Tax II Chapter 7

Spring 2013
Notes

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.
S

H
Co

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.

Client

Company

Business

4.

Assume the business has been run well and the facts are:
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Client

$50k
Corporate
share capital

FMV $1.0 m
10
ACB is $50k
shares
Company

$100k
Cash

$900k
Active Business
Assets

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

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).

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.

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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.

8.

Paragraphs (a) & (c) of the PUC definition are really nondefinitions: 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.

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):

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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-arms 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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Employee

Client
FMV $900k
ACB $45k
tax PUC ?

9 shares

$100,000
Cash

1 share

Company

FMV $100k
ACB $100k
tax PUC ?

$900,000
Active Business
Assets

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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One Share Bought Back

Client
10 shares

Amount paid
ACB of share
Tax PUC of share

Repurchase 1 share

Company

$100k
Cash

$100k
$ 5k
$ 5k

$900k
Active Business
Assets

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

amount paid
tax PUC of share
s.84(3) deemed dividend

$100k
$5k
$95k

(ii)

Capital gain calculation

PD
ACB
capital gain

$5k ($100k less $95k dividend)

$5k
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 its one year later.

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Employee

Client
FMV $900k
ACB $45k
tax PUC $45k

9 shares

1 share

Company

FMV $100k
ACB $100k
tax PUC $5k

$900,000
Active Business
Assets

$100,000
Investment
Assets

No material change. Now the employee wants out. The company

purchases the employees 1 share for $100,000? What is the result?
(i)

Deemed dividend calculation

AP
tax PUC of share
s.84(3) dividend

$100k
$5k
$95k

(ii)

Capital gain calculation

PD
ACB
capital loss

$5k ($100k less $95k dividend)

$100k
$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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Client B
10 shares

Per share
FMV $10k
ACB $2k
Tax PUC $5k

FMV $100k
ACB $20k
tax PUC $50k

9 shares
FMV $90k
ACB $18k
tax PUC $45k

Company

$100,000 Cash

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

AP
tax PUC of 9 shares
s.84(3) dividend

$90k
$45k
$45k

(ii)

Capital gain calculation

PD
ACB of 9 shares
capital gain

$45k ($90k less $45k)

$18k
$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.

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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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.

Client
10 shares

FMV $100k
ACB
$50k
tax PUC $20k

Company

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?
Client
10 shares

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

ACB $35k (ACB reduced by $15k)
tax PUC $5k ($20k less $15k)

Company

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
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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:

17.

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.

Now, consider the stock dividend exclusion in s.84(1).

definition of stock dividend in s.248(1).

Read the

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).
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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.

Shareholder
- Public

Pubco

Listed on
TSE for
trading

Pubco engages
broker to buy its
stock in the open market.

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
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to distribute what would otherwise be an annual dividend paid by

the public company?

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