Dividend With Negative Retained Earnings: Allowed or a Loan?

Can a corporation pay a dividend with negative retained earnings or no profit?

Yes. Under the federal and British Columbia statutes a corporation does not need positive retained earnings to pay a dividend, and a deficit in the books is not, on its own, a bar. Section 42 of the Canada Business Corporations Act does not use retained earnings as a test. It asks whether the corporation can pay its debts as they come due and whether its assets are worth at least its liabilities plus stated capital (mostly what shareholders paid for their shares) (section 42). British Columbia asks only whether the company is, or would become, insolvent (section 70).

A deficit is still a warning. It often means past losses have used up what the owners put in, so the margin may be thin. The case is not simple when:

• the books carry assets at cost and what they could sell for is unclear;
• bills fall due soon after the payment, or the owner needs the money now and the numbers are close;
• the corporation owes the CRA tax, GST/HST or payroll amounts, which can come back to the owner or the directors;
• more than one person owns shares, or there is more than one class of shares;
• the books are behind or do not reconcile, so there is no reliable balance sheet to test;
• the money has already been taken.

Gather before deciding: the balance sheet at the declaration date, the articles and share register, every liability with its due date (loans from the owner, with their paperwork, and taxes owing included), support for what each non-cash asset could sell for, and the dividend resolution.

What are the legal tests for a dividend, and who decides?

The directors decide, by resolution, and the directors carry the risk if the test fails. Federal law bars a corporation from declaring or paying a dividend if there are reasonable grounds for believing either of two things (section 42):

Failing either test blocks the dividend. Three terms decide the result:

• Realizable value is roughly what an asset could be sold for, not the figure in the books. The Act does not define it, so directors must be able to support the number they use.
• Liabilities is not defined. Section 42 has no exception for debts owed to shareholders. How an owner's loan counts, given its terms, is worth settling before declaring.
• Stated capital is the amount credited to the stated capital accounts, mainly what shareholders paid for their shares (section 26). It is a separate account from retained earnings.

The pay-its-bills test looks at the corporation now and after the payment; the asset test looks at it after the payment. Both apply when the dividend is declared and when it is paid. In a corporation with one owner who is also the only director, the same person decides, signs and receives. The resolution itself is covered in how to pay yourself a dividend.

Does my province or incorporating statute change the test?

Yes. The test comes from the statute the corporation was incorporated under, federal or provincial or territorial (Canada.ca). A federal corporation applies the federal test wherever its owner lives.

On the wording, British Columbia has no asset test against liabilities plus stated capital. A corporation with thin asset cover that can still pay its bills may therefore pass in British Columbia and fail federally. British Columbia also lets a director ask the court whether a dividend would break the test (section 70(3)), and its section 70(1) yields to the company's charter or another enactment if either provides otherwise.

How do I show the corporation passes the test?

Build a dated balance sheet and cash forecast, keep them with the resolution, and run them again if payment comes later than the declaration. The steps:

1. Start from books reconciled to the declaration date.
2. Restate each asset at what it could realistically be sold for: collectable receivables, inventory, equipment, property, investments. Keep the support: an appraisal, a listing, a recent sale.
3. List every liability with its due date: suppliers, loans, tax and payroll remittances owing, and anything owed to the owner.
4. Asset test: subtract the proposed dividend from the assets. The result must not fall below the liabilities plus the stated capital.
5. Pay-its-bills test: list what falls due after the payment and confirm cash and expected receipts cover it. The Act sets no look-ahead period, so use one you can defend.
6. File the working with the resolution.

Books that are out of date or do not reconcile give little to rely on for the directors' defences described below.

What happens if the dividend should not have been paid?

Directors who vote for or consent to a dividend that breaks the test are jointly and severally liable (each can be pursued for the whole amount) to restore to the corporation what was paid and not otherwise recovered (federal section 118(2); B.C. section 154(1)). A director who attends the meeting is treated as consenting unless an objection (a dissent) is entered in the minutes or sent in. A director who is absent is treated as consenting unless a dissent is delivered within seven days of learning of the resolution. A director who votes for the resolution cannot dissent (federal section 123; B.C. section 154).

• Recovery from the owner. A court can order the shareholder who received the money to repay it to the director (federal section 118(4) and (5), where the court finds it equitable). In British Columbia the court can order delivery to the director or the company (section 156).
• Void or valid. The federal Act does not say the dividend is void; it sets liability and recovery. British Columbia says a dividend is not invalid merely because it breaks the test (section 70(4)).
• Defences. Good-faith reliance on financial statements an officer represents as fairly reflecting the corporation's condition, or on a professional's report, is a defence. Federally, the director must also have shown the care a reasonably prudent person would have used (federal section 123(4); B.C. section 157(1)). British Columbia also excuses a director who did not know and could not reasonably have known the act was contrary to the Act.
• Time limit. Federal (section 118(7)) and B.C. (section 154(9)) proceedings must begin within 2 years of the resolution.
• Bankruptcy. If the corporation goes bankrupt, a trustee can ask a court to inquire into a dividend paid from one year before the initial bankruptcy event until the bankruptcy. If the corporation was or became insolvent, the court can order repayment of the unreturned amount by directors who had no reasonable grounds to believe otherwise, and by a shareholder related to a director or to the corporation (Bankruptcy and Insolvency Act, section 101). Its insolvency test also counts assets, fairly valued, that would not pay all obligations (section 2).
• Tax the corporation owes. An owner who controls a corporation and gets money or property from it for less than its value is jointly liable for the corporation's unpaid tax for that year and earlier years, up to the value not paid for, even if a dividend passes the test (Income Tax Act, section 160, which has no exception for dividends; for GST/HST, Excise Tax Act, section 325). A controlling owner is not at arm's length with the corporation (section 251). The CRA can assess this at any time, so the limit above does not apply.

How the CRA treats a dividend paid in breach of the test, and whether a repayment to the corporation changes the T5, is not settled by the sources read for this page. Take advice before amending anything.

Does the CRA need retained earnings before it treats a payment as a dividend?

No. The CRA's main dividend folio does not mention retained earnings, and the Income Tax Act does not specifically define a dividend for a Canadian corporation. The folio describes a pro rata distribution among shareholders of a class (paid in proportion to the shares held) as one that may be a dividend where the relevant corporate law requirements to pay one are met. A distribution can also be a dividend where other factors show the corporation intended to pay one, and a payment's label does not change its nature (CRA folio S3-F2-C2, paragraphs 2.16 and 2.17). Whether a dividend that breaks the corporate-law test still counts as one for tax is the open point noted above.

A payment that is a dividend is not also a shareholder benefit: section 15(1) excludes a benefit conferred by paying a dividend (Income Tax Act, section 15), and the CRA calls dividends a return on the shareholder's investment (CRA: Shareholder).

If a dividend is not available, what are my options?

When the test fails, the owner can wait, take salary or bonus, take back money the owner lent, or take a loan. Each has its own rules.

Salary and loans do not get around a cash shortage. If the corporation cannot pay what it owes as it falls due, any payment to an owner can raise creditor and director questions this page does not cover; take advice first. Directors can also be personally liable, with the corporation, for payroll deductions and GST/HST it fails to remit, unless they took the care a reasonably prudent person would have to prevent the failure; the CRA has two years after the director last ceased to be a director to pursue them (Income Tax Act, section 227.1; Excise Tax Act, section 323).

A later dividend that passes the test can be applied against a loan balance (CRA folio S3-F1-C1, paragraphs 1.82 and 1.86). A federal corporation can also return stated capital to a shareholder by special resolution under a separate test (section 38); its tax result is not covered here, so take advice before using it.

What if the money has already left the corporation?

What the money is now depends on what happened, not on what the books call it. The CRA says whether a loan was received "is not based on accounting entries"; the substance of the transaction governs (CRA folio S3-F1-C1, paragraph 1.14).

If an amount is a loan, the deadline for the repayment exception in section 15(2.6) is one year after the end of the corporation's tax year in which the loan was made, so the dates in step 2 matter. Work in this order:

1. Consider pausing further withdrawals until you know what the earlier ones were.
2. List each withdrawal with its date and amount from the bank statements.
3. Run the test as of each date to see whether a dividend could have been declared.
4. Decide, with the facts, whether each amount is a dividend, loan, salary or benefit, and document it.
5. Record it. A journal entry now cannot change what an earlier payment was.

A new resolution carries the day it is actually passed, and a dividend is allowed only if the corporation passes the test on that day. What a new resolution does for money already taken is a question for advice. See shareholder loans and paying yourself a salary after the fact.

Which cases need a professional before declaring?

A professional is worth consulting when a wrong call lands on the directors personally or changes the owner's tax:

• The deficit comes from past losses and asset values are not in the books. Realizable value is a judgment the Act leaves undefined.
• There is more than one shareholder or class. With a single class, shareholders' rights are equal, including the right to receive a declared dividend; different amounts for different holders generally need classes set out in the articles (section 24).
• The corporation owes the owner money, a lender or the CRA. Each debt goes into the test, and how an owner's loan counts is a point to settle. Tax owing can also make the owner personally liable (section 160, above).
• The test is close. One more bill or a lower asset value flips it.
• Money has already been taken. The answer decides loan, benefit, dividend or salary.

Example

These examples are illustrative. All figures are in Canadian dollars.

A deficit, with real asset value

A federal corporation's books show a deficit of $40,000 from early losses. Its assets are carried at cost (such as property bought years ago), but could be sold for $250,000. Liabilities are $120,000, stated capital is $100, and after the dividend cash and expected receipts still cover every bill as it comes due. A $30,000 dividend leaves assets of $220,000, above the $120,100 of liabilities plus stated capital, so it passes the asset test. The books then show a deficit of $70,000. That is a bookkeeping result, not a breach.

Thin cover

A federal corporation's assets are worth $130,000, liabilities are $120,000 and stated capital is $100. A $30,000 dividend leaves assets of $100,000, below $120,100, so it fails the asset test. On that test alone, a dividend above $9,900 fails. At $9,900 there is no margin, so a small change in an asset value or one more bill flips the result, and the corporation must still pass the pay-its-bills test.

Already paid

An owner drew $30,000 in cash before any resolution, from a corporation whose assets were worth $130,000 before the draw, with liabilities of $120,000 and stated capital of $100. No dividend was declared. If the owner does not owe the money back, assets after the draw are $100,000, below $120,100: the draw would have failed the asset test had it been a dividend, and no dividend can pass until assets recover. If it is a loan the owner must repay, the $30,000 receivable counts as an asset only as far as it can be collected, and a dividend applied against it still cuts assets by the same amount, so a $30,000 dividend fails either way. A resolution passed now cannot reach back to the draw. For tax, the CRA looks at substance: whether it is a dividend, a loan under section 15(2) or a benefit under section 15(1) depends on the facts. The owner and advisor look at repayment, or at how the amount is treated, before anything else is paid.

Different for you?

• You need money out now and the test is close or fails: ask how salary, a loan or waiting would work, with corporate tax help before anything is paid.
• Money has already left the corporation: see shareholder loans and paying yourself a salary after the fact, then get corporate tax help to decide how each amount is treated.
• The corporation owes the CRA tax, GST/HST or payroll amounts: the owner and the directors can be personally liable; get corporate tax help before anything is paid, and see catching up on unfiled corporate returns.
• The CRA says an expense was personal: see a shareholder benefit found in an audit.
• Your books are behind or do not reconcile, so you cannot build the balance sheet: get bookkeeping help first.
• There is more than one owner or class of shares: get corporate tax help before declaring; see shareholders taking different amounts.
• The owner lives outside Canada: the test is the same, but the corporation must withhold tax from a dividend paid to a non-resident, at 25% before any treaty reduction, and is liable if it does not (section 215); see non-resident owners of a Canadian corporation.
• The corporate-law question is close or disputed: a lawyer may also be needed for the articles, share classes or creditor claims.
• The corporation is incorporated in Ontario, Quebec or another province: read its statute; see how to pay yourself a dividend.
• The dividend passes and you need the mechanics: see how to pay yourself a dividend and recording dividends in the books.