Chapter One – Lecture Notes - Thor



Chapter Seven Lecture Notes

Specific Dealings in Share Capital and the Deemed Dividend

David Christian Spring Term 2013

Thorsteinssons LLP UBC Faculty of Law

______________________________________________________________________________

Notes

Parliament has the power to deem cows to be chickens.

Bowman, J.

(1997)

1. Welcome to the deemed dividend. We are still dealing with the “zone” involving transactions in shares and share capital.

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2. This chapter introduces the notion of “tax paid-up capital”, or “tax PUC” for short, and the deemed dividend (in s.84). You cannot understand the latter without first understanding the former – they go hand and hand.

3. Consider an example.

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4. Assume the business has been run well and the facts are:

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The client wants the $100k of cash out of the company. The client asks: “Can the company repurchase, or buy back, one share for $100k?” That is, each share is worth $100,000 ($1m/10 = $100,000). The corporate law answer is yes, the company can buy-back its shares.

The client says: “I would have a capital gain of $95k, right?” That is, cash proceeds of $100k less $5k ACB applicable to that share.[1]

What do we say? Seems right. Notice, the money is coming from the company.

5. Read s.84(3).

• The company is deemed to have paid a dividend equal to “an amount” by which:

• the amount paid to the client on the buy-back exceeds;

• “the paid-up capital in respect of the shares” acquired by the company (on the buy-back).

• This amount is deemed to be received by the client as a dividend.

6. Notice, not all of the amount paid is necessarily a dividend. The only amount that constitutes a dividend is the excess over the “paid-up capital” of the shares purchased by the company. Thus, “paid-up capital” that is effectively returned by the company cannot be a deemed dividend.

7. What then is “paid-up capital” (“PUC” for short)? Read the definition in s.89(1).

Notice the structure: paragraph (c) is PUC of shares of all classes;

paragraph (b) is PUC of shares of a class;

paragraph (a) is PUC of a share;

PUC attaches to shares of a class, not to any shareholder (or taxpayer). PUC is computed without regard to who owns the share. Compare adjusted cost base (ACB for short) in s.54 which refer to “a taxpayer”.

• Paragraphs (a) & (c) of the PUC definition are really non-definitions: paragraph (c) is the sum of all classes and paragraph (a) divides the class PUC by the number of shares in the class, to get the PUC per share.

• Paragraph (b) is the heart of the PUC definition. PUC in respect of a class of shares is (after 1977 ( (iii)):

• PUC “without reference to the Act”, except certain specific subsections, which can alter this number.

• The specific subsections include s.84.1 and s.85(2.1). These are adjustments to PUC that will be discussed in other chapters.

8. What is PUC determined “without reference to the Act”? There is no direct authority. It is commonly accepted to be the share capital of the class for corporate law purposes:

• Under the Business Corporations Act (British Columbia):

• it is the “par value” of the shares issued, if the shares have par value; and

• if the shares have no par value, it is the consideration received by the company on the original issuance of the shares.

• Under the federal Canada Business Corporations Act (CBCA), and in provinces that use the CBCA as a model, such as Ontario and Alberta, it is the “stated capital” account maintained for the class: namely

• the consideration received on the original issuance of the shares; or

• a lesser amount in “non-arm’s length” circumstances.

This is PUC of a class “without reference to the Act”. This is the opening PUC of a class for tax purposes. Call it “corporate share capital”.

9. Note: opening PUC is basically what the directors have recorded as the amount the corporation received on issuance of the shares (the actual amount, the par value, or possibly lower stated capital). Again, it attaches to the whole class of shares, and not to any particular shareholder. This PUC is the tax PUC – unless one of the specific sections noted adjusts this tax PUC further.

Can you think of a situation where the ACB of shares to a particular shareholder will differ from the tax PUC of the shares?

Consider the above example. There is total $50k corporate share capital of the issued class and assume there has been no further adjustment under the sections mentioned – thus the total tax PUC of the class is $50k, and tax PUC per share is $5k (PUC of the class divided by the 10 shares).

The client sells 1 common share to an employee for $100,000 cash.

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What is tax PUC? Has the sale affected the tax PUC of the class of common shares? Go back to the PUC definition in s.89(1), paragraph (b).

The starting point for tax PUC is corporate share capital. That amount has not changed. The company received only $50k on original issuance of the shares. What the employee paid to the client is irrelevant in determining tax PUC, because the amount was not paid to the company. The company is not involved in this transaction.

The total tax PUC of the class is still $50k, with each share having a tax PUC of $5k.

10. Now go back, for a moment, to the repurchase example at the outset. Read s.84(3):

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By reason of s.84(3), the $95k is deemed to be a dividend (remember, cows and chickens). Amount paid in excess of the tax PUC of the share.

11. Is there also a capital gain of $95k? It should be (proceeds less ACB, right?). Read s.40(1)(a): “proceeds of disposition” (PD), and the definition of that term in s.54.

PD does not include (paragraph (j)) any amount that would otherwise be proceeds to the extent deemed by s.84(3) to be a dividend. Thus, there are two separate calculations required any time the company is involved in a transaction with one of its own shares.

|(i) |Deemed dividend calculation |(ii) |Capital gain calculation |

| | | | |

|amount paid |$100k |PD |$5k ($100k less $95k dividend) |

|tax PUC of share |$5k |ACB |$5k |

|s.84(3) deemed dividend |$95k |capital gain |0 |

In any disposition involving the company as purchaser, you must do both calculations: the amount of the dividend, and the amount of any capital gain. Do the dividend calculation first, because the dividend is excluded from PD in the gain calculation.

12. This can give rise to surprising results. Go back to the employee example. Say it’s one year later.

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No material change. Now the employee wants out. The company purchases the employee’s 1 share for $100,000? What is the result?

|(i) |Deemed dividend calculation |(ii) |Capital gain calculation |

| | | | |

|AP |$100k |PD |$5k ($100k less $95k dividend) |

|tax PUC of share |$5k |ACB |$100k |

|s.84(3) dividend |$95k |capital loss |$95k |

The tax rate on the dividend is 33.71% (assuming it is not an eligible dividend) and no offset for a $95k capital loss. A capital loss can only be used against capital gains (Tax I). What is your advice to the employee?

13. Imagine other situations. What if the ACB is lower than tax PUC? Could you have a capital gain and a deemed dividend? Assume a new client (A) invests $50k in original share capital for 10 shares. The company loses money, such that the value of the shares drops to $20k. The client then sells the 10 shares to client (B) for $20k. Client (B) turns the company around. Say the company then sells its assets, and nets $100k cash after tax at the company level.

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Remember, tax PUC of the 10 shares was unaffected by the sale to client (B) because the company was not involved in that transaction. Say 9 shares are now bought back by the company, for $90k cash. What is the result?

|(i) |Deemed dividend calculation |(ii) |Capital gain calculation |

| | | | |

|AP |$90k |PD |$45k ($90k less $45k) |

|tax PUC of 9 shares |$45k |ACB of 9 shares |$18k |

|s.84(3) dividend |$45k |capital gain |$27k |

Get the idea? The economic gain to the client on the 9 shares is $72k (value of $90k less cost of $18k). Of this $72k amount, $45k is a deemed dividend and the rest, $27k, is a capital gain. The tax result is driven by the tax PUC of the shares bought back.[2]

14. The rules in s.84(2) and s.84(4) are variations on this tax PUC theme.

• s.84(2): the amount is paid on a winding-up of the whole company (we come back to this);

• s.84(4): the amount is paid on a simple corporate “reduction of share capital”, without any shares being bought back.

Read how the dividend calculation works.

What about the effect on the ACB of the shares to the shareholder? On s.84(2) the share is disposed of, thus you have the same capital gain calculation as in s.84(3).

What about s.84(4)? The share capital has simply been reduced (cash is paid out as reduction of capital), but the client still has all the shares. They are not “disposed of”. Read s.53(2)(a)(ii): the amount paid on a reduction of capital reduces the ACB of the share to the shareholder unless the amount is deemed to be a dividend. If the ACB goes “negative”, a capital gain is realized by the shareholder under s.40(3).

Consider this example. A client bought the company when its value was $50,000. The tax PUC was $20k.

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Later the company pays $15k on a simple “reduction of its corporate share capital” - without any buy-back of shares. The 10 shares remain issued.

What is the result?

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15. Discuss the rule in s.84(4.1) for public companies.

16. What about s.84(1)? Much the same. The corporate law procedure: the company simply adds an amount to its corporate share capital, without making any payment or receiving any cash or property. One example is where retained earnings are “capitalized” by being added to the issued share capital account. Here the company has set itself up to make a capital reduction, having created tax PUC “room”.

s.84(1) causes a deemed dividend at the time of the addition to the corporate share capital. It is as if a dividend is first paid and then reinvested in share capital. What about the effect on the ACB of the shares? See s.53(1)(b) – there is an increase to the ACB of the shares to the holder for the deemed dividend amount.

Notice the important exceptions in s.84(1): no dividend on the:

• increase on the issuance of a share, such that value of assets also increase (paragraph (b)) – common sense result.

• increase to one class of shares, offset by a corresponding decrease to another class of shares (paragraph (c)) – common sense result.

• conversion of “contributed surplus” (at the time share was issued) into to share capital (paragraph (c.3)(i) and (ii)). Consider a $1 “par value” share issued for $10. What is the excess of issue price over PUV? Contributed surplus.

17. Now, consider the “stock dividend” exclusion in s.84(1). Read the definition of stock dividend in s.248(1).

• means a dividend declared in stock;

• s.82 includes in income the “amount of a dividend”;

• s.248 defines “amount” of a “stock dividend” as the amount of the increase to the tax PUC on the dividend;

• as the dividend is already taxed as an ordinary dividend, it is excluded from the deemed dividend rules in s.84(1). While there has been an increase in tax PUC as described in that section it is taxed as a dividend under section 82. No need for 84(1).

18. Have you been wondering about “benefits” and s.15(1) in this discussion? Notice the exclusions in s.15: share buy-backs, reduction of capital, winding-up, stock dividend, contributed surplus and “rights offering” (the latter meaning all shareholders treated equally). Apart from the last, all these are dealt with in s.84 and the stock dividend rule. As they are already dealt with in other parts of the Act, they are excluded from s.15 to avoid double taxation.

19. Two public company rules.

• Start with s.84(6)(b). There is an exception to the deemed dividend rule. If Pubco buys-back its shares in the “open market”, there is no deemed dividend despite s.84(3). The tax policy? The shareholder may not know it is Pubco buying the shares.

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The shareholder (public) has a capital gain, not a dividend.

• But, watch for Part II.1 tax (s.183.1). The thought: “A capital gain is better than an ordinary dividend” (22% versus 30%, or non-resident shareholders). So, Pubco buys back its shares in the open market so as to distribute what would otherwise be ordinary dividends of Pubco. Problem: the tax on the company is 45% of the buy-back price s.183.1(2).

This rule does not apply if “none of the purposes” was to distribute funds to shareholders as proceeds of disposition rather than an ordinary taxable dividend s.183.1(6). Question: “Is this a scheme to distribute what would otherwise be an annual dividend paid by the public company?”

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[1] Recall from Tax I the ACB averaging rule in s.47 – here there are 10 shares with a total ACB of $50k, or $5k per share. ACB is “adjusted cost base”, defined in s.54 as “cost” adjusted in accordance with s.53.

[2] This result may be denied under the general anti-avoidance rule in subsection 245(2) of the Income Tax Act: see Copthorne Holdings Ltd. v. The Queen, 2011 SCC 63, Dec. 16, 2011.

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SH

Co

Company

Business

Client

Company

$100k

Cash

Client

$900k

Active Business Assets

FMV $1.0 m

ACB is $50k

$50k

Corporate share capital

10 shares

(“m” is for million and “k” is for thousand.)

Company

$100,000

Cash

Client

$900,000

Active Business Assets

FMV $100k

ACB $100k

tax PUC ?

9 shares

Employee

1 share

FMV $900k

ACB $45k

tax PUC ?

Company

$100k

Cash

Client

$900k

Active Business Assets

Repurchase 1 share

One Share Bought Back

Amount paid $100k

ACB of share $ 5k

Tax PUC of share $ 5k

10 shares

Company

$100,000

Investment

Assets

Client

$900,000

Active Business Assets

FMV $100k

ACB $100k

tax PUC $5k

9 shares

Employee

1 share

FMV $900k

ACB $45k

tax PUC $45k

Company

$100,000 Cash

Client B

FMV $100k

ACB $20k

tax PUC $50k

Per share 9 shares

FMV $10k FMV $90k

ACB $2k ACB $18k

Tax PUC $5k tax PUC $45k

10 shares

Company

Client

FMV $100k

ACB $50k

tax PUC $20k

10 shares

Company

Client

FMV $85k ($100k less $15k)

ACB $35k (ACB reduced by $15k)

tax PUC $5k ($20k less $15k)

10 shares

(

Shareholder

- Public

Pubco

Listed on

TSE – for

trading

Pubco engages

broker to buy its

stock in the “open market”.

Client

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