Ak/Adms 4562 - Corporate Tax Lecture 6 Notes
4562-6: 1
AK/ADMS 4562 - CORPORATE TAX LECTURE 6 NOTES
Last updated on December 15, 2011
This Lecture’s Topics and Problem Set
This Lecture’s Topics and Recommended Problems
1. Taxation of Corporation Distributions (Deemed Dividend Rules)
1. Paid-up Capital
2. Capital Dividend Account
3. Summary of Different types of Corporate Distributions and their Tax Treatment (Stock dividends, Dividends in Kind, Deemed dividends)
Readings
FIT Ch. 15, but SKIP Capital Dividend Account detail in 15180
ITA 82, 83, 84, 89(1) 184(3)
Review Questions 2, 4-6, Multiple Choice Questions 1,2 & 5, Exercises 1 to 5
2. Winding up a corporation after assets are sold and 3. Sale of Un-Incorporated Business / Sale of Assets
Readings
FIT Ch. 15, (Example Problem 15240 and Example Problem 15320, but SKIP Parts (B) to (D) of the Example Problem in 15320)
SKIP 15400 on GST
Review Questions 7, 9, Multiple Choice Questions 3, 4 & 6, Exercises 6 to 8
Problem Set: (in separate document)
1 TAXATION OF CORPORATION DISTRIBUTIONS (DEEMED DIVIDEND RULES)
1.1 PAID-UP CAPITAL
WHAT IS THE PAID-UP CAPITAL (PUC) OF A SHARE?
THE PUC OF A CLASS OF SHARES = LEGAL STATED CAPITAL (LSC) OF THAT CLASS SUBJECT TO ADJUSTMENTS found in the Act.
99% OF THE TIME THERE ARE NO ADJUSTMENTS.
WHAT IS THE LSC OF A CLASS OF SHARES?
UNDER the Ontario Business Corporations Act (OBCA) AND the Canada Business Corporations Act (CBCA), THE LSC OF SHARES ISSUED IS GENERALLY
= FMV OF THE NET ASSETS TRANSFERRED IN AS CONSIDERATION FOR THE SHARES ISSUED [1](see Note at bottom of page*)
IN MOST CASES, CASH IS PAID FOR THE ISSUED SHARES, SO THE LSC AND PUC IS THE ORIGINAL ISSUE PRICE.
The legal stated capital (LSC) is typically found on the company’s balance sheet (i.e., share capital)
UNDER THE ACT [S. 89(1)] PUC OF A SHARE = AVERAGE PUC OF THE CLASS
THIS MEANS THAT IF SHARES ARE ISSUED AT DIFFERENT TIMES, THE PUC OF THE SHARES ARE AVERAGED
EXAMPLE:
X LTD. ISSUES 100 SHARES FOR $1 EACH IN 1990 TO MR. A and 100 shares for $2 each in 2005 TO MR. B.
WHAT IS THE PUC OF EACH SHARE OF X LTD. today?
$1.50
100 x $1 = $100
100 x $2= $200
200 $300
$300/200 shares = $1.50 per share
WHAT IS THE ACB OF EACH SHARE OF X LTD. OWNED BY MR. A and by MR. B?
$1 for Mr. A
$2 for Mr. B
WHY DO WE CARE ABOUT PUC?
1. IF INCREASE IN PUC > INCREASE IN FMV OF NET ASSETS TRANSFERED IN, THE SHAREHOLDER RECEIVES A DEEMED DIVIDEND: s. 84(1)
2. IN THE CASE OF A PRIVATE CORPORATION, A PAYMENT IN RESPECT OF A REDUCTION OF PUC IS RECEIVED TAX-FREE: s. 84(4)
3. PUC IS RECEIVED AS PROCEEDS ON A REDEMPTION OF SHARES: s. 84(3) OR A WINDING-UP OF A COMPANY: s. 84(2)
- we will now look at these three reasons in more depth
1.11 Deemed Dividends S. 84(1)
IF INCREASE IN PUC INCREASE IN FMV OF NET ASSETS TRANSFERED IN,THE SHAREHOLDER RECEIVES A DEEMED DIVIDEND: S. 84(1)
If a person contributes cash or assets worth $7 to a company in return for shares with a LSC and a PUC of $8, they are getting back too much PUC and will be deemed to have received a dividend for tax purposes of $1 and the corporation will be deemed to have paid a dividend of $1
- a subsection 84(1) deemed dividend from a taxable Canadian corporation received by an individual is grossed up and included in income (eligible for dividend tax credit); if received by a corporation, a section 112 deduction is available
- the ACB of the shares received is increased by the s. 84(1) deemed dividend: s. 53(1)(b)).
Note: that deemed dividends triggered under different subsections such as 84(2); 84(3); and 84(4); (discussed later in these notes) are not added to the ACB of the shares
Example #1
Mary, the sole-shareholder, transfers land (FMV $100,000) and a mortgage ($20,000) to her company and consideration of 100 shares with a LSC and PUC of $100,000 is received. (Assume the PUC of all previously issued shares is also $1,000 per share.)
What is the increase in the net assets of the corporation?
$80,000 ($100,000 - $20,000)
Is there a deemed dividend? How much?
Yes, there is a $20,000 deemed dividend under s. 84(1) because the increase in net assets is < increase in PUC.
What are the PUC and the ACB of the shares received?
The PUC of the shares received is $100,000. The ACB of the shares received is also $100,000 [$80,000 plus $20,000 s. 84(1), 53(1)(b)]
1.12 PUC Reduction S. 84(4)
IN THE CASE OF A PRIVATE CORPORATION, A PAYMENT IN RESPECT OF A REDUCTION OF PUC IS TAX-FREE: s. 84(4)
A REDUCTION IN PUC BY A PRIVATE CORPORATION RESIDENT IN CANADA:
1. IS DISTRIBUTED TAX-FREE
2. REDUCES THE ACB OF THE SHARES: s. 53(2)(a)(ii))
3. ANY PAYMENT IN EXCESS OF PUC IS a deemed dividend: s. 84(4))
IN THE CASE OF A PUBLIC CORPORATION, generally speaking, the ENTIRE PAYMENT IS A DIVIDEND (i.e., taxable): s. 84(4.1)
Example# 1
Cap Limited, a CCPC, has shares with a FMV of $435,000 and a PUC of $5,500. Cap Limited is considering making a non-dividend payment (as part of a PUC reduction) of $8,750 to its sole shareholder whose shares have an ACB of $17,500. Which of the following statements is correct?
(a) The payment of $8,750 will result in $8,750 of income for the shareholder under s. 15(1).
(b) The payment of $8,750 will result in no tax consequences to the shareholder and the company since it is a non-dividend payment.
(c) The payment of $8,750 will result in an immediate deemed dividend of $3,250. The ACB of the shares will be unaffected.
(d) The payment of $8,750 will result in an immediate deemed dividend of $3,250. The ACB of the shares will be reduced to $12,000.*
Example #2
You own half of the shares of a private company. The PUC of all the shares is $2,000. The ACB of your shares is $5,000 (you bought them last year from someone else). The corporation has decided to reduce the paid up capital of the corporation and pay out $2,800 to the shareholders.
What amounts do you receive tax-free?
$1,000 (half the PUC since you own half the shares)
What amount do you receive as a dividend?
$400 ($2,800 minus $2,000 (i.e., the PUC) = $800 and you own half the shares)
What is the new ACB of your shares?
$4,000 ($5,000 ACB – half of $2,000 tax-free distribution since you own half the shares)
1.13 Redemption of Shares S. 84(2) and S. 84(3)
PUC IS RECEIVED AS PROCEEDS ON A REDEMPTION OF SHARES BY A PRIVATE CORP. (S. 84(3)) OR A WINDING-UP OF A COMPANY: S. 84(2)
PUC is returned tax-free, any excess is a deemed dividend. Also, there is a disposition (of shares) which may trigger a capital gain or a capital loss to the shareholder
1. ON A REDEMPTION OF SHARES BY A PRIVATE CORP. (I.E., WHEN SHARES ARE REPURCHASED BY A PRIVATE CORP.)
2. ON A WINDING-UP OF A COMPANY
PROCEEDS OF DISPOSITION MINUS ACB = CAPITAL GAIN OR LOSS
NOTES:
1. If a public company redeems its shares (via an open market purchase), the above rules do not apply [s. 84(6)]. This course will only focus on redemption of shares by private corporations.
2. If a private company redeems its shares, the PUC is typically returned as proceeds of disposition and any remaining amount is a dividend [i.e., there is a 2 step procedure: 1) deemed dividend and 2) capital gain/capital loss].
Example #1
X Ltd. (a CCPC), redeems all of its 2,000 redeemable preference shares for $120 per share. The PUC of each share is $100. How would the owner of 1 share (ACB = $122) be affected by the redemption?
(a) The owner would have a $1 allowable capital loss.
(b) The owner would have a $2 allowable capital loss.
(c) The owner would have a $20 capital dividend.
(d) The owner would have a $20 taxable dividend and a $11 allowable capital loss.*
Example #2
You own half of the shares of a private company. The PUC of all the shares is $2,000. The ACB of your shares is $5,000 (you bought them last year from someone else). The corporation decides to redeem your shares for $6,000.
What are the tax consequences?
Redemption amount (RA) – PUC = Deemed Dividend
$6,000 - $1,000 (since own half the shares) = $5,000 Deemed Dividend
RA – Deemed dividend = Adjusted proceeds of disposition
$6,000 - $5,000 = $1,000
Adjusted proceeds of disposition – ACB = CG (CL)
$1,000 - $5,000 = ($4,000 CL)
1.14 Contributed Surplus
CONTRIBUTED SURPLUS RESULTS WHEN THE INCREASE IN THE FMV OF NET ASSETS transferred into the corporation in return for shares of the corporation > THE INCREASE in legal stated capital (LSC)
CONTRIBUTED SURPLUS CAN BE CONVERTED TO PUC UNDER S. 84(1)(c.3).
PLANNING: DO CONVERSION TO AVOID DEEMED DIVIDEND
Example #1
The sole shareholder of X Corp. transferred assets worth $38,400 to the corporation in return for cash of $15,400 and preference shares with a legal stated capital of $21,000 (redemption and retraction value of $23,000). Which of the following statements is correct?
(a) The shareholder will realize a $2,000 capital gain.
(b) The shareholder will realize a deemed dividend of $2,000.
(c) There will be a $2,000 increase in contributed surplus which can be converted to PUC pursuant to par. 84(1)(c. 3) of the Act.*
(d) The shareholder will realize a deemed dividend of $23,000.
Example #2
Net assets worth $80,000 are transferred to a corporation in consideration for shares with a LSC of $75,000. These are the only shares issued by the corporation in that class.
What are the tax consequences if the shares are redeemed immediately for $80,000?
RA – PUC = Deemed Dividend
= $80,000 - $75,000 = $5,000 Deemed Dividend
RA – Deemed dividend = Adjusted proceeds of disposition – ACB = CG or CL
$80,000 - $5,000 = 75,000 - $80,000 = $5,000 CL or $2,500 allowable capital loss
How can a conversion under s. 84(1)(c.3) help matters?
It would increase the PUC by $5,000 which would reduce the deemed dividend and capital loss to zero.
1.2 CAPITAL DIVIDEND ACCOUNT S. 89(1)
WHAT IS IT?
AN ACCOUNT FOR PRIVATE CORPORATIONS =
1. Non-taxable portion of capital gains minus non-allowable portion of capital losses*;
2. Tax-free portion of eligible capital property (ECP) gains**;
3. Capital dividends received; and
4. Life insurance proceeds received minus ACB*** of policy
minus
Capital dividends paid
* Recall: that with charitable donations of marketable securities to a registered charity (or other qualifying institution) the taxable portion of the capital gain is now 0%, and in these cases 100% of the capital gain is added to the capital dividend account
** The tax-free portion of ECP gains only adds to the capital dividend account at year-end. Hence, capital dividends based on such ECP gains should only be paid after year-end
*** The ACB is typically nil (i.e., $0) for (simple) term life insurance
WHY DOES IT EXIST?
INTEGRATION - IT ALLOWS TAX-FREE AMOUNTS TO FLOW OUT TAX-FREE TO SHAREHOLDERS
WHY IS IT IMPORTANT?
DIVIDENDS ELECTED TO BE PAID FROM THE CAPITAL DIVIDEND ACCOUNT ARE TAX-FREE TO CANADIAN RESIDENTS: s. 83(2)
ADMINISTRATIVE DETAILS
YOU MUST ELECT TO PAY A CAPITAL DIVIDEND BEFORE YOU PAY IT
(SPECIAL FORMS MUST BE FILED BEFORE IT IS PAID)
EXCESS CAPITAL DIVIDEND IS SUBJECT TO A PART III PENALTY TAX OF 60%
S. 184(3) ALLOWS A CORP. TO AVOID the 60% PENALTY IF IT ELECTS TO TREAT THE DIVIDEND AS A TAXABLE DIVIDEND WITHIN 90 DAYS OF DATE OF MAILING OF NOTICE OF ASSESSMENT RE THE 60% PENALTY TAX - SHOULD ALWAYS ELECT (if an excess capital dividend is paid)
EXAMPLES OF USES OF S. 184(3) ELECTION ON EXCESS CAPITAL DIVIDENDS
1. IF capital gain (CG) ON SALE OF REAL ESTATE IS REASSESSED AS INCOME AND NON-TAXABLE PORTION OF THE GAIN HAS ALREADY BEEN PAID OUT AS A CAPITAL DIVIDEND (AND TAXPAYER IS NOT DISPUTING THE REASSESSMENT)
2. IF PART OF THE DIVIDEND ON A SHARE REDEMPTION IS A CAPITAL DIVIDEND AND PART IS NOT and a capital dividend in excess of the capital dividend account balance has been paid.
PLANNING:
1. PAY OUT a CAPITAL DIVIDEND prior to selling capital assets at a loss
- SINCE 1/2 OF THE capital loss (CL) WILL typically REDUCE THE CAPITAL DIVIDEND ACCOUNT
2. DELAY PAYMENT OF CAPITAL DIVIDEND IF UNCERTAIN WHETHER GAIN IS CAPITAL OR INCOME
- WAIT TO SEE IF REASSESSED
1.3 SUMMARY OF DIFFERENT TYPES OF DIVIDENDS
Dividends can be paid (in cash, stock or property) or deemed to be paid (by s. 84). Dividends can be taxable or capital (tax-free). Some taxable dividends may be eligible dividends (entitled to an enhanced (1.41) gross-up in the hands of individuals). Here are some definitions:
Stock dividends
Stock dividends are dividends paid in the company’s stock. The “amount: of a stock dividend that is included in the recipient’s income is the increase in the PUC: s. 248(1), “stock dividend” and “amount”. The cost (i.e., ACB) of the share received is the amount of the dividend
Dividends in Kind
A dividend paid in kind is a dividend paid with corporate property (i.e., assets) other than cash. The corporation would have a disposition at FMV and would pay tax on any taxable capital gains and/or recapture (losses are denied if the property is distributed to a controlling shareholder or other affiliated person (discussed in a future lecture))