Tax Free Inter-Corporate Dividends

Dividends are distributions of a company’s assets to one or more classes of shareholders proportional to the shares owned. This commonly involves distributions of profits held as retained earnings, but can also be in many forms, including shares, physical assets, and writing off debts owed to the company.

Inter-corporate dividends refer to dividends that are paid by one company to another company holding shares in the first, particularly where the companies are operated by the same person or group of people (as with a holding company structure).

When individuals receive dividends, those dividends go through the “integration” process, with the intended result of taxing the corporation’s profits at the individual recipient’s marginal tax rate. Dividends received are presumptively included in the corporate recipient’s income pursuant to section 82 of the ITA. However, when dealing with a pair of Canadian companies, the recipient company can claim an offsetting deduction from income equal to the value of the dividend under Section 112 of the Income Tax Act.

The goal in that case is to have the profits taxed once, and only once, when earned by a company, after which they can flow through a corporate group freely. Subsequently, when paid out to an individual, the dividend will be integrated and taxed at the individual’s marginal rates.

Companies may only pay dividends where it would not prevent them from meeting their obligations as they become due or where it would not mean that the company’s assets were less than its liabilities. Because of these restrictions, companies cannot pay dividends in the face of threats to their solvency. This means that companies want to pay dividends proactively, to reduce the exposure of their assets. The use of inter-corporate dividends that qualify for a section 112 deduction allows companies to pay dividends to a corporate parent, keep investments out of the hands of creditors, and continue to defer the tax recognition that will occur when paid to an individual.

F.A.Q’s:

I received a dividend that wasn’t from a related company, but from a public corporation it invested in. Will my company need to pay tax on it?

Probably. In contrast to distributions between related companies, where private Canadian companies receive “portfolio dividends” (i.e. from unconnected companies) from Canadian companies, they do pay tax on the receipt. However, they do not technically include these amounts in income, but rather pay a special type of tax that is refunded to them when they pay dividends. This is intended to prevent them from using the deduction for dividends received to defer income tax.

I received dividends from a non-Canadian company; will I need to pay tax on this?

This deduction is not generally available where the company receives dividends from foreign companies, although there are narrow exceptions when the company operates in Canada.

Are dividends received that relate to all types of shares eligible for the deduction?

No. While dividends received as a result of ownership of the basic shares typically issued by small businesses allow corporate holders to claim this deduction, there are exceptions that function as anti-avoidance rules.

– James Alvarez, Tax Counsel