In my article on multiple classes of shares, I described the difficulties that can arise where shareholders subscribe for shares of a class in the capital of a corporation at different times and at different prices per share. How does one solve the problems that can arise where shareholders own shares with tax costs that differ from the paid-up capital (“PUC”) of their shares for the purposes of the Income Tax Act (Canada) (the “Act”)?
Consider the position of Mr. X who owns 100 Common Shares that have a total tax cost and value of $100 but PUC of only $50. Let’s say that Mr. Y owns another 100 Common Shares with a total tax cost that is nominal and PUC of $50. The issuer of X’s Common Shares (“Opco”) wishes to purchase them from X for $100. If Opco simply purchases the shares for $100, X will be deemed to receive a dividend of $50 and to realize a capital loss in that same amount.
X can likely avoid this problem if he incorporates a new corporation (“Newco”) and then transfers his Opco shares to Newco for a note for $100. Section 84.1 should not apply to the transaction because X’s shares have “hard basis”. When Opco redeems the shares held by Newco, Opco is deemed to pay a dividend equal to $50 to Newco, but Newco should be entitled to receive the dividend tax free (subsection 55(2) of the Act shouldn’t apply because the proceeds received for the shares are equal to their tax cost). X can then cause Newco to repay his note. As a result, X receives back his investment tax free, which is the “right” result.
Some time ago, the CRA issued a technical interpretation on a method that is easier and cheaper to implement than the one described above, provided X and Y can cooperate (see document 9613115 dated May 8, 1996). Opco could file articles of amendment to create two new classes of common shares (let’s call them Class 1 and Class 2 Common Shares. X and Y, as part of the series of transactions that included the filing of the articles of amendment, would exchange their Common Shares of the old class for shares of the new classes. X would receive 100 Class 1 Common Shares and Y would receive 100 Class 2 Common Shares. The share exchange would occur on a tax-deferred basis under section 86 of the Act. In the directors’ resolutions issuing the shares of the new classes to X and Y, the directors would specify that $100 would be added to the stated capital of the Class 1 Common Shares belonging to X and a nominal amount would be added to the stated capital of the Class 2 Common Shares belonging to Y. X’s shares in the capital of Opco would then have a PUC equal to their tax cost and fair market value. Opco could purchase the shares for cancellation for $100, and X would receive the proceeds (a return of his investment) tax free.
In its technical interpretation (document 9613115), the CRA stated that it did not find the transactions offensive
where one class of shares owned by three shareholders who deal with each other at arm’s length will be exchanged for three new classes of shares of the same corporation in order to restore each shareholder to the amount of PUC each would have had, had he originally purchased a separate class of shares.
The CRA agreed that the Act did not provide for a PUC grind or a deemed dividend where the total PUC of the issued shares before and after the reorganization did not change even though the PUC of one shareholder’s shares increased and the PUC of the other shareholder’s shares decreased. The CRA also volunteered that the GAAR should not apply in these circumstances.
Of course, a PUC shift using section 86 of the Act will work only if the shareholders can cooperate. It is almost certain that, under corporate law, it will be necessary for the shareholders to approve the transactions—particularly the additions to stated capital—by way of special resolutions (see, for example, subsection 24(6) of the Ontario Business Corporations Act). If X can’t convince Y to play ball for whatever reason, then X might be stuck with having to use Newco to avoid the income inclusion associated with receiving a return of his investment.
