Tax II Chapter 4
Spring 2013
Notes
Chapter Four Lecture Notes
Special Refundable Tax System
For Investment Income of
Certain Private Corporations
David Christian
Spring Term 2013
Thorsteinssons LLP
UBC Faculty of Law
______________________________________________________________________________
Notes
In my own case the words of such an act as the Income Tax, for example,
merely dance before my eyes in meaningless procession – cross-reference to
cross-reference, exception upon exception – couched in abstract terms that offer
no handle to seize hold of – leave in my mind only a confused sense of some
vitally important, but successfully concealed, purport, which it is my duty to
extract, but which is within my power, if at all, only after the most inordinate
expenditure of time.
Hand J.
1.
The focus of this Chapter is on a special refundable tax system at the
corporate level, which is fundamentally designed to:


prevent deferral of tax by earning the investment income inside a
corporation; and
permit integration of tax when comparing the earning of
investment income personally or inside a corporation.
The Chapter will look at two types of special taxes on “investment
income” and will examine the “refundable nature” of these taxes. The
investment income in this context consists of two broad categories: (i) all
investment income except dividends received from other Canadian
corporations, and (ii) dividends received from other Canadian
corporations.
The refund of the tax imposed on these two categories of investment
income is handled through a mechanism that is referred to as the “RDTOH
account”. The name will become clear below. Dividends paid by a
certain type of corporation that earns this investment income, and pays the
special taxes on the investment income, will trigger a refund of tax to the
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Notes
corporation. The RDTOH account is a method of tracking the amount of
tax the corporation can potentially get refunded to it upon payment of
sufficient dividends by that corporation.
This Chapter will also look at how the corporate tax system deals with the
one half tax-free portion of capital gains realized by a CCPC.
Investment Income Except Dividends from Other Canadian Corporations
2.
This scheme imposes a special tax on the “aggregate investment income”
of a Canadian-controlled private corporation (CCPC). We are familiar
with the legal concept of a CCPC. What is captured by “aggregate
investment income”? Read the definition of that term in subsection
129(4). This consists of the following net income amounts:

The amount, if any, by which the “eligible portion” of the
corporation's taxable capital gains for the year exceeds the total of (i)
the eligible portion of its allowable capital losses for the year and (ii)
net capital losses for other taxation years deducted in the year
(paragraph (a)).

The corporation's “income for the year from a source that is a
property” other than the portion of any dividend from another
Canadian corporation that was deductible under section 112 in
computing the corporation's taxable income for the year (paragraph
(b)). (Dividends from other corporations are subject to the other
special refundable “Part IV” tax below.)
3.
The “eligible portion” of a taxable capital gain is defined in subsection
129(4) as the portion of a taxable capital gain (or allowable capital loss, as
the case may be) of the CCPC for the year from a disposition of a property
that cannot reasonably be regarded as having accrued while the property
was held by a non-CCPC. How could the latter arise?
4.
What constitutes “income from a source that is a property”? Recall the
concept of “income from property” in Tax I? Krishna describes it this
way:
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Generally, income from property is the investment yield on an asset. Rent,
dividends, interest, and royalties are typical examples. We earn the yield on the
investment by a relatively passive process. For example, where an individual
invests in land, stocks, bonds, or intangible property, and collects investment
income therefrom without doing much more than holding the property, the
income is … income from property.
5.
Remember Chapter 3 and the notion of a “specified investment business”?
Income from that business did not qualify as an “active business” of a
CCPC. Now read the definition of “income from a source that is a
property” in subsection 129(4).

You specifically include as this type of income the income from a
specified investment business carried on by the CCPC in Canada
(paragraph (a)). Consider some examples (rental apartment building,
franchising business, investing in second tier mortgage financing, etc.).

You specifically exclude from this type of income:
o the income from any property that is incident to or pertains to
an active business carried on by the CCPC, and
o the income from any property that is used or held principally
for the purpose of gaining or producing income from an active
business carried on by it.
6.
Read the decision in Shamita Inc. v. The Queen (copy enclosed with these
materials).
7.
What tax rate applies to a CCPC’s “aggregate investment income” and
how does the refundable portion of that tax work? Remember Chapter 1,
where we said the “base case” tax rate on a corporation’s income was as
follows.
“Base case” tax rate to be applied to
the corporation’s taxable income to
arrive at the tax owing by the
corporation
start with (historical) federal tax rate
%
Section references and notes
38
123(1)(a) - most recent, but still historical, base
federal rate
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Notes
8.
subtract the federal “general rate
reduction”
13
subtract the “provincial abatement”
10
add the base case provincial tax rate on
the corporation’s income earned in the
province
10
thus, the total tax “base case” tax rate on
the corporation’s taxable income in
Canada is
25
123.4(2) - this gives us the current base federal rate
of 25% before making “room” for the provincial
and territorial taxes - assume here the corporation’s
income is basic “full rate taxable” income
124(1) – makes “room” for the provinces and
territories to impose their own tax rate on the
corporation’s “taxable income earned in a province”
– this gives us the net current federal rate of 15%
where the corporation’s income is subject to
provincial or territorial tax
the provincial rate here is the base rate of 10% in
subsection 14(2) Income Tax Act (British Columbia)
the base corporate tax will vary across Canada as
provinces and territories impose tax at rates
different from British Columbia
Recall in Chapter 3 the “base case” is modified where the corporation is a
CCPC and the income is “active business income” under $500,000. The
“base case” is also modified where the corporation is a CCPC and the
income is “aggregate investment income”. In this event, the corporate tax
rate that applies to the aggregate investment income is built as follows.
start with initial base federal tax rate
general federal rate reduction
38
123(1)(a) - most recent, but still
historical, base federal rate.
0
Read paragraph (b)(iii) of the
definition of “full-rate taxable
income” in 123.4(1), which backsout of the income qualifying for the
general rate reduction a CCPC’s
“aggregate investment income”.
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Notes
subtract the “provincial abatement”
add the special tax
provincial tax
Total initial corporate tax on a
CCPC’s
aggregate
investment
income
(10)
124(1) – recall this makes “room”
for the provinces and territories to
impose their own tax rate on the
corporation’s “taxable income
earned in a province” – this gives us
the net current federal rate of 28%
before the “special” additional tax on
aggregate investment income.
6.67
123.3 - this is the special additional
tax applies to a CCPC’s aggregate
investment income. This gives us the
net federal rate of 34.67% -
10
the general corporate rate in British
Columbia.
44.67
Note: This is the tax rate before any
refund out of the RDTOH account
below.
The object of adding the refundable tax is that there be “no deferral of tax”
on investment income earned by a corporation. Imagine an individual
who would otherwise earn aggregate investment income personally. The
personal tax rate (top rate) in British Columbia we saw from Chapter 1 is
43.7%. If that same income is earned inside a CCPC, the tax rate
applicable to that income is 44.67%. There is certainly no deferral
advantage gained by earning the aggregate investment income inside the
CCPC. In fact, there is a 0.97% disadvantage to earning the income inside
a CCPC.
9.
This is not the end of the tax system for a CCPC’s aggregate investment
income. Turn to the rules for a “refund” of some of the 44.67% tax paid
by the CCPC as shown above. Read subparagraphs 129(1)(a)(i) and (ii).
When a tax return is filed for a year, the Minister refunds to the CCPC
(actually any private corporation – which will become relevant for Part IV
tax below as well) an amount equal to the lower of two amounts:

1/3rd of all taxable dividends paid by the CCPC in the year; and

the CCPC’s “refundable dividend tax on hand account” (RDTOH
account for short) at the end of the year.
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The amount refunded to the CCPC is called the “dividend refund” for the
year.
10.
The foregoing leads to the question: What amounts are in a CCPC’s
RDTOH account at the end of a current year? Read subsection 129(3).
The CCPC’s RDTOH account at the end of a current year means:
The amount by which the total of:

26 2/3% of the CCPC’s aggregate investment income for the
current year (paragraph a), and

the taxes payable under Part IV for the current year on dividends
from other corporations (discussed below), and

the CCPC’s RDTOH account at the end of the preceding year
exceeds:

11.
the CCPC’s dividend refund for its preceding year.
How does this look numerically?
(slowly).
Walk through the following chart
CCPC
$
1.
2.
3.
CCPC’s aggregate investment income in year
one is
Individual
Shareholder
Recipient of
Dividend $
Paid to and
refunded by the
Government
100
CCPC’s tax paid on its aggregate investment
income in year one as determined above is
44.67
CCPC’s remainder, say, cash in the bank is
55.33
44.67
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Notes
4.
5.
6.
7.
8.
CCPC’s RDTOH account at the end of year one
– 26.67% of its aggregate investment income in
year one (assume no Part IV tax or prior year
RDTOH). Note, this is an asset of the CCPC
because the government must refund it upon
payment of sufficient dividends by the CCPC.
26.67
Assume the CCPC pays a taxable dividend of
$82.00 (sum of cash and RDTOH) in year two
– which is included in the shareholder’s income
in year two under 82(1)(a).
The payment of the dividend in year two allows
the CCPC to claim a refund under 129(1)(a)
equal to the lower of (i) 1/3rd of the dividend
and (ii) its RDTOH at the end of year two –
assume the RDTOH has remained at 26.67 at
the end of year two for simplicity.
The CCPC’s net tax paid on the aggregate
invesment income is thus the initial tax less the
amount refunded to it (44.67 – 26.67 = 18.00).
The individual shareholder must include the
additional “gross-up” amount in income equal
to ¼ of the dividend paid under 82(1)(b).
82.00
26.67
18.00
18.00
20.50
The individual shareholder’s total income is
102.50
10. The individual’s tax at the top rate of 43.7%
(recall from Chapter 1) is
44.79
11. The shareholder is entitled to the dividend tax
credit, which from Chapter 1 was 83.67% of the
gross-up amount.
17.15
12. The individual shareholder’s net tax is
27.64
9.
13. Total net tax paid by CCPC and individual
shareholder is
27.64
45.64
In broad tax policy terms, the dual objective of this special system for
taxing a CCPC’s “aggregate investment income” is (i) to prevent the
deferral of taxation by earning the income inside a CCPC (which is
accomplished by, effectively, requiring the prepayment of shareholder
distribution tax), and (ii) to achieve a very rough integration of tax when
dividends are paid out of the CCPC. Notice, the net tax rate inside the
CCPC, after the refund of a portion of the tax initially paid on the
aggregate investment income, is roughly the 20% corporate tax rate that,
in policy terms, was the basis for the “gross-up and dividend tax credit”
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Notes
system seen in Chapter 1, which is designed in policy terms to avoid
double taxation.
Of course, there are variations from year-to-year in the initial corporate tax
rate and the total tax paid on the aggregate investment income. The
variations arise as the corporate and personal tax rates are changed at both
the federal and provincial levels. Compare the top personal rate on
aggregate investment income in British Columbia (43.7%) with the initial
tax rate inside the CCPC (44.67%) and the total tax paid by the CCPC and
the individual shareholder (45.64%). As matters currently stand, there is
no deferral advantage (in fact, in our example there is a slight initial cost
of 0.97%) and perfect integration is not achieved (in fact, there is a slight
absolute cost of 1.94%).
12.
Recall one point from Chapter 3. Certain income that would otherwise
qualify as a CCPC’s “income from a source that is property”, and would
thus otherwise be subject to the refundable tax system above, is deemed
instead to be the CCPC’s “active business income” in cases described in
subsection 129(6). Read subsection 129(6), which is sometimes called the
“source preservation rule” for associated CCPCs. Recall the examples:
Mr. X
“associated””
CCPC 1
CCPC 2
loan
active
business
interest
The interest income is deemed to be “active
business income” to CCPC 2
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Notes
Mr. X
“associated”
CCPC 1
dental
business
CCPC 2
lease
building
rent
The rental income is deemed to be active
business of CCPC 2
income.
The interest income and the rental income would in the first instance be
“aggregate investment income” of CCPC 2. However, that income (paid
by associated CCPC 1 to CCPC 2) is deemed not to be part of its
aggregate investment income if the amount was deducted in computing the
“active business income” of the associated CCPC 1. The apparent policy
is that one should not be allowed to “convert” what is fundamentally
active business income (in CCPC 1) into aggregate investment income in
CCPC 2 by the mechanism of having two CCPCs. Some commentators
view this as making sure that the rough integration system for aggregate
investment income cannot, indirectly, be superimposed on active business
income of a CCPC that could, in theory, exceed the $500,000 small
business limit. This policy objective has been rendered irrelevant by the
introduction of the enhanced dividend tax credit. In fact, one would now
seek to have property income converted to active business income, as it
defers 19.67% of corporate tax.
Private Corporations that Receive Dividends from other Canadian Corporations
13.
Recall that excluded from aggregate investment income is “… the portion
of any dividend from another Canadian corporation that was deductible
under section 112 in computing the corporation's taxable income for the
year”. Because such dividends are deductible in computing a corporate
shareholder’s ordinary income under Part I of the Act, such dividends are
not subject to any tax at all under Part I of the Act
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14.
This potential to receive tax free dividends under Part I of the Act has
spawned a number of separate and distinct rules that we examine
throughout the course. The first set of such rules we look at is called the
refundable Part IV tax, which is payable by private companies (and a very
limited subset of other companies) on certain dividend income received
from other Canadian companies. In order to understand the first main
policy behind Part IV tax, we need to go back, once again, to some basic
points made in Chapter 1.
15.
Consider an individual shareholder that invests in shares of a Canadian
corporation. Apply what you know now and determine the “effective tax
rate” focusing only on the actual dividend received by the individual and
the tax paid on that actual dividend. How? We have “run” the tax system
for (i) the “base rate” for all corporations, (ii) the “small business rate” for
CCPC active business income, and (iii) the refundable tax system for
CCPC aggregate investment income. In each case we looked at the total
tax paid by the corporation and the individual shareholder. For ease of
reference these charts appear below assuming the corporation’s income is
$100 in each case.
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Base Rate Case
the corporation’s tax on $100 of income at the
base rate of 25% is
the actual dividend paid to the individual
shareholder
“gross-up” the dividend by 38% of the
dividend
$25.00
$75.00
$28.50
shareholder tax at the top federal-provincial
tax rate of 43.7%
$45.23
deduct the enhanced “dividend tax credit”,
being 89.99% of the gross-up,
$25.65
net shareholder tax
$19.58
the total $44.58 of tax on $100 of income
translates to an effective tax rate of 44.58%, or
rounded to
45%
Small Business Rate Case
tax at the small business rate (13.5%)
13.50
after-tax dividend to the individual shareholder
86.50
gross-up (1/4 of the dividend)
21.63
shareholder’s income
108.13
shareholder tax (43.7%)
47.25
dividend tax credit (83.67% of gross-up)
18.10
net shareholder tax
29.15
the total $42.65 of tax on $100 of income
translates to an effective tax rate of 42.65%, or
rounded to
43%
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Notes
Refundable Aggregate Investment Income Case
1.
CCPC’s aggregate investment income in year
one is
100
CCPC’s tax paid on its aggregate investment
income in year one as determined above is
44.67
3.
CCPC’s remainder, say, cash in the bank is
55.33
4.
CCPC’s RDTOH account at the end of year one
– 26.67% of its aggregate investment income in
year one (assume no Part IV tax or prior year
RDTOH). Note, this is an asset of the CCPC
because the government must refund it upon
payment of sufficient dividends by the CCPC.
2.
5.
6.
7.
8.
26.67
Assume the CCPC pays a taxable dividend of
$82.000 (sum of cash and RDTOH) in year two
– which is included in the shareholder’s income
in year two under 82(1)(a).
The payment of the dividend in year two allows
the CCPC to claim a refund under 129(1)(a)
equal to the lower of (i) 1/3rd of the dividend
and (ii) its RDTOH at the end of year two –
assume the RDTOH has remained at 26.67 at
the end of year two for simplicity.
The CCPC’s net tax paid on the aggregate
invesment income is thus the initial tax less the
amount refunded to it (44.67 – 26.67 = 18.00).
The individual shareholder must include the
additional “gross-up” amount in income equal
to ¼ of the dividend paid under 82(1)(b).
44.67
82.00
26.67
18.00
18.00
20.50
The individual shareholder’s total income is
102.50
10. The individual’s tax at the top rate, recall from
Chapter 1 is
44.79
11. The shareholder is entitled to the dividend tax
credit, which from Chapter 1 was 83.67% of the
gross-up amount.
17.15
12. The individual shareholder’s net tax is
27.64
9.
13. Total net tax paid by CCPC and individual
shareholder is
27.64
45.64
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Notes
Now answer the question posed. What is the “effective tax rate” on a
dividend from a Canadian corporation received by an individual
shareholder - focusing only on the actual dividend received by the
individual and the actual tax paid on that actual dividend?
In the base rate case the actual dividend was $75.00 and the actual tax paid
by the shareholder was $19.58. The effective tax rate is thus 26.11%. In
the small business rate case the actual dividend was $86.50 and the actual
tax was $29.15. The effective tax rate is thus 33.7%. And finally, in
aggregate investment income case the actual dividend was $82.00 and the
actual tax was $27.64. The effective tax rate is thus 33.7%.
The “effective tax rate” on a dividend received by an individual is the
same on all income other than eligible dividends paid from income taxed
at the top corporate tax rate (GRIP): 33.7%. It will become obvious why
this is the case: the same variables apply to each dividend, namely the
gross-up, the personal tax rate, and the dividend tax credit. The result is
the same effective tax rate on the dividend in each case in which the
variables are equal, regardless of what type of corporation is paying the
dividend and what tax the corporation may or may not have paid. It is
only when the variables are changed – by increasing the gross-up, and thus
the dividend tax credit – that the shareholder tax is reduced.
16.
Now consider the follow case. An individual wants to use excess funds to
invest in shares of Telus or the Royal Bank (both Canadian corporations).
It occurs to the individual that the funds could be invested in a private
company.
Ind’l
Private Co.
Publi
c
Telus
(TSE)
Publi
c
Royal
Bank
(TSE)
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Notes
17.
Rather than pay 26.11% tax on any eligible dividends received by the
individual personally (or 33.7% if the dividend is not an eligible dividend)
the private company will receive them and get a the subsection 112(1)
deduction so there is no Part I tax paid at all on the dividends.
Admittedly, there will be a tax when the private company pays dividends
to the individual, but not until that time. Thus, there is a potential for
unlimited deferral of tax on dividends in this classic case. Enter Part IV
tax.
First Aspect of Part IV Tax (and the RDTOH Account - Again)
18.
The above is one classic example to which the rules in Part IV (sections
186 to 186.2) are targeted. The first aspect of Part IV tax is to impose a
33.33% tax on the dividends received by the private corporation from
certain Canadian corporations.
19.
Read paragraph 186(1)(a) and all the related rules that apply to it.

Subsection 186(1) applies the 33.33% Part IV tax to “assessable
dividends” received by a “private corporation” or a “subject
corporation”.
The definition of a “private corporation” was reviewed in Chapter
2. The second type of corporation is defined in subsection 186(3),
and includes the relatively rare case of a corporation (other than a
private corporation) resident in Canada and controlled by, or for
the benefit of, an individual (other than a trust), or a related group
of individuals (other than trusts). Subsection 186(5) deems a
subject corporation to be a private corporation for purposes of a
refund out of the RDTOH account (described below).

An “assessable dividend” is defined in subsection 186(3) as a
taxable dividend that is deductible under subsection 112 in
computing Part I income. This deduction is, of course, the reason
for the existence of Part IV tax.
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
The rule in paragraph 186(1)(a) looks to whether the company
paying the dividend to the private corporation, or subject
corporation, is not “connected with” the private corporation or
subject corporation. “Connected with” is a vitally important test
and is defined in subsections 186(2) and (4).

20.
1
The corporations are “connected” where the paying
corporation is “controlled” by the private corporation or
subject corporation, or is so “controlled” by persons who
“do not deal at arm’s length with” the private corporation
or subject corporation – and note in this context that:
(i)
“controlled” means “owning more than 50% of
payer corporation’s shares that have full voting
rights under all circumstances, and
(ii)
persons are deemed not to deal at arm’s length with
each other when they are “related” for tax purposes,
a concept you will recall from Chapter 3 (read
paragraph 251(1)(a)),1

The corporations are also “connected” where the private
corporation or subject corporation owns shares of the
paying corporation that represents: (i) more than 10% of
shares having full voting rights under all circumstances,
and (ii) more than 10% of the value of all shares of the
payer corporation.

The foregoing “connected corporation” tests are sometimes
referred to as the “control test” and the “10% votes and
value” test. Note these are alternate tests.
However, all the Part IV tax in paragraph 186(1)(a) is refundable to the
private corporation when that company pays taxable dividends. The
refund mechanism is effected through the addition of Part IV tax to a
private corporation’s RDTOH account, and the refund of tax is subject to
There are other tests for “not dealing at arm’s length”, which we will look at later in the course. Those
tests will also apply here. The “related person” test is most often encountered in this context.
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Notes
the same limitations in paragraph 129(1)(a). Read paragraph 129(3) again.
You add to the RDTOH account of a private corporation “the total of the
taxes under Part IV payable by the corporation for the year”. Thus, the
payment of a dividend by a private corporation will trigger a refund of tax
out of the RDTOH account pursuant to subsection 129(1).
Dividends received by Private Co
Part IV tax paid (and addition to the
RDTOH account)
dividend paid by Private Co
refund to the Private Co out its
RDTOH account below, subject to
the 129(1)(a) limit of 1/3rd of the
dividend paid by the Private Co
Private Co’s net tax on dividends
received
100
(33.33)
100
33.33
0
The general object of this first aspect of Part IV tax is to prevent deferral of
tax when you compare the situation of an individual receiving the
dividends with a private corporation receiving the dividends. There is a
very slight cost (0.37%) on dividends that are not eligible dividends, and a
significant interim cost (8.28%) on eligible dividends. However, as most
dividends subject to the first aspect of Part IV tax will be eligible dividends
(as they will be paid by public corporations) the cost is a significant
disincentive to a private corporation receiving eligible dividends.
Second Aspect of Part IV Tax
21.
This second aspect of Part IV tax operates to “preserve” the tax effect of a
prior addition to the RDTOH account of a payer corporation that is
connected with the private corporation that receives the dividend. This
aspect ties-in both of the additions to the RDTOH account that we have
seen thus far, namely, the 26.67% of a CCPC’s aggregate investment
income and the Part IV itself.
22.
This second aspect of Part IV tax in contained in paragraph 186(1)(b).
The tax applies where the payer private corporation is connected with the
receiving private corporation, and the dividend paid to the receiving
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Notes
private corporation triggers a refund of tax to the underlying payer private
corporation out of its RDTOH account. The amount of the Part IV tax is
equal to the relative portion of the refund to the paying corporation, that
relative portion being determined with reference to the amount of
dividends paid by the paying corporation in the year. The precise
language of paragraph 186(1)(b) is worth quoting here. The Part IV tax
amount is equal to:
“…all amounts, each of which is an amount in respect of an assessable
dividend received by the particular [private] corporation in the year
from a private corporation or a subject corporation that was a payer
corporation connected with the particular [private] corporation, equal to
that proportion of the payer corporation's dividend refund (within the
meaning assigned by paragraph 129(1)(a)) for its taxation year in which
it paid the dividend that:
(i)
the amount of the dividend received by the particular
corporation
is of
(ii)
23.
the total of all taxable dividends paid by the payer corporation
in its taxation year in which it paid the dividend …”
Consider one example applying paragraph 186(1)(b).
Individual
Privateco B Ltd.
teco B Ltd.
Privateco A Ltd.
Apartment
Building
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Company
Holdco
1.
Privateco A Ltd’s rental income, being its “aggregate
investment income”
100
2.
Initial tax on Privateco A Ltd’s aggregate investment
income
44.67
3.
Addition to Privateco A Ltd’s RDTOH account
26.67
4.
Dividend to Privateco B Ltd
5.
Dividend refund to Privateco A Ltd under paragraph
129(1)(a) out of its RDTOH
6.
Net tax paid by Privateco A Ltd
7.
Part IV tax payable by connected Privateco B Ltd under
under paragraph 186(1)(b)
26.67
8.
Addition to Privateco B Ltd’s RDTOH account
26.67
9.
Dividend to the individual shareholder of Privateco B
Ltd
Gov’t
44.67
82.00
26.67
18.00
26.67
82.00
10. Dividend refund to Privateco B Ltd under paragraph
129(1)(a)
26.67
11. Net tax paid by Privateco B Ltd Holdco tax – after
refund
0
24.
Ind’l
Take another example as follows.
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Tax II Chapter 4
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Notes
Individual
Holdings Ltd.
dividend
Investments
Ltd.
Publi
c
dividend
Telus
dividend
Publi
c
Royal
Bank
Investments Ltd. receives $100 in dividends from Telus and Royal
Bank, and pays $33.33 Part IV tax under paragraph 186(1)(a) on
dividends from Telus and Royal Bank. This amount is added to its
RDTOH account.
Investments Ltd. then pays a $100 dividend to Holdings Ltd. This
payment of a $100 dividend generates a refund to Investments Ltd.
equal to $33.33 out of its RDTOH account.
Holdings Ltd. is “connected with” Investments Ltd. and the
dividend it received generated a refund of Part IV tax to
Investments Ltd. out of its RDTOH account. Accordingly
Holdings Ltd. becomes liable to pay $33.33 of Part IV tax under
paragraph 186(1)(b), and that amount is added to its RDTOH
account, and so on.2
2
Note that if the initial dividends received are “eligible dividends”, they will be added to the GRIP of Investments Ltd. The
dividend paid by Investments Ltd. will also be designated as an “eligible dividend”, and added to Holdings Ltd.’s GRIP.
The designation is irrelevant to each corporation (as the dividend is deductible for purposes of Part I tax, and the designation
has no effect on Holdings’ liability for Part IV tax) but preserves the ability of the individual shareholder to utilize the
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Tax II Chapter 4
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Notes
The Capital Dividend Account – Tax Free Portion of Capital Gains
25.
There is one last “integration” systems point. It is called the “Capital
Dividend Account” (CDA). The essence is simply this: the untaxed one
half of capital gains go into this account and are then available to be paid
as a tax-free dividend out of the corporation. Why? Because this amount
would not be subject to tax if the shareholder realized the gain personally.
The other half of the capital gain is included in “aggregate investment
income” as a “taxable capital gain” (as we have already seen).
26.
Read subsection 89(1) and the definition of “capital dividend account”.
The account includes the following items:
(a)
(b)
(c)
(d)
(e)
the tax free one half of capital gains (less the one half of capital
losses),
“capital dividends” (below) received from other companies,
the tax-free portion of gains from eligible capital property,
life insurance proceeds, and
the tax-free portion of capital gains flowed through trusts (such as
mutual funds).
27.
An election must be filed with CRA (Canada Revenue Agency) to pay a
tax-free “capital dividend”. Read subsection 83(2). The election must be
filed before the dividend is paid. There is an ability to file late (read
subsection 83(3)) on payment of a penalty. The company need only be a
private company (Chapter 2) to pay a capital dividend.
28.
If you elect too high, i.e., the dividend is greater than CDA, a penalty tax
of 60%3 of the excess applies (read subsection 184(2), called Part III tax).
One can elect, if all shareholders agree, to treat the excess as a taxable
dividend within 90 days of a Part III assessment (read subsections 184(3)
& (4)).
3
enhanced dividend tax credit when the GRIP dividend is ultimately paid as an eligible dividend to the individual
shareholders.
In accordance with proposed legislation to be effective in respect of capital dividends paid after 1999. The legislation is
expected to be passed in due course.
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Tax II Chapter 4
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Notes
29.
Read the anti-avoidance rules for the CDA and the RDTOH contained in
subsection 83(2.1) and subsection 129(1.2). The test is “one of the main
purposes”. Read the decision in Canwest Capital Inc., a copy of which is
enclosed with these materials.
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