One of the most commonly used methods of returning investments to shareholders is the declaration of dividends. In this article, we summarize the tax treatment of some different types of dividend income for Canadian resident investors.
Canadian corporations can declare both eligible or ordinary cash dividends. The distinction reflects the difference in tax treatments on the source income of the dividend.
Eligible dividends are taxed at a lower rate to a shareholder in comparison to an ordinary dividend. An eligible dividend is paid out of income of a corporation that was taxed at a high corporate rate. A Canadian-controlled private corporations (CCPCs) can only pay eligible dividends to the extent of its general rate income pool which reflects income that has not benefited from a preferential tax rate. Generally, a CCPC is a private corporation that is controlled by Canadian residents. Non-CCPCs may also pay eligible dividends to the extent that they do not have a low rate income pool. This pool accounts for income subject to preferential tax rates, such as income that is taxed at the small business rate. To pay out an eligible dividend, the corporation must designate the dividend as such in writing before or at the time the dividends are paid.
Another useful dividend that a private corporation can pay is a capital dividend. These dividends are tax-free to Canadian resident investors. The capital dividend must be paid out from the capital dividend account of the corporation, which tracks the non-taxable portion of capital gains and gains on the sale of eligible capital property received by the corporation. To elect dividends from being paid out from the capital dividend account, the corporation must complete form T2054 and submit it to the CRA on or before the capital dividend is paid or becomes payable.
Lastly, capital gains dividends are distributions made by mutual fund corporations, investment corporations or mortgage investment corporations. They are treated as capital gains for tax purposes.
In the context of M&A, a vendor to a transaction should consider whether to distribute part of the proceeds from a sale to its shareholders and what type of dividend would be most beneficial for the company and its shareholders. Further, in instances where a corporation is being sold, the status of its tax accounts, such as its capital dividend account, may be important considerations for valuing that corporation.
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