ARCHIVED - Capital dividends
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IT SUBJECT: INCOME TAX ACT Capital Dividends
NO: IT-66R6 DATE: May 31, 1991
REFERENCE: Section 184, subsections 83(2) to (2.4), 89(1.1) and (1.2), paragraphs 89(1)(b) and (b.1) (also section 14, subsection 212(2), paragraphs 87(2)(z.1) and 88(1)(e.2), subparagraph 40(1)(a)(iii) of the Act, and sections 2101 and 2106 of the Regulations)
This bulletin cancels and replaces Interpretation Bulletin IT-66R5 dated July 22, 1985. Current revisions are designated by vertical lines.
This bulletin discusses the concept of capital dividends and the capital dividend account. The capital dividend account keeps track of various tax-free surpluses accumulated by a private corporation. These surpluses may be distributed as capital dividends free of tax to the corporation's Canadian-resident shareholders. A corporation paying a capital dividend must file an election in respect of the dividend when the dividend is paid or becomes payable, although, in certain circumstances, a late- filed election is acceptable. If the corporation pays a capital dividend which is in excess of the balance in its capital dividend account an additional tax may be payable on the non- qualifying portion of the dividend. However, this additional tax may be avoided by making the appropriate elections.
Discussion and Interpretation
Election under Subsection 83(2)
1. A private corporation may elect, under subsection 83(2), in prescribed manner and form (section 2101 of the Regulations and Form T2054) to pay its shareholders a dividend out of its capital dividend account. Subject to 17 to 19 below, no part of a capital dividend is included in computing Part I income of a shareholder resident in Canada. Additionally, no amount is deducted in computing the adjusted cost base of a shareholder's shares for such a dividend, provided that the election is made for the full amount of the dividend. Capital dividends paid to non-residents are subject to non-resident tax under subsection 212(2).
2. An election to pay a capital dividend should be filed on Form T2054 no later than the day on which the dividend becomes payable or the first day on which any part of the dividend is paid, whichever is earlier. For this purpose, a dividend becomes payable on the day stipulated by the resolution of the directors declaring the dividend. An election must be made on the full amount of the dividend and, accordingly, may not specify that the dividend is payable partly from its capital dividend account and partly from another source. A capital dividend may not be paid by a public corporation even though it previously had been a private corporation and there was a balance in its capital dividend account immediately before it became a public corporation.
3. A late-filed election that would otherwise qualify for a capital dividend is acceptable (subject to 5 below) provided that:
(a) the election is made in the prescribed manner and on the prescribed form as set forth in 1 above, and
(b) the estimated penalty for the election is paid when the election is made.
4. The estimated penalty in 3(b) above is computed as the lesser of:
(a) 1/12 of 1% of the amount of the dividend, and
multiplied by the number of months and part-months between the due date stated in 2 above and the actual filing date.
5. The late filing provisions described in 3 above cease to be available for a particular dividend if a taxpayer does not comply with a written request from the Minister to make a late-filed election for that dividend within 90 days from the date of service of the request.
CAPITAL DIVIDEND ACCOUNT
Components of the Capital Dividend Account
6. The rules for determining the balance in the capital dividend account are provided in paragraph 89(1)(b). The amount of each component of the capital dividend account is computed on a cumulative aggregate basis for a particular "period". This "period" begins on
* the first day of the first taxation year ending after 1971 and after the corporation last became a private corporation,
* immediately before the balance in the capital dividend account is to be determined.
For example, if a corporation that has been a private corporation with a March 31 year-end since its incorporation in 1960, pays a capital dividend on April 1, 1989, the relevant "period" for the calculation of its capital dividend account is April 1, 1971 to April 1, 1989.
The capital dividend account for a given "period" consists of:
The aggregate of:
(a) the excess of the non-taxable portion of capital gains over the non-deductible portion of capital losses (including business investment losses) incurred by the corporation (see 8 and 9 below for exclusions),
(b) the aggregate of capital dividends received by the corporation,
(c) the non-taxable portion of gains resulting from the disposition, in the period, of eligible capital property of each business of the corporation as described in subparagraph 89(1)(b)(iii) (see the related Department of Finance Explanatory Notes for S.C. 1988, c.55 (formerly Bill C-139; Royal Assent September 13, 1988) dated June 1988 and the current version of IT-123),
(d) the net proceeds of a life insurance policy received after May 23, 1985 by the corporation as beneficiary under the policy and such proceeds received after 1971 and before May 24, 1985 where the corporation was a beneficiary under the policy prior to June 29, 1982 (see the current version of IT-430 entitled, Life Insurance Proceeds Received by a Private Corporation or a Partnership), and
(e) the balance, if any, in the corporation's life insurance capital dividend account immediately before May 24, 1985
(f) the aggregate of all capital dividends that became payable by the corporation in the period.
7. In addition to receiving capital dividends by way of a cash, stock, specie or deemed dividend, a corporation's capital dividend account may also be increased as a result of an amalgamation of two or more corporations or a winding-up of a subsidiary. Paragraph 87(2)(z.1) provides for the transfer of the capital dividend account of a predecessor corporation to the new corporation on an amalgamation. Similarly, by a cross-reference to paragraph 87(2)(z.1), paragraph 88(1)(e.2) provides for the transfer of the capital dividend account of a subsidiary corporation to its parent on a winding-up. However, for amalgamations or windings-up occurring after 4 P.M. Eastern Daylight Time, September 25, 1987, paragraph 87(2)(z.1) provides circumstances in which the capital dividend account of a predecessor or subsidiary corporation will not be transferred on an amalgamation or winding-up. The capital dividend account of a corporation will not be transferred in any case where, if immediately before the amalgamation or winding-up, a capital dividend were paid by it, the dividend would have been deemed to be a taxable dividend by reason of the anti-avoidance rule in subsection 83(2.1) (see 21 and 22 below). For example, if a corporation acquires all of the shares of another corporation that had a balance in its capital dividend account and winds it up, the capital dividend account of the other corporation will not be transferred if one of the main purposes of the share acquisition and wind-up was to obtain the capital dividend account.
8. Excluded from the amount determined in 6(a) above, for dispositions occurring after November 12, 1981, is the portion of realized capital gains or losses on property, other than designated property, which can reasonably be considered to have accrued during any period that the property was held by a corporation when it was not a private corporation, an investment corporation, a mortgage investment corporation, or a mutual fund corporation.
Under paragraph 89(1)(b.1) "designated property" of a private corporation includes:
(a) any property acquired by it before November 13, 1981, or after November 12, 1981 pursuant to a written agreement entered into on or before November 13, 1981,
(b) any property acquired by it from another private corporation with which it was not dealing at arm's length (other than pursuant to paragraph 251(5)(b)) at the time, if the property was designated property to the other private corporation,
(c) a share acquired by it in exchange for another share that was designated property of the corporation in a transaction to which section 51, 85.1, 86 or 87 or subsection 85(1) applied, or
(d) a replacement property (as described in section 44 and discussed in the current version of IT-259 entitled, Exchanges of Property) for a designated property that was disposed of involuntarily as described in subparagraphs 54(h)(ii), (iii) or (iv).
9. Also excluded from the amount determined in 6(a) above, for dispositions occurring after November 26, 1987, is the portion of the realized capital gains or losses on property, other than designated property, which can reasonably be considered to have accrued during any period that the property or property for which it was substituted, was held by a corporation that was
(a) controlled, directly or indirectly in any manner whatever (see subsection 256(5.1)), by one or more non- resident persons and, after November 26, 1987, the property became the property of a Canadian-controlled private corporation, otherwise than as a consequence of the change in residence of one or more shareholders of the corporation, or
(b) exempt from tax under Part I of the Act and, after November 26, 1987, the property became the property of a private corporation that was not exempt from tax under Part I.
These exclusions apply where the status of the corporation changes after November 26, 1987 or the property is acquired, after November 26, 1987 on a rollover basis by the Canadian- controlled private corporation or the private corporation that was not exempt from tax as the case may be.
Note: If draft legislation released by the Minister of Finance on February 18, 1991 is passed into law as currently proposed, the exclusions discussed in (a) and (b) above will also apply to dispositions of designated property after November 26, 1987.
Change in the Status of a Corporation
10. Subsection 89(1.1) provides that if a private corporation that was controlled, directly or indirectly in any manner whatever, by one or more non-residents becomes a Canadian- controlled private corporation after March 31, 1977 (otherwise than by a change in residence by one or more shareholders of the corporation), its capital dividend account is reduced by the full amount of the account as it stood immediately prior to the change in the corporation's status. Subsection 89(1.2) similarly applies to reduce a corporation's capital dividend account to nil, where, after November 26, 1987, the corporation ceases to be exempt from tax under Part I of the Act.
Capital Gains Reserve
11. Since the definition of "capital gain" in paragraph 39(1)(a) applies throughout the Act, the calculation of the non-taxable portion of a capital gain for the purposes of 6(a) above must take into consideration any applicable reserve under subparagraph 40(1)(a)(iii). When the balance of a corporation's capital dividend account is computed at any time during a taxation year, the amount of the reserve that will ultimately be claimed at year-end in respect of each gain realized before that time should be reflected in that calculation. Payment of a capital dividend based on a calculation which overstates the actual balance in the capital dividend account may give rise to an assessment of tax under subsection 184(2) (see 17 to 20 below).
12. An overstatement of the capital dividend account can arise when, subsequent to paying a capital dividend based on a capital gain reported in that year, a replacement property is acquired and the provisions of section 44 are applied to retroactively reduce the previously reported capital gain. Another example would be the filing of amended returns regarding proceeds from the granting of an option under section 49.
13. The non-deductible portion of capital losses reduces the balance in the capital dividend account only to the extent of the non-taxable portion of capital gains included therein as determined in 6(a) above. The full amount of those items in 6(b) to (e) above may be added to the capital dividend account although the aggregate capital losses sustained by the corporation since January 1, 1972 may have exceeded the aggregate capital gains realized since then. For example, if by the end of its 1988 taxation year a corporation that has been a private corporation since incorporation in 1971 sustained a capital loss of $15,000 in its 1982 taxation year and realized a capital gain of $10,000 in its 1985 taxation year but had received a capital dividend of $1,000 in its 1988 taxation year, the balance in the capital dividend account at the end of that 1988 year would be $1,000. The excess of the non-deductible portion of capital losses ($7,500) over the non-taxable portion of capital gains ($5,000) equalling $2,500, must be absorbed by the non-taxable portion of capital gains realized subsequent to the 1988 taxation year before any amount in respect of capital gains may be added to the capital dividend account.
Receipt of a Capital Dividend
14. The full amount of any dividend received by a corporation in respect of which the payer corporation made an election under subsection 83(2) is normally added to its capital dividend account regardless of whether or not the full amount is deemed to be a capital dividend. However, where a subsection 184(3) election is made by the payer for such a dividend, only the amount of the deemed separate capital dividend under paragraph 184(3)(a) is added. (see 18 to 19 below).
Life Insurance Capital Dividend Account
15. Where a private corporation became a beneficiary under a life insurance policy after June 28, 1982 and received, before May 24, 1985, the proceeds of the policy as a consequence of the death of the person whose life was insured, the net proceeds were included in the corporation's life insurance capital dividend account (see the current version of IT-430 entitled, Life Insurance Proceeds Received by a Corporation or Partnership). The corporation could elect to pay tax free life insurance capital dividends from this account which, when received by another private corporation before May 24, 1985, would be included in its life insurance capital dividend account. The balance in this account immediately before May 24, 1985 was transferred to the corporation's capital dividend account (see 6(e) above).
16. A life insurance policy is any policy of insurance where one of the risks covered is the death of the person insured but not an insurance policy which covers death only by reason of accident. This is relevant for the purposes of 6(d) and 15 above.
17. Where a corporation makes an election described in 2 or 3 above, and the full amount of the dividend does not qualify as a capital dividend, subject to 18 and 19 below, none of it will be included in computing the income of a shareholder resident in Canada but the corporation would be subject to tax under subsection 184(2). The applicable rate of tax is 75% of the non-qualifying portion of the dividend. If the non-qualifying portion of a dividend paid by a corporation in its 1988 taxation year and before June 18, 1987 resulted from the change in the portion of capital gains and losses that are included in computing the capital dividend account, subsection 184(2.1) will give relief from the tax otherwise payable under subsection 184(2) by providing that the non-qualifying portion be determined as if the corporation's taxation year ended December 31, 1987. The liability for the tax arises at the time that the election is made and (unless the tax is paid when the election is filed) interest at prescribed rates is added for the period from the date of the election to the date of payment.
Note: If draft legislation released by the Minister of Finance on February 18, 1991 is passed into law as currently proposed, every person who has received a capital dividend or capital gains dividend will, by virtue of subsection 185(4), be jointly and severally liable with the corporation for any Part III tax that becomes payable as a result of the dividend. The nature and extent of this potential liability, which will apply to dividends paid after July 13, 1990, is discussed in proposed subsections 185(4) to (6).
18. As an alternative to the payment of tax under subsection 184(2) in respect of an excessive election, a private corporation, with the concurrence of every shareholder entitled to the dividend and whose address was known to the corporation, may elect under subsection 184(3) to have the portion of the dividend that does not qualify as a capital dividend treated as a separate taxable dividend. The election must be made in the manner prescribed in section 2106 of the Regulations and within 90 days from the date of mailing of a notice of assessment in respect of the tax under subsection 184(2) that would otherwise be payable. If the dividend became payable after June 28, 1982 and before May 24, 1985, the election could specify that some or all of the excess be a separate dividend paid out of the corporation's life insurance capital dividend account and only the balance of the dividend that did not qualify as a capital dividend or a life insurance capital dividend would be a taxable dividend.
Note: If draft legislation released by the Minister of Finance on February 18, 1991 is passed into law as currently proposed, there will be a further restriction on filing the election under subsection 184(3). In addition to the current restrictions detailed above, the election will not be valid, by virtue of subsection 184(4), unless
(a) it is made within thirty months of the day on which the dividend became payable, or
(b) all the shareholders concur with the election, in which case, notwithstanding subsections 152(4) to (5), such assessment of tax, interest and penalties payable by such shareholders for any taxation year may be made as is necessary to take the corporation's election into account.
These additional restrictions will apply to elections made after July 13, 1990.
19. Where a valid election is made as described in 18 above, each shareholder resident in Canada entitled to receive a proportionate share of the actual dividend is deemed to receive, at the time that the actual dividend was paid, a share of each deemed separate dividend proportionate to the shareholder's holdings of the particular class of shares at that time. The amount of each separate dividend deemed to be received by a non-resident shareholder is computed in the same manner, but a separate capital dividend or a separate taxable dividend is deemed to have been paid on the date of the subsection 184(3) election for purposes of the non-resident tax under subsection 212(2) with the result that section 215 will apply at that time if the dividend had not been paid before that time.
20. A further alternative existed under subsection 184(3.2) for excessive elections on capital dividends that became payable after December 3, 1985 and before January 1, 1986. If the corporation had made a reasonable attempt to determine the correct amount of its capital dividend account immediately before the dividend became payable, the corporation, with the concurrence of every shareholder who received or was entitled to receive all or a portion of the dividend, could elect that all or any portion of the dividend be treated as a loan. The election was required to be made within the period set forth in paragraph 184(3.2)(a) and be accompanied by the payment for the penalty described in subsection 184(5). Provided that the amount of the dividend that was the subject of the election was repaid in full to the corporation before a date that was stipulated by the Minister the amount would be considered to be a loan to which sections 15 and 80.4 did not apply.
21. Subsection 83(2.1) is an anti-avoidance rule which may apply to a capital dividend paid after 4 p.m. Eastern Daylight Saving Time on September 25, 1987 where one of the main purposes for which the shareholder acquired the share on which the dividend was paid was to receive the capital dividend. Where subsection 83(2.1) applies, the dividend will be received by the shareholder as a taxable dividend and consequently will be included in the shareholder's income. Further, if the dividend is received by another corporation, it will not be included in computing the recipient corporation's capital dividend account. The dividend will be a capital dividend, however, for the purposes of determining any liability of the payor corporation for tax pursuant to section 184 in respect of an excessive election and of computing its capital dividend account.
22. Subsections 83(2.2) to (2.4) provide exceptions where the anti-avoidance rule in subsection 83(2.1) will not apply. They are as follows:
(a) Subsection 83(2.2) provides that the anti-avoidance rule will not apply to a capital dividend paid to an individual where all or substantially all of the corporation's capital dividend account consisted of amounts other than those specified in paragraphs 83(2.2) (a) to (d).
(b) Subsection 83(2.3) provides that capital dividends paid by a corporation will be exempt from the anti-avoidance rule in situations where it is reasonable to consider that the purpose for paying the dividend was to distribute net life insurance proceeds which were received due to death.
(c) Subsection 83(2.4) provides that the anti-avoidance rule will not apply, in most circumstances, to a capital dividend paid to a related company where all or substantially all of the corporation's capital dividend account consisted of amounts other than those specified in paragraphs 83(2.4) (a) to (e).
For further reference see the related Department of Finance Explanatory Notes for S.C. 1988, c.55 (formerly Bill C-139; Royal Assent September 13, 1988) dated June 1988 which introduce the above anti-avoidance provisions.
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