Dividends play a significant role in distributing profits to shareholders and rewarding them for their investments in a corporation. As a business owner or director in Canada, determining the appropriate timing for declaring dividends is crucial.
Several factors come into play when making this decision, including financial performance, tax implications, shareholder expectations, and legal considerations. In this article, we will explore these factors in detail to help you understand when dividends should be declared for a corporation in Canada. We will then briefly describe the process for declaring dividends.
Financial Performance
One key aspect to consider when declaring dividends is the corporation’s financial performance. Ensuring that the company generates sufficient profits, has reinvested funds wisely, and has retained earnings available for distribution is essential. Before declaring dividends, it is prudent to assess the company’s financial statements, including the income and cash flow statements, to gauge its profitability and cash flow position. A stable and consistent pattern of earnings and positive cash flow is typically preferable when considering dividends.
Tax Implications
Tax considerations play a significant role in determining the timing of dividend declarations in Canada. Both the corporation and its shareholders are subject to taxation, and understanding the impact is crucial. For the corporation, declaring dividends reduces retained earnings, which may have tax advantages, such as minimizing the corporation’s taxable income. However, it is important to be mindful of the tax implications, such as the refundable dividend tax on hand (RDTOH) account and the corporation’s eligibility for the small business tax rate.
Shareholders’ tax positions must also be considered, particularly for small and/or closely held corporations. Dividends are generally taxable in the hands of shareholders, and the timing of the dividend payment may affect their individual tax liabilities. Considering the timing of dividend payments in relation to their personal tax situations can provide shareholders with tax-planning opportunities. For example, if a shareholder expects to be in a higher tax bracket in the future, deferring dividends to a subsequent year may be beneficial.
Shareholder Expectations
Shareholders’ expectations and preferences should be considered when deciding on dividend declarations. Understanding the needs and desires of the shareholders can help align the corporation’s dividend policy with its expectations. Regular and consistent dividend payments can provide stability and attract long-term investors, while sporadic or irregular dividend distributions may lead to dissatisfaction. On the flip side, if shareholders want the directors to reinvest a larger portion of retained earnings in order to grow the corporation for greater long-term gain, then that needs to be taken into consideration as well.
Another important consideration regarding shareholder expectations is whether dividends will be paid via cash or the issuance of additional shares. The issuance of additional shares has more administrative and legal costs associated with it but might be a method preferred by the corporation (and its shareholders) in certain circumstances.
Legal Considerations
When declaring dividends, adhering to legal requirements and regulations is essential. The Canada Business Corporations Act (CBCA) and the provincial corporations acts contain provisions stating when dividends can and cannot be paid out.
The wording in the CBCA (s.42) is clear:
A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that
- (a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or
- (b) the realizable value of the corporation’s assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.
If directors authorize the payment of dividends when either of those two criteria is not met, then the directors can be personally liable for any shortfall owing to third parties.
Another source of legal requirements can be found in contracts, such as unanimous shareholder agreements. Some shareholder agreements contain provisions stating that dividends can only be paid out once all shareholder loans are first paid out in full. Shareholder agreements also sometimes contain a provision stating that the shareholders, not the directors, decide whether the corporation issues dividends. You will need to review any shareholders’ agreement in advance of making a decision about whether or when to issue dividends.
What is the process for declaring dividends?
Once a decision is made to declare a dividend, a formal process needs to be followed to document the dividend issuance properly. The corporation will need to work closely with its accountants and seek their guidance.
Typically it begins by passing a director’s resolution (The exception would be if the shareholders’ agreement requires it to be a shareholders’ resolution instead). The resolution should specify that the corporation meets the test set out in the CBCA (or applicable provincial statute), how much the aggregate dividend will be, what shares the dividend is being declared on, the date and form of payment, and so on.
After the resolution is passed, it is important to issue a written communication to the shareholders about the dividend. Shareholders will need this so that they can understand what the tax treatment of the dividend will be and so that they can communicate that with their accountants.
Finally, the funds will need to be transferred to the shareholder on the schedule identified in the resolution (or shares issued, in the case of dividends being paid by way of issuing shares).
Throughout the process, it is important to carefully document the dividend payment. Without proper documentation, the corporation (and the shareholders receiving the dividend) risk CRA not treating the transfer of funds as a dividend and subsequently taxing it at a higher rate—this is especially true for smaller corporations where shareholders are actively involved in the business and might take funds from the company both as employment income and dividends.
We hope this article gives you a better understanding of when to declare dividends for Canadian corporations. Contact us today if you have any questions.
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