Inclusion Rates and the Capital Dividend Account

The capital dividend account (CDA) is one of the most tax-efficient ways of extracting cash out of a corporation. It provides shareholders the flexibility to access a portion of the investment earnings and/or life insurance proceeds from a corporation as tax-free cash!

Changes to capital gains inclusion rate

Throughout the past year, there have been a lot of changes noted on the capital gains inclusion rate. On March 21, 2025, Prime Minister Mark Carney announced the government’s intention not to proceed with an increase to the capital gains inclusion rate (CGIR)¹. While plans to reintroduce legislation on the CGIR for January 1, 2026, have been abandoned, a continued fiscal budget deficit may affect future governments and their propensity to revisit talks on the CGIR. Should that happen and if the last released August 2024 proposals on the CGIR resurface, business owners that are proactive and nimble can best tackle such obstacles with an understanding of modern tax scenarios.

Indeed, we know that any changes would have likely impacted the capital dividend account (CDA) for Canadiancontrolled private corporations (CCPCs). Given that we know there won’t be changes to the CDA for the foreseeable future, we wanted to take this opportunity to provide a reminder of how the CDA works in the current environment, and how business owners can benefit from it.

The last CGIR change came from the year 2000 and provided 3 rates. The table below summarizes historical CGIRs²:

What is the capital dividend account

All Canadian-controlled private corporations (CCPCs) have access to a “notional” account representing the non-taxable portion of capital gains and non-allowable portion of capital losses. This “CDA” was introduced to help ensure individual and corporate taxpayers were effectively taxed the same on capital gains earned inside vs. outside a corporation (untaxed portion flowing through CCPCs, without attracting extra levels of tax)³. The CDA represents the tax-free surplus accumulated by CCPCs and can include amounts from other tax years. A non-exhaustive summary of CDA components generally includes the following⁴:

• The non-taxable portion of realized capital gains
• Capital dividends received from other CCPCs
• The non-taxable portion of eligible capital amounts
• Life insurance policy proceeds in excess of adjusted cost basis

Although the CRA is not going ahead with any CGIR changes, there are still some risks with respect to CDAs in the current environment as explored below.

Negative balance in capital dividend account

The payout of capital dividends while the CDA is in a negative balance is considered an “excessive election” per subsection 184(2) of the Income Tax Act⁵. Business owners must exert caution in tracking CDAs because of the risk of Part III tax, which is calculated at 60% of the excess amount and accrues interest at the prescribed rates (until taxes are paid). Under said circumstances, it’s common for corporations to make a subsection 184(3) election to treat any excess as a separate taxable dividend (gross-up and dividend tax credit)⁶.

Example: CDA balance from realizing capital losses^†

The risk of Part III tax exists when electing CDA payouts after a series of realized capital losses to the extent the CDA balance falls below zero. The table below illustrates the impact of capital gains and losses on the CDA:

*Electing CDA payouts on August 31, 2024, when CDA balance has gone negative would attract Part III tax.

Any Part III penalty tax would have accrued interest in 2024 at the prescribed rate of 10% per annum in Q1-Q2, and 9% from Q3-Q4⁷.

Potential CGIR impacts on a capital dividend account

Although existing proposals to increase the CGIR have essentially died on the table, any subsequent government’s reintroduction of similar measures would have a material impact on a CDA. Looking back at the 2024 proposals, the CGIR would have changed from 1/2 to 2/3, which would have meant the non-taxable/non-allowable portion of capital gains/losses changing from 1/2 to 1/3. If higher inclusion rates (IRs) are ever at play again, business owners ought to be aware of the effects of realizing capital transactions. The slower build-up of a CDA by realizing capital gains means smaller tax-free dividends going to shareholders looking to rely on that cash. The pausing of realized capital losses could help curb the risks of a negative CDA from a smaller buffer (previously created by CDA increases from a 50% IR). If new inclusion rates are ever brought back into the mix, here’s what some of those scenarios could look like (based on the later instalments of proposed changes to IRs and CDA rules).

Capital loss carryforward planning

For environments that revisit IR changes, corporate taxpayers may need to understand the impacts to capital loss carryforward planning for those years. To trigger, or not to trigger? That was the question leading up to June 24, 2024. Although taxpayers were originally faced with a decision to accelerate dispositions to access a 1/2 inclusion rate on their capital gains before June 25, 2024, decisions on applying loss carryforwards would have remained flexible. Taxpayers cannot undo physical sale transactions for tax purposes (custody and ownership changes are final), but taxpayers can generally carryback capital losses 3 years and forward indefinitely to offset capital gains. This could present unique opportunities when multiple inclusion rates are at play.

Given that currently every $1 of capital losses can reduce taxable income by 50 cents, a hypothetical IR increase to 2/3 would then suggest every $1 of capital loss carryforwards reduces taxable income by 66.7 cents (in higher inclusion rate periods). Although carryforwards could come from years with different inclusion rates, the Department of Finance had previously released a table of “adjustment factors” that ensured capital loss carryforwards fully offset capital gains at the same inclusion rate as the year the gain is being offset. Refer to the exhibit below for details.

Table of adjustment factors under par. 111(1.1)(a)⁸

To illustrate, the Department of Finance released some examples of capital loss carryforward planning in their backgrounder on changes to the capital gains inclusion rate. Examples in the link below provide some clarity on the application of the adjustment factors above:

• Capital Gains Inclusion Rate - Canada.ca

These examples also highlight opportunities for deferring capital loss carryforward deductions to apply towards years with higher inclusion rates to maximize the dollar-for-dollar impact.

Adjustments to capital dividend account from capital loss carryforwards in years with different inclusion rates

While the capital loss carryforward adjustment factors proposed under paragraph 111(1.1)(a) of the Act were designed to convert IRs of loss carryforwards to match IRs of their offsetting gain years, the additional rules under subsection 89(1.3) aimed to do the same for CDAs. Specifically, where the IR of the capital loss year differs from the capital gain year in which loss carryforwards are deducted, either a subparagraph 89(1.3) (a) deemed capital loss or 89(1.3)(b) deemed capital gain would be calculated to eliminate any overstatement/understatement, respectively, to the CDA calculated as⁹:

(1 / (1 – A)) × (B – C), where

“A” is the inclusion rate for the loss year and “B–C” is the excess of allowable cap losses created in one year (with a higher IR) over the amount deducted in a previous year (with a lower IR). The amount deducted, or C, is lower than B because it’s adjusted to match the IR of the year of offsetting gain that has a lower IR. Similarly, an insufficient CDA balance (NCLs at a lower IR that are carried forward against future TCGs in a year with a higher IR) is formulated as:

(1 / (1 – D)) × (E – F), where

“D” is the inclusion rate for the gain year and “E–F” is the excess of allowable cap losses deducted in a future year (with higher IR) over cap losses created in a previous year (with a lower IR). The amount deducted, E, is higher than F because it’s adjusted to match the IR of the year of offsetting gain that has a higher IR.

The Department of Finance provides some illustrative examples such as what a “deemed capital loss” could look like in tax environments with multiple inclusion rates for capital loss carryovers:

• Capital dividend account – net capital loss carryover ITA 89(1.3) Deemed capital loss example

Note that whenever there’s an insufficient CDA a corporation misses an earlier opportunity to distribute out the tax-free surplus from a corporation since a deemed capital gain is determined at the end of the year.

The role of the CDA in corporate class funds

In consideration of higher CGIR periods, corporate class funds tend to offer control and access to tax-efficient forms of investment income. They generally have a lower payout policy because of expense sharing that could prove attractive to investors, especially in an increased inclusion rate environment that reduces credits to the CDA. It’s worth noting that any future re-introduction of a 2/3 IR would then require 1.5 times the capital gain proceeds to replicate the same increases to the CDA. The tax-efficient nature of corporate class funds, driven by their low dividend payout policy, typically allows for a continued tax deferral which can be advantageous in an increased capital gains inclusion rate environment. For more information on the taxation of investment income in a corporation, see the following CI GAM resource:

• CCPC investments and the taxation of income
  

Future considerations

In higher IR years, high-net-worth individuals can evaluate the incentives of withdrawing from their corporation and investing personally to access a lower IR when exemptions exist at the personal level (i.e., the proposed $250,000 exemption for individuals and most trusts for 2024). When deciding to realize capital gains in a corporation vs. a payout to individual shareholders for personal investing, decision factors may include:

• Spreading out the realization of capital gains over time, or on the personal side, multiplying the exemption through joint ownership
• Maintaining lower tax rates (marginal tax rates for individuals and the small business tax rate for corporations by managing passive income thresholds)
• Anticipating future income splitting opportunities
• Exposure to lower tax brackets because of reduced income from major life events like retirement, becoming temporarily disabled, maternity leave, job changes, or the death of a spouse
• Business risk and impacts to taxable income (e.g., legal settlements, introduction of market competitors, seasonal cycles)
• Market shifts and the availability of offsetting capital losses

Business owners may additionally consider the use of CDA proceeds to continue making contributions to their own TFSAs, which typically experience annual increases to contribution limits. Where business owners have maxed out CDA and dividend refunds from their Refundable Dividend Tax on Hand (RDTOH) accounts, they can pay out higher salaries to themselves to amplify RRSP contribution room (because of “earned income”) and build up earnings eligibility for the Canada Pension Plan.

Scaling back taxable capital gains

While addressing the challenges of a possibly higher CGIR, business owners could always consider loss harvesting strategies to realize capital losses as offsets towards years where an organization needs to lock in gains on good investments (before the market turns), but only up to the extent it doesn’t increase their marginal tax rate. Taxpayers also have the option of deferring receipt of fair market value consideration via instalment payments over multiple tax years and electing a capital gains reserve to potentially minimize taxes paid.

Final thoughts

With respect to any future re-introduction of CGIR increases such as the cancelled increase to 2/3, a corporation’s access to the small business deduction could be compromised by the fact that an increased taxable portion of capital gains may result in a 16.7% acceleration of adjusted aggregate investment income. As a result, business owners may ponder a defer-and-hold strategy until a more favourable tax climate presents itself. With different business scenarios, a holistic strategy should consider all the needs of the organization and offer some hybrid of reducing tax while accelerating investment growth. Depending on the compatibility of the above-noted strategies, we encourage clients to consult with their tax accountants, investment advisors and legal experts about the quantitative and qualitative risks/opportunities associated with a future proposed capital gains inclusion rate change.

Sources:

¹ https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-12700-capital-gains/whats-new-capital-gains.html
² https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-yourtax-return/tax-return/completing-a-tax-return/personal-income/line-12700-capital-gains/you-calculate-your-capital-gain-loss/inclusion-rates-previous-years.html
³ https://fin.canada.ca/drleg-apl/2024/ita-lir-0824-n-2-eng.html
⁴ https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-3-property-investments-savings-plans/series-3-property-investments-savings-plan-folio-2-dividends/income-tax-folio-s3-f2-c1-capital-dividends.html
⁵ https://laws-lois.justice.gc.ca/eng/acts/I-3.3/section-184.html
⁶ https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-12000-taxable-amount-dividends-eligible-other-than-eligible-taxable-canadian-corporations.html
⁷ https://www.canada.ca/en/revenue-agency/services/tax/prescribed-interest-rates.html
⁸ https://www.canada.ca/en/department-finance/news/2024/06/capital-gains-inclusion-rate.html
⁹ https://fin.canada.ca/drleg-apl/2024/ita-lir-0824-n-2-eng.html
^† The calculations provided herein are for illustrative purposes only, may not reflect the circumstances of all taxpayers, and should not be construed as tax or investment advice. Individuals should seek the advice of professionals, as appropriate, regarding their own investment, tax, retirement or estate planning.