Did someone say…tax free?
Author: Joey San, Financial Advisor
How business owners can get money out of their company tax free
Attention shareholders and owners of a Canadian-controlled Private Corporation (CCPC)! This could be your “Diamond in the Rough”. What is that Diamond? Capital Dividends -the holy grail of dividends. Why? Funds that are allowed to go into the Capital Dividend Account can be paid out of the corporation to you personally…TAX FREE. I got ahead of myself a bit here. Let me back up a bit.
To understand what the Capital Dividend Account (CDA) is and how it works, there is one thing we need to clarify first: a CCPC can pay three types of dividends to its shareholders.
Two of these dividends are often referred to as a “Regular Dividend” which is paid from the company’s earnings or profits and is taxable to the shareholder. Within the regular dividend there is a distinction; Eligible and Ineligible dividends. We’ll leave the definition of these to another blog but simply, ineligible dividends are from active small business income and eligible generally covers the rest.
The other dividend is through what is called a “Capital Dividend” which is paid from the company’s assets or capital base and is TAX FREE to the shareholder. So how do you get Capital Dividends?
The Income Tax Act (ITA) defines the CDA as a special Corporate Tax Account which is not included in the company’s financial statement, that gives its shareholders designated capital dividends, tax free. This notional account tracks capital gains and losses from the sale or disposal of a company asset. This asset can be in the form of Real Estate, Stocks/Bonds and proceeds of Life Insurance. Let’s look at a couple of examples:
- The sale of a building or stock. The CCPC bought the asset for $100k and sold it for $1 million. The capital gain on this asset is $900k ($1 million – $100,000) and 50% ($450,000) is taxable. The corporation pays its tax and distributes the rest to its shareholders as a taxable “regular” dividend. The other 50% of the gain ($450,000) which was tax free to the corporation is still held in the corporation. How do we get that to the shareholders? Since this gain creates a $450k credit to the CDA ledger, according to the ITA, it can now be distributed to its shareholders tax free as a “capital” dividend.
- Life insurance proceeds. If a CCPC is the owner, payor and beneficiary of a Life Insurance policy to fund a shareholder’s agreement, keyman protection or debt elimination, the proceeds of that policy will also create a credit to the CDA ledger. If an insurance company paid $1 million as a death benefit to the Corporation, then the CDA gets a credit of $1million less the ACB (adjusted cost base varies depending on the type of Policy) according to the ITA. This means that the shareholders can get roughly $1 million as a tax free “capital” dividend.
Without getting too technical, this is one valuable way for businesses to get tax free income out of their CCPC. The most important thing about working with the CDA ledger is timing. Since this account tracks both Gains and Losses, planning is critical! CDA is not available to public corporations and does not work well for foreign/non-Canadian shareholders. Working with your financial professional can help facilitate the opportunities the CDA offers in the most effective and efficient way for the business and its shareholders.
Connect Wealth is an independent financial planning firm that offers holistic advice to clients based on their current goals and future aspirations. We use well-established workflows and cutting edge technology to maximize planning efficiencies while simplifying the process for clients. Learn how you can maximize your financial opportunities at www.connectwealth.ca