Section 84.1 prevents an individual shareholder from converting what would otherwise be a taxable dividend into a tax-free return of capital by using non-arm’s-length transactions. These transactions are often called surplus-stripping transactions or dividend-stripping transactions.
These impugned surplus-stripping transactions sometimes rely on the lifetime capital gains exemption (LCGE). For example, an individual owns an operating corporation with a $1 million surplus (retained earnings). Instead of drawing the $1 million as a taxable dividend, the individual transfers his shares to a holding company for $1 million in additional equity in the holding company. By claiming the LCGE, the individual avoids the taxable capital gain that would otherwise have arisen when disposing of the shares in the operating corporation. In addition, the individual may now draw the $1 million from the holding company as a tax-free return of capital.
Section 84.1 prevents this result by ensuring that the individual can’t draw a return of capital from the holding company that exceeds the return of capital that the individual could have drawn from the original operating company. In addition, if the individual had received non-share consideration from the holding company—for example, a promissory note or cash—section 84.1 deems the individual to have received a dividend in the amount of the non-share consideration. By converting these proceeds into a dividend, the rule disqualifies the individual not only from the lifetime capital gains exemption but also from the favourable tax treatment on capital gains. Dividend income doesn’t qualify for the lifetime capital gains exemption, and, unlike a capital gain, which is only half taxable, the deemed dividend is fully taxable.
Although many surplus-stripping transactions rely on the lifetime capital gains exemption, section 84.1 tax trap doesn’t solely target transactions involving the lifetime capital gains exemption (since, over the years, there have been many different surplus-stripping transactions set up by creative Canadian tax lawyers). It potentially applies anytime an individual transfers shares to a holding corporation. And when it applies, section 84.1 can lead to severe tax costs. Yet the section 84.1 tax trap often goes unnoticed by tax advisers when structuring a share-sale transaction or a corporate reorganization. This is why you should consult one of our experienced Canadian tax lawyers to review pending transactions or for advice on reducing the risk of triggering section 84.1.
After examining the important background concepts of stated capital, paid up capital, deemed dividends, and adjusted cost base, this article details the application and effects of section 84.1
To understand the mechanics of section 84.1, you need a handle on three important tax concepts: stated capital, paid up capital (or PUC), deemed dividend, and adjusted cost base (or ACB).
Stated Capital
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 should 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. It is important that the corporation’s accountant coordinate with the corporation’s Canadian tax lawyer to ensure proper tax record keeping.
The corporation’s stated capital discloses the shareholders’ skin in the game. That is, the stated-capital account shows how much the shareholders have invested in the corporation. Because the stated capital represents the amount that the shareholders have invested in the corporation, it serves as a measure of shareholders’ limited liability. In other words, 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 at cost under section 85 of the Income Tax Act. (If the transaction qualifies, section 85 allows a taxpayer to avoid a taxable capital gain by transferring property to a corporation at the property’s tax cost.) In this case, your share’s PUC will be $50,000, yet 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 may sometimes adjust the stated capital to match the PUC. The default, however, is a mismatch.)
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. To this end, section 84 (which is different from section 84.1) of Canada’s Income Tax Act contains several rules that deem a shareholder to have received a dividend in certain cases.
Why does the 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.
The deemed-dividend rules all revolve around the notion of paid up capital (PUC). And for the purposes of this article, the main takeaway about the deemed-dividend rules is this: any alleged return of capital in excess of PUC results in a deemed dividend. In particular, if a shareholder holds shares with PUC of $100, yet draws $100,000 from the corporation as a purported return of capital, the shareholder is deemed to have received a dividend in the amount of $99,900 ($100,000 – $100)
