It should be noted that the taxation of corporations is based on the principle of “integration,” meaning that the profit earned by a corporation and distributed to a shareholder must be subject to the same taxation as if it had been earned directly by the shareholder.
The corporation may choose to pay capital dividends to its shareholders at any time, provided it has a positive balance in its capital dividend account (CDC) at the time of payment. The corporation must then file a capital dividend form no later than the day the dividend is paid; this form must indicate the amount of the dividend and the payment date. The corporation must also send a copy of the form to each shareholder receiving this dividend. The corporation must ensure that the amount of the dividend does not exceed the balance of the CDC at the time of payment; otherwise, it could be subject to a tax penalty on the excess amount.
Unlike ordinary dividends, capital dividends are tax-free for shareholders, because they are paid out of the capital dividend account (CDC); in fact, these dividends are not taxable because they are considered a refund of capital that shareholders contribute or have contributed. However, the company may only pay capital dividends when the CDC balance is positive; this CDC balance is calculated at the end of each tax year and may be affected by various transactions and events. To receive their dividend tax-free, however, the shareholder in question must be a Canadian resident; otherwise, they will be subject to tax. Capital dividends are payable at the time such dividends are declared.
To pay a capital dividend to the relevant shareholders, the corporation must therefore follow these rules: (a) the amount of the designated dividend must correspond to the balance of the CDC, which must be positive; (b) the capital dividend is allocated equally among each share of the same class of stock; (c) a tax election must be filed using the prescribed tax form, accompanied by a request to verify the CDC balance, which must be confirmed by the tax authorities before the dividend is paid. The corporation must therefore exercise a “dividend election on its capital dividend account.”