If you worked for a small Canadian controlled private corporation (CCPC) and were offered shares in that corporation there may be tax consequences if the shares are redeemed by the corporation.
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.
Situation
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.
Scenario A – Sale of Shares to a Third Party
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.
Related Articles
- Capital Gains Exemption on Foreign Investment
- Canadian-controlled private corporation (CCPC)
- Selling Your Business & Saving Taxes
- Reader Mail Bag Update: Lifetime Capital Gains Exemption
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If you are buying a business, let me help you conduct the due diligence. We can look at the financial and operating information to determine if they support the sellers claims. We can then bring in other professionals to help you valuate and structure the purchase0
What happens if shares are bought and sold though a Trust which was
setup by the corp.?
Could the Trust act as a qualified shareholder?
Hazy,
I suppose, but where woukd the trust get the funds?
Hazy,
I suppose, but where would the trust get the funds?
Could the Trust not borrow money from a bank?
Loan payments would be made with a dividend payed out on the shares purchased.
Does the the amount of shares certificate above have to be in the dollar value of the shares sold back to the company? Is this considered a legal receipt by revenue canada?
@Northgirl61
I’m not entirely sure what you are asking. If the company redeems the shares they are taking the shares back and giving the shareholder money for them. It’s a tax event for the the shareholder.
Example: Married couple A + B each own 50% in Class A shares of a company. A + B disolve the partnership. Equity is $100,000.00. But the debt is just over $100,000.00. B agrees to sell his shares to A for $50.00 as the debt wipes out his share of the equity….
However at the end of the year A puts through approx $50,000.00 as a bonus to A for the division of personal assets not related to the company. A t4 is issued and min tax taked off so CRA wants it’s share. B is disputing the T4.
A claims it was for B’s share of the company but the transfer of shares documentation show that those shares were sold to A for $50.00.
Question: Does the transfer of shares doc and certificate act as a receipt for CRA to prove that the $50,000.00 was not for B’s equity in the company??
First of all, the value of the shares for the purposes of any transaction for tax purposes will be deemed to be fair market value (FMV). This amount is generally considered to be an amount that an arms length person would pay for the shares. If the transaction occurred at any value other than FMV, the CRA will reassess the transactions at FMV.
In terms of valuation, I would question whether B’s shares were worth $50. Although you indicate debt = equity (I suspect you mean assets = debt because equity = assets – liabilities), A was able to pay a $50,000 bonus which would lead any reasonable person to believe that the company has intrinsic value since it was able to pay a bonus!
The corporation and the shareholders are separate and distinct entities and the fact that the corporation paid a bonus to a shareholder is not really relevant to the overall outcome. Although possible unfair from a divorce standpoint, I would argue that the “sale” of shares should have occurred at FMV.
In terms of the documentation, the CRA will certainly consider it but as I said the transaction must have occurred at FMV and if nit the CRA has the authority to deem the transaction to have occurred at FMV. Also, there is a provision in the income tax act that will unwind any transactions that were not within the spirit of the act (known as the general anti-avoidance rules).
If these were actual transactions, I would suggest strongly that you hire a very good corporate accountant to review the situation and handle the dispute with the CRA. I think these taxpayers have made some seriously costly errors that could have been avoided by engaging a professional at the start.
In scenario A, what if the shareholder that acquire the shares was related to Investco but not John?
I’m not sure what your question is. Neither of the shareholders is related to the company. People cannot be related to a company.
Hello Tax Guy,
What if the intent was to sell shares of the CCPC for an amount significantly less than FMV, to an arm’s length key employee as part of the founder’s succession plan.
Is the difference treated as an income inclusion for the employee? a deemed dividend, or capital gain? a gift? Are their any implications for the founder? Any implications if the CCPC is a farm?
The excess above fair market value would be a taxable benefit.
Thanks Tax Guy, could you comment on a possible Scenario C: Assume John acquires shares via option agreement equal to 49% of the value of the company, he remains with the company & founder wants John to succeed him, can he exchange the shares (after 2 years) acquired via option agreement for the founder’s common shares? If so what are tax consequences for the founder and for John?
Ray,
The option to buy would give rise to a taxable benefit if the exercise amount is less than the fair market value. The exercise of which would realize the benefit but it may be deferred. See the link in my last comment.
For the original owner: Its a deemed dividend if the company redeems the shares and its a capital agin if he sells them to John.
I would suggest that you hire an accountant to arrange this as corporate taxation has far too many variables that can go wrong.
What if the sale of the Shares in Invesco were being sold at FMV but to the brother John, who also works for Invesco?
This would require more research, but at first blush it would appear that as long as the transaction occurred at fair market value, the gain would be realizable. Whether the CGE applies would be a question of law. At this point I am not aware of any specific exclusion.
I’m not sure if any other pro’s who read this have a comment.
What practical method (aside from a formal valuation) of determining a FMV of a CCPC would you suggest if there are no arms length persons interested in buying shares of the CCPC.
You can hire a CBV, ask your accountant or contact a real estate agent (real estate agents have access to business brokers).
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