A capital dividend account (CDA) is a notional, cumulative tax account — defined in section 89(1) of the Income Tax Act — that lets a private corporation pay certain amounts to its shareholders completely free of income tax, provided it elects correctly and does not overstate the balance.
Section 89(1)’s CDA formula adds together the non-taxable half of the corporation’s own capital gains, capital dividends received from other corporations, and — often the largest single addition in an owner-managed target — the amount by which a life insurance death benefit exceeds the policy’s adjusted cost basis. Overstate it and the exposure is real: section 184 imposes a 60%% Part III tax on the excess of an elected capital dividend over the corporation’s true balance, though a timely relief election under 184(3) can recharacterise the excess as an ordinary taxable dividend instead.
For a fund’s tax diligence, the practical task is to recompute the CDA balance independently rather than accept the target’s election history at face value — a corporation the fund is about to own inherits any past over-election, penalty and all. Getting the life-insurance component right also means checking the policy’s adjusted cost base, since that is what the death benefit is netted against. One Ontario firm’s own client explainer illustrates the mechanic simply: “if the CDA balance is $80,000, the corporation can elect a capital dividend of $80,000 and a regular (taxable) dividend for any additional amount.”
A target sold a non-core property for a $400,000 capital gain, crediting $200,000 (the non-taxable half) to its CDA. It also collected a $500,000 key-person life insurance death benefit against a policy with a $60,000 adjusted cost basis, adding $440,000 more. Total CDA: $640,000. If the target’s board, working from an old estimate, elects a $700,000 capital dividend, the $60,000 excess is exposed to the 60%% Part III tax under section 184(2) unless the 184(3) election is filed in time — exactly the kind of pre-closing housekeeping error a fund does not want to inherit.
See also: Adjusted cost base · Deemed dividend.
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