The new rules for dividend taxation announced in 2006 by the federal government received royal assent on February 21, 2007. This legislation aims to decrease the tax rate on "eligible dividends". The legislation results in a reduction of 5.03% in the federal tax rate on eligible dividends received by taxpayers subject to tax at the highest rate.
The purpose of this newsletter is to briefly describe the new legislation with a focus on how to comply with the legislation so that the opportunity for tax savings is not lost inadvertently. This newsletter is meant only as a brief introduction to these issues. Please contact us for more information if you have any specific questions.
Designation must be made at time dividend is paid
In order for shareholders to benefit from the tax reduction, the new rules require corporations, both public and private, to designate dividends paid after February 20, 2007 as eligible dividends by notifying all shareholders receiving the dividend in writing at the time the dividend is paid. It is only the shareholders receiving the dividend that must be notified that it is an eligible dividend. If a corporation has more than one class of shares and is paying an eligible dividend on only one of them, only the holders of shares of the class receiving the dividend need to be notified.
For eligible dividends paid on or after January 1, 2006 and before February 21, 2007, the notification may be made up to 90 days after February 21, 2007 (May 22, 2007). Dividends paid on or after February 21, 2007 do not benefit from this extension. This means that dividends paid on or after February 21, 2007 must be designated as eligible dividends at the time the dividend is paid. This is of utmost importance as there is no allowance in the new rules for late, amended, or revoked designations. If the proper designation is not made at the time the dividend is paid, shareholders will not be eligible for the reduced rate. The extra tax payable by shareholders in this situation could be significant.
A designation will apply to all shareholders of the particular class. It is not possible to designate part of a dividend paid to certain shareholders of a class but not to other shareholders of that class. Non-resident shareholders must be notified if they are receiving the dividend, even though the dividend paid to them will not qualify as eligible because they are not resident in Canada.
Application of the rules
The new rules contain provisions that apply to both Canadian-controlled private corporations (CCPCs) and non-CCPCs (i.e., public corporations or non-CCPC private corporations) that are resident in Canada. However, the requirements for CCPCs and non-CCPCs are different.1 For both types of corporations, the definition of an eligible dividend is the same: a dividend paid after 2005 by a Canadian resident corporation to a
Canadian resident shareholder that is designated as an eligible dividend in an appropriate manner. However, the amounts that may be designated as an eligible dividend are computed differently for CCPCs and Non-CCPCs. The accounts described below are used to determine when a corporation can pay an eligible dividend without being at risk for Part III.1 penalty tax on excess designations.
CCPCs – General rate income pool (GRIP) account
A CCPC may pay an eligible dividend up to the amount of its GRIP account at the end of the taxation year in which the dividend was paid. Therefore, CCPCs will need to calculate their GRIP at the end of the applicable taxation year. The GRIP includes, among other items, post-2000 taxable income that was taxed at the general corporate income tax rate (i.e., not at the reduced small business income rate or the higher rate for investment income), certain dividends received from foreign affiliates of a corporation after 2005, and eligible dividends received from other corporations (public or private) after 2005. It also includes dividends received from "connected" corporations2 during taxation years of the corporation that ended after 2000 and before 2006, if those dividends could reasonably be considered to have been paid out of the payor corporation’s full-rate income.
Although most investment income is excluded from GRIP, eligible dividends received from other corporations and certain dividends received from foreign affiliates are not. Therefore, a holding company with only investment income could be able to pay eligible dividends if it has received such dividends from other corporations.
Non-CCPCs – Low rate income pool (LRIP) account
Non-CCPCs must pay out dividends from their LRIP first until the balance is reduced to nil and then may pay eligible dividends. Therefore, non-CCPCs are required to compute their LRIP at the time a dividend is paid. LRIP includes, among other items, non-eligible dividends received from other corporations. Many non-CCPCs will have little or no LRIP, meaning that they will be able to designate all dividends paid as eligible dividends without incurring a Part III.1 penalty tax liability.
Only a taxable dividend may be designated as an eligible dividend. Therefore, non-taxable capital dividends are not eligible. However, the rules do apply to taxable deemed dividends (which can arise when shares are redeemed or purchased for cancellation) and should be considered when these arise.
For dividends paid after 2006, it is not possible to designate only a portion of a dividend that is received by a shareholder as being an eligible dividend. For example, if the sole shareholder of a corporation receives a dividend of $100, either all of the dividend or none of it can be designated as an eligible dividend. If the corporation wanted only $20 to be an eligible dividend it would need to pay two dividends - a $20 dividend and an $80 dividend. This may also affect how share redemptions (giving rise to deemed dividends) are completed. As with capital dividends, it may be necessary to do two separate share redemptions. For dividends paid in 2006, such partial designations will be allowed, as the dividends have already been paid and the legislation is retroactive.
The new rules require that a corporation notify all shareholders receiving the dividend in writing that a designation has been made in respect of a particular dividend. The administrative guidelines issued by the Canada Revenue Agency in December 2006 (the "Guidelines") outline what will be considered sufficient notice in this regard.
For dividends paid in 2006 the Guidelines indicate that identification of eligible dividends on the T3 and T5 slips of a corporation will qualify as a valid designation. It may also be acceptable to post a notice on a corporation’s website, in a corporate report or in another shareholder publication. However, this is subject to the general caveat that a corporation must make every effort to notify shareholders that an eligible dividend has been paid. For a private corporation with few shareholders whose identity and location are known to the corporation, an appropriate notification may more likely be in the form of a letter.
2007 and subsequent years
For public corporations, the Guidelines state that a designation made before or at the time the dividends are paid stating that all dividends are eligible dividends unless indicated otherwise will be accepted as notification. Acceptable methods of making a designation are posting a notice on a corporation’s website, in corporate quarterly or annual reports or in shareholders’ publications. A notice posted on a corporate website will be considered notification that an eligible dividend is paid to shareholders until the notice is removed. Similarly, a notice published in a quarterly or annual report is considered valid for that year or quarter, respectively. A press release issued by the corporation each time a dividend is paid will count as sufficient notice applicable only to that dividend.
For private corporations, the notice requirement must be met each time a dividend is paid. A notation in the minutes will suffice only if all shareholders receiving the dividend are directors of the corporation. Otherwise, notice may be given by a letter to each shareholder receiving the dividend or on the dividend cheque stub.
In each case, a statement that the dividend is an eligible dividend is sufficient.
Penalties on excess designation
The new rules impose penalties where an excess designation is made. The penalty is 20% of the amount of the excess designation, unless it is reasonable to consider that the eligible dividend was paid in a transaction, or as part of a series of transactions, one of the main purposes of which was to artificially maintain or increase the corporation’s GRIP or LRIP, in which case the penalty is 30% of the entire dividend. If the 20% rate applies, the corporation may be able to elect to redesignate the excess portion of the dividend as a non-eligible dividend and avoid the penalty. However, the concurrence of shareholders receiving the dividend will generally be necessary.
A shareholder not dealing at arm’s length with a CCPC, who has received a dividend from the CCPC in relation to which an excess designation was made, is jointly and severally liable with the corporation for a proportionate amount of any Part III.1 tax liability.
The rules for computing a corporation’s LRIP or GRIP are much more complex than the brief outline given above. Tax professionals should be consulted in order to determine what the appropriate balance is for a specific corporation before it declares or pays what it believes are eligible dividends. It is important that this issue is considered whenever any corporation, private or public, pays a dividend. It should also be considered in transactions where deemed dividends may arise (e.g., redemptions or purchases for cancellation), even though actual dividends may not be paid. It should be determined whether dividends are being paid from a corporation’s LRIP or GRIP accounts prior to the dividend being paid. The appropriate designation is essential as there is no allowance for late, amended or revoked designations. The designation must be made at the time the dividend is paid otherwise shareholders receiving the dividend may be subject to an extra tax liability that might have been avoided by a timely designation.
It is not necessary to designate a dividend as eligible in the directors' resolution when the dividend is declared. However, it will be prudent for corporations to include, in directors' resolutions that declare and make dividends payable, a resolution authorizing a particular person to make designations. In that way, the directors are reminded to turn their minds to whether or not the dividends are eligible dividends, and ensure someone is given the task of making the appropriate designation when the dividend is paid.
A further issue that must be considered is whether or not dividends paid in 2006 or early 2007 will also qualify as eligible dividends. If so, the corporation must designate them as such before May 22, 2007, or the opportunity for tax savings for shareholders will be lost.
1 Under the new legislation a CCPC may also elect to be treated as a non-CCPC.
2 In general, a corporation paying a dividend is considered "connected" to the corporation receiving the dividend if the payer corporation is controlled by the recipient corporation, or the recipient corporation owns more than 10% of the voting shares of the payer corporation and owns shares the fair market value of which is more than 10% of the fair market value of all of the shares of the payer corporation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.