What Is A Capital Dividend?
A capital dividend is a dividend that a company pays its investors out of shareholders’ equity or paid-up capital. It gives a company’s existing investors a second chance to collect dividends even if the organization is not generating enough profits. Thus, it serves as a safety net.
Such dividend payouts indicate poor financial health as a company only makes this payment if it does not generate adequate profits to issue regular dividends. One can get tax benefits on these dividends as the Internal Revenue Service (IRS) views this payment as a return of capital dividend or a refund on the original share price.
Table of contents
- Capital dividend definition refers to dividend payments made to investors from shareholders’ equity instead of profits.
- Companies only pay this dividend when they do not have sufficient profits to make the scheduled dividend payments. In other words, organizations pay this dividend when their financial position is weak.
- This dividend is not taxable as the IRS considers it to be the refund on the initial amount investors pay to purchase the shares.
- When companies pay this dividend, investors lose their confidence in the management team as the payout reduces the available capital and impacts the business’s growth potential.
Capital Dividend Explained
Capital dividend definition refers to the amount companies pay investors as dividends by drawing out money from shareholders’ equity instead of taking out the funds from its profits. Typically, a company only makes this payment when it cannot generate sufficient profits to cover the regular dividend payments. Thus, it indicates that an organization is in financial trouble.
Moreover, by paying out this dividend, companies shrink their capital base, restricting future growth and investment opportunities. As a result, investors may lose confidence in a company’s management team if the organization pays this dividend.
Nevertheless, one should also know that this dividend comes with certain benefits. First, this form of dividend is not taxable in investors’ hands as the IRS considers it to be a return of a portion of funds that investors paid when they purchased the company’s shares. Secondly, companies can use such dividends to justify lowering their initial stock price when filing an income tax return.
One must note that a company only issues tax free capital dividends if it has a contractual obligation to pay the scheduled dividends to its preferred shareholders. Financially weak organizations not having such an obligation can stop paying dividends altogether.
In Canada, a capital dividend refers to the dividend paid via an appreciating asset’s sale. For instance, suppose a company sells an asset that increased in value significantly from the date of purchase. It has to pay capital gains tax worth 50% of the total realized gain. The company places the tax-exempt portion in a capital dividend account (CDA). It can draw money from this account to pay capital dividends to the shareholders.
Let us look at a capital dividend example to understand the concept better.
Suppose ABC is a pharmaceutical company with shareholders’ equity of $600 million. It pays out dividends to shareholders every six months. Under normal circumstances, the company pays dividends from its profits. That said, let us say that the company fails to generate adequate profits for a few months and does not have enough funds to make the scheduled dividend payments. They will have to pay a capital dividend in this case. In other words, they will draw funds from their shareholders’ equity to pay the scheduled dividends.
Although the payment will appease ABC’s shareholders for a short period, the company will want to strengthen its financial position as soon as possible and cover the losses to regain investors’ confidence.
Capital Dividend vs Regular Dividend
Regular dividends refer to a portion of a company’s profits that the organization may issue in additional shares, cash payments, or a different form of property. A cash dividend is the most popular form of dividend payment. As the name suggests, companies pay this dividend in cash. Typically, they make the payment via electronic funds transfer or cheque.
The board of directors decides the dividend amount along with the timing and type of payout. Regular dividend payments indicate that a company can generate free cash flow consistently. The main distinction between regular and tax free capital dividends is that a company pays a regular dividend out of its profits, not shareholders’ equity.
Startups and companies solely focusing on growth hardly pay out any dividends. Instead, they utilize the funds for research and development to boost growth.
Dividend Paying Stocks
Contrary to new companies focusing on growth, well-established organizations generate predictable profits. Hence, they can pay substantial dividends. Examples of such companies are Invesco Ltd., Ford Motor Co., Best Buy Co. Inc., and Stanley Black & Decker Inc.
Recently, Best Buy’s BOD authorized a regular quarterly cash dividend payment worth $0.88 for each common share. This dividend is payable on October 11, 2022.
Also, on July 20, 2022, Stanley Black & Decker disclosed that their BOD gave the green signal to increase the company’s quarterly cash dividend by $0.01 to $0.80 for every common share.
High dividend-yielding stocks offer little capital appreciation; the dividend offered by these securities is what incentivizes investors to keep them in their portfolio. Thus, individuals who invest in such stocks seek passive income and do not focus on growth.
Traditionally, one can find these dividend-paying companies in certain sectors like oil, pharmaceuticals, financial, utilities, and healthcare.
Frequently Asked Questions (FAQs)
Capital dividends are not subject to taxation in Canadian resident shareholders’ hands. A capital dividend account or CDA tracks a private company’s tax-free surpluses. This account consists of the tax-exempt portion of the overall realized capital gains. Its balance increases by 50% of the realized gains or decreases by 50% of the capital losses incurred by the company.
A company must file an election to make this dividend payment on Form T2054 before the following days:
– The first day on which the company pays a portion of this dividend
– The day on which this dividend becomes payable
To report such dividends on T2, one must enter the total taxable dividend amount deductible from the taxable income u/s 112, subsections 138(6), 113(2), and paragraphs 113(1)(a), (d), (a. 1) or (b) on line 320.
Main Street Capital had an annual dividend yield of roughly 6.3% as of 31 August 2022.
This has been a guide to What is Capital Dividend. We explain it with an example, dividend-paying stocks, & comparison with the regular dividends. You may also find some useful articles here –