Intercorporate dividends: deductible under s.112, Part IV may apply

Which intercorporate dividends end up taxed, and how?

Subsection 112(1) lets a corporation deduct a taxable dividend received in the year from a taxable Canadian corporation, or from a corporation resident in Canada that it controls laws-lois.justice.gc.ca. The dividend goes into income first and comes back out in computing taxable income, so Part I tax on it is nil. What's left depends on who receives it and why it was paid.

Part IV sits in s.186(1). The 38 1/3% applies to assessable dividends from payers that are not connected, while a dividend from a connected private or subject corporation attracts only the recipient's proportion of that payer's dividend refund laws-lois.justice.gc.ca. The full Part IV mechanics are on the Part IV tax page.

When is a payer connected for Part IV?

A payer is connected with the recipient if the recipient controls it, or if the recipient owns more than 10% of the issued share capital with full voting rights and shares worth more than 10% of the fair market value of all the issued shares laws-lois.justice.gc.ca. Both 10% tests have to be met under the ownership branch. Nonvoting freeze shares alone don't make a payer connected, however much they're worth.

Control for this purpose is broader than the usual test: s.186(2) counts shares held by persons who don't deal at arm's length with the recipient, so a Holdco can control an Opco it owns only a minority of when related shareholders hold the rest laws-lois.justice.gc.ca.

Worked example: Holdco owes $44,600 of Part IV tax on $312,000 of dividends

Holdco owns 100% of Opco, a CCPC. Opco pays Holdco a $300,000 non eligible dividend. Opco's non eligible RDTOH is $40,000 at year end, so its dividend refund is the lesser of 38 1/3% of $300,000 ($115,000) and $40,000. Holdco also owns 2% of a public company and receives $12,000 of eligible dividends from it.

If Holdco instead owned 40% of Opco and received $120,000 of a $300,000 dividend, Part IV on it would be $40,000 × $120,000 ÷ $300,000 = $16,000. If Opco had no RDTOH at all, Part IV on the Opco dividend would be nil.

Part IV is refundable. Holdco gets it back at 38 1/3% of the taxable dividends it pays out, which pool it lands in matters, and the RDTOH page walks through which dividends release which pool.

When does s.55(2) turn the dividend into a capital gain?

Subsection 55(2) can apply to a taxable dividend received by a corporation resident in Canada that is deductible under s.112(1) or (2). It needs one of the purpose tests in s.55(2.1)(b): a significant reduction in the capital gain on a share, or (for shares held as capital property) a significant reduction in fair market value or a significant increase in the cost of the recipient's property laws-lois.justice.gc.ca.

It only reaches the part of the dividend that exceeds the income earned or realized after 1971 that could reasonably contribute to the gain on the share, which is safe income. When it applies, the dividend is deemed not to be a dividend: it becomes proceeds of disposition on a redemption, or otherwise a gain from the disposition of capital property laws-lois.justice.gc.ca. For a dividend on a redemption or wind up to which s.84(2) or (3) applies, subsection 55(3)(a) excepts series with no disposition to, or significant increase in interest of, unrelated persons. Safe income calculations and the purpose test have their own section 55(2) page.

Which dividends get no s.112 deduction at all?

The deduction is denied for dividends on term preferred shares held by specified financial institutions (s.112(2.1)), guaranteed shares (s.112(2.2)), shares under a dividend rental arrangement (s.112(2.3)) and the loss protected shares in s.112(2.4). Financial institutions also lose it on shares that are mark to market property laws-lois.justice.gc.ca. The CRA's T2 guide flags that last restriction for certain dividends received after 2023 canada.ca.

Dividends from a corporation exempt from Part I tax don't qualify either, and deducting taxable dividends can create or increase a noncapital loss for the year canada.ca. That's why a Holdco with expenses and only dividend income often shows a loss.

Later, if Holdco sells the shares at a loss, s.112(3) grinds the capital loss by dividends it deducted on them. Qualified dividends, received while the holder owned no more than 5% of the shares and held them for 365 days or more, are left out of that grind laws-lois.justice.gc.ca.

How are dividends on taxable preferred shares taxed?

The recipient pays Part IV.1 tax of 10% on dividends on taxable preferred shares that were deductible under s.112 laws-lois.justice.gc.ca. Excepted dividends are left out, including every dividend received by a private corporation and dividends from a corporation in which the recipient has a substantial interest laws-lois.justice.gc.ca. Substantial interest means related, or at least 25% of the votes and 25% of the value laws-lois.justice.gc.ca.

The payer may owe Part VI.1 tax on those dividends above a $500,000 dividend allowance: 40% on short term preferred shares, and 25% on other taxable preferred shares, or 40% if it elects under s.191.2(1) so holders escape Part IV.1. The allowance shrinks when the prior year's taxable preferred share dividends exceeded $1,000,000, and associated corporations share one $500,000 laws-lois.justice.gc.ca. Dividends paid to a shareholder with a substantial interest are excluded dividends laws-lois.justice.gc.ca.

On the T2, Part IV.1 goes on line 716 and Part VI.1 on line 724, both from Schedule 43, and Part IV.1 on a dividend reduces the Part IV tax on it canada.ca.