Tax Implications of Corporate Dividends vs Share Buybacks
By Bader A. Chowdry, CPA, CA, LPA | Insight Accounting CPA
# Tax Implications of Corporate Dividends vs Share Buybacks
By Bader A. Chowdry, CPA, CA, LPA | Insight Accounting CPA
When it’s time to distribute wealth to shareholders in a Canadian private corporation, business owners face a critical decision: pay dividends or execute a share buyback (share redemption)? While both methods move money from the corporation to shareholders, the tax implications, timing, and strategic considerations differ significantly.
This comprehensive guide examines the tax treatment of dividends versus share buybacks in Canada, helping business owners in Mississauga, the Greater Toronto Area (GTA), and across Ontario make informed decisions about shareholder distributions.
Understanding the Two Distribution Methods
What Are Corporate Dividends?
Dividends are distributions of corporate after-tax earnings to shareholders. In Canada, dividends can be classified as:
- Eligible dividends: Paid from income taxed at general corporate rates (typically paid by CCPCs with active business income above the small business limit)
- Non-eligible dividends: Paid from income that benefited from the small business deduction
- Capital dividends: Tax-free distributions from the capital dividend account (CDA), typically arising from the non-taxable portion of capital gains
- Gross-up: 38%
Dividends do not reduce a corporation’s paid-up capital (PUC) and do not affect the number of shares outstanding.
What Are Share Buybacks?
Share buybacks (also called share redemptions or share repurchases) occur when a corporation purchases its own shares from shareholders. The transaction has two components:
1. Return of capital: The amount equal to the paid-up capital (PUC) of the shares
2. Deemed dividend: The excess of the redemption price over the PUC
Share buybacks reduce both the corporation’s cash and the number of shares outstanding.
Tax Treatment for Shareholders
Dividend Taxation in Canada
Dividends received by individual shareholders are subject to the dividend gross-up and tax credit mechanism:
Eligible Dividends (2026 rates):
- Federal dividend tax credit: 15.02% of grossed-up amount
- Provincial dividend tax credit (Ontario): approximately 10% of grossed-up amount
- Combined top marginal rate in Ontario: approximately 39.34%
- Gross-up: 15%
Non-Eligible Dividends (2026 rates):
- Federal dividend tax credit: 9.03% of grossed-up amount
- Provincial dividend tax credit (Ontario): approximately 3.12% of grossed-up amount
- Combined top marginal rate in Ontario: approximately 47.74%
- Redemption proceeds: $X
Dividends paid to corporate shareholders are generally tax-free between Canadian corporations due to the Part IV tax refund mechanism and inter-corporate dividend rules.
Share Redemption Taxation
When shares are redeemed, the tax treatment has two elements:
1. Deemed Dividend Component:
The amount by which the redemption price exceeds the PUC is treated as a deemed dividend (subsection 84(3) of the Income Tax Act), taxed at regular dividend rates.
2. Capital Gain/Loss Component:
After accounting for the deemed dividend, any difference between the redemption proceeds and the adjusted cost base (ACB) is treated as a capital gain or loss.
Formula:
- Less: PUC: ($Y)
- Deemed dividend: $Z
- Redemption proceeds less deemed dividend: ($X – $Z)
- Less: ACB: ($W)
- Capital gain/loss: (Net amount)
- Shares have high ACB relative to PUC
For shares with low PUC (common in many private corporations), most of the redemption amount is treated as a deemed dividend.
Strategic Comparison: Dividends vs Buybacks
Advantage 1: Capital Gains Treatment Opportunity
Share Buybacks Win When:
- Shareholders want to trigger capital losses to offset other capital gains
- Planning for the lifetime capital gains exemption (LCGE)
- ACB: $500,000
If a shareholder has qualifying small business corporation (QSBC) shares eligible for the LCGE (up to $1,016,836 in 2026), a share redemption structured to create a capital gain can utilize this valuable exemption.
Example:
Sarah holds shares with:
- PUC: $1
- FMV: $1,000,000
- Deemed dividend: $999,999
On redemption:
- Capital gain: ~$0
- Corporation has a capital dividend account (CDA) balance
Because the PUC is only $1, nearly all proceeds are deemed dividend-no LCGE benefit.
To access the LCGE, Sarah might sell shares to a third party or use an estate freeze structure instead.
Advantage 2: Corporate Tax Efficiency
Dividends Win When:
- Corporation wants to preserve share structure
- Simplicity and lower legal costs are priorities
- Corporation wants to reduce share count and simplify ownership structure
Capital dividends paid from the CDA are tax-free to shareholders, making them the most tax-efficient distribution method when available.
Share Buybacks Win When:
- Buyback can be structured to create capital gains eligible for LCGE
- Estate planning requires reduction in FMV of estate
- Flexibility to pay to all shareholders proportionally
Advantage 3: Flexibility and Control
Dividends Offer:
- No change to share structure or voting control
- Lower administrative complexity
- Selective distribution to specific shareholders
Share Buybacks Offer:
- Ability to adjust ownership percentages
- Reduction in shares outstanding (useful for estate freezes and succession planning)
- Eligible dividends: Top marginal rate approximately 39.34%
Ontario-Specific Tax Considerations
Provincial Dividend Tax Rates
Ontario has specific dividend tax rates that affect the overall tax burden on dividends:
- Non-eligible dividends: Top marginal rate approximately 47.74%
- Year 1: Pay $250,000 capital dividend (if CDA available)
These rates are among the highest in Canada, making tax planning around shareholder distributions particularly important for Mississauga and GTA business owners.
Impact on Ontario Health Premium
Both dividends and capital gains from share redemptions increase net income for purposes of the Ontario Health Premium (OHP). The OHP ranges from $0 to $900 annually for individuals with taxable income over $20,000.
Large distributions in a single year can trigger the maximum OHP, making income splitting or multi-year distributions advantageous.
Common Scenarios: Which to Choose
Scenario 1: Retirement Distribution for Owner-Manager
Situation:
A 65-year-old business owner in Mississauga wants to withdraw $500,000 from their corporation over two years.
Best Strategy:
- Year 1: Pay $250,000 non-eligible dividend
- Year 2: Consider share redemption to utilize LCGE on remaining shares before age 70
- Stay in lower marginal tax brackets
Why:
Spreads tax burden, uses CDA tax-free room, preserves LCGE opportunity.
Scenario 2: Removing Inactive Shareholder
Situation:
A corporation wants to buy out a minority shareholder who no longer contributes.
Best Strategy:
Share redemption (buyback)
Why:
Simplifies ownership structure, removes shareholder from cap table, provides clear exit mechanism.
Scenario 3: Annual Profit Distribution
Situation:
Corporation earns $300,000 annually and wants to distribute after-tax earnings to two equal shareholders.
Best Strategy:
Regular dividends (eligible or non-eligible depending on tax pool)
Why:
Simple, proportional, preserves share structure, lower administrative costs.
Scenario 4: Estate Planning for Business Succession
Situation:
An owner wants to transfer ownership to children while extracting lifetime wealth.
Best Strategy:
Estate freeze with preferred shares, followed by redemption or sale
Why:
Locks in current value, allows future growth to accrue to next generation, creates exit path.
CRA Scrutiny and Anti-Avoidance Rules
Section 84.1: Surplus Stripping Rules
When an individual sells shares of a Canadian corporation to another Canadian corporation with which the individual does not deal at arm’s length, section 84.1 can re-characterize what would otherwise be a capital gain into a deemed dividend.
Impact:
This prevents “surplus stripping”-extracting corporate surplus as capital gains rather than dividends to benefit from the 50% capital gains inclusion rate.
General Anti-Avoidance Rule (GAAR)
The CRA applies GAAR to transactions designed primarily to obtain a tax benefit. Share redemptions structured solely to convert dividends into capital gains to access the LCGE may face GAAR challenges.
Best Practice:
Ensure share redemptions have legitimate business purposes beyond tax reduction (e.g., estate planning, ownership simplification, succession planning).
Case Law: Evans v. The Queen
In Evans v. The Queen, the Tax Court found that a share redemption structured to trigger capital gains eligible for the LCGE was legitimate tax planning, not abusive under GAAR. The decision reinforced that accessing the LCGE through proper share redemption is permissible when done within the legislative framework.
Planning Strategies for Tax Efficiency
1. Multi-Year Income Splitting
Rather than taking large lump-sum distributions, split distributions over multiple years to:
- Reduce OPP (Ontario Health Premium) impact
- Preserve access to income-tested benefits
- Track eligible additions (non-taxable capital gains, life insurance proceeds)
2. Use of Capital Dividend Account
Monitor and maximize CDA distributions:
- File Form T2054 before paying capital dividends
- Coordinate timing to match shareholder liquidity needs
- Ensure shares qualify as QSBC shares (90% active business assets at sale, 50% over prior 24 months)
3. LCGE Planning
To maximize LCGE access:
- Purify assets if needed (remove passive investments)
- Consider crystallization strategies before LCGE reduction or elimination
- Contribute capital via section 85 rollovers
4. Paid-Up Capital Planning
Increase PUC where possible to reduce deemed dividend on future redemptions:
- Use paid-in capital contributions
- Carefully plan share structure on incorporation
- CPP/OAS eligibility and clawbacks
5. Timing Coordination with Other Income
Coordinate distributions with:
- RRSP/RRIF withdrawals
- Spousal income for pension income splitting
- Model after-tax outcomes for different distribution scenarios
Role of Professional CPA Guidance
The tax implications of dividends versus share buybacks are complex and highly fact-specific. A qualified CPA in Mississauga or the GTA can:
- Prepare corporate reorganizations to optimize tax outcomes
- Ensure compliance with CRA rules and filing requirements
- Integrate shareholder distributions into broader estate and succession plans
- Coordinate timing with personal tax planning
- Shareholder objectives (income, estate planning, exit)
At Insight Accounting CPA, we specialize in tax-efficient shareholder distribution strategies for private corporations in Ontario. Our patent-pending AI governance framework ensures compliance while maximizing after-tax wealth for business owners. Whether you need corporate tax planning or fractional CFO guidance on capital allocation, our team delivers expert solutions.
Frequently Asked Questions
Q1: Can a corporation pay both dividends and execute share buybacks in the same year?
A: Yes. Many corporations use a combination-paying regular dividends for ongoing distributions and executing selective share buybacks for specific shareholders or estate planning purposes.
Q2: How does a share buyback affect my RRSP contribution room?
A: The deemed dividend portion increases your earned income, potentially increasing RRSP contribution room for the following year. The capital gain component does not affect RRSP room.
Q3: Are there any restrictions on when a corporation can buy back shares?
A: Yes. Under the Ontario Business Corporations Act (OBCA), a corporation cannot buy back shares if it would be unable to pay its liabilities as they become due, or if the corporation’s realizable assets would be less than liabilities plus stated capital of all share classes.
Q4: How do I report a share redemption on my personal tax return?
A: Report the deemed dividend in the dividend section (grossed up and with dividend tax credit). Report any capital gain or loss on Schedule 3. Your corporation should issue a T5 slip showing the deemed dividend.
Q5: Is there a limit on how much I can withdraw via dividends or share buybacks?
A: There is no specific tax limit, but withdrawals are limited by the corporation’s retained earnings, legal capital maintenance rules, and solvency tests. Large distributions may also trigger alternative minimum tax (AMT).
Q6: Can I use share redemptions to income split with family members?
A: Yes, but be cautious of the Tax on Split Income (TOSI) rules. Share redemptions paid to family members may be subject to the highest marginal tax rate unless certain exceptions apply (e.g., excluded shares with required ownership and activity tests).
Conclusion
Choosing between dividends and share buybacks is not a one-size-fits-all decision. The optimal strategy depends on:
- Corporate structure and capital accounts (PUC, ACB, CDA)
- Tax attributes (LCGE availability, other income sources)
- Provincial tax considerations (Ontario rates and health premium)
- Long-term business succession and ownership goals
With proper planning and professional CPA guidance, business owners in Mississauga, Toronto, and across the GTA can maximize after-tax wealth while maintaining compliance with Canadian tax rules.
Ready to optimize your shareholder distributions?
Contact Insight Accounting CPA in Mississauga at (905) 270-1873 or visit insightscpa.ca to schedule a consultation. Our team specializes in tax-efficient shareholder distribution strategies for private corporations across Ontario.
Let us help you navigate the complexities of dividends, share buybacks, and corporate tax planning with precision and confidence.
This article is for informational purposes only and does not constitute professional tax advice. Tax laws change frequently. Consult a qualified CPA for advice specific to your situation.
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