Principal Issues: Whether a share of the capital stock of a corporation would qualify as a taxable preferred share in the hypothetical scenarios described?
Reasons: Depends on the particular facts and circumstances.
Position: General comments provided.
FEDERAL TAX ROUNDTABLE, OCTOBER 7, 2022
APFF CONFERENCE 2022
2. Taxable preferred shares and shareholders' agreement
The tax under Part VI.1 of the Income Tax Act [footnote 1] is a 25% tax that applies to taxable dividends paid on taxable preferred shares ("TPS"). The characterization of a share as a TPS is determined in accordance with the definition in subsection 248(1) at the time the dividend is paid, and in determining whether a share is a TPS, the characteristics of the shares must be considered, as well as any agreement that would have the effect of modifying the characteristics of such shares. The definition of a TPS includes a share that is a short-term preferred share ("STPS"). A STPS is, among other things, a share that the issuing corporation may be obliged to redeem within five years of its issue. An exception exists where the share is acquired for an amount not exceeding its FMV at the time of acquisition.
It is common for a minority shareholder of a private corporation disposing of its shareholding to wish to obtain compensation if certain events occur after its disposition and within a certain period of time (e.g. 12 months) and, as a result of these events, the value of the corporation's shares exceeds the value determined at the time of its withdrawal. The events generally covered are public offerings, the sale of a significant part of the assets or a change of control of a corporation.
Questions to the CRA
(a) Shareholders who hold only common shares pursuant to the articles of incorporation may enter into an agreement whereby redemption, tag-along or drag-along rights may be exercised at an amount equal to FMV.
To the extent that the exercise of the redemption, tag-along or drag-along rights would result in actual or deemed dividends, can the CRA confirm that such shares would not be TPSs because the redemption, tag-along or drag-along rights would only be exercised at FMV?
(b) Under a shareholders' agreement, it is provided that a shareholder may request the redemption of its common shares at FMV.
If the agreement also provides that compensation would be payable (for example, in the event of a public offering under which the value of the shares exceeds the price agreed to at the time of redemption) within 12 months of a shareholder redemption transaction under such agreement, resulting in a deemed dividend, would that compensation result in shareholders not being considered to transact at FMV at the redemption time?
c) If such compensation were instead paid by another shareholder in the situation described in Question (b), rather than by the corporation that redeemed the common shares of its capital stock, and the payment were included in the redeeming shareholder's income, either pursuant to paragraph 12(1)(g) or as an inclusion in its proceeds of disposition, would the payment of that compensation have the effect of causing the redeemed shares to be TPSs because the amount received was in addition to the amount determined as the FMV on the redemption?
(d) What if the compensation was provided for in the share purchase agreement rather than in the shareholders' agreement? Would this change the result?
(e) Would the fact of the compensation being paid within a particular specified period of time have an impact on the characterization as a TPS? (6 months vs. 12 months vs. 24 months)?
CRA Response
I.T.A. subsection 248(1) defines a TPS as any of the following:
- a share issued after December 15, 1987 that is a short-term preferred share at that particular time within the meaning of the definition in subsection 248(1);
- a share which, at that particular time, has terms or conditions, or there is an agreement to which the issuing corporation or a person related to the issuing corporation (within the meaning assigned by paragraph (h) of the definition of TPS in subsection 248(1) is a party in respect of the share which, inter alia, make it reasonable to consider, that the amount that the shareholder is entitled to receive in respect of the share on the dissolution, liquidation or winding-up of the corporation or on the redemption, acquisition or cancellation of the share (unless the requirement to redeem, acquire or cancel the share arises only in the event of the death of the shareholder or by reason only of a right to convert or exchange the share) or on a reduction of the paid-up capital of the share by the corporation or by a specified person in relation to the corporation is, by way of a formula or otherwise, fixed, limited to a maximum, or established to be not less than a minimum.
Subparagraph (f)(ii) of the definition of TPS in subsection 248(1) provides an exception (the "FMV Exception") by virtue of which an agreement in respect of a share is to be read without reference to, inter alia, a clause under which a person agrees to acquire the share for an amount that does not exceed the FMV of the share at the time of the acquisition - determined without reference to the agreement - or an amount determined by reference to the assets or earnings of the issuing corporation where that determination may reasonably be considered to be used to determine an amount that does not exceed the FMV of the share, determined without reference to the agreement, at the time of the acquisition.
Furthermore, paragraph (a) of the definition of STPS [short-term preferred shares] in subsection 248(1) generally defines a STPS to mean a share that at that particular time, is a share where, under the terms and conditions of the share, any agreement relating to the share or any modification of those terms and conditions or that agreement, the corporation or a specified person in relation to the corporation (within the meaning of paragraph (j) of the definition of STPS in subsection 248(1)) may, at any time within 5 years after the date of its issue, be required to redeem, acquire or cancel, in whole or in part, the share (unless the requirement to redeem, acquire or cancel the share arises only in the event of the death of the shareholder or by reason only of a right to convert or exchange the share) or to reduce the paid-up capital of the share.
Clause (a)(i)(B) of the definition of STPS in subsection 248(1) also contains a FMV Exception that provides that an agreement in respect of a share shall, inter alia, be read without regard to a clause under which a person agrees to acquire the share for an amount that does not exceed the fair market value of the share at the time of the acquisition, determined without reference to the agreement, or for an amount determined by reference to the assets or earnings of the corporation where that determination may reasonably be considered to be used to determine, without reference to the agreement, an amount that does not exceed the fair market value of the share at the time of the acquisition.
The question of whether a share that otherwise constitutes an STPS and/or a TPS qualifies for the FMV Exception in clause (a)(i)(B) of the definition of STPS or the FMV Exception in subparagraph (f)(ii) of the definition of TPS in subsection 248(1) is a question of fact that can only be resolved after a thorough analysis of all the facts of a particular situation. Since the statement in this question only briefly describes hypothetical situations, it does not appear to us to be possible to make a definitive determination as to the application of the FMV Exception in the situations described therein. Depending on the circumstances, it is indeed possible that the conditions set out therein may be satisfied to the extent that an agreement relating to a share contains a provision that a person agrees to acquire the share for an amount not exceeding the FMV of the share at the time of the acquisition, determined without reference to the agreement.
October 7, 2022
2022-094209
FOOTNOTES
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 R.S.C. (1985), c. 1 (5th Supp.) (”I.T.A.”).