Capital dividends are a delightful thing to receive. They are completely tax-free. Generally speaking, a private corporation can pay a capital dividend out of its “capital dividend account”. Public corporations and non-resident corporations cannot pay capital dividends.
The corporation paying the capital dividend must make an election on Form T2054 and file it with the Canada Revenue Agency (CRA) no later than when the dividend becomes payable. A late-filed election can be made, but with a late filing penalty which is generally $500 per year or 1% of the dividend (whichever is lower), prorated for the number of months of lateness.
Capital dividend account
Typically the corporation will make the election to the extent of its capital dividend account immediately before the dividend is declared. This notional account includes certain items that are normally exempt from tax such as the non-taxable half of the corporation’s realized capital gains (only half of capital gains are included in income as taxable capital gains). The capital dividend account therefore includes the following:
- One-half of the corporation’s capital gains in excess of one-half of its capital losses; plus
- Life insurance proceeds where the corporation was the beneficiary of the life insurance; plus
- Capital dividends that the corporation has received from other corporations; minus
- Capital dividends that the corporation has previously paid.
Dividend in excess of capital dividend account
If the dividend paid by the corporation exceeds its capital dividend account at that time, but the corporation still files the above-noted election, the entire dividend is still tax-free to the shareholders. However, the corporation may be liable to a severe penalty tax of 60% of the excess, plus interest. And although the shareholders receive the dividend tax-free, they are jointly liable to pay their relative proportions of the corporation’s penalty tax!
Alternatively, instead of paying the penalty tax, the corporation can make a further election that deems the excess amount to be a separate taxable dividend in the hands of the shareholders. In such case, the first portion of the dividend (to the extent of the capital dividend account) will be tax-free, but the excess separate dividend will be included in the shareholders’ income. This further election is available only if all shareholders who were entitled to the dividend and whose address is known to the corporation provide their consent.