How do I save taxes using capital dividends?
The Canadian tax system allows a corporation to take out tax-free dividends using a Capital Dividend Account (CDA). The CDA includes the following:
- Non-taxable portion of company’s capital gains net of capital losses
- Non-taxable portion of gains on sale of eligible capital property (phased out in 2016)
- Proceeds of life insurance policies on death (not discussed below)
When an asset is sold for a profit, 50% of the profit is not taxable. If the asset is owned personally, the owner has direct access to the tax free profit. If the asset is owned by the corporation, the tax free profit is trapped inside the company. The Canadian tax system is based on the concept of integration. It should not matter whether you earn the income inside or outside a corporation, the tax treatment should be equal. Therefore, shareholders are permitted to withdraw the tax free profit by way of a Capital Dividend and this avoids double taxation. This dividend is not reported on the shareholders tax return as no tax is owed on the amount.
In order to designate a capital dividend, you must file an election with Canada Revenue Agency and special paperwork and procedures are required prior to and through the issuance.
You should consider the following strategy when deciding to pay out a capital dividend. Pay out the CDA as the balance accumulates before it is eroded by capital losses. For example, you may trigger a large capital gain on a transaction but the CDA balance will be reduced by any future capital losses. Therefore, prior to realizing any capital losses, you should designate a capital dividend to withdraw the tax free profit.
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