Inter-corporate dividends, and the conditions on them

Why the dividend is not taxed twice

Corporate profit is taxed once, in the company that earns it. If a dividend paid to another corporation were taxed again, every layer of ownership would add a layer of tax on the same profit. The Act avoids that by allowing the receiving corporation to deduct dividends received from taxable Canadian corporations in computing its taxable income. The result is that the profit reaches the shareholder — the person — having been taxed at the corporate level once, and it is taxed personally only when a corporation finally pays it out to an individual.

Condition one: connected, or a refundable tax applies

Where the payer and the recipient are connected — in broad terms, the recipient controls the payer or holds more than a stated share of its votes and value — the dividend flows through with no further corporate tax. Where they are not connected, the recipient pays a refundable tax on the dividend. It is refundable: the recipient recovers it when it pays taxable dividends to its own shareholders. But it is a real cash cost in the meantime, and it is the reason portfolio dividends received by a holding company behave differently from dividends from a subsidiary.

Condition two: the anti-avoidance rule on dividend stripping

If a corporation is about to be sold, paying a large dividend to the shareholder-corporation first would reduce the sale price and convert what would have been a capital gain into a tax-free inter-corporate dividend. The Act contains a rule aimed at exactly that. Where one of the purposes of a dividend is to reduce a capital gain on a share, and the dividend exceeds the “safe income” the payer has earned and retained while the shares were held, the dividend can be treated as proceeds of sale — a capital gain — instead. The rule has been broadened over time and is one of the reasons a pre-sale reorganisation is planned with an accountant well ahead of the sale, not the week before.

What this means in practice for an owner-manager

• Operating company to your own holding company: the ordinary case. Connected, so no refundable tax; safe income usually covers the dividend, so no recharacterisation. This is how surplus profit is moved out for creditor protection.
• Dividends on shares your corporation holds in a public company: not connected, so the refundable tax applies until your corporation pays dividends out to you.
• A dividend paid right before a sale: the case the anti-avoidance rule exists for. Safe-income calculations come first.

Related

Holding companies: when they make sense · Eligible vs non-eligible dividends · The capital dividend account · Selling your corporation · Glossary

Sources: Income Tax Act (the dividend deduction, the refundable tax on dividends, and the anti-avoidance rule on dividends paid to reduce a capital gain) · CRA — T4012 T2 Corporation Income Tax Guide. General information, not advice.