According to the Income Tax Act (Canada) (the “Act”), when computing paid-up capital (“PUC”) for tax purposes, one must begin with “an amount equal to the paid-up capital in respect of that class of shares at the particular time, computed without reference to the provisions of this Act”.
What is PUC “computed without reference to the provisions of this Act”? Tax professionals generally accept that this phrase refers to paid-up capital for corporate law purposes. Under the Ontario Business Corporations Act (the “OBCA”) and the Canada Business Corporations Act, such paid-up capital is called “stated capital”. Both statutes require a corporation to “maintain a separate stated capital account for each class and series of shares it issues” and to “add to the appropriate stated capital account in respect of any shares it issues the full amount of the consideration it receives as determined by the directors” (OBCA subsections 24(1) and (2)).
PUC for tax purposes, then, begins with stated capital, which is a concept wrapped up with the legal formalities surrounding share capital transactions. Therefore, the authoritative source for determining the legal stated capital of a class of shares of a corporation is its minute book, and an accountant who is asked to compute PUC can request that the corporation’s lawyer help with a minute book review to confirm legal stated capital.
In this regard, it might be helpful in appropriate circumstances if, in addition to containing registers and ledgers that summarize the issued shares in the capital of a corporation, the minute book also contained a summary of the additions and deductions from legal stated capital for each class of shares. (On the other hand, this extra information will not be necessary for many if not most private corporations because they generally do not frequently issue or cancel shares or pass resolutions reducing or increasing stated capital.)
The Act provides that the PUC of a share is “an amount equal to the paid-up capital at that time, in respect of the class of shares of the capital stock of the corporation to which that share belongs, divided by the number of issued shares of that class outstanding at that time” [emphasis added]. That is, the PUC of a share is averaged, and the PUC of a shareholder’s shares, unlike tax cost, can change if others subsequently subscribe for shares in the capital of the issuer. The PUC of a shareholder’s shares can also be much less than their tax cost if the shareholder subscribes for shares of a class that includes already issued and outstanding shares.
The latter result can be important to the tax consequences to a shareholder of a disposition of those shares. For example, assume that X and Y each own 500 Common Shares in the capital of Opco. X subscribed for his shares for $50 upon incorporation. Y came along later, when the value of Opco’s Common Shares had increased, and so she paid $100,000 to Opco for her shares.
Later, X and Y begin to fight, and so X agrees to cause Opco to purchase Y’s shares for cancellation for their fair market value or $500,000. Y does not object because she believes that the shares do not qualify for the $500,000 capital gain exemption anyway.
Y’s economic gain is $400,000, but the Act deems Y to have received a dividend on the purchase of her Common Shares. The amount of the dividend is not $400,000 or the difference between her proceeds and the tax cost of her shares. Rather, the dividend is the difference between Y’s proceeds and the PUC of her shares. The PUC of her shares is 50% of $100,050 or $50,025. The deemed dividend is $449,975. Y is allowed a capital loss of $49,975, which she cannot use to reduce the deemed dividend.
Y might be entitled to claim the capital loss as a “business investment loss” under the Act. A taxpayer can deduct the amount of a business investment loss from income, not just taxable capital gains, and so Y’s deemed dividend could be reduced somewhat.
The Act, however, imposes numerous conditions on claiming a business investment loss, and even if the loss is available, Y is still likely to be worse off because only one-half of the loss can be deducted from the grossed-up dividend. (Of course, Y is also worse off because the tax rate applicable to capital gains is lower than that applicable to dividends, but that is not a PUC-related problem.)
How could Y have prevented this problem? The simplest solution would have been to file articles of amendment for Opco before Y subscribed for her shares to create another class of Common Shares. Y could have subscribed for shares of the new class, and as a result the PUC of her shares would not have been averaged with X’s. Upon the purchase for cancellation of her shares, then, the deemed dividend (before the gross-up) would have been equal to her economic gain.
The problem described above is not so unlikely – we have been called upon to fix such problems after the fact numerous times, which generally involves more trouble and expense than the solution described in the previous paragraph. Moreover, PUC can be useful in other ways. For example, in general the shareholders of a corporation can reduce the PUC of their shares and pay the amount of the reduction to themselves free of tax. Y will limit herself in this regard if the PUC of her shares is averaged with those belonging to X.
[This article by Joseph Monaco and John Loukidelis will appears in the May 2006 issue of The Bottom Line.]
