Corporate-owned life insurance and the Capital Dividend AccountNovember 25, 2021
A Capital Dividend Account lets a company receive the proceeds from life insurance and distribute it tax-free to shareholders. Here’s what the account is, and how it works.
A Capital Dividend Account is not a bank account. It’s a notional company account that’s only relevant for tax purposes. Companies don’t include it on their balance sheets. However, they may include reference to it in a footnote to their financial statements.
How it works
With a Capital Dividend Account, companies identify amounts they receive that are non-taxable, such as life insurance death benefits. They then credit these non-taxable amounts to this notional account. They can then distribute these amounts tax-free to shareholders after filing an election with the Canada Revenue Agency.
Only dividends paid by private corporations qualify for this election. And any non-resident shareholders are subject to a 25% withholding tax on Capital Dividend Account distributions. That means these dividends are not tax effective for non-residents.
The Capital Dividend Account is part of Canada’s integrated tax system. The goal of the system is to ensure that the government taxes income the same whether:
- An individual earns the income directly, or
- A company earns the income and then distributes it to an individual.
How companies calculate their Capital Dividend Account balance
A company’s Capital Dividend Account balance is a cumulative calculation, which the company carries forward from year to year. The following events will increase the Capital Dividend Account balance:
- Capital gains. This is the excess of the non-taxable portion of capital gains over the non-allowable portion of capital losses incurred by the corporation.
- Capital dividends. A company may receive these from other companies
- Gains from property sales. These are the non-taxable portion of gains resulting from the disposition of eligible capital property
- Life insurance proceeds. These are the net proceeds of a life insurance policy received by the company, less the policy’s adjusted cost basis.
Of course, a Capital Dividend Account balance can decrease as well, by any tax-free dividend payments. The balance in the Capital Dividend Account balance will be positive or nil.
Note that the cash used to pay a tax-free dividend can come from any source. The Capital Dividend Account is truly notional: there’s no tracking of the actual tax-free cash received by the company.
How to declare a tax-free capital dividend
- Corporation directors declare a dividend payable to one or more shareholders. They record this in the minutes of the corporation.
- The company files a capital dividend election with the Canada Revenue Agency (Form T2054, or Form CO-502 in Québec).
The election must be on the full amount of the dividend. If the total dividend is greater than the Capital Dividend Account balance, the company should declare two separate dividends. The first would equal the amount the company will pay as a capital dividend. The second would be a taxable dividend for the remainder. It’s not necessary that the dividend from the Capital Dividend Account be paid in a lump sum.
The Capital Dividend Account and life insurance
Companies and business owners have long used life insurance as a financial and estate planning tool. It can help cover a tax liability at death, ensure adequate funding for a shareholders’ agreement, and more.
When a private company is a policy beneficiary, they can credit the proceeds (less the policy’s adjusted cost basis) to the company’s Capital Dividend Account.
Here’s an example. A private company is the beneficiary of a life insurance policy with a death benefit of $1 million. The adjusted cost basis of the policy at the time of the insured shareholder’s death is $150,000. The company credits $850,000 to their Capital Dividend Account ($1,000,000 – $150,000). The company can pay this amount tax-free to shareholders as a capital dividend. They can pay the balance of $150,000 to the shareholders as a taxable dividend.
Calculating the adjusted cost basis
Insurance companies calculate the adjusted cost basis of a policy using a complex formula that considers:
- policy deposits
- policy withdrawals or loans,
- policy dividends, and
- the cost of insurance charges of a policy.
Here’s a simplified definition for most policies. We’re assuming no cash withdrawals, cash dividends or loans from the policy:
The total premiums paid, excluding accidental death benefit, disability benefits, sub-standard ratings and other ancillary benefits minus the net cost of pure insurance (NCPI). The insurance company calculates the NCPI based on a prescribed mortality charge applied to the amount at risk.
In general, the ACB increases in the early years when the premium is greater than the NCPI. It then gradually reduces to zero in later years when the NCPI is greater than any policyholder premium payments.
Structuring policy ownership
Private corporations that acquire a life insurance policy can structure ownership of the policy in various ways. For example, one company might be the policy beneficiary (typically the operating company). Another company would be the owner of the policy and will pay the premiums (typically a holding company).
In the past, using such structures let companies credit the full death benefit to their Capital Dividend Account. There was no corresponding reduction for the policy’s adjusted cost basis.
That is no longer the case. Regardless of ownership structure, a company must reduce the death benefit by the adjusted cost basis for Capital Dividend Account purposes.
Using life insurance as collateral for a corporate loan
Companies may sometimes assign a life insurance policy to a financial institution as collateral for a loan. Upon the insured’s death, the insurer generally pays the benefit to the lending institution up to the loan amount. The insurer pays any remaining balance to the company designated as the policy beneficiary.
In such cases, the regular Capital Dividend Account rules apply. The company can add the death benefit amount (less the adjusted cost basis) to their Capital Dividend Account. This occurs even when the insurer pays some of the insurance proceeds directly to the lending institution.
The Capital Dividend Account is a critical component of estate and tax planning for private corporation shareholders. Life insurance policy proceeds received by a corporation will give rise to a Capital Dividend Account credit. This credit can be paid out to the shareholders as a tax-free capital dividend.
There are many ways that this structure can be optimized to create advantageous and cost-effective strategies. We encourage business owners to consider the many benefits of corporate-owned life insurance and the Capital Dividend Account.