It should be noted that the taxation of corporations is based, in particular, on the principle of “integration,” which generally aims to bring the total tax paid on income earned through a corporation and distributed to a shareholder as close as possible to what would have been paid had that income been earned directly by the shareholder.
A private corporation may choose to pay dividends as capital dividends to its shareholders, provided it has a sufficient balance in its capital dividend account (CDC). The corporation must then file the prescribed tax form to exercise the election regarding the capital dividend, no later than the earlier of the date the dividend becomes payable and the date a portion of the dividend is actually paid. This election must, in particular, indicate the amount of the dividend and be accompanied by the required documents. The corporation must also ensure that the amount of the capital dividend does not exceed the available balance of its applicable CDC; otherwise, it could be subject to a special tax on the excess amount.
Unlike taxable ordinary dividends, dividends capital dividends can generally be received tax-free by shareholders residing in Canada when the applicable tax conditions are met, since they are paid out of the corporation’s capital dividends (CDC) account. The CDC is a tax account used, among other things, to record certain amounts that may be distributed to shareholders as capital dividends, including certain amounts derived from the non-taxable portion of capital gains as well as certain capital dividends received by the corporation. It is therefore not simply a refund of the capital that shareholders have contributed to the company. The CDC balance is cumulative and can be affected by various transactions and events throughout the different tax years of the company. To receive a tax-free capital dividend, the relevant shareholder must, among other things, be a resident of Canada; different tax rules apply when the shareholder is a non-resident.
To pay a dividend in capital to the relevant shareholders, the corporation must therefore, among other things, follow these rules: (a) determine the available balance of its CDC and ensure that the amount of the capital dividend does not exceed that balance; (b) declare the dividend with respect to the relevant shares in accordance with the rights attached to them and the resolution adopted by the board of directors; and (c) file a tax election using the prescribed tax form and submit the required documents to the tax authorities. The corporation may also, where appropriate, request a verification of the balance of its CDC, but prior confirmation of this balance by the tax authorities is not a general condition for the payment of the dividend. The corporation must therefore exercise a “capital dividend election” on its capital dividend account.