Under the Income Tax Act (“the Act”) a “capital dividend” (“CD”)[1] paid by Canadian resident corporation is not included in the income of a recipient shareholder.
A CD is an actual or deemed dividend paid with respect to which a specified election in prescribed form[2] has been filed by the paying corporation.
A CD may be paid by a private corporation. However, if an amount paid exceeds its “capital dividend account” (“CDA”) on hand at the relevant time a penalty will apply[3].
In general terms, the CDA can consist of amounts derived from the following:
- CD’s received from other corporations
- Life insurance proceeds, and
- The non-taxable portion of capital gains, in excess of the non-allowable portion of capital losses[4].
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However, even though a CD may not be included in income of the recipient shareholder, if that shareholder is a non-resident of Canada, non-resident withholding tax under Part XIII will apply in the same way as if the dividend were a taxable dividend[5].
In fact, Part XIII tax can even apply to a CD received by a Canadian resident trust that is distributed to a non-resident beneficiary, even if not in the same year[6].
In situations where there are also Canadian resident shareholders of the relevant corporation, prudent tax planning would usually dictate that steps should be taken so that none of the CDA is paid to the non-residents. Doing so would generally be a total waste-better to use it for the benefit of the Canadian residents.
A CD must be paid to all of the shareholder of a particular class. However, if the residents and non-residents hold shares of a different class, the CDA can be used solely to pay dividends on the residents’ class; the non-residents can receive taxable dividends on their class.
If there is only one class, it should be possible to undertake a reorganization such that the Canadian residents hold shares of a different class than the non-residents. That way, the CDA can be used strictly for the benefit of the residents. Normally, this would be accomplished by obtaining Articles of Amendment to create another class of shares that has the same or substantially the same attributes as the existing class, and having either the Canadian residents or the non-residents exchange their existing shares for shares of the new class[7].
If the shares are “taxable Canadian property” in the hands of the non-resident, it may be preferable for the Canadian residents to implement the exchange, and allow the non-residents to retain their original shares. That way, there would be no need for any concern regarding certain notification requirements in section 116.
If the residents exchange their shares, thought must be given regarding the question of whether or not the anti-avoidance rule in subsection 83(2.1) can apply. In general terms, that provision can apply where shares are acquired for the purposes of receiving a CD. This provision is designed to prevent “trafficking” in CDAs in situations where the existing shareholders cannot effectively use them. Nevertheless, a literal reading of that provision could lead one to conclude that it might apply to a Canadian resident who exchanges his or her shares to receive a CD on the newly acquired shares in the type of situation discussed above. Where applicable, the CD will be treated as a taxable dividend.
However, in virtual all cases, the conclusion would be reached that subsection 83(2.1) would not apply in such situations for one or both of the following reasons:
- Subsections 83(2.2) to 83(2.4) provide exclusions from the application of subsection 83(2.1) for most situations, other than those where the CDA relates to a period where the relevant corporation was controlled by non-residents, and
- Statements issued by the CRA, suggest that it is their administrative policy that subsection 83(2.1) should not be applied where existing shareholders exchange their shares for another class. Or, to put it another way, it is the purpose of the acquisition of the original shares which should govern[8].
[1] Subsection 83(2) (all statutory references are to the Act).
[2] Form T2054
[3] Under Part III, subject to an ability to elect to treat the excessive amount as a taxable dividend.
[4] The CDA can also consist of tax-free components arising on the sale of “goodwill” or other “eligible capital property” before the taxation of gains on such property was merged into the capital gains regime after 2016.
[5] Paragraph 212(2)(b)
[6] Subparagraph 212(1)(c)(ii)
[7] This would be a tax-free exchange under either section 86 or 51.
[8] See paragraph 6 of IT-146R4 and CRA document 2000-0026615