On June 25, 2024, the changes proposed by the federal budget took effect and the capital gains inclusion rate (CGIR) rose from one-half to two-thirds. However there are still some details that need to be ironed out, particularly for private corporations.

 

A complex calculation is now in place to determine how much corporations can distribute from their Capital Dividend Account (CDA) and, if done incorrectly, they could be facing a big tax bill.

Understading CDAs and Capital Gains

A CDA is a special tax account that keeps track of any tax-free amounts accumulated by a corporation, which can then be paid out to shareholders in the form of tax-free dividends.

 

Previously, when a company generated a capital gain from disposing of an asset, 50% of that gain would be subject to capital gains tax. The non-taxable portion of the total gain would then be added to the CDA and eventually distributed to shareholders.

 

The new rules change how gains are added to the CDA, adding complexity and confusion.

What's changing? 

According to rules released by the federal government in June, the CDA balance for a corporation’s fiscal year that includes June 25, 2024 will be determined based on a blended CGIR.

 

The new formula to calculate taxable gains while also accounting for the two CGIRs in 2024 works like this:

 

Multiply your pre-June 25 (Period 1) net capital gains by half, then multiply your post-June 24 (Period 2) net capital gains by two-thirds and add the two numbers together. Then divide that number by the total gains in Periods 1 and 2 (the full fiscal year’s net gains).

 

Check out this report from EY Canada for an example.

Potential tax pitfalls

Some corporations may have been operating on the assumption that the calculation for determining their CDA balance would be based on 50% CGIR before June 25 and 67% after June 25. Those corporations may now have a lower CDA balance than expected when they distribute a capital dividend in the 2024 fiscal year.

 

If a corporation distributes more capital dividends than are in the CDA, it could have a 60% tax on the excess. However, one option to avoid this penalty is to elect to treat the excess as taxable dividends.

Uncertainty moving forward 

The proposed rules for this transitional year create a lot of uncertainty for corporations.

 

A corporation that realized a gain in Period 1 and would like to distribute a capital dividend this fiscal year will not be able to calculate its blended CGIR by the end of the year, unless it knows exactly how much it will realize in capital gains for Period 2.

 

Corporations will likely not have all of the numbers they need to make an informed decision.

 

They could opt to pay out a capital dividend assuming the highest possible CGIR (two-thirds blended CGIR). And if the blended CGIR is lower than what they estimated, the higher CDA balance could be redistributed at a later time.

 

However, if corporations have the ability to wait to distribute capital dividends until fiscal year end, they will be able to calculate the blended CGIR for 2024 with certainty.

Get the advice you need 

We are currently waiting until draft legislation implementing the capital gains taxation changes is released this summer to see if and how this issue is addressed. In the meantime, talk to a tax advisor who can help you navigate the new rules and avoid unexpected tax penalties when you’re claiming your CDA.

 

For more information from the Department of Finance Canada, click here.