Most accountants and lawyers are aware of the fact that a
private corporation can pay dividends to its shareholders with no
tax impact on them if the dividends are paid out of the capital
dividend account ("CDA"). This tax account may consist,
among other things, of the nontaxable portion of capital gains
realized by a private corporation, life insurance proceeds received
by this type of corporation, or capital dividends received from
another private corporation. The purpose of the CDA is essentially
to ensure that these amounts, which would not be taxable if they
were received by the shareholder directly, are treated in the same
manner when they are realized through a private corporation. The
CDA is therefore a very valuable mechanism because of the
favourable tax treatment attached to it.
Subsection 83(2.1) of the Income Tax Act (Canada)
("ITA") provides for an anti-avoidance rule whose purpose
is to prevent the shares of a private corporation from being
purchased in order to benefit from the available CDA. It reads as
(2.1) Notwithstanding subsection 83(2), where a dividend that,
but for this subsection, would be a capital dividend is paid on a
share of the capital stock of a corporation and the share (or
another share for which the share was substituted) was acquired by
its holder in a transaction or as part of a series of transactions
one of the main purposes of which was to receive the dividend,
the dividend shall, for the purposes of this Act (other than
for the purposes of Part III and computing the capital dividend
account of the corporation), be deemed to be received by the
shareholder and paid by the corporation as a taxable dividend and
not as a capital dividend; and
paragraph 83(2)(b) does not apply in respect of the
In a recent decision in the matter of Groupe Honco Inc. et
al. v. The Queen (file no. 2009- 2134 (IT)G), rendered on
September 4, 2012, the Tax Court of Canada specifically considered
subsection 83(2.1) ITA. The Court held that subsection 83(2.1) ITA
applies in a situation in which the shares of a corporation (the
"Target") were acquired where the Target was the
beneficiary of an insurance policy in the amount of $750,000 on the
life of the seller, who was very sick at the time of sale of the
shares. Since the seller died shortly after the transaction, the
insurance proceeds were received by the Target after the
acquisition, thereby creating a significant CDA for the Target.
Dividends from the CDA, thus created, were subsequently paid by the
Target (since merged) to its shareholders. These dividends were
redefined as taxable dividends by the Canada Revenue Agency on the
basis of subsection 83(2.1) ITA.
The taxpayers unsuccessfully attempted to argue that the main
purpose for the acquisition of the Target's shares was not to
receive the capital dividends, but rather that it was done for
other business and tax reasons (e.g. to benefit from the
Target's accumulated losses).
However, the Court concluded that subsection 83(2.1) ITA applied
and, accordingly, that the dividends paid were in fact taxable
This decision underscores the importance of considering the
potential application of subsection 83(2.1) ITA in any situation
involving the acquisition of a private corporation in which a CDA
remains unused or may be created subsequent to the acquisition.
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.
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