Introduction – The What And Why of a Deemed Dividend
What is a deemed dividend? Even in the absence of an explicit distribution from a corporation to its shareholder, Canada's income-tax law forces the shareholder to recognize dividend income when certain transactions take place. These deemed-dividend rules are found in section 84 of Canada's Income Tax Act.
Yet a deemed dividend is still a dividend. In other words, a deemed dividend qualifies for the tax treatment that would otherwise apply to a conventional dividend. For example, a deemed dividend to an individual shareholder qualifies for the dividend tax credit. Similarly, just like it can with a conventional dividend, a corporation can designate the deemed dividend as a capital dividend if the corporation has a balance in its capital dividend account. Capital dividends are tax free for the recipient. Further, like conventional inter-corporate dividends, a deemed dividend from one corporation to another is fully deductible for the recipient under subsection 112(1) of the Income Tax Act.
Why does Canada's Income Tax Act contain deemed-dividend rules? Generally, these rules serve two purposes. First, Canada's tax law allows a shareholder to withdraw a capital contribution from the corporation on a tax-free basis. The deemed-dividend rules preserve the integrity of this system by ensuring that corporate distributions exceeding contributed capital are taxed as dividends. Second, Canada generally taxes capital gains at a lower rate than that applied to dividends. The deemed-dividend rules hinder some transactions under which taxpayers could convert otherwise taxable dividends into capital gains--an effort known as "surplus stripping."
After examining the concepts of stated capital, paid up capital, and adjusted cost base, this article discusses the deemed-dividend rules found in subsections 84(1), 84(2), 84(3), and 84(4) of the Income Tax Act.
Important Concepts: Stated Capital, Paid Up Capital, and Adjusted Cost Base
To understand the mechanics of the deemed-dividend rules, you need a handle on three important concepts: stated capital, paid up capital, and adjusted cost base.
A corporation's stated-capital account tracks the consideration that the corporation received in exchange for issuing its shares—in other words, the account tracks the amount paid by the shareholder to the corporation. The corporation will keep a separate stated-capital account for each class or series of shares. And proper accounting should allow you to discern the stated capital for each issued share.
The corporation's stated capital reveals the shareholders' skin in the game. The stated-capital account shows how much the shareholders have invested in the corporation. Because the stated capital represents the amount that shareholders commit to the corporation, it serves as a measure of shareholders' limited liability. That is, the stated-capital account shows exactly how much the shareholders have risked by investing in the corporation. As a result, it alerts potential future investors or lenders of risk when investing or lending to a corporation.
Generally, the stated-capital account tracks the fair market value of the consideration that the corporation received upon issuing a class or series of shares. But, in certain circumstances, corporate law allows the corporation to increase its stated capital by less than the full fair market value of the consideration received. The amount of the consideration that isn't added to the stated capital is called a "contributed surplus," and it can later be capitalized and added to the appropriate stated-capital account.
In addition, the stated-capital account for a class or series of shares must decrease if the corporation purchases, acquires, or redeems shares in that class or series.
Paid Up Capital (PUC)
Paid up capital (PUC) measures the contributed capital and capitalized surpluses that a corporation can return to its shareholders on a tax-free basis.
Paid up capital and stated capital are closely related concepts. The corporation's stated capital serves as the basis for computing the paid up capital of its shares. And, like stated capital, PUC is an attribute of each issued corporate share.
But PUC may deviate from stated capital. Stated capital is a corporate-law concept; paid up capital is a tax-law concept. So, while PUC derives from stated capital, the two may diverge. For example, say you bought a property for $50,000 a few years ago. Now, the property is worth $100,000, and you transfer that property to a corporation in exchange for a single share, thereby incurring a capital gain. Your share's stated capital and PUC will each be $100,000. In contrast, say you transferred the same property to the corporation under section 85 of the Income Tax Act, which allows you to effect the transfer at the property's cost and thus avoid incurring a taxable capital gain. In this case, your share's PUC will be $50,000, and its stated capital will be $100,000. (A section 85 rollover typically qualifies as a circumstance where corporate law allows a reduced stated capital. So, experienced Canadian tax planning lawyers will often adjust the stated capital to match the PUC. The default, however, is a mismatch.)
Adjusted Cost Base (ACB)
The adjusted cost base (ACB) is the shareholder's tax cost for purchasing the shares. The ACB, when deducted from the proceeds of disposition, determines the amount of a capital gain or capital loss when the shareholder disposes of the shares.
The ACB is an attribute of the shareholder; stated capital and PUC are attributes of the shares. So, the shareholder's ACB for a share need not accord with the share's stated capital or PUC. The stated capital and PUC only capture a shareholder's contribution to the corporation for a share; the ACB captures a shareholder's contribution to any vendor for a share.
To illustrate, we continue with the example above: you transfer that property worth $100,000 to a corporation in exchange for a single share. Your share's stated capital and PUC will each be $100,000. And your ACB will also be $100,000. You later sell your share to a buyer for $150,000. The corporation gets nothing out of this transaction. So, the share's stated capital and PUC each remain at $100,000. But the buyer paid $150,000 for the share. So, the buyer's ACB is $150,000.
Deemed Dividend Upon an Increase of PUC: Subsection 84(1)
Subsection 84(1) deems a corporation to have paid a dividend on a class of shares for which the corporation has increased PUC. In turn, paragraph 53(1)(b) increases the shareholder's share ACB by the amount of the deemed dividend. The ACB bump ensures that the shareholder isn't double taxed when selling the affected shares.
But subsection 84(1) doesn't apply and no deemed dividend will arise if the increase in PUC resulted from any of the following:
- the payment of a stock dividend (i.e., a corporation's capitalizing retained earnings);
- a transaction where the PUC increase matches either an increase in the corporation's net assets or a decrease in the corporation's net liabilities;
- a transaction where the PUC increase matches a PUC decrease for shares in another class; or
- conversion of contributed surplus into PUC (i.e., a corporation's capitalizing contributed surplus).
For example, a corporation issues shares with a PUC of $500 to a creditor in settlement of a $450 debt. (The corporation didn't decrease the PUC of any other share class.) As a result, the creditor receives a deemed dividend of $50 ($500 PUC minus $450 decrease in liability). And the creditor's ACB for the shares is $500 ($450 initial ACB plus $50 deemed dividend).
Deemed Dividend Upon Winding Up: Subsection 84(2)
When a corporation is wound up or liquidated, its assets are sold, liabilities paid, and the remaining cash is distributed to the shareholders thus canceling their shares. Under subsection 84(2), upon the corporation's liquidation or winding up, any property or cash distributed to a shareholder in excess of a share's PUC is deemed a dividend.
But when computing the capital gain for disposing the shares, the shareholder reduces the liquidation proceeds by the amount of the deemed dividend. This ensures that the shareholder's liquidation proceeds aren't double taxed as both deemed dividends and capital gains.
For example, after selling its assets and paying its liabilities, the liquidating corporation pays $800 to its shareholder in cancelation of shares with PUC of $200. The shareholder's ACB for the shares is also $200. As a result, the shareholder receives a deemed dividend of $600 ($800 distributed minus $200 PUC). And the shareholder's capital gain is nil ($800 distributed minus $600 deemed dividend minus $200 ACB).
The deemed-dividend rule in subsection 84(2) doesn't apply if: (1) subsection 84(1) applies to the same transaction; or (2) the corporation's share purchase for cancellation was an open-market transaction.
Deemed Dividend Upon Share Redemption: Subsection 84(3)
A share redemption occurs when a corporation purchases its shares from a shareholder and cancels those shares. Subsection 84(3) deems the shareholder to have received a dividend to the extent that the redemption proceeds exceeded the share's PUC.
But when computing the capital gain for disposing the shares, the shareholder offsets the redemption proceeds by the amount of the deemed dividend. This ensures that the shareholder's redemption proceeds aren't double taxed as both deemed dividends and capital gains
For example, a corporation redeemed its shares and paid the shareholder $200. The shares had a PUC of $75, and the shareholder's ACB for the shares was also $75. As a result, the shareholder received a deemed dividend of $125 ($200 redemption price minus $75 PUC). And the shareholder's capital gain is nil ($200 proceeds of disposition minus $125 deemed dividend minus $75 ACB).
The deemed-dividend rule in subsection 84(3) doesn't apply if: (1) subsection 84(1) applies to the transaction; (2) the corporation's share purchase for cancellation was an open-market transaction; or (3) the redeeming corporation was a public corporation.
Deemed Dividend Upon a Reduction of PUC: Subsections 84(4) and 84(4.1)
Subsection 84(4) applies where a Canadian resident corporation reduced its PUC for any class of shares. Generally, a corporation reduces its PUC when it pays a tax-free return of capital to its shareholders. Subsection 84(4) anticipates situations where the corporation pays an amount exceeding the appropriate corresponding decrease in PUC. Basically, the provision says that, to the extent that the payment exceeds the amount of the PUC reduction, it is deemed a dividend.
Moreover, subparagraph 53(2)(a)(ii) accounts for the tax-free return of capital by reducing the ACB of the shareholder's shares. The provision reduces the ACB in proportion to the PUC reduction of the shareholder's shares.
For example, a shareholder owns a share with an ACB of $10 and PUC of $10. The corporation pays the shareholder $8 as a return of capital but only reduces the share's PUC account by $7. As a result, the shareholder receives a deemed dividend of $1 ($8 distribution minus $7 PUC reduction). The shareholder's ACB for the share is reduced by $7. So, the shareholder owns a share with an ACB of $3 and PUC of $3.
So, subsection 84(4) permits a private corporation to distribute a tax-free return of capital so long as the distribution corresponds with the PUC reduction. But public corporations can only distribute a tax-free return of capital in limited circumstances.
Subsection 84(4.1) applies to public corporations. The general rule deems as a dividend any payment by a public corporation to its shareholders even if the payment doesn't exceed the reduction of PUC. In other words, public corporations generally can't pay a tax-free return of capital to their shareholders.
The public corporation may, however, pay a tax-free return of capital to its shareholders only if the amount came from proceeds that the corporation realized from a transaction "outside the ordinary course of the business of the corporation." This carve out allows a public corporation to, say, sell a business unit and distribute the proceeds to its shareholders as a return of capital.
Tax Tips - Deemed Dividends
The corporation's stated capital need not accord with PUC. This inconsistency is a common trap for those relying solely on the corporation's financial statements. Unaware that share capital exceeds PUC and issuing what appears to be a tax-free return of capital, inexperienced accountants and corporate lawyers often trigger deemed dividends for their clients. Consult one of our experienced Canadian tax lawyers to review pending transactions or for advice on reducing the risk of a deemed dividend. For instance, one simple strategy is to reduce the corporation's stated capital so that it matches the PUC.
If you have already triggered a deemed dividend but failed to report the income on your return, speak with our Canadian tax lawyers about your options. For instance, you may qualify for relief under the Voluntary Disclosures Program, a rectification order, or a late-filed capital-dividend election.