Capital loss planning for a corporation.
Triggering capital losses to offset capital gains is a common tax-planning strategy. And when a private corporation is looking to offset capital gains in the year or to carry a capital loss forward or back, it’s important to think about the capital dividend account, or CDA.
The CDA is a notional tax account available to private corporations for the purpose of tracking certain tax-free surpluses they may accumulate, such as:
- The tax-free portion of capital gains in excess of capital losses
- The tax-free portion of dispositions of eligible capital property (like goodwill)
- Capital dividends received from other corporations
- Life insurance proceeds received by the corporation as beneficiary on the death of the life insured, in excess of the policy’s adjusted cost basis (ACB)
These surpluses may be distributed in the form of tax-free capital dividends to the shareholders of the corporation who reside in Canada.
When engaging in capital loss tax planning, a key recommendation is to clean out any positive balance in the CDA before triggering the capital loss. However, triggering a capital loss after a capital dividend is paid may impair the ability to use CDA additions resulting from receipt of life insurance proceeds in the future.
At any given time, the CDA balance is the cumulative sum of the various CDA components, minus the total of all capital dividends paid by the corporation in the past. Let’s look at an example.
Florence Marino, B.A., LL.B, TEP
Head of Tax, Retirement and Estate Planning, Individual Insurance, Canada
Florence Marino is the Head of Tax, Retirement and Estate Planning Services, and she provides tax, retirement, estate and insurance planning support and consultation to advisors regarding complex cases in the affluent and business markets. She leads a team of professionals providing this type of support and consultation across the country.
Scenario: Investment Holdco capital loss planning
Due to the economic environment during COVID-19, there is a possibility of triggering some capital losses in Holdco’s portfolio in 2020. Holdco must consider the possible impact on the CDA balance.
In 2019, Holdco realized a capital gain of $1 million, resulting in a credit to the CDA of $500,000. Holdco declares a capital dividend to the shareholder of $500,000. The CDA balance is now at zero.
Holdco triggers a capital loss for $400,000. There would be a $200,000 reduction to the portion of the formula relating to capital gains and losses. Although this has no immediate tax consequences, it may prevent the distribution of all or a portion of the CDA credit arising from the receipt of life insurance by the corporation in the future.
For example, if in 2021 the corporation receives a $500,000 death benefit of a life insurance policy with no ACB, the credit to the CDA will be $500,000. But only $300,000 may be paid out as a capital dividend because at that point, the cumulative CDA balance would be calculated as follows:
$300,000 Excess of non-taxable portion of capital gains over non-deductible portion of capital losses ($500,000 – $200,000)
$500,000 Plus excess of life insurance proceeds over the ACB of the policy
($500,000) Less cumulative capital dividends paid by the corporation
$300,000 CDA balance at that time
Alternative scenarios
It’s interesting to note that even where capital losses exceed capital gains and there is a negative balance in that part of the formula (negative amounts in the formula are deemed to be nil), this would not necessarily limit the ability for life insurance proceeds received subsequently to be paid as a capital dividend. The ability would depend on whether capital dividends had been paid, for example, in respect of a prior capital gain. Again, a numerical example is helpful:
If, in the scenario above, the capital loss realized was $1.2 million, resulting in a $600,000 reduction in that portion of the formula, while everything else remained the same, the calculation would be 0 + $500,000 – $500,000 = 0. Therefore, the corporation has no ability to distribute the life insurance proceeds via a capital dividend at this point.
However, if there had not been a prior distribution of capital dividends, the full life insurance proceeds could be distributed. In this case, the formula would be 0 + $500,000 + 0 = $500,000.
Triggering capital losses may be top of mind for some investment holding companies to capture current tax benefits. However, it’s important to acknowledge the impacts this planning could have on the future ability to distribute capital dividends arising from life insurance. Because the calculation is cumulative, a lot of water could have passed under the bridge by the time a death benefit is payable. Furthermore, it’s not commonly known that even though one factor can fully credit the CDA, another factor can prevent the ability to distribute that credit in whole or in part.
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