Under subsection 83(2) of the Income Tax Act (“the Act”) a Canadian private corporation (“Canco”) can pay special dividends out of its “capital dividend account” (“CDA”).
The CDA of a corporation may be derived from any of the following four sources:
- The tax-free portion of capital gains
- The tax-free portion of proceeds from the sale of “eligible capital property”, such as “goodwill”
- Life insurance death benefits, or
- CDA dividends received from other corporations
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Although a dividend paid pursuant to subsection 83(2) of the Act is tax-free when paid to a Canadian resident, it is subject to normal Part XIII withholding tax when paid to a non-resident (general 15% when paid to a US resident).
But what happens when a Canadian resident trust (including an estate), that owns shares of a Canco, receives such a tax-free dividend under subsection 83(2) of the Act, and then distributes it to a non-resident beneficiary?
The normal provision of the Act that subjects trust income distributions to non-residents (subparagraph 212(1)(c)(i)) will not apply, since the distribution is not derived from taxable income of the trust.
Because, of that, a special provision, subparagraph 212(1)(c)(ii), specifically targets this type of situation. It is very broadly worded, and applies to:
“income of or from an estate or a trust to the extent that the amount…..
(ii)can reasonably be considered (having regard to all the circumstances including the terms and conditions of the estate or trust arrangement) to be a distribution of, or derived from, an amount received by the estate or trust as, on account of, in lieu of payment of or in satisfaction of, a dividend on a share of the capital stock of a corporation resident in Canada, other than a taxable dividend;”
It is important to read this provision in conjunction with subsection 212(11) of the Act, which states:
“An amount paid or credited by a trust or an estate to a beneficiary or other person beneficially interested therein shall be deemed, for the purpose of paragraph (1)(c) and without limiting the generality thereof, to have been paid or credited as income of the trust or estate, regardless of the source from which the trust or estate derived it.”
Thus, even an amount which might be considered a distribution of capital under trust law can be considered “income” for this purposes.
For example, if an amount received by a trust from Canco as a dividend out of CDA is added to the trust’s capital, and then distributed as capital many years later, it may still be subject to tax under Part XIII when distributed. This is consistent with the position that the CRA took in CRA document 2003-0020695.
Is there a treaty defense to the imposition of Canadian tax in such circumstances? In each case, one would have to look at the terms of the specific tax treaty that applies to the beneficiary. In the case of an American resident, it is unlikely that the treaty would provide any barrier to Canadian taxation. Article XXII(2) of US Treaty refers to “income distributed by an estate or trust”, and allows Canada to impose tax if derived from Canadian sources. Since the treaty does not define “income” for this purpose, Article III(2) says that it has the meaning it has under Canadian tax law. Likely, that would incorporate the deeming rule in subsection 212(11), as discussed above.
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
