What it means
Company profits are normally taxed twice: once in the company and again in the shareholder's hands when a dividend is paid. Some corporate receipts, though, are deliberately not taxed at all, and taxing them on the way out to shareholders would be unfair.
The capital dividend is the mechanism that lets those specific amounts flow through untouched. The balance available is tracked in a notional ledger called the capital dividend account.
It grows with the non-taxable half of capital gains, with life insurance proceeds above the policy's adjusted cost basis, and with capital dividends received from other companies. It shrinks with the non-deductible half of capital losses and with capital dividends already paid.
Timing matters more here than in almost any other tax planning area. The balance is measured at the moment of payment, so a later capital loss cannot retroactively reduce a dividend already declared, but a loss realised before payment can.
Paying more than the balance allows triggers a heavy penalty tax, so most advisers verify the account with the tax authority before the company declares. Corporate-owned life insurance is the classic use case.
When a shareholder dies, the company receives the proceeds tax free, credits the account, and pays a capital dividend to the estate or surviving shareholders, which funds the buyout of the deceased person's shares without an extra layer of tax. The phrase is also used more loosely elsewhere to describe a distribution paid out of capital rather than earnings, which is really a return of capital and reduces the shareholder's cost base.
The two ideas are related but not identical, so it is worth clarifying which sense someone means before assuming the tax outcome.
In practice
Real-world examples.
Example
Two partners fund a shareholders' agreement with corporate-owned life insurance. When one dies, the company receives $2,000,000 on a policy with an adjusted cost basis of $250,000, credits $1,750,000 to the account, and pays that amount to the estate as a capital dividend to redeem the shares.
Example
A family holding company sells an investment property at a gain of $600,000. Half, $300,000, is credited to the account, and the owner takes a $300,000 capital dividend instead of salary, saving the personal tax that a comparable taxable payment would have attracted.
Example
A company declares a capital dividend in November based on gains realised in June, then crystallises a large capital loss in December. Because the balance is tested at the date of payment, the earlier dividend stands, but the account is reduced going forward.
Formula
Calculation
Capital dividend account balance = non-taxable portion of capital gains - non-deductible portion of capital losses + life insurance proceeds received less the policy's adjusted cost basis + capital dividends received - capital dividends already paid
A company sells surplus land for $900,000 that had cost $500,000, producing a capital gain of $900,000 - $500,000 = $400,000. Half of that gain, $200,000, is taxable and the other $200,000 is credited to the capital dividend account. The company also receives $1,000,000 of life insurance proceeds on a policy with an adjusted cost basis of $150,000, adding $1,000,000 - $150,000 = $850,000. The balance is therefore $200,000 + $850,000 = $1,050,000, all of which can be paid out tax free. Paid instead as an ordinary taxable dividend to a shareholder facing a 45% rate, the same $1,050,000 would have cost $1,050,000 x 45% = $472,500 in tax, leaving only $577,500.Case study
Seen in the real world.
Halverton Machining is a fictional company created to illustrate this concept. It sold a surplus plot of land for $1,400,000 that had cost $800,000, giving a capital gain of $600,000, of which $300,000 was taxable and $300,000 was credited to its capital dividend account.
The two owner-shareholders took the $300,000 as a capital dividend, $150,000 each, and paid no personal tax on it. Had the same amount been paid as an ordinary dividend at a 47% personal rate, the tax bill would have been $300,000 x 47% = $141,000, so the planning preserved that amount for the family.
The illustrative warning is procedural. The election had to be filed on or before the day the dividend became payable, and the company's adviser noted that missing that deadline would have made the entire $300,000 a fully taxable dividend with a penalty on top.
Watch out
Common mistakes.
- Assuming any dividend paid out of asset sale proceeds is tax free, when only amounts sitting in the capital dividend account qualify.
- Declaring a capital dividend without confirming the account balance first, which risks a substantial penalty tax on the excess.
- Forgetting that capital losses reduce the account, so realising a loss before payment can shrink the amount available.
Questions
People also ask.
Is a capital dividend the same as a return of capital?
Not exactly: a return of capital reduces the shareholder's cost base in the shares, while a capital dividend is a distribution of specific untaxed corporate receipts.
Can a shareholder receive a capital dividend tax free anywhere in the world?
No, the mechanism is a feature of Canadian tax law, and other countries handle untaxed corporate receipts through different rules.
Does paying a capital dividend reduce the company's retained earnings?
Yes, it reduces distributable reserves like any dividend, even though the tax treatment for the shareholder is different.
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