Income Tax Act’s Deemed Dividend Rules – Canadian Tax Lawyer Analysis

The Deemed Dividend Rules under Section 84 of the Income Tax Act
– Canadian Tax Lawyer Analysis

Introduction – The Definition of a Dividend and a Deemed Dividend

Canada’s Income Tax Act does not contain a comprehensive definition of what constitute a dividend. Subsection 248(1) of the Income Tax Act defines a “stock dividend” to include any dividend “paid by a corporation to the extent that it is paid by the issuance of shares of any class of the capital stock of the corporation”. However, in the absence of a statutory definition of a dividend, Canadian courts have accepted the Common Law definition which states that distribution from a corporation to its shareholders is a dividend unless the distribution is made upon “liquidation” or an “authorized reduction of corporate capital”, as stated in Hill v. Permanent Trustee of New South Wales. In certain circumstances, however, where there is an equivocal distribution of a taxable dividend, Canada’s Income Tax Act deems a dividend to be paid by the corporation and received by its shareholders. The deemed dividend rules are in section 84 of the Income Tax Act.

The Purpose of the Deemed Dividend Rules under the Income Tax Act

The purpose of the deemed dividend rules in section 84 of the Income Tax Act is to ensure that paid-up capital can be returned to shareholders of the corporation on a tax-free basis, but any excess payment from the corporation to its shareholders is treated as a dividend. As such, the deemed dividend rules protect the integrity of Canada’s tax system by ensuring that if and when corporate distributions to shareholders exceed its paid-up capital, that such amounts are taxed as dividends. In addition, since Canada taxes capital gains at tax rates lower than tax rates for dividends, the deemed dividend rules prevent taxpayers from converting otherwise taxable dividend transactions into taxable capital gains. For tax purposes, only one half of the capital gain realized is included in a taxpayers’ income. However, dividends received by shareholders who are individuals are taxed again in the hands of the shareholder, and dividend received by a corporate shareholder are generally received tax-free, pursuant to the inter-corporate dividend deduction in subsection 112(1) of the Income Tax Act.

To illustrate, the gross-up rate in Ontario for eligible dividends are 38% and for non-eligible dividends are 15%. Accordingly, a taxpayer who receives $100 eligible dividends and $100 non-eligible dividends must (1) gross up the eligible and non-eligible dividends by 38% and 15%, respectively; and, (2) report $138 eligible dividend and $115 non-eligible dividend on their income tax for that year. However, to account for the taxes already paid by the corporation issuing the dividend, the individual receiving the dividend is entitled to both a federal (15.02%) and provincial (10%) dividend tax credit. In Ontario, for an individual who receives a $100 eligible dividend with a grossed-up value of $138, his or her combined federal/provincial dividend tax credit would be $34.53 (($138 x 15.02%) + ($138 x 10%)). Assuming that this individual is in the highest tax bracket in Ontario (53.53%), the tax would be $73.87 (53.53% x $138) on their $100 eligible dividend less the dividend tax credit resulting in a liability of $39.34 (($138 x 53.53%) – $43.53), representing a 39.34% tax rate on their $100 eligible dividend.

By comparison, since the capital gains tax paid on 50% of the capital gain amount is taxed at the individuals’ marginal tax rate, where a taxpayer earns $100 in capital gains and he or she is in the highest tax bracket in Ontario (53.53%), he or she will (1) claim $50 in taxable capital gains income on their returns; and, (2) pay $26.76 in capital gains tax on the $100 gains.

Significant Legal Concepts – Stated Capital, Paid Up Capital, and Adjusted Cost Base

To better understand the deemed dividend rules under the Income Tax Act, this section presents the following significant concepts: stated capital, paid up capital, and adjusted cost base.

Stated capital is a corporate law concept. It is the amount of money received by a corporation for issuing shares to its shareholders. When a share is issued by a corporation, corporate law requires the corporation to maintain a separate stated capital account for each class and series of shares and any amount received by the corporation for the issue of each share must be allocated to the stated capital account for shares of such class or series.

Paid-up capital (also known as PUC) is a significant income tax concept in Canada’s Income Tax Act. It represents (1) the amount that can be returned by a corporation to its shareholders tax-free, and (2) the after-tax amount contributed by a shareholder in exchange for shares of the corporation. Paid-up capital is a significant tax law concept for shareholders because it helps to determine whether (or not) a redemption or a repurchase of shares by a corporation results in a taxable deemed dividend. To illustrate, where a corporation redeems or repurchases its shares from its shareholders for the purpose of cancelling those shares, a deemed divided arises and is taxable to the shareholders equal to the difference between the redemption amount for the shares and the paid-up capital. In certain circumstances, where the shares of a corporation are issued in exchange for property, under taxation law the paid-up capital of the share may be less than the stated capital of those shares. Unlike stated capital which is determined per a class or series of shares, paid-up capital may be determined for (1) each class of shares (2) for one share, or (3) for all shares of the corporation.

Adjusted cost base (also known as ACB) of an asset is the aggregate amount paid to acquire the asset and its related expenses. The adjusted cost base of a capital asset is its tax cost. Under certain circumstances and transactions, the adjusted cost base of an asset may be further adjusted by section 53 of the Income Tax Act.

Deemed Dividend Upon Share Redemption – Subsection 84(3) of the Income Tax Act

Redemption of shares is the most common scenario wherein taxpayers may be treated as receiving a deemed dividend under the Income Tax Act. This means that where a corporation purchases and redeems its shares from a shareholder and cancels those shares, a taxable share redemption transaction has occurred. Subsection 84(3) of the Income Tax Act provides that a taxable deemed dividend is paid by the corporation to its shareholder to the extent that the amount paid on redemption exceeds the paid-up capital of such shares.

Subsection 84(3) applies where “a corporation resident in Canada has redeemed, acquired, or canceled in any manner whatever [..] any of the shares of the any class of its capital stock” (otherwise than by way of a transaction described in subsection 84(2)). In this context, paragraph 84(3)(a) provides that “the corporation shall be deemed to have paid [..] a dividend [..] equal to the amount [..] by which the amount paid by the corporation on the redemption, acquisition or cancellation [..] exceeds the paid-up capital [..] of those shares”. In addition, paragraph 84(3)(b) provides that a “dividend shall be deemed to have been received [..] by each person who held any of the shares of that separate class [..] equal to [..] the amount of the excess determined under paragraph 84(3)(a)”.

The purpose of subsection 84(3) is to ensure that the paid-up capital can be returned to the shareholder tax-free. To avoid double taxation on redemption, acquisition or cancelation of shares, shareholders must offset the redemption proceeds by the amount of the deemed dividend when computing the capital gain tax for disposing the shares back to the corporation.

For the purpose of subsection 84(3), “amount” is defined in subsection 248(1) of the Income Tax Act as the amounts paid in cash or in-kind in the redemption, acquisition or cancellation of shares are determined “in terms of the amount of money or the value in terms of money”.

The deemed dividend on redemption rule under subsection 84(3) does not apply where the redemption is carried out by a non-resident corporation, in which case the redemption is treated as a taxable disposition under the Income Tax Act.

Deemed Dividend on Increase of Paid-Up Capital – Subsection 84(1) of the Income Tax Act

As explained below, subsection 84(1) of the Income Tax Act deems the excess amount added to the stated capital account of a corporation for a class of shares to be a taxable dividend to its shareholders.

Specifically, subsection 84(1) of the Income Tax Act provides that where a corporation is a Canadian resident and it increases its paid-up capital in respect of the shares of any of its capital stock, otherwise than by:

• Payment of stock dividend,
• A transaction involving an increase in the corporation’s assets or a decrease in its liabilities that is not less the increase in the paid-up capital in respect of its shares,
• A transaction by which the paid-up capital in respect of shares of other classes is reduced by an amount not less than the increase in the paid-up capital in respect of shares of the particular class
• ((c.1) pertains to the conversation of contributed surplus into paid-up capital by an insurance company,
  (c.2)
  pertains to the conversation of contributed surplus into paid-up capital by a bank,
  (c.3)
  pertains to the conversation of contributed surplus into paid-up capital by a corporation that is neither an insurance company nor a bank,
• on issuances of shares;
  (ii) on the acquisition of property by the corporation where shares were substituted for no consideration; or
  (iii) results of any action by which the paid-up capital in respect of that class is reduced by the corporation, to the extent of the reduction in a paid-up capital that result from the action,

Under these circumstances, the provision deems the corporation “to have paid at that time a dividend on the issued shares of the particular class” equal to the amount by which (1) the increase in the paid-up capital exceeds the total of any increase in assets or decreased in liabilities; (2) any reduction in the paid-up capital in respect of shares of other classes; and (3) any increase in paid-up capital resulting from the conversion of the contribute surplus, and deems a taxable dividend “to have been received at that time by each person who held any of the issued shares” equal to the amount of the deemed dividend “to have been paid by the corporation that the number of shares” held by the shareholder “is of the number of the issued shares”.

The exclusion of “stock dividend” under paragraph 84(1)(a) demonstrates that the increases in paid-up capital pertaining to the payment of a “stock dividend” are already subject to tax per the “amount” definition under subsection 248(1).

Amounts excluded under paragraph 84(1)(b) are a reflection of the purpose of the paid-up capital rules under the Income Tax Act which permit for the tax-free return on capital that was initially invested in the corporation by its shareholders. This is consistent with the notion that capital may be invested in a corporation by way of transactions that either increase its assets or decrease it liabilities by an amount not less than the increase in the paid-up capital.

Likewise, paragraphs 84(1)(c.1), (c.2) and (c.3) allow for the conversion of contributed surplus that was not added to the corporation’s stated capital account at the time of the transaction into the corporation’s paid-up capital.

Further, paragraph 84(1)(c) allows certain tax-free transactions to occur in which the corporation’s paid-up capital is transferred between different classes of shares, thereby permitting increases in the paid-up capital of classes of shares to offset decreases in the paid-up capital of other classes of shares.

Preventing Double Taxation – Section 84(1) of the Income Tax Act

Subsection 84(1) deems a dividend to have been paid by the corporation to its shareholder if the paid-up capital of a share is increased. Paragraph 53(1)(b) of the Income Tax Act allows this deemed dividend to increase the adjusted cost base in order to prevent double taxation on the sale of the share. The increase to the adjusted cost base reduces the capital gains realized on the disposition of shares.

Since the paid-up capital of a share or a class of shares allows for tax-free return on capital of a corporation, shareholders dealing with the corporation are more likely to guard their tax-free return on capital of the corporation by minimizing any reduction of paid-up capital through the mechanism mentioned in paragraph 84(1)(c) of the Income Tax Act. Further, shareholders will also guard their paid-up capital from being diluted as their corporation issues new shares of the same class with a lower paid-up capital amount. This is called paid-up capital averaging.

To prevent paid-up capital averaging, where new shares are being issued at an amount different from the amount paid for the corporation’s outstanding shares, existing shareholders are likely to vote for the new shares to be issued in a separate class or series of shares. Subsection 26(5) of the Canada Business Corporations Act provides that a special resolutions approved by not less than two-thirds of voting shareholders of the corporation is required where a corporation with more than one outstanding class or series of shares wishes to increases its stated capital of a class or a series of shares by an amount not received by the corporation as consideration to issue shares of such class or series. The tax implications to increasing the stated capital of a class or a series of shares is that the rules in subsection 84(1) of the Income Tax Act will deem any excess amount added to the stated capital account of the corporation to be a dividend to its shareholders.

Deemed Dividend Upon Winding-up – Subsection 84(2) of the Income Tax Act

In a winding-up, discontinuance or reorganization of a corporation, the corporation sells its assets, pays off its outstanding liabilities and distributes the remaining cash among its shareholders in exchange of their shares, resulting in the cancellation of the shares that can give rise to tax obligations for its shareholders.

Subsection 84(2) of the Income Tax Act applies “where funds or property of a corporation resident in Canada [..] have been distributed or otherwise appropriated in any manner [..] to or for the benefit of shareholders [..], on the winding-up, discontinuance or reorganization of its business”. In this circumstance, the corporation “shall be deemed to have paid [..] a dividend on the shares [..] equal to the amount, if any, by which”:

• the amount or value of the funds or property distributed or appropriated, exceeds
• the amount, if any by which the paid-up capital in respect of the shares of that class is reduced on the distribution or appropriation.

This means that corporate distributions to shareholders upon winding-up, discontinuance or reorganization of the business in excess of the share’s paid-up capital constitutes a taxable deemed dividend. To avoid double taxation on liquidation proceeds, shareholders must reduce the amount received by the amount of the deemed dividend when computing the taxable capital gain for disposition of shares.

If there is no true winding-up, discontinuance or reorganization of the corporation, the deemed dividend rules under subsection 84(2) do not apply, as was the case in the Federal Court of Appeal decision Canada v. Vaillancourt-Tremblay.

Deemed Dividend on Reduction of Paid-Up Capital – Subsection 84(4) of the Income Tax Act

Subsection 84(4) of the Income Tax Act applies where a corporation resident in Canada reduces its paid-up capital for any class of shares (otherwise than by way of a transaction described in subsections 84(2), 84(1) or 84(4.1)). The purpose of subsection 84(4) is to “tax other distributions by corporations to their shareholders as income to the extent those distributions are in excess of the shares’ paid-up capital”, as stated in the Tax Court decision Collins & Aikman Products Co. v. The Queen.

Paragraph 84(4)(a) provides that a “corporation shall be deemed to have paid at that time a dividend [..] equal to the amount [..] by which the amount paid by it on the reduction of the paid-up capital, [..] has been so reduced”. In addition, paragraph 84(4)(b) provides that “a dividend shall be deemed to have been received at that time by person who held any of the issued shares at that time equal to that portion of the amount of the excess referred to in paragraph 84(4)(a)”.

Subsection 84(4) permits shareholders to receive a tax-free return of their contributed capital from the corporation provided that such amount does not exceed the reduction on the paid-up capital of the share. However, a reduction of the paid-up capital by a public corporation may result in a different tax treatment to shareholders pursuant to subsection 84(4.1) of the Income Tax Act. Subsection 84(4.1) limits a public corporation’s ability to return capital to its shareholders on a tax-free basis. However, a public corporation may pay a tax-free return of capital to its shareholders if such amount is from proceeds that the corporation realized from a transaction “outside the ordinary course of business of the corporation”. In this context, under certain circumstances public corporations are permitted to sell an asset and distribute the sale proceeds to its shareholders as a return of capital.

In summary, the Income Tax Act permits corporation, excluding public corporations, to return capital amounts to its shareholders tax-free on shares consistent with paid-up capital reduction of such shares. While public corporations are permitted to make tax-free distributions to their shareholders, they are limited by subsection 84(4.1) to certain circumstances and transactions. It should be noted that reducing the paid-up capital of a class of shares by returning paid-up capital to shareholders of the corporation also reduces that shareholder’s adjusted cost base of those shares by the amount of tax-free capital returned to that shareholder, thereby increasing the shareholders’ future capital gain tax (s. 53(2)(a)(ii) Income Tax Act).

Pro Tax Tips – Deemed Dividend

The deemed dividend rules under the Income Tax Act are a complex area of law that require detailed analysis and advice from an experienced Canadian tax lawyer. If you have questions pertaining to a specific transaction and require legal advice or for questions relating to any of the deemed dividend rules, and their restrictions, under the Income Tax Act, please contact our tax law office to speak with one of our experienced Certified Specialist in Taxation Canadian tax lawyers.