Capital Dividend Accounts for Corporate Investments
Attention business owners:
There may be a better way to get those retained earnings out of your holding company! Many business owners accumulate after-tax profits in their company and are wondering what the most tax efficient way is to get them out.
These retained earnings are often invested in low risk instruments such as money market, GIC or other fixed income assets. While doing a good job of protecting the capital, any growth on these investments is taxed at the highest corporate rate. Investing this money in corporate class & capital yield funds instead may allow for significant tax breaks when accessing this cash while keeping the risk at a low level.
Corporate class and capital yield investment funds are offered by many investment companies and come in a wide variety of options. It’s important to understand the different features and build a portfolio that is suitable for you and your company’s individual situation.
A Capital Dividend Account (CDA) is a notional account that keeps track of tax free surpluses accumulated by a private corporation. These amounts are eligible for distribution to shareholders as tax-free dividends, referred to as capital dividends. To fund the CDA, the investments held should generate capital gains instead of interest income. When earning capital gains, both individuals and corporations are subject to tax, and are taxed on only 50% of the capital gains. The difference is that in the case of the corporation, the other 50% can be added to a CDA and distributed to the shareholder as a tax-free capital dividend. This strategy reduces the corporate tax liability by replacing investment income (taxed at approximately 44%) with capital gains (taxed at 22%, because only 50% of the gain is taxable), while funding the CDA to distribute tax-free dividends to the shareholders.
While not an overly complex strategy, it is important that it’s executed properly. First of all, only Canadian-controlled private corporations (CCPCs) are eligible and the shareholder(s) must be Canadian residents. Capital dividends paid to non-residents are subject to withholding taxes. Secondly, before a capital dividend is paid, the corporation must file an election with the Canadian Revenue Agency. This step should be done with proper consultation of a tax professional. If this election is filed late, it could be subject to a penalty. For many investors, it may also make sense to transfer the funds from your operating company over to a holding company and managing the investments there.
This article is not intended as specific tax advice since each investor’s situation is unique. Although this strategy is a great way to reduce your tax bills, please consult with a financial professional before implementing it in your own plan. There is no way to cover all of the details in a short article like this so if you would like some more information, feel free to send me an email.
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