Ways to optimize estate planning in the wake of COVID-19
Using a Capital Dividend Account to generate tax-free distributions
TAX ALERT |
It is difficult to summarize the toll that COVID-19 has taken on our physical, financial, mental and emotional health. As an incorporated business owner, what can you do to maintain your business’s health if it is suffering from a significant drop in revenue in these difficult times?
For owners of private corporations, good places to start are revisiting prior estate freezes if freeze values have gone down, reviewing the corporate structure for efficiency, effecting income-splitting plans to reduce overall tax when the crisis subsides, and developing strategies to access cash efficiently.
This article focuses on accessing cash efficiently and, in particular, highlights the importance of timing with respect to a corporation’s Capital Dividend Account (CDA).
Overview of the Capital Dividend Account
A corporation’s CDA is valuable because it indicates the amount that an individual shareholder can receive as tax-free distributions from the corporation. As a result, it provides an opportunity for an individual to avoid the tax that would otherwise arise when receiving dividends from a corporation. However, timing can be crucial to maximize the benefit of the CDA. If a corporation crystalizes losses as a way of reducing taxable income – which is certainly a strategy that many businesses are considering due to COVID-19’s effect on the economy – the corporation may be unknowingly reducing (or even eliminating) the CDA balance. If this occurs, the shareholder would miss an opportunity to withdraw corporate funds tax-free, either immediately or in the future.
The CDA is a notional account that tracks various tax-free amounts that a private corporation receives. A private corporation for CDA purposes generally refers to a Canadian resident corporation that is not a public corporation and is not controlled by public corporations or Crown corporations. The following are amounts, among others, that are added to a private corporation’s CDA balance:
- Non-taxable portion of capital gains in excess of non-deductible portion of capital losses realized by the corporation;
- Capital dividends received by the corporation; and
- Proceeds of life insurance policies that are tax exempt.
For example, when a corporation sells capital property (such as investments, rental properties and real estate) and realizes a capital gain, only 50 per cent of the gain is subject to tax. The other 50 per centof the capital gain is a non-taxable gain. However, shareholders are subject to an additional layer of tax at the personal level when a corporation makes distributions to an individual shareholder unless the distributions relate to the corporation’s CDA balance.
To avoid the personal layer of tax on distributions of non-taxable corporate surplus (such as the non-taxable portion of capital gains), the non-taxable receipts identified above are first recorded in the CDA. Then, the balance in the CDA, which is a cumulative balance over the lifetime of a corporation, is available to be distributed to individual shareholders on a tax-free basis, thereby providing similar tax treatment as if the individual had earned the non-taxable amounts directly.
However, a corporation’s capital losses are also included in computing the corporation’s CDA balance. In particular, the non-deductible portion of a capital loss will reduce the CDA balance. As a result, a corporation’s CDA balance can fluctuate during a taxation year based on the corporation’s activities. A tax-free capital dividend may only be paid to a shareholder at a point in time when the CDA has a positive balance. In addition, the capital dividend paid to a shareholder cannot exceed the balance of the CDA. Significant penalties apply to a capital dividend paid in excess of the CDA balance.
To pay a tax-free dividend from its CDA, the corporation must file a tax election to designate the amount of the dividend to be a capital dividend and must file prescribed supporting documents. The election must be filed using Form T2054 Election for a Capital Dividend Under Subsection 83(2), and the election and supporting documents must be filed on or before the earlier of the date on which the dividend is paid or becomes payable. Failure to file the tax election and supporting documents by the due date will result in a penalty that increases monthly, so it is best to submit the forms by or before the due date.
Cash management strategies using CDA
In a down economy, business owners may look to crystalize capital losses to reduce current tax or to generate refunds of prior tax paid by carrying the losses back against prior years’ capital gains. However, doing so will reduce or eliminate the CDA balance, thereby reducing the shareholder’s opportunity to pay out corporate funds tax-free. Remember, tax-free capital dividends may be paid to resident shareholders up to the balance in the CDA immediately before the dividend is paid or becomes payable. To this end, business owners who plan to incur capital losses as part of a plan to generate liquidity through the reduction of current year taxes, or recovery of prior year taxes, should consider paying out the full balance of the CDA before crystalizing those losses.
For example, suppose a company was incorporated several years ago and, during its existence, has realized cumulative capital gains of $100,000. At this point, the CDA balance will be $50,000, representing the non-taxable portion of the historic capital gains. Today, the shareholders are looking for liquidity and the company is considering another asset sale that will trigger a capital loss of $100,000 to be carried back to a prior year to recover tax paid in that year on capital gains. The company can pay out the $50,000 CDA balance tax-free to its shareholders before selling the asset that will trigger the capital loss, but not after. If the company does not distribute its CDA account prior to the sale of the asset triggering the loss, the $50,000 non-deductible portion of the capital loss will reduce the CDA balance to nil, thereby squandering the opportunity to receive tax-free corporate distributions.
A capital dividend does not necessarily need to be paid by distributing cash, especially in a time when the cash may be needed in the business to maintain operations. The availability of tax-free cash may be conserved by (1) recording the payment of the capital dividend account as a credit on the shareholder loan account or (2) increasing the stated capital of shares and designating the resulting deemed dividend to be a capital dividend.
CDA is valuable corporate asset
The CDA is a key part of the estate plan for owners of private corporations. By following steps in the right order – paying out the CDA balance first and then crystalizing capital losses – a business owner can maximize both the corporation’s ability to survive tough economic times and the shareholder’s ability to access cash without incurring tax.