Introduction: What is Share Redemption? What is Share Retraction?
Corporate structures in Canada often involve various strategies for managing share ownership, capital returns, and shareholder interests. Two important concepts in corporate law and taxation that frequently arise are share redemption and share retraction.
Share redemption occurs when a corporation repurchases its own shares from shareholders, generally but not always cancelling them. This process is typically initiated by the corporation and is often stipulated in the terms of the share issuance but may be negotiated between the Corporation and the shareholder.
From a legal perspective, share redemption is governed by the corporate statutes applicable in the jurisdiction (e.g., the Canada Business Corporations Act, the Ontario Business Corporations Act, or other provincial equivalents). A company must comply with certain procedural requirements, including authorization in the articles of incorporation or a special resolution by shareholders, to redeem shares.
Retraction of shares is a specific type of share return to the Corporation where the shareholder has the right or option to require the corporation to buy back their shares. Unlike a voluntary share redemption initiated by the corporation, a retraction typically occurs at the shareholder's request under terms set out in the company's articles of incorporation or a shareholders' agreement.
This is common in private companies where shareholders want a clear exit mechanism or may be part of a corporate share reorganization. The shareholder exercises this right, and the company is obligated to buy back the shares on pre-agreed terms.
| Share Redemption | Share Retraction | |
|---|---|---|
| Initiated by | The corporation (board/directors) | The shareholder |
| Typical context | Often voluntary, corporate decision | Contractual right of shareholder |
| Purpose | Capital management, restructuring, liquidity | Exit strategy for shareholder, or required as part of a share reorganization |
| Control | Company controls timing and terms | Shareholder controls timing |
| Common in | Public and private companies | Mostly private companies |
Terminology: Adjusted Cost Base (ACB) and Paid-Up Capital (PUC)
The adjusted cost base (ACB) of company shares refers to the original purchase price of the shares, adjusted for certain factors such as additional purchases, stock splits, reinvested dividends, or return of capital distributions, which is used to calculate capital gains or losses when the shares are eventually sold or disposed of.
In other words, the ACB is the shareholder's "cost" in the shares for tax purposes. When a shareholder sells or retracts shares, the difference between the proceeds the shareholder receives and the ACB of the shares disposed of determines the capital gain or capital loss, which in turn affects your taxable income. Adjusting the cost base ensures that the calculation accurately reflects your actual investment over time.
Paid-up capital (PUC) of shares is the amount of money or property that a shareholder, or the person from whom the shareholder has acquired the shares, has actually paid to a corporation in exchange for the shares owned. It represents the corporation's equity capital received from a shareholder for the issuance of shares and is recorded on the corporation's balance sheet as part of the shareholder's equity.
In practical terms, PUC reflects the capital investment made by shareholders, excluding any additional amounts that might arise from later changes in share value or market price. It's an important figure for tax purposes because it helps determine the tax treatment of share redemptions or other transactions involving shares. For example, when shares are redeemed, the PUC is compared to the redemption proceeds to decide whether the excess is treated as a return of capital (non-taxable) or a taxable dividend.
If you would like to learn more about the terminologies related to a corporation's shares, please refer to our previous article on this topic: How Are Corporate Dividends Taxed and What are the Types of Tax?
Tax Treatment of Share Redemption and Share Retraction
When a shareholder's shares are redeemed by a corporation, or when a shareholder exercises the right to retract shares of a corporation, the shareholder is deemed to have disposed of the shares at the amount received on redemption or retraction.
For tax purposes in Canada, the redemption or retraction of shares is considered a disposition for the shareholders, which may result in a capital gain or loss. The capital gain is calculated as the difference between the redemption or retraction proceeds and the adjusted cost base (ACB) of the shares. Capital gains are included in income at a 50% inclusion rate.
However, if the redemption or retraction proceeds exceed the paid-up capital (PUC) of the shares, the excess amount is treated as a deemed dividend. This deemed dividend is subject to dividend taxation rules. For individual shareholders, deemed dividends are grossed-up and eligible for the dividend tax credit.
For example, a corporation redeems its Class A Preferred Shares at $100 per share. A shareholder with 10 Class A Preferred Shares thereby receives $1,000. The shares had a Paid-Up Capital (PUC) of $75 per share as this was the amount paid for by the shareholder to acquire the shares, totalling $750. The Adjusted Cost Base of shares generally equals to or exceeds the PUC of the shares unless the shares were purchased from another shareholder who originally subscribe to them and the fair market value of the shares had gone down.
- If the ACB for these shares is $75 per share, totalling $750, then the shareholder receives a deemed dividend of $250, and no capital gain or loss.
- If the ACB for these shares is $90 per share, totalling $900, then the shareholder receives a deemed dividend of $250, and a capital loss of $1000 – $250 – $900 = ($150).
If the Paid-Up Capital (PUC) is less than the redemption price, then the shareholder receives no dividends.
Pro Tax Tips – Share Retractions and Redemption Can Be Useful Tax Planning Tools
Share retractions and redemptions can serve as effective tax planning tools for private corporations and their shareholders. A share redemption occurs when a corporation repurchases its own shares, typically pursuant to its articles of incorporation. A share retraction, on the other hand, is initiated by the shareholder under rights granted in the share terms, requiring the corporation to repurchase the shares. In both cases, these transactions can allow for the extraction of corporate funds in a structured way.
When planned properly, they may enable taxpayers to receive proceeds taxed as dividends or capital gains, depending on the adjusted cost base (ACB), paid-up capital (PUC), and redemption price involved. Dividends may be eligible or non-eligible depending on the type of corporation and may benefit from preferential tax rates, while capital gains may be offset by available capital losses.
From a tax planning perspective, share retractions and redemptions offer flexibility in managing a shareholder's income. However, the Income Tax Act has specific anti-avoidance rules, such as subsection 84(3) for redemptions, that can recharacterize what might otherwise appear to be capital gains into dividends. Therefore, careful planning and professional advice are essential to maximize tax efficiency and avoid unintended tax consequences.
If you believe that you need assistance with tax planning advice or if you need advice on the tax treatment of a recent share redemption/retraction, you should engage with one of our expert Canadian tax lawyers. Our expert Canadian tax lawyers can identify potential options to minimize your tax liability and provide tax advice specific to your case.
FAQ
What is Share Redemption?
A share redemption is a corporate transaction in which a company repurchases its own shares from a shareholder, typically under terms set out in the corporation's articles or a shareholder agreement. The redemption is usually initiated by the corporation and involves preferred or special classes of shares that are redeemable at a predetermined price.
Once redeemed, the shares are cancelled and no longer outstanding. Share redemptions are commonly used in tax planning strategies, such as when a company repurchases shares from a retiring owner and then cancels the shares. The corporation can also require shares from a shareholder and then transfer to a third party without cancellation.
From a tax perspective, the redemption of shares has important consequences. Under subsection 84(3) of the Income Tax Act, the portion of the redemption proceeds that exceeds the paid-up capital (PUC) of the shares is treated as a deemed dividend to the shareholder. The portion up to the PUC is considered a return of capital and is generally not taxable unless it exceeds the shareholder's adjusted cost base (ACB), in which case it may trigger a capital gain. Because of these rules, the tax treatment of a redemption depends on the relationship between the PUC, ACB, and redemption price.
What is Share Retraction?
A share retraction is a transaction where a shareholder exercises their right to compel a corporation to repurchase their shares, typically under the terms set out in the corporation's articles or the share class provisions. This right is often attached to preferred shares and allows the shareholder, rather than the corporation, to initiate the repurchase. When a retraction occurs, the shareholder receives a retraction price—usually predetermined or based on a formula—and the shares are then cancelled.
For tax purposes, a share retraction is treated similarly to a share redemption. Under subsection 84(3) of the Income Tax Act, the amount received by the shareholder in excess of the paid-up capital (PUC) of the shares is treated as a deemed dividend. The portion equal to the PUC is considered a return of capital.
If the amount returned exceeds the shareholder's adjusted cost base (ACB), it may result in a capital gain. Despite the difference in who initiates the transaction—shareholder in a retraction, corporation in a redemption—the tax treatment is generally the same, and both tools can be used strategically in tax planning.