Most dividends are taxable to the recipient shareholder. Taxable dividends are included in the shareholder’s income. However, if they are received from a Canadian corporation, they qualify for the dividend tax credit, which results in a lower tax rate for the shareholder compared to most other forms of income (though the amount initially included in income is actually higher than the dividend received, as it is “grossed up” to equal the corporation’s theoretical pre-tax income represented by the dividend).
But if you receive a capital dividend, it is completely tax-free.
What is a capital dividend? Basically, it is a dividend paid by a private corporation (so not publicly listed corporations) out of its “capital dividend account” (CDA). Although the calculation of the account can be complex, it basically consists of certain amounts that are not otherwise taxable to either the corporation or an individual.
The basic element of the CDA is one-half of net capital gains realized by the corporation. Only half of capital gains are included as taxable capital gains for any taxpayer, meaning the other half is tax-free and this “untaxed half” goes into the CDA. Another common component is life insurance proceeds received by the corporation on the death of an individual, which are also tax-free for all taxpayers.
The corporation must elect for the dividend to be a capital dividend, using a particular prescribed form (form T2054) no later than the time the dividend becomes payable. A late election is allowed, with payment of a penalty (maximum $8,000).