The taxation of private corporations in Canada is based upon the principle of integration. Income earned by a private corporation and distributed as a dividend to its shareholders is subject to approximately the same amount of tax as if the income had been earned directly by the shareholders.
One mechanism that has been devised to ensure integration of taxes payable by a corporation and its shareholders is the capital dividend account (CDA). The purpose of the CDA is to keep track of certain amounts received by a corporation that, had they been received directly by the shareholder, would have been tax-free (for example, the non-taxable portion of a capital gain and a portion of life insurance proceeds payable at death). These receipts, credited to the CDA, can be passed through to the shareholders on a tax-free basis as a capital dividend. A private corporation resident in Canada may have a CDA. Public corporations, however, are not eligible.
As previously indicated, one of the items that creates a credit to the CDA is the receipt of life insurance death benefits. The life insurance proceeds are received by the company tax-free, and may then be used to any business-related purpose. For instance, collaterally assigned insurance would be used to clear the bank loan; this would leave no cash in the company but does create a credit to the CDA.
There is a common misconception that it the life insurance death benefit that is credited to the CDA. Another even more common misconception is that the credit is determined by subtracting the premiums paid from the life insurance death benefit. However, the appropriate credit is the amount by which the life insurance death benefit exceeds the adjusted cost basis of the policy. The adjusted cost basis of a life insurance policy issued after December 1st, 1982 is generally equal to the premiums paid for the policy, less the net cost of pure insurance (NCPI) for calendar years ending in taxation year, commencing after May 31st, 1985.
The NCPI is the pure mortality expense of the policy as prescribed by the Income Tax Regulations and increases as the policyowner gets older. Thus, in the later years of the policy, the adjusted cost basis will start declining as a result of the NCPI adjustment. This may have favorable implications for a corporation that owns insurance, since the lower adjusted cost basis of the plan, the greater the credit to the CDA on the death of a life insured. This in turn increases the amount which may be flowed through tax-free to the shareholders in the form of a capital dividend.
A corporation may purchase life insurance for any number of reasons (retirement planning, buy-sell agreement funding, collateral, for a loan, key employee insurance, etc). In addition to the normal benefits associated with the receipt of life insurance proceeds, the credit to the CDA permits an immediate or future tax-free distribution of dividends to the shareholders. This additional benefit should not be ignored when considering the purchase of corporate-owned life insurance.
The payment of capital dividends is wholly elective and a private corporation is entirely free to pay and ordinary taxable dividend even if, at the time, it has an amount in its CDA. The procedure for payment of capital dividends is fairly straight forward. The corporation, usually through its accountant, completes a Form T2054 in which it elects, under subsection 83(2) of the Act, that the dividend it proposes to pay out will be treated as a capital dividend. A copy of this form, along with a certified copy of the director's resolution authorizing the election, must be sent to the District Taxation Office, on or before the date on which the dividend becomes payable or was paid, which ever occurs first. A penalty is payable for late filing.
Calculation of the CDA must always be left to the corporation's accountant for two reasons. Firstly, it can be very involved and complex calculation and secondly, an error in paying an amount in excess of the CDA will result in a tax penalty. The timing of the payment of a capital dividend is at the discretion of the corporation. It does not have to wait until the end of a fiscal year, nor does it have to pay amounts out as soon as they are credited to the CDA. However, where the CDA is used in conjunction with a buy-sell agreement, great care should be taken with respect to the timing of the payment.
There is no requirement that a corporation file any sort of document with Canada Revenue Agency such a Form T5, reporting the amount of a capital dividend pay by it to each of its shareholders. However, as a practical matter, shareholder's receiving such dividends should be advised to be sure that they are aware of their tax-free nature.
Reference should also be made to Interpretation Bulletin IT-66R6 dated May 31st, 1991 which discusses the procedure to be followed when making an election to pay capital dividends, the determination of the CDA and the liability of a corporation on an excessive election. |
