While intercorporate dividends can be an effective tool for tax optimization during the sale of an operating business, there are several important factors and potential flaws to be aware of. These include legal, tax, and strategic considerations that could impact the outcome of the exit strategy. Let’s explore these in more detail.
1. Potential Risks of Avoiding Capital Gains Tax
A common strategy for corporations using intercorporate dividends in an exit strategy is to distribute dividends from the operating subsidiary to the holding company before a sale. This can reduce the overall tax burden at the time of the transaction. However, one important consideration is that dividends are typically paid out of a corporation’s after-tax profits, which could still result in an initial tax liability at the corporate level (despite the receiving corporation generally not being taxed on these dividends).
Moreover, if the sale involves the liquidation of the subsidiary or the sale of shares in the subsidiary, any capital gains from that sale may still be subject to tax at the individual shareholder level (depending on the nature of the sale). The distribution of dividends before the sale does not completely shield these gains from tax, especially if the transaction qualifies as a sale of shares. In this case, relying too heavily on dividend strategies might obscure the larger tax implications of the eventual capital gain that will arise from the sale of shares or assets.
2. Tax Compliance and Substantive Issues
The Income Tax Act has strict regulations governing the transfer of funds between corporations, and failing to meet these requirements can lead to undesirable tax consequences. For instance, the receiving corporation (in this case, the holding company) may face taxes if the intercorporate dividend is not properly structured or if the paying subsidiary has not met specific requirements for tax-free dividends (e.g., ensuring the dividend is paid from income that has already been taxed).
Additionally, if the dividends are paid out of retained earnings that were not taxed appropriately or were inappropriately classified, it may attract scrutiny from the Canada Revenue Agency (CRA), potentially triggering audits or reassessments. Proper documentation, corporate compliance, and advice from tax professionals are essential when structuring this type of strategy.
3. Dividend Limits and Share Ownership Rules
To qualify for tax-free dividends, certain requirements must be met, including the parent company’s share ownership in the subsidiary. If the holding company does not own the appropriate percentage of shares (usually a minimum of 10% in most cases), the dividends may not be considered tax-free. In such cases, dividends could be subject to corporate tax rates and may result in the unintended consequence of higher taxes than anticipated.
If the subsidiary is not a Canadian-controlled private corporation (CCPC) or does not qualify under specific provisions of the ITA (for instance, if it’s a public corporation or not actively carrying on business), intercorporate dividends may not be eligible for tax-free treatment. Therefore, any changes in ownership, share structure, or business activity should be carefully considered when structuring this type of exit strategy.
4. Capital Dividend Account (CDA) Limitations
While dividends paid out of the Capital Dividend Account (CDA) are tax-free, using the CDA as part of an exit strategy can become tricky if the corporation has not properly accumulated tax-free amounts in the CDA. For example, if the corporation has capital gains that have not been allocated to the CDA, those gains could be subject to tax upon distribution. This could potentially limit the tax-free portion of the dividends, especially if you plan on utilizing the CDA for a significant portion of the dividend payout.
Furthermore, the distribution of funds from the CDA must adhere to very specific rules to avoid triggering unintended tax consequences. If the CDA balance is mismanaged or if there are any mistakes in the calculation or transfer of these funds, the tax-free benefit could be lost, which would significantly undermine the planned exit strategy.
5. Potential Impact on Shareholders’ Tax Positions
One significant factor in an exit strategy involving intercorporate dividends is that the ultimate tax benefit may depend heavily on the shareholder’s tax position. If a holding company receives dividends from a subsidiary and then distributes those funds to its shareholders, the shareholders may still face taxes on those distributions.
In many cases, dividends are taxable to shareholders when they are distributed, depending on the type of dividends and the individual’s tax situation. For example, Canadian residents receiving dividends may be eligible for the dividend tax credit, which reduces the tax impact of receiving such dividends. However, these taxes are still an important consideration when planning an exit strategy, as they can reduce the overall benefit of using dividends as a liquidity tool.
6. Corporate Restructuring and Exit Timing
Timing is critical when using intercorporate dividends as part of an exit strategy. If the strategy is executed too late or with poor timing, there may not be enough time to accumulate the necessary dividends or to structure the transactions in a way that maximizes the tax benefits. A company should carefully plan the dividend distributions ahead of a sale or liquidation, ensuring that the tax consequences are minimized and the distributions are well timed within the broader context of the sale or restructuring.
Moreover, the structure of the deal itself – whether it’s an asset sale or a share sale – can significantly affect the tax implications. For example, if the sale is structured as an asset sale, the proceeds might be subject to taxation at the corporate level, rather than flowing through the holding company tax-free. In such a case, the intercorporate dividend strategy may not provide the expected benefits.
Conclusion
While using intercorporate dividends as part of an exit strategy can provide significant tax advantages, it is not without its potential flaws and complexities. Careful planning, compliance with tax rules, and proper structuring are essential to ensure the benefits are realized. Corporate owners should be mindful of the risks, such as the impact of capital gains tax, the timing of dividend distributions, and the ownership requirements for tax-free dividends. Seeking guidance from tax professionals and legal advisors is critical to navigating these complexities and ensuring the exit strategy is effective and tax-efficient.
If you’re considering an exit strategy involving intercorporate dividends or need help navigating the tax implications of your business sale, Rozvytok is here to provide expert advice and strategic solutions tailored to your needs.
Source: Income Tax Folio S3-F2-C2, Taxable Dividends from Corporations Resident in Canada
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