Frequently when restructuring a closely held private corporation shareholders must decide whether to transfer shares from one shareholder to another with a share purchase and sale or to have the corporation redeem (i.e. buy back) the shares from the shareholder, resulting in a reduction in the total number of issued and outstanding shares and increased ownership among the remaining shareholders. This article provides an overview of related tax considerations.
Share Purchase and Sale Between Shareholders
When shares have appreciated in value transferring them to another shareholder is generally the more advantageous course of action for sellers from a tax perspective. If you sell your shares to another shareholder, you will be considered to have made a “capital gain.” Capital gains are treated favourably compared to other forms of income; only 50% of a capital gain is taxable, and capital gains are subject to favourable tax rates.
If the shares in question are considered qualified small business corporation shares, you will also be able to claim the lifetime capital gains exemption. Briefly, a share will generally be considered a qualified small business corporation share if:
- At the time of sale, and throughout the 24 month period immediately before the share was disposed of, the share was owned by you, your spouse or common-law partner, or a partnership of which you were a member;
- Throughout the 24 months immediately before the share was disposed of, it was a share of a Canadian-controlled private corporation; and,
- More than 50% of the fair market value of the assets were used mainly in an active business carried on primarily in Canada by the Canadian-controlled private corporation, or by a related corporation, or were certain shares or debts of connected corporations.
However, the rules governing both the lifetime capital gains exemption and qualified business corporation shares are highly complex; contact a qualified tax professional for further information on how these rules apply to your situation.
Corporate Share Redemption
When shares have appreciated in value share redemptions generally have unfavourable tax consequences to sellers compared to transfers to other shareholders. If the corporation redeems your shares the redemption will result in a “deemed dividend.” A deemed dividend is determined by deducting the paid-up capital (“PUC”) of the shares from the price paid by the corporation for their redemption. PUC is calculated by averaging the total amount of shareholder capital paid in the issued shares of that class. It is important to note that if the shares were bought at lower rates by other shareholders, the PUC could be less than what you paid for the share and thus, you will have a larger deemed dividend than capital gain.
The capital gain and the dividend tax rates vary by province; however, in most provinces, dividends are taxed at higher rates than capital gains, and sometimes by large margins. Though there are two rates for dividends depending on whether the corporation deems them “eligible” or “ineligible” dividends, again, both are generally higher than the capital gains tax rate. In the 2015 tax session in Ontario, those in the highest tax bracket were taxed at 24.77% for capital gains, while they were taxed at 33.82% for eligible dividends, and at 40.13% for ineligible dividends.
For further information on the tax consequences of share transfers, redemptions and dividends, contact a professional advisor. Nick Wright is a Toronto business lawyer. Contact him at nick[at]wrightbusinesslaw.ca to arrange a time to discuss your legal needs.
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