If you receive a dividend from a corporation, the dividend is normally included in your income.
However, a capital dividend is not included in your income. In other words, it is received free of tax.
In general terms, a private corporation can pay capital dividends to the extent of its “capital dividend account”. Public corporations cannot pay capital dividends.
The capital dividend account includes certain amounts that are tax-free to the private corporation, and that are allowed to pass tax-free to the shareholders. For example, one-half of capital gains are not subject to tax. Therefore, if a corporation earns net capital gains (capital gains in excess of its capital losses), one-half of that amount is added to the corporation’s capital dividend account and can be paid out as a tax-free capital dividend. In addition, the corporation’s capital dividend account includes:
• Most life insurance proceeds received by the corporation on policies where it was the beneficiary; and
• Capital dividends that the corporation received from other corporations.
The capital dividend account is computed immediately before the earlier of the time that the capital dividend became payable and the time it was paid. (It is usually payable at the time indicated by the directors of the corporation in the corporate resolution declaring the dividend.) Furthermore, the corporation must elect that the dividend is a capital dividend. This election must be filed with the CRA by the earlier of the two times indicated above.
The election is made on Form T2054, including a schedule showing the calculation of the capital dividend account balance immediately before the election. The CRA T2 Schedule 89 (Form T2SCH89, Request for Capital Dividend Account Balance Verification) can be used to ask the CRA to confirm the balance.
Late filing of the form T2054 may be allowed, but with a monetary penalty.
What if the dividend exceeds the capital dividend account?
A corporation declaring a capital dividend should have a capital dividend account equal to or greater than the capital dividend.
If the corporation makes a mistake, and pays a dividend that exceeds its capital dividend account, but still makes the election in respect of the dividend, the dividend will remain non-taxable to the recipient shareholder as a capital dividend. However, the corporation will be subject to a penalty tax equal to 60% of the excess, plus interest to the date of payment. The recipient shareholder will be jointly and severally liable with the corporation to pay the penalty.
As an alternative to the penalty, the corporation can elect to treat the excess amount as a taxable dividend, meaning that the shareholders will include that excess amount in income as a taxable dividend rather than a capital dividend. The shareholders must agree to this election.