Many business owners are unaware that corporate owned life insurance combined with the Capital Dividend Account (CDA) provides an opportunity to distribute corporate surplus on the death of a shareholder to the surviving shareholders or family members tax-free.
Income earned by a corporation and then distributed to a shareholder is subject to tax integration which results in the total tax paid between the two being approximately the same as if the shareholder earned the income directly. Integration also means that if a corporation is in receipt of funds which it received tax-free, then those funds should be tax free when distributed to the shareholder.
The Capital Dividend Account is a notional account which tracks these particular tax-free amounts accumulated by the corporation. It is not shown in accounting records or financial statements of the corporation. If there is a balance in the CDA it may be shown in the notes section of the financial statements for information purposes only.
Generally, the tax-free amounts referred to, are the non-taxable portions of capital gains received by the corporation and the death benefit proceeds of life insurance policies where the corporation is the beneficiary.
Life insurance proceeds received by a private corporation
The death benefit of a life insurance policy that is owned by a private Canadian corporation less the adjusted cost basis (ACB) of that policy, can be credited to the Capital Dividend Account. The government’s reasoning in deducting the ACB from the CDA credit is that if the corporation had paid the premiums to the individual shareholder to pay for the insurance, those payments would have been taxable.
In calculating the ACB, the following factors are taken into account:
- Premiums or deposits made to the policy increase the ACB;
- Policy loans, paying of dividends in a participating policy and partial dispositions reduce the ACB;
- Repaying policy loans, purchasing paid-up insurance and adding any term insurance riders increase the ACB;
- The annual net cost of pure insurance (NCPI) reduces the ACB.
The NCPI is the pure mortality cost of the life insurance and is contained in a table in the Income Tax Act. The NCPI, which increases each year with age, is applied to the net amount at risk in determining the reduction of the ACB for that policy year. The net amount at risk is defined as the total death benefit minus the cash value of the policy.
Normally, the ACB of the policy increases each year ultimately resulting in a total erosion. Once the ACB reaches zero, the full amount of the death benefit is eligible for Capital Dividend Account credit.
Frequently asked questions about the Capital Dividend Account
Does the corporation have to be Canadian controlled? No. It is only required that the company is a Canadian private corporation.
Can the corporation be publicly owned? No. Only private corporations qualify.
What is the tax treatment of a Capital Dividend paid to a non-resident shareholder? Capital dividends paid to a non-resident shareholder are subject to a withholding tax. In the absence of a resident of a country without a Canadian tax treaty the withholding tax is 25%. With a tax treaty, the rate will be reduced. For an individual living in the U.S. for example the withholding rate would be 15%. The capital dividend would most likely be taxable to the non-resident in their own country.
Does the company still get a CDA credit when a policy is assigned to a bank and the death benefit is paid directly to the lender? Yes. Although the proceeds of the life insurance policy may never actually be received directly by the corporation, it still creates a CDA balance equal to the total death benefit minus the ACB of the policy.
For many business owners the ability to have life insurance paid with lower taxed corporate dollars and still be able to have the proceeds eventually flow to their families on a tax free basis is an opportunity that should not be overlooked.
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