What is a Capital Dividend Account?
The capital dividend account (CDA) is a special corporate tax account which gives shareholders designated capital dividends, tax-free. This account is typically used in Canada and is not recorded in the corporation's taxable accounting entries or financial statements.
Understanding Capital Dividend Accounts (CDA)
A capital dividend is a type of payment a firm makes to its shareholders. The payment is taken out from paid-in capital, and not from the company’s retained earnings as is the case with regular dividends. When capital dividends are paid out to shareholders, these are not taxable because the dividends are viewed as a return of the capital that investors pay in.
When a company generates a capital gain from the sale or disposal of an asset, 50% of the gain is subject to a capital gains tax. The non-taxable portion of the total gain realized by the company is added to the capital dividend account (CDA). The capital dividend account is part of a tax provision whose goal it is to enable tax-free money received by a company to be given to its shareholders, tax-free. Therefore, shareholders are not required to pay taxes on these distributions. As long as the company has this notional account, they can designate an appropriate amount of dividends as a capital dividend.
The balance in the CDA increases by 50% of any capital gains a company makes and decreases by 50% of any capital losses incurred by the company. A business’ CDA also increases when other companies pay capital dividends to the business. A company that receives life insurance proceeds in excess of the cost basis of the life insurance, will have the excess amount added to the CDA balance. Lastly, certain distributions made by a trust to a corporation at the end of the trust’s taxation year increase the balance in a firm’s capital dividend account.
A capital dividend can only be declared if the CDA balance is positive. A company that pays dividends to shareholders in an amount that is more than what is available in the CDA will be subject to a steep tax penalty of 60% of the excess dividend. The CDA balance is not found in a business' financial statements but may be reported in the notes to financial statements for information purposes only.
The capital dividend account is more commonly used in Canada. A shareholder who is a non-resident of Canada must pay a 25% flat withholding tax on any capital dividends received. The withholding tax rate may be reduced if the dividend is paid to a shareholder who has his/her residence in a country that has a tax treaty with Canada. For examples, a U.S. shareholder who receives a capital dividend from a Canadian corporation will be subject to a withholding tax of only 5%. In addition, non-resident investors would most likely be taxed under the tax laws of their country of residence.