Calculating CDA
Canada’s income tax system aspires to “neutrality” so that, in theory, an individual should be indifferent about whether he earns income directly or through a corporation. The CDA is one of the mechanisms employed to achieve this neutrality. Certain receipts of a corporation that would be earned tax-free by an individual “one-half of capital gains and insurance proceeds, for example” are added to a corporation’s CDA. Dividends paid from the CDA of a corporation are not taxable to the payee. Without the CDA, the non-taxable portion of a capital gain or insurance proceeds received by a corporation could only be paid as a taxable dividend by the corporation and neutrality would be thwarted.
The Income Tax Act (Canada) (the Tax Act) contains a detailed formula for calculating the CDA of a corporation. For present purposes, let us consider the formula as it would apply to a corporation that had only gains and losses, insurance proceeds and capital dividends received from other corporations. The formula, then, can be paraphrased as follows: CDA (at a particular time) = (A + B + C) – D where
‘A’ is the amount, if any, by which the total of the non-taxable portion of the corporation’s capital gains realized before that time exceeds the non-allowable portion of its capital losses realized before that time;
‘B’ is the amount by which the proceeds of an insurance policy exceeds the adjusted cost basis of that policy;
‘C’ is the amount of any capital dividend received by the corporation before that time; and
‘D’ is the total of all dividends paid from the corporation’s CDA before that time.
The CDA of a corporation is always calculated at a point in time. In addition, note two points about ‘A’:
- A cannot be negative because it is the amount ,if any, by which gains exceed losses and because, in general, formulas in the Tax Act cannot yield negative amounts. Accordingly, if a corporation’s capital losses exceed its gains, its CDA nevertheless can be positive if, for example, it has received insurance proceeds. In such a case, and assuming that C and D are nil, A would be nil and B would be positive so that the CDA of the corporation would be positive.
- The calculation in A only takes into account realized gains and losses. A corporation may have realized gains and significant accrued but unrealized losses that, if realized, would exceed the gains. A would still be positive in such a case because the formula ignores the unrealized losses. Moreover, the Tax Act does not contain a specific anti-avoidance rule that would change this result. The CRA might consider applying the general anti-avoidance rule, but it appears it has not publicly announced any such disposition, and a Court would likely refuse to uphold it in any case.
With respect to ‘B’, the Tax Act contains detailed rules for calculating the adjusted cost basis of an insurance policy. In general, ‘adjusted cost basis’ includes premiums paid on the policy. The calculation is quite detailed, however, and usually it is best simply to request the amount of the basis from the issuer of the policy. The issuer generally keeps track of the basis as a matter of course.
Paying a Dividend from CDA
The following steps must be completed to pay a dividend from CDA (per section 2101 of the Income Tax Regulations).
First, the corporation paying the dividend (Holdco) should calculate the amount of its CDA. Typically, the accountant for Holdco will perform this task using, among other things, the gains and losses reported by Holdco before that time on Schedule 6 of its T2.
Next, the directors of Holdco should pass a resolution declaring a dividend and designating the amount of the dividend as payable from Holdco’s CDA. Holdco’s lawyers should prepare this document.
Before the CDA dividend is paid or payable, Holdco must execute and file CRA election form T2054 so that the dividend will be considered to be paid tax-free from Holdco’s CDA. A certified copy of the dividend resolution and a copy of the CDA calculation must accompany the form.
After the T2054 is filed, Holdco can pay the capital dividend to its shareholders. Holdco need not issue T5 slips for the capital dividends it pays (see CRA’s publication entitled “T5 Guide – Return of Investment Income 2005″ (T4015(E) Rev. 05)).
