The following article appeared in a recent edition of the Hamilton Law Association Law Journal.
Why have separate classes of shares in the capital of a corporation for new investors? Creating separate classes of shares creates its own problems both from a tax and non-tax perspective. Nonetheless, for tax purposes it is sometimes desirable to have different groups of investors subscribe for different classes of shares in the capital of a corporation.
Consider the position where Mike and John decide to form Opco to operate that lemonade stand business they’ve always wanted to run. On the incorporation of Opco under the Business Corporations Act (Ontario), each of Mike and John subscribe for 50 Common Shares in the capital of Opco at $1 per share. As a result, the tax cost and tax paid-up capital (”PUC”) of their shares is $100 in total.
Let’s move forward three years. Opco has been a success. Edgar, who is a friend of Mike and John, wants in. Mike and John are amenable—serving lemonade is hard work, and they could use the help and the extra capital—and so they agree to allow Edgar to subscribe for 50 Common Shares. Opco’s value, however, has increased so that its issued shares are worth $500 in total ($5 per share), and so it is only fair that Edgar pay more for his shares than $1 per share (the original subscription price paid by Mike and John). Edgar should pay $5 per share, or $250 in total, for his 50 Common Shares.
Let’s say that Edgar pays the required $250 in total for his 50 Common Shares. What are the tax consequences? The tax cost of Edgar’s shares is $250 in total or $5 per share, but their stated capital per share is only $2.33 because the stated capital of a share is the total stated capital of the class to which the share belongs divided by the number of issued shares of the class.
PUC is valuable because it can be returned to a shareholder tax free. The calculation of PUC begins with stated capital for corporate law purposes (not accounting purposes). If the stated capital of a class of shares issued by an Ontario corporation is $50, then, in general, the PUC will be $50 as well. Of course, the Income Tax Act (Canada) wouldn’t be the Income Tax Act (Canada) if it didn’t contain numerous rules that provide for adjustments to PUC to ensure that a taxpayer can’t artificially increase it. Nevertheless, if one is concerned only with subscriptions for shares, then stated capital and PUC are usually equal to each other.
The key point to note is that both stated capital and PUC are calculated by reference to a class of shares unlike tax cost or “adjusted cost base”, which is calculated by reference to the holder of the shares. PUC is averaged across all of the shares of a particular class rather than just all shares held by a particular individual. As a result, Edgar’s cost per share of his Common Shares in the capital of Opco is $5 ($250/50), but the PUC of each of his shares is only $2.33 (($250+$100)/150).
So what? This discrepancy is only likely to matter if Opco purchases Edgar’s shares for cancellation. On a sale to an arm’s-length third party, it is highly likely that the only relevant tax characteristic of Edgar’s shares will be their tax cost. He paid $250 for his shares. If he sells them for $500, he will realize a gain of $250. There’s no magic to that, and it’s the appropriate result. It’s what a rational person would expect.
A rational person will have a much harder time with a purchase for cancellation of shares that have attributes like Edgar’s. On a purchase for cancellation, the Act deems a shareholder to have received a dividend and proceeds of disposition. The deemed dividend is calculated first, and it is equal to the purchase price paid for the shares minus their PUC. If Edgar were to turn around and sell his shares back to Opco for the amount he paid ($250), he would be required to include in income a deemed dividend! The amount of the deemed dividend would be equal to $133.33 (50*($5 – $2.33)).
As for Edgar’s proceeds of disposition, the Act reduces them by the amount of the deemed dividend he received, so that on the purchase for cancellation he is deemed to receive proceeds equal to $2.33 per share ($5 – $2.66). That is, Edgar is deemed to realize a capital loss on the purchase for cancellation of his shares in an amount equal to the deemed dividend. The capital loss, however, cannot be used to reduce or eliminate the deemed dividend. Economically, when Edgar’s shares are purchased by Opco for $5 per share, he is simply receiving his money back. For tax purposes, he is treated as having received income![1]
The results described above are perverse. An experienced and intelligent Justice lawyer of my acquaintance once attempted to provide a policy justification for these rules. She didn’t convince me; I’m not sure she convinced herself. In any case, rational or not, these are the rules.
Issuing separate classes of shares will avoid this problem. If Edgar, instead of subscribing for Common Shares in the capital of Opco, subscribes for Class 1 Common Shares (common shares of a different class), and no one else subscribes for shares of that class, then the tax cost and PUC of his shares will be equal to his purchase price. If, therefore, Opco repurchases Edgar’s shares immediately after he paid for them, he will not receive a deemed dividend or realize proceeds of disposition, and all will be right with the world.[2]
Issuing multiple classes of common shares has its own problems, however. If the different classes have different rights to dividends or liquidation amounts, then a shareholder agreement might be necessary to protect the minority shareholders. If the classes have identical rights, then the issue becomes whether the classes really are separate classes such that their stated capital and PUC can be computed separately (see blog.simpsonwigle.com/2007/10/classes-of-shares/). A cautious tax adviser, who decides to insert, say, a liquidation preference to ensure that classes can be distinguished, will need to consider the implications under Parts IV.1 and VI.1 of the Act. In short, the decision to issue multiple classes to avoid the complexities associated with Edgar’s circumstances will create their own complexities. The tired tax adviser, who is confident that Opco will never repurchase Edgar’s shares, might content herself with allowing him to subscribe for ordinary Common Shares in the capital of that corporation.
[1] Note that the PUC of Mike and John’s shares has increased from $1 per share to $2.33 per share even though they haven’t put any more money into Opco. That doesn’t mean, however, that they can necessarily derive any benefit from the increase. For example, if they attempted to effect a tax-free return of PUC of $2 per share, they would trigger a gain. The Act provides that a return of PUC reduces the tax cost of an individual’s shares. If the tax cost of an individual’s shares becomes “negative”, then the negative amount is treated as a capital gain. For Mike and John, if they took back $2 per share of PUC, the tax cost of their shares would be negative $1, so that they would be deemed to realize a gain of $1 per share.
[2] All is not lost even if multiple shares weren’t used but it becomes necessary to repurchase shares. Extra steps, such as the incorporation of a holdco for the seller, can be taken to ensure that the shareholder doesn’t end up in Edgar’s predicament.
