DFK Tax Newsletter
Capital Dividend Election Trap
There has been a lot of coverage in the media lately about the Federal Government changing the inclusion rate for capital gains (the part of a capital gain that is taxed) from 50% to 66.7%. One issue that has not received as much attention is the impact this change has on capital dividend elections. And it is an issue that could prove to be quite costly if you are not careful.
First, a little background on capital dividend elections. Without getting into all of the technical definitions and Income Tax Act references associated with capital dividend elections, corporations have a tax account called a capital dividend account. When this account has a positive balance, you can file an election to pay out a tax-free capital dividend to shareholders. The main (but not the only) item that gets added to, or subtracted from, this account is the non-taxable portion of capital gains and losses realized by a corporation when it sells assets or investments. Prior to June 24, 2024, 50% of the capital gain was taxable and 50% of the gain was not taxable. The non-taxable portion would get added to the capital dividend account balance and could be paid out to shareholders as a tax-free capital dividend when you file a capital dividend election. Under the new rules for capital gains realized on June 25, 2024 or later, 66.7% of the gain is taxable and 33.3% of the gain is not taxable.
When the change in the inclusion rate from 50% to 66.7% was announced as part of the Federal Budget released on April 16, 2024, many practitioners in the tax community assumed that calculating the capital dividend account balance would still be a simple exercise based on the date of the transactions and the inclusion rate that applied on that date. However, when the actual legislation to implement this change was released on June 10, 2024, many were surprised to learn that the calculation was not as simple as we had anticipated. In fiscal periods that include both the old 50% inclusion rate and the new 66.7% inclusion rate there is an averaging calculation which occurs. This could cause problems if you file a capital dividend election before you reach the end of your fiscal period.
A basic example of how this works would be the following:
A corporation with a January 1, 2024 to December 31, 2024 fiscal period sells assets or investments both before and after the June 25, 2024 inclusion rate change. To keep the math simple, let’s assume that they realize capital gains of $10,000 before the inclusion rate change and $10,000 after the rate change. Many would assume that the $10,000 of capital gains before the rate change would result in $5,000 ($10,000 x 50%) being added to the capital dividend account and that you would be safe to file a capital dividend election to pay this assumed tax-free portion out to shareholders. However, because of the averaging over the fiscal period, the amount which is added to the capital dividend account is not known until the fiscal period is complete. The additional $10,000 of capital gains realized after the inclusion rate change results in an addition to the capital dividend account of $3,333 ($10,000 x 33.3%). Over the course of the year the total addition to the capital dividend account is $8,333 ($5,000 + $3,333). This total addition to the capital dividend account of $8,333 on total capital gains of $20,000 works out to an average of 41.67%. So the $10,000 gain in the first part of the year that you thought would result in an addition of $5,000 to the capital dividend account only results in $4,167 of addition to the capital dividend account. And there is no way to know what the results of these calculations will be until you reach the end of the fiscal year and look back on all of the gains and losses for the year.
In addition to creating uncertainty in calculating the capital dividend balance part way through the year, any excessive election on a capital dividend could be subject to significant penalties. Penalties for an excessive capital dividend election can be as high as 60% of the amount of the excess. That means that in the example above, an election filed for $5,000 when only $4,167 is available, the penalties could be up to $500 ($5,000 - $4,167 = $833 x 60% = $500). This example is using relatively small figures to illustrate the impact and the risks associated with filing an election before the end of the year. If a corporation were to sell, for example, a commercial property or some other asset for a much larger gain, the penalties on a capital dividend over election could be much larger.
Fortunately this is only an issue for fiscal periods that include both the old and the new inclusion rates. However, given the risks and potential penalties involved, you should consult with your local DFK tax advisor for advice before filing a capital dividend election.
