Paying a Dividend: It Ain’t Easy
Declaring a dividend is not as easy as it used to be. As a result of new eligible dividend rules, a Canadian-Controlled Private Corporation (CCPC) that pays out a dividend to its individual shareholders who are Canadian residents must specify if the dividend paid will be an eligible dividend.
An eligible dividend is paid out of a corporation’s general rate income pool (GRIP) and is capped at the amount of GRIP the CCPC has at the end of the taxation year in which the dividend is paid. Generally speaking, GRIP is comprised of the after-tax earnings of the CCPC, excluding any earnings that have been subject to the small business deduction or refundable tax on investment income. Additionally, GRIP is increased by any eligible dividends received from another corporation, and is reduced by any eligible dividends that have previously been distributed. When a taxable dividend is paid during the taxation year, the CCPC is now required to calculate its GRIP balance at the end of that taxation year and file this information along with its T2 Corporation Income Tax Return.
In most cases, a Canadian resident individual shareholder will prefer to receive an eligible dividend as opposed to an ordinary dividend, as the former receives preferential tax treatment.
Designation of eligible dividends
A corporation must designate the dividend as eligible when it is paid. In many cases, this could present a problem; for example, where a corporation plans to pay an eligible dividend to eliminate a shareholder debit balance, but the debit balance amount is not calculated until after the end of the taxation year.
A common way to eliminate a shareholder loan balance and prevent an income inclusion for the shareholder is to declare and pay a dividend at the end of the taxation year. However, when a shareholder loan issue is discovered subsequent to the taxation year end, the corporation cannot reduce this loan through payment of an eligible dividend. A corporation cannot designate a dividend as eligible after the dividend has been declared and paid. By contrast, an ordinary dividend does not need to be designated, and therefore no designation documentation is necessary.
In order to prevent this problem, a shareholder should regularly monitor his or her loan balance. Should the shareholder expect their loan balance to be outstanding for two consecutive year ends, the corporation can still pay out an eligible dividend if the loan issue is caught before the second taxation year end, because it can designate the dividend as being eligible early enough to meet the requirements stated above.
A corporation can designate an eligible dividend in several ways, including the following:
* Indicating it as such on the cheque stub that accompanies the dividend payment;
* Recording it in the directors’ minutes if all the shareholders are directors; or
* Notifying each shareholder in writing.
In addition, the T5 form, which is required to report dividends paid by a corporation, also has a separate box to report the eligible dividend.
There are other specific rules with respect to designating eligible dividends:
* A dividend is declared on a particular class of a corporation’s shares. This means that when a dividend is designated as eligible, all shareholders of that particular class of shares will receive an eligible dividend.
* If non-residents of Canada own shares of a class, some GRIP will be wasted on them.
* A corporation cannot designate only a portion of a dividend paid as an eligible dividend.
Excessive eligible dividends
When a corporation pays an eligible dividend in excess of its GRIP balance at the end of a taxation year, the excess is subject to a tax of 20%. Alternatively, the corporation can elect to treat the excessive portion of the eligible dividend as an ordinary dividend, thereby avoiding the requirement to pay the 20% tax. However, even though the additional tax will be avoided at the corporate level, the shareholders will be required to pay additional taxes as a result of receiving an ordinary dividend instead of an eligible one. Furthermore, these additional taxes payable may result in interest and penalties payable by the shareholder.
If a corporation’s taxation year is reassessed and the amount or nature of taxable income is adjusted, the corporation’s GRIP balance and the eligible dividends that were previously paid could be affected. For example, if a sale of land that had been reported on income account is reassessed and treated as being on capital account, the taxable capital gain will be subject to refundable tax rates and will not result in an accretion to the GRIP balance.
If the GRIP balance increases as a result of a reassessment, there is no adverse affect on the corporation or the shareholders who received an eligible dividend. However, if the GRIP balance decreases as a result of the reassessment, the corporation may have unwittingly paid an eligible dividend in excess of its GRIP balance at year end. An election to treat the excessive portion of the eligible dividend as an ordinary dividend will be accepted by the CRA only if certain conditions are met: The election must be made within 90 days of the mailing date of the notice of assessment requiring the corporation to pay the 20% tax; the corporation and all its shareholders must be in agreement on the election; and all the shareholders must pay the additional personal income tax, interest, and penalties as a result of the election.
Plan before you pay
Consult a tax specialist before paying a dividend, as the new rules are complex and require compliance with documentation and calculations within time limits.
By Bernice Yip, CA
Bernice Yip, CA, is a senior analyst in Tax Services with Grant Thornton LLP in Vancouver.
Copyright Institute of Chartered Accountants of British Columbia Sep 2007
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