Small corporations, like large corporations, will often allow key employees to purchase shares of the corporation to allow key employees to share in the profits of the company. As profits are earned, they are distributed to all shareholders based on their shareholdings. These distributionsare normally taxes as dividends in the shareholders hands.
Sales Of Shares Are Often Restricted
The stocks of small corporations cannot be sold on stock exchanges and shareholders agreements often restrict to whom the shares may be sold to (normally other existing shareholders). As a result, if funds are required by the shareholder or if the shareholder terminates employment with the corporation, and qualified buyer is not available, then the corporation may redeem the shares at a specified price.
On the face of it sounds like you are saved if you can’t find a qualified buyer. But the tax treatment of a share-redemption may be very different than a sale of shares to another person.
John was an employee of Investco Ltd. and was invited to purchase shares in the corporation as a reward for good service. The shareholders agreement restricts the re-sale of the shares issued to other qualified employees of Investco. As an alternative, Investco will redeem the shares at their fair market value using a prescribed valuation formula.
John purchased 1,500 shares in 2004 for $100 each. The paid up capital (PUC) of these shares was also $10 each.
In 2008, John left the corporation and the fair market value of the shares had grown to $400 each. John’s marginal tax rate is 45% on normal income, 22.5% on capital gains, 33.33% on ineligible dividends and has never claimed any capital gains or losses in the past.
At the time, Investco was a CCPC and a qualified small business corporation. The company does not have a GRIP balance and therefore all dividends would be considered ineligible.
If a qualified shareholder was available to purchase the shares, and assuming that shareholder is not related to John and Investco, the tax consequences of the sale are as follows:
John will realize a capital gain of 1,500 shares x ($400- $100) = $450,000. Since Investco is a qualified small business corporation and the capital gain is less than the $750,000 lifetime capital gains exemption, there are no tax consequences.
Scenario B – Investco Redeems The Shares for $400 Each
If John cannot find a buyer and Investco redeems the shares, then the Income Tax Act looks at the transaction differently:
- The redemption at $400 per share results in a deemed dividend of 1,500 x ($400 – $10) = $585,000. The marginal tax on the ineligible dividend would be $195,000.
- The redemption also results in taxable capital loss of $67,500 that may qualify is an allowable business investment loss (ABIL) and could be deductible against other income. If the loss were an ABIL, the tax savings realized would be $30,375.*
- The total tax, assuming the ABIL may be fully claimed would be $164,625.
* The taxable capital loss is the proceeds of the redemption at $600,000 less the deemed dividend of $585,000, less the shareholders adjusted cost base of $150,000 times 50%.
Clearly an arms-length sale of the share shares is a better result as it would avoid the deemed dividend.