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Paid-up Capital 

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Tax Strategy

Paid-up Capital

A comprehensive understanding of ways to account for PUC certainly pays off.


Based on my experience, it appears that accountants have difficulty with the corporate share capital amount that is considered "paid-up" for income tax purposes. The CRA seems to have noticed the trouble too, as a CRA official recently commented to me that the agency often raises reassessments after reviewing transactions involving shares issued as consideration for property.

I'm not sure why the difficulty persists but I strongly suspect two reasons. First, the inconsistency between the legal, accounting, and tax concepts of share capital and second, the fact that paid-up capital (PUC) issues generally only arise on tax-deferred assets for shares transactions, which are far less common than ordinary cash for treasury shares transactions.

The accurate determination of PUC is essential because the Income Tax Act stipulates that a corporation can return PUC to the shareholder as capital rather than income, and that return of capital is generally tax-free. Amounts returned in excess of PUC are considered dividend income to the shareholder. Obviously an incorrect PUC results in a misstatement of income, and generally that constitutes an under-declaration of income. Not surprisingly, this is not a situation clients are thrilled to find themselves in.

To understand the Act's concept of paid-up capital, we need to begin with the Canada Business Corporations Act (CBCA). Under subsection 26(2) of the CBCA, a corporation is to add to its stated capital account "the full amount of any consideration it receives for any shares it issues." Picture a transfer of an asset with a fair market value of $100,000 to newly-created XYZ Corporation in exchange for 100 common shares. The asset has an adjusted cost base (ACB) of $25,000 to the transferring taxpayer, and to avoid recognizing the $75,000 accrued gain as income, an election is filed under section 85 of the Act, electing proceeds of disposal for income tax purposes, at $25,000.

Pursuant to the terms of the CBCA, XYZ Corporation adds $100,000 to its common shares stated capital account. The asset is similarly recorded on the books of XYZ at $100,000. (Some accountants would show stated capital as $25,000, with $75,000 as contributed surplus, but contributed surplus is an accounting presentation not a legal one and so it's ignored here.)

If XYZ was to subsequently redeem those common shares, the taxpayer would have $100,000 returned as PUC, which, given the taxpayer's $25,000 ACB on the shares, would result in a capital gain of $75,000 rather than dividend income. This capital gain will bear less tax than if it was a dividend, and in fact, it might not bear any tax at all, due to the capital gains deduction for qualified small business corporation shares.

The foregoing capital gain is not the result intended by the Act, and so it provides for a reduction in stated capital, what we can loosely refer to as legal-PUC, to arrive at a
tax-purpose PUC. This reduction is called a "grind," and for this particular transaction it is found at subsection 85(2.1). By applying the formula found there, the PUC of the shares is ground down to $25,000, which is the amount elected and recognized as proceeds of disposition for income tax purposes on the original asset transfer. When the corporation redeems the shares, there is a deemed dividend to the shareholder of $75,000 ($100,000 – $25,000) and a capital gain of nil ($25,000 – $25,000). Needless to say, the tax impact is substantially different.

Having set the background for the tax-PUC process and the rationale, let us now look at a slightly different transaction that a client is considering. Assume your client Jill owns all the shares of CCPC Ltd., and that they have a value of $500,000, a hard ACB to your client of $50,000, but a stated capital amount (same as the tax-purpose PUC) of five dollars.

Note that hard ACB refers to the amount actually paid for the shares in an arm's length transaction and not ACB as a result of some previous tax election, V-Day value, or a non-arm's length transaction. Your client is considering an estate freeze and you are trying to decide which of three possible alternatives you'll use. While it's natural to think there aren't any tax differences between the choices, there are.

The first choice is to simply exchange the existing common shares held in CCPC Ltd. for new special shares of CCPC Ltd., which are redeemable/retractable for $500,000. This share swap is governed by section 86 of the Act, which doesn't require any elections to be filed, and which provides that the ACB of the new shares is the same $50,000 that was the ACB of the old shares. To prevent $500,000 as being the tax-PUC of the new special shares, subsection 86(2.1) grinds the legal stated capital of the shares down by $495,995 to give a tax-PUC of five dollars, which is the same as the PUC of the old shares.

Now assume that Jill wants to recognize a gain on her common shares, but she likes the simplicity of a single corporation. She'll proceed exactly the same way as she did with the first choice except this time a section 85 election will be filed to recognize the desired proceeds as something more than the $50,000 ACB (section 86 doesn't permit that choice, it is a pure rollover).

This second choice is known as an offside 86. Here the PUC-reduction is determined under subsection 85(2.1), and it is different and more complex than that at subsection 86(2.1). (For ease of comparison, we're going to ignore the higher elected amount and work with the $50,000 as if it were the elected amount.)

The legal stated capital is again $500,000, but the PUC grind is now only $450,000 because subsection 85(2.1) allows the PUC of the newly-issued shares to be the same as the section 85 elected proceeds, which we're assuming to be $50,000. Consequently, it appears that an advantage is gained over the first choice.

The advantage is that on a redemption/ retraction of the special shares under the first choice, there would be a dividend of $499,995 ($500,000 less five dollars PUC) along with a capital loss of $49,995 ($50,000 ACB less five dollar proceeds). Under the second choice, there would be a $450,000 dividend on retraction/redemption along with a capital gain/loss of zero. Alas, everything is not what it appears!

While true that subsection 85(2.1) does indeed provide a tax-PUC of $50,000, subsection 84(1) of the Act kicks in to eliminate this "advantage." A corporation cannot increase its PUC without a concomitant increase in its assets or a decrease in its liabilities. That hasn't happened here. PUC has increased, but the assets and liabilities are unchanged. Subsection 84(1) provides that the $49,995 PUC increase, from five dollars to $50,000 is an immediate dividend to the shareholder.

To avoid double taxation on the ultimate redemption/retraction of the special shares, that dividend is added to the ACB of the special shares. The overall end result is the same as it was under the first choice, but the timing is different in that $49,995 in dividends is recognized immediately. The immediate dividend can be eliminated if CCPC Ltd. takes advantage of the choice to write-down its legal stated capital as permitted by subsection 26(3) of the CBCA: "... add to the stated capital account ... the whole or any part of the amount of the consideration received...."

This write-down needs to be effected by a director's resolution. The appropriate write-down is $49,995, leaving the legal stated capital at the same five dollars as the exchanged shares (there is then no PUC-grind under the Act). This would be the superior choice because it eliminates the immediate dividend.

Under the third choice, Jill would transfer her common shares in CCPC Ltd. to Holdco. To avoid recognizing any of the gain accrued on the shares, an election would be filed under section 85, electing proceeds as $50,000, which equals her ACB.

Yet an interesting thing happens with this choice, as the legal stated capital of the special shares issued to Jill in exchange for the 100 common shares of CCPC is again $500,000 (the value of the exchanged property), but the PUC-grind for income tax purposes, found now at subsection 84.1(1), results in a tax-PUC of $50,000. This is the greater of the five dollar PUC and the $50,000 ACB of the old shares.

Unlike with the offside 86 choice, there is no immediate dividend as the assets of Holdco have increased. Now on a future redemption/retraction of the special Holdco shares, Jill will have a dividend of $450,000, not $499,995 and a capital gain/loss of zero, not a capital loss of $49,995.

As you can see, an understanding of paid-up capital is vital to maximizing value for clients.

Acknowledgement is due to Bruce Reed, CGA, and Glen Schmidt, FCGA, for their contributions to this column.

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