By: Rajesh K. Sharma, Advocate (LinkedIn)

A capital dividend is a dividend that can be paid out of a corporation's Capital Dividend Account (CDA) to shareholders. The key feature of a capital dividend is that it is received tax-free by the shareholders, unlike regular dividends, which are subject to personal income tax.

Explanation with a Fact Pattern

Fact Pattern:

John is the sole shareholder and director of a private Canadian corporation, XYZ Ltd. XYZ Ltd. has been in operation for several years and has accumulated significant assets. Recently, the company sold an investment property, realizing a capital gain of $200,000. Additionally, XYZ Ltd. received $100,000 as a death benefit from a life insurance policy after the passing of a key executive. The policy's adjusted cost basis (ACB) was $20,000. John is considering paying himself a dividend and is exploring the option of declaring a capital dividend.

Understanding Capital Dividend:

Components of the Capital Dividend Account (CDA):

1. Untaxed Portion of Realized Capital Gains:

When XYZ Ltd. sold the investment property, it realized a capital gain of $200,000.
In Canada, only 50% of a capital gain is taxable, which means the other 50% ($100,000) is untaxed.
This untaxed portion of the capital gain ($100,000) is added to the CDA.

2. Life Insurance Proceeds:

XYZ Ltd. received a $100,000 death benefit from a life insurance policy.
The ACB of the policy was $20,000, so the net addition to the CDA is $100,000 - $20,000 = $80,000.

3. Eligible Capital Property (ECP) / Class 14.1 Property:

Suppose XYZ Ltd. also sold some goodwill before 2018, generating a non-taxed capital gain of $50,000.
Alternatively, if XYZ Ltd. sold Class 14.1 property after 2018, half of the excess of the proceeds over the actual cost would also be added to the CDA. For simplicity, let's assume this was $25,000.

4. Capital Dividends Received:

XYZ Ltd. might have received capital dividends from other private corporations it holds shares in. For this example, let’s say XYZ Ltd. received $10,000 in capital dividends from another corporation, which is also added to the CDA.

Calculation of the CDA:

Untaxed portion of the realized capital gains: $100,000
Life insurance proceeds (net of ACB): $80,000
Non-taxed portion of the capital gain from ECP/Class 14.1: $25,000
Capital dividends received: $10,000

Total in the Capital Dividend Account (CDA): $215,000

Declaration of a Capital Dividend:

John, as the sole director, decides to pay himself a capital dividend. The amount of the capital dividend is deducted from the CDA. Suppose John decides to declare a capital dividend of $200,000.

Steps to Declare a Capital Dividend:

1. Directors' Resolution:

The board of directors (in this case, John) must pass a resolution to declare the dividend as a capital dividend.

2. Election Form T2054:

XYZ Ltd. must file Form T2054 with the Canada Revenue Agency (CRA) to elect that the dividend is a capital dividend.
This form must include the calculation of the CDA and a certified copy of the directors' resolution.

3. Tax-Free Dividend to Shareholders:

Once the election is filed, John, as the shareholder, receives the $200,000 dividend tax-free.

Conclusion:

Capital dividends are a powerful tool for private corporations to distribute tax-free income to shareholders. However, strict compliance with the filing requirements is essential. If XYZ Ltd. fails to file the election (Form T2054) before paying the capital dividend, the corporation could face significant penalties. In John’s case, by correctly declaring and filing the capital dividend, he effectively receives $200,000 without any personal tax liability, utilizing the corporation’s CDA.