. The dividend amount must be within a specified amount of the payor’s expected dividend refund.
• A loss restriction event, such as an acquisition of control, occurs within 30 days of the dividend payment—or within 12 months if the dividend was paid in contemplation of the event.

Suspended dividends can also be released—meaning the refund will be paid—if the following conditions are all met:

• Dividends with the same eligible or ineligible character as the dividend being paid were paid outside the affiliated and connected corporate group in an amount at least equal to the suspended amount.
• No loss-restriction event occurred while the dividend was suspended.
• The dividend used to satisfy this test was not used by another corporation to receive a dividend refund or was excluded from the suspended dividend rules.