How business owners can benefit from the capital dividend account

The changes tabled in the Liberals’ 2024 federal budget would have likely impacted the capital dividend account (CDA) for Canadian-controlled private corporations (CCPC). Since there won’t be changes to the CDA in the short-term, it’s worth revisiting how the CDA works in the current environment and how business owners can benefit from it.

Tax-free cash

The CDA was introduced to help ensure individual and corporate taxpayers are effectively taxed the same on capital gains earned inside or outside a corporation. It provides shareholders access to a portion of investment earnings, and/or life insurance proceeds, from a corporation as tax-free cash.

CCPCs have access to a notional account representing the non-taxable portion of capital gains and a non-allowable portion of capital losses. The untaxed portion flows through the CCPC, without incurring additional tax.

The CDA represents tax-free surplus accumulated by CCPCs, and can include amounts from other tax years, usually including:

• The non-taxable portion of realized capital gains.
• Capital dividends received from other CCPCs.
• The non-taxable portion of eligible capital amounts.
• Life insurance policy proceeds in excess of the adjusted cost basis.

A negative CDA balance

Although the Canada Revenue Agency is not going ahead with CGIR changes, there are still risks with respect to CDA.

The payout of capital dividends while a CDA is in a negative balance is considered an excessive election, per subsection 184(2) of the Income Tax Act. Business owners must be cautious tracking CDAs because of the risk of the additional tax on excessive elections. It is calculated as 60% of the excess amount, and it accrues interest at the prescribed rates until taxes are paid.

Under these circumstances, it’s common for corporations to make a subsection 184(3) election to treat any excess as a separate taxable dividend gross-up and dividend tax credit.

For example

The risk of the additional tax on excessive elections exists when CDA payouts follow a series of realized capital losses, to the extent the CDA balance falls below zero.

This table illustrates the impact of capital gains and losses to a CDA:

Date	Capital gain/loss	CDA earned at 50%	CDA balance before payout	Elected CDA payout	Ending CDA
Opening balance	–	–	–	–	$5,000
Mar. 31, 2024	$2,000	$1,000	$6,000	($5,000)	$1,000
Aug. 31, 2024	($8,000)	($4,000)	($3,000)	($5,000)	($8,000)

Note: Electing CDA payouts on Aug. 31, 2024, when a CDA balance has gone negative, would attract the additional tax on excessive elections.

Any penalty tax would have accrued interest in 2024 at the prescribed rate of 10% per annum in Q1 – Q2, and 9% from Q3 – Q4.

If a future government retables the CGIR change, business owners ought to be aware that the slower build-up of a CDA from realizing capital gains means smaller tax-free dividends to shareholders. Pausing the realization of capital losses may help curb the risk of a negative CDA, as an acknowledgement of the smaller buffer previously created by CDA increases from a 50% inclusion rate.

The role of corporate class funds

Corporate class funds tend to offer control and access to tax-efficient forms of investment income. They generally have a lower payout policy because of expense sharing. That can be attractive to investors, especially in an increased inclusion rate environment that reduces credits to the CDA.

Any future reintroduction of a 2/3 inclusion rate would require 1.5 times the capital gain proceeds to replicate the same CDA increases. The tax-efficient nature of corporate class funds typically allows for a continued tax deferral which can be advantageous in an increased capital gains inclusion rate environment.

Future considerations

In higher inclusion-rate years, high-net-worth individuals can evaluate the incentives of withdrawing from their corporation and investing personally to access a lower inclusion rate when exemptions exist at the personal level (e.g., the proposed $250,000 exemption for individuals and most trusts for 2024).

When deciding to realize capital gains in a corporation vs. a payout to individual shareholders for personal investing, consider:

• Spreading out the realization of capital gains over time. Or, on the personal side, multiplying the exemption through joint ownership.
• Maintaining lower marginal tax rates for individuals, and the small business tax rate for corporations, by managing passive income thresholds.
• Anticipating future income-splitting opportunities.
• Lower tax brackets for taxable income because of major life events like retirement, job change or the death of a spouse.
• Business risk and impacts to taxable income (e.g., legal settlements, introduction of market competitors, seasonal cycles, etc.).
• Market changes and the availability of offsetting capital losses.

Business owners may also consider the use of CDA proceeds to continue making contributions to their own TFSAs. Those contribution limits rise periodically.

If a business owner has maxed out a CDA, and dividend refunds from their refundable dividend tax-on-hand accounts, they can also pay themselves higher salaries to amplify RRSP contribution room. This will build up earnings eligibility for the Canada Pension Plan.

Business owners can also consider loss-harvesting strategies to realize capital losses in years where an organization wishes to lock in their gains on good investments before the market turns. They should keep an eye on their marginal tax rate, however.

Taxpayers also have the option of deferring receipt of fair market value consideration via instalment payments received over multiple tax years, and electing a capital gains reserve to potentially minimize taxes paid.

The small-business deduction

Should a CGIR increase materialize in the future, corporations’ access to the small-business deduction may be compromised by the fact that the increased taxable portion of capital gains would result in a 16.7% rise in adjusted aggregate investment income.

Business owners may consider a defer-and-hold strategy until a more favourable tax climate presents itself.

A holistic strategy should consider all needs of the organization and offer some combination of reducing tax and accelerating investment growth.