This paper will focus on the rules in the Income Tax Act (Canada)1 relating to taxable preferred shares2 ("TPS") and short-term preferred shares3 ("STPS") as they might apply in the private corporation context. There is detailed discussion of the particular exemptions relied upon for private corporation share structures and planning. Other categories of preferred shares – term preferred shares and guaranteed preferred shares – are not discussed herein as their related rules generally require a "specified financial institution".
Other writers have commented on these rules and references are provided for the interested reader.4 Particular inspiration for this paper has been taken from a paper that was presented at the 1997 Annual Conference of the Canadian Tax Foundation - "The Preferred Share Rules: Yes, They Can Apply to You!"5 - much of which still resonates today.
Purpose of the Rules
The taxable preferred share rules were introduced as part of the 1987 tax reform. The White Paper on Tax Reform was replete with references to preferred shares as a form of after-tax financing and the proposals, as announced, were intended to reduce this tax advantage. It is instructive to understand the policy rationale as this informs the consideration of whether these rules should apply to normal course private corporation arrangements. The following are illustrative extracts from the White Paper:6
The tax on preferred shares has been designed to reduce the advantages for non-taxpaying corporations associated with preferred share financings ...
The advantage derived from the use of preferred share as a form of after-tax financing arises because of the different tax treatment of dividends and interest. Where a corporation issues debt it may deduct the interest it pays and the recipient is subject to tax on this interest. Dividends on the other hand, are presumed to be paid out of earnings that have been subject to tax.
Where the issuing corporation is tax paying these two forms of financing have the same after-tax consequence and so the choice of one or the other has no impact on government revenues. However, a non-tax paying corporation can take advantage of the dividend relief by issuing preferred shares even though the income out of which the dividend has been paid has not borne tax and therefore reduce its after-tax cost of capital as compared with debt. The consequence of substituting a dividend-paying instrument for an interest-bearing one in such circumstances is that government revenue are reduced. The new tax is designed to ensure that tax has been paid with respect to dividends on preferred shares when relief is given at the shareholder level. As such it will affect dividends paid by non-taxpaying corporations and will have no impact on a taxpaying corporation issuing preferred shares.
The White Paper listed the following as situations where the tax would not apply:7
- the new tax will not be applied to dividends on common shares as common shareholders participate fully in the risks facing the corporation;
- an exemption of up to $500,000 of preferred share dividends for any group of corporations will allow small corporations and venture capital start-up companies to continue to use preferred shares as an integral part of financing arrangements;
- no tax will be payable on dividends to individual or corporate shareholders with a significant interest in the payer corporation to ensure a free flow of funds within commonly owned entities;
- the previous two provisions will allow preferred shares to be used in private financing arrangements and joint ventures where the shares may be necessary to recognize different ownership interests among shareholders;
- no tax will be payable by intermediary type companies, such as mutual funds and certain private holding companies which are structured to hold portfolio investments to allow continued use of such flow-through vehicles.
While acknowledging that the above were intended as general statements, the rules can apply to common shares and ownership arrangements in private structures that do not necessarily fit the legislated exemptions to permit funds to flow among commonly-owned entities. A private corporation may issue shares not to raise capital and not with a view to after-tax financing, yet such shares may fall within the TPS definition. The rules can become a trap and be costly in what are likely unintended situations.
It is interesting to note that the taxable preferred share rules and related definitions have not been subject to any significant amendments since enactment.8
Commentary on this topic often refers to corporations potentially subject to Part VI.1 tax as the issuer, e.g., the issuer of TPS. It is acknowledged that for securities law purposes, an issuer is simply a corporation that issues securities. Securities law applies to private corporations. However, the focus of this paper is the ordinary share structure and arrangements of a private corporation and not private corporations that are engaged in financing and issuing securities to raise capital. Accordingly, the writer has deliberately chosen not to use the term "issuer" (as that may have financing and securities connotations) but rather simply refers to the dividend payor corporation.
Pursuant to subsection 191.1(1), tax is imposed on the dividend payor corporation upon the payment of a taxable dividend on TPS or STPS (referred to herein as "Part VI.1 tax") unless certain exceptions apply. The tax is recoverable by way of deduction (as explained below) and is imposed as a percentage of the dividend. The percentage or rate differs for TPS dividends versus STPS dividends. Pursuant to subparagraph 191.1(1)(a)(iii), where a corporation pays a taxable dividend on TPS, tax is imposed at a rate of 25% of the amount of the dividend and pursuant to subparagraph 191.1(1)(a)(i). Where a corporation pays a taxable dividend on STPS, tax is imposed at a rate of 40% of the amount of the dividend.
Part VI.1 applies only to a taxable Canadian corporation. Corporations that are not resident in Canada or not incorporated in Canada are not subject to Part VI.1 tax.
There is a corresponding tax applicable to a corporate dividend recipient. A corporation that receives a taxable dividend on TPS9 may be subject to a tax at a rate of 10% of the amount of the dividend pursuant to section 187.2 (referred to herein as "Part IV.1 tax") unless it is an "excepted dividend".10 A dividend received by a private corporation is an "excepted dividend". As a result, given the private corporation focus of this paper, Part IV.1 tax should not be a concern.
A $500,000 threshold referred to as a "dividend allowance" is provided for in subsection 191.1(2). Only taxable dividends on TPS in excess of a corporation's dividend allowance for its particular taxation year are subject to Part VI.1 tax. In each taxation year, the corporation's dividend allowance must be reviewed because it may be "ground" by the amount of a prior year's dividend. Specifically, the amount of the dividend allowance is reduced dollar-for-dollar by dividends on TPS (which are not excluded dividends) in excess of $1 million paid in the calendar year immediately preceding the calendar year in which the corporation's taxation year ends. The dividend allowance must be allocated among associated corporations and is pro-rated for short taxation years.
In light of the dividend allowance (the amount of which has remained unchanged since enactment), Part VI.1 tax would most likely become of concern to a private corporation where sizable dividends are paid. For example, shares could be redeemed either post-mortem or in a reorganization resulting in a substantial dividend. A sizable dividend (which is not an excluded dividend) effectively has a two-year impact – in the year of payment, such dividend may itself exceed the dividend allowance for the particular taxation year and in the subsequent year, the prior year's dividend may grind the corporation's dividend allowance.
If a dividend paid on TPS constitutes an "excluded dividend" as defined,11 it is not subject to Part VI.1 tax and, as noted above, it is also not included in the computation of the dividend allowance grind.
In the private corporation context, the portion of the "excluded dividend" definition that is particularly relevant is paragraph (a) which states that a dividend paid by a corporation to a shareholder who had a substantial interest in the corporation at the time the dividend was paid is an excluded dividend. There is also a particular exclusion available to certain deemed dividends upon a share redemption. Both of these exclusions are discussed further below.
Recovery of Part VI.1 Tax
Where the dividend payor corporation is subject to Part VI.1 tax, the tax may effectively be recovered by means of a paragraph 110(1)(k) deduction in the computation of taxable income. The deduction is supposed to offset the Part VI.1 tax. At present, paragraph 110(1)(k) permits a deduction equal to 3.5 times the Part VI.1 tax. This ratio assumes that the taxpayer is subject to a combined federal–provincial corporate tax rate of 1/3.5 or 28.5%. Where the taxpayer is subject to a lower combined rate, paragraph 110(1)(k) does not operate as a full offset and Part VI.1 tax becomes a cost. In Ontario, the combined federal-provincial rate is 26.5%. Therefore an Ontario corporate taxpayer subject to tax at the combined rate of 26.5% which pays a dividend subject to Part VI.1 tax effectively bears a cost of approximately 1.8%. Clearly, the cost is greater for a Canadian-controlled private corporation claiming the small business deduction and subject to tax at the combined rate of 15%.
The TPS DefinitionCharacterization Triggers in Paragraph (b)
TPS characterization may result from the terms or conditions of the share or any agreement to which the dividend payor corporation or a "specified person" in relation to the corporation is a party. The term "specified person" is defined in paragraph (h) of the TPS definition as any non-arm's-length person. A partnership or trust of which the corporation is a partner or beneficiary, as the case may be, is also a specified person. Because a corporation is typically a party to a shareholders' agreement or unanimous shareholder agreement entered into by its shareholders, the terms of such an agreement could contain the characterization triggers.
Although it is sometimes thought that TPS characterization requires a fixed dividend right, this is an understatement. Subparagraph (b)(i) of the TPS definition refers to the "dividend entitlement". The mantra in the TPS definition to describe the characteristics of the amount are the words: fixed, limited to a maximum, or established to be not less than a minimum. With respect to the latter, i.e., established to be not less than a minimum, there must be a preference over any other class of shares. Clearly, shares that have a set percentage dividend rate or a rate of "up to" a specified percentage will meet the requirement of "fixed" or "limited to a maximum". Shares whose dividend tracks a particular asset or branch or subsidiary will likely meet this requirement, too.12 If the corporation establishes a dividend policy (which might be set out in a shareholders' agreement), the terms of this policy may be such that it may reasonably be considered that the amount of dividends paid on a particular class of shares is established to be not less than a minimum. These could be the common shares of the corporation. It seems implicit in the decision to document in a dividend policy that there is an intended preference over any other class of shares and, if so, such shares may have a dividend entitlement triggering TPS characterization.13
Subparagraph (b)(ii) of the TPS definition refers to the "liquidation entitlement" and describes the characteristics of the amount received using the same mantra of fixed, limited to a maximum, or established to be not less than a minimum. Clearly, fixed value preferred shares, such as the typical redeemable retractable preferred shares issued in connection with section 85, 86 or 51 transactions, will be caught. Such shares commonly have a dividend rate that is fixed as a percentage of the redemption amount and, in any event, are redeemable and retractable. In addition, upon liquidation or dissolution of the corporation, such shares typically are entitled to a return of an amount per share equal to the redemption amount. The foregoing attributes fit within the characterization triggers in both the subparagraph (b)(i) dividend entitlement and subparagraph (b)(ii) liquidation entitlement.
Notwithstanding the use of the term "liquidation entitlement", subparagraph (b)(ii) is not limited to the amount received upon liquidation, dissolution, or winding up of the corporation. It also applies to the amount received upon redemption, acquisition, or cancellation of the share or on a reduction of the paid-up capital of the share by the corporation or a specified person in relation to the corporation. This means that any shareholders' agreement which provides for a corporate repurchase of shares, or a purchase by a controlling shareholder, or other person non-arm's-length with the corporation may cause the shares in question to be characterized as TPS (even though these may be designated as common shares) provided that the price is fixed, limited to a maximum, or established to be not less than a minimum. In the case of a shareholders' agreement, the common procedures for the determination of price include: (1) a price that is supposed to be determined at the time the shareholders' agreement is entered into and updated periodically; (2) a price determined by a formula set out in the shareholders' agreement; or (3) a price determined at the relevant time by an independent third party such as the corporation's accountants or a certified business valuator. If the first two of the above procedures are used, the amount could be considered to be fixed, limited to a maximum, or established to be not less than a minimum.
Subparagraph (b)(ii) expressly excludes the situation where the requirement to redeem, acquire, or cancel arises only in the event of the death of the shareholder.14 The limited utility of this express exclusion is caused by the word "only", i.e., "only in the event of the death." A shareholders' agreement may provide for compulsory acquisition of shares by the corporation in other situations. For example, a compulsory acquisition event may be triggered by disability (permanent or possibly shorter term) of a shareholder (or the principal of a corporate shareholder); resignation, retirement or other termination of employment in the case of a shareholder who is also an employee; a shareholder declaring a bankruptcy or making a proposal in bankruptcy; the date that a spouse of a shareholder brings an application under applicable family law legislation that he/she is entitled to the shares; or a shareholder being in breach of certain covenants in the shareholders' agreement, such as a failure to capitalize as required. Other than death, it is never certain that any of the typical compulsory acquisition events in a shareholders' agreement outlined above will occur. Subparagraph (b)(ii) of the TPS definition asks not about the certainty of receipt of the amount but rather, whether it may reasonably be considered that the amount which the shareholder is entitled to receive is fixed, limited to a maximum, or established to be not less than a minimum. If a shareholders' agreement fixes a price in an amount or by formula for compulsory acquisition events, then notwithstanding that the occurrence of such events may be uncertain, the amount which the shareholder is entitled to receive in respect of the share on redemption, acquisition, or cancellation of the share is certain.
In some planning situations, it may be desirable to have multiple classes of common shares. To the extent that it is regarded as necessary for tax or other reasons to have a differentiating characteristic rather than identical terms, care must be exercised for TPS reasons. A differentiating characteristic such as a priority $1 return on dissolution may be a TPS characterization trigger pursuant to subparagraph (b)(ii) of the TPS definition.15
Subparagraph (b)(iv) of the TPS definition refers to a guarantee agreement and should be considered in the context of exit or buy-sell clauses of a shareholders' agreement. Subparagraph (b)(iv) applies if a person (other than the dividend payor corporation) is obligated, either absolutely or contingently and either immediately or in the future, to effect an undertaking including a covenant or agreement to purchase the share, which ensures that any loss that the shareholder may sustain by virtue of ownership of the share is limited or ensures that the shareholder will derive earnings by reason of the ownership of the share. There is limited marketability for shares of a private corporation if the shareholder has a minority interest. It could be argued that the buy-sell clauses of a shareholders' agreement operate to provide some degree of liquidity and if so, this could be considered protection against loss thereby triggering subparagraph (b)(iv).16
1 R.S.C. 1985, c. 1 (5th Supp.), as amended (herein referred to as "the Act"). Unless otherwise stated, statutory references in this paper are to the Act.
2 As defined in subsection 248(1) (such shares being referred to herein as "TPS" and the definition being herein referred to as the "TPS definition"). This paper assumes that shares are not "grandfathered shares" as defined in subsection 248(1).
3 As defined in subsection 248(1) (such shares being referred to herein as "STPS" and the definition being herein referred to as the "STPS definition").
4 See, for example, Donald M. Sugg, "Preferred Share Review: Anomalies and Traps for the Unwary," Report of Proceedings of Forty-Fourth Tax Conference, 1992 Conference Report (Toronto: Canadian Tax Foundation, 1993), 22:1-31; David Downie and Tony Martin, "The Preferred Share Rules: An Introduction," Report of Proceedings of Fifty-Fifth Tax Conference, 2003 Conference Report (Toronto: Canadian Tax Foundation, 2004), 52:1-28; Michelle Chang and David Christian, "Shares Attributes," in 2016 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2016), 4:1-17 at p.12/13 – p.16/17; Evelyn R. Schusheim, "Shareholders' Agreements," in 2012 Ontario Tax Conference (Toronto: Canadian Tax Foundation, 2012), 12:1-23 at p. 8/9/10- p.13; Nancy Diep, "Preferred Share Rules: The Expected, Unexpected and Unintended," in 2017 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2017), 13:1-29.
5 Evelyn P. Moskowitz, "The Preferred Share Rules: Yes, They Can Apply to You!," Report of Proceedings of Forty-Ninth Tax Conference, 1997 Conference Report (Toronto: Canadian Tax Foundation, 1998), 9:1-47.
6 White Paper on Tax Reform, June 18, 1987 (herein the "White Paper"), "Taxation of Preferred Shares, General Notes on Proposed Regime". See page 245 of the commercially published version of the White Paper by CCH Canadian Limited Special Report 9994.
7 White Paper. See page 246 of the commercially published version of the White Paper by CCH Canadian Limited Special Report 9994.
8 Largely enacted with the Phase One tax reform bill, Bill C-139, S.C. 1988, c.55.
9 The corporate recipient of a taxable dividend received on a STPS is generally not subject to Part IV.1 tax (see paragraph (d) of the definition of "excepted dividend" in subsection 187.1). The dividend payor corporation is subject to Part VI.1 tax on a STPS dividend at the rate of 40% of the amount of the dividend. Where a dividend payor corporation elects to pay the higher 40% rate on TPS dividends under Part VI.1 , then the corresponding Part IV.1 tax on the corporate dividend recipient is eliminated.
10 See paragraph 187.1(c).
11 See definition in subsection 191(1).
12 See CRA document no. 2012-0443471E5, March 15, 2013 where in CRA's view, shares entitled to 75% of the profit resulting from an adventure in the nature of trade were TPS because the amount of dividend was fixed by formula notwithstanding the existence of variables. This is discussed in Marc Richardson Arnould, "Interpretation of Fixed Dividend Entitlement Ends Questions on Taxable Preferred Share Status" (2013) 18:4 Corporate Finance (Federated Press)
13 But see CRA document no. 2003-0034073, 2003. This was a ruling where the board of directors of a public company established a dividend policy which was not documented in an agreement. The company had two classes of shares, Class A and Class B which participated equally in dividends provided that no dividend could be paid on the Class A shares until a dividend of [redacted] was paid on the Class B shares. The board of directors adopted a policy and proposed to pay dividends aggregating [redacted] on the Clas A shares and Class B shares annually. The dividend policy was ruled not to cause the Class B shares to be TPS.
14 For this purpose, this also includes a shareholder of a shareholder.
15 See CRA document no. 3-2558, September 28, 1989 and Larry Nevsky, "Corporate Law Considerations for the Tax Practitioner," in 2016 Ontario Tax Conference (Toronto: Canadian Tax Foundation, 2016), 3:1-30 at 15 p.11/12. See also Douglas S. Ewens, "The New Preferred Share Dividend Tax Regime," Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 21:1-18 at p.21:16/17.
16 Consideration should be given to Howe v. The Queen 2004 TCC719. This case involved a limited partner's at- risk amount pursuant to paragraph 96(2.2)(d). A covenant which provided liquidity in respect of limited partnership units was held to not have been given "for the purpose of reducing the impact, in whole or in part, of any loss that the taxpayer may sustain because the taxpayer is a member of the partnership" (as those words are used in paragraph 96(2.2)(d)). By analogy, reference may also be made to Citibank Canada v. The Queen 2002 FCA 128 for interpretation of the words "guarantee, security or similar indemnity or covenant" in the definition of "term preferred share" in subsection 248(1), and to C.S. Esplen v. The Queen 96 DTC 1272 (TCC) for interpretation of the words "guarantee, security or similar indemnity" in Regulation 6202(1)(b).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.