Part VI.1 tax under the Income Tax Act is often described as a “trap for the unwary” because it can apply unexpectedly and at a steep rate. This 25% tax is levied on the corporation paying the dividend, not the recipient, and is calculated based on the dividend amount rather than annual taxable income.
For business owners, this means that a misstep in structuring a shareholders’ agreement could expose the company to significant liability. Understanding how “taxable preferred share” rules operate is therefore essential to avoid inadvertent exposure.
What is Part VI.1 Tax and why does it matter?
Part VI.1 tax applies to dividends paid on a “taxable preferred share,” a term that is broader than many expect. It can extend beyond what corporate law traditionally considers a preferred share.
While exemptions exist, they depend on the relationship between the particular shareholder and the corporation, or on certain share-related conditions. Relief is available through a deduction, but its effectiveness depends on whether the dividend-paying corporation can absorb a certain deduction against taxable income and on the corporation’s effective tax rate. Given the complexity, it is almost always preferable to avoid falling within the ambit of the tax in the first place.
Can a shareholders agreement turn garden variety common shares into “taxable preferred shares?”
The definition of a “taxable preferred share” is not limited to what appears in a corporation’s articles. The terms of a shareholders’ agreement – whether or not it is a unanimous shareholders’ agreement – are also relevant. In fact, any agreement relating to the shares in question, where the corporation or a non-arm’s length person to the corporation is a party, is relevant to the analysis.
A potential issue arises where an agreement contains a buy-sell clause. Part VI.1 tax can be triggered if the clause specifies the amount a shareholder may receive on the acquisition of the share (excluding an acquisition triggered by the shareholder’s death) as a fixed amount or as an amount subject to a floor or ceiling price. On its face, many buy-sell clauses appear to meet this test. Does that mean all such clauses are problematic?
Fortunately, the legislation includes a specific carve-out, which provides that, in the case of an agreement, any provision under which a person agrees to acquire a share for not less than its fair market value is ignored. Although this statement glosses over certain timing and valuation technical considerations, the key takeaway is that careful drafting can help prevent adverse tax consequences.
What did the Canada Revenue Agenda say in Ruling 2023-0970691R 3?
In a recent ruling, the Canada Revenue Agency (the “CRA”) examined a shareholders’ agreement involving common shares. The relationship among the shareholders was not clearly defined. The shareholders’ agreement, among other things, gave certain shareholders the right to require the corporation to repurchase their shares (described as Class B common shares), either as of a specified date or in the event of default under the agreement. A bonus was also payable if certain triggering events occurred within 12 months of the disposition, calculated based on the transaction value. In other words, it seemed that the shareholders whose Class B common shares were repurchased would be entitled to additional compensation if the subsequent transaction value was higher.
The CRA ruled that this particular clause, in itself, would not cause the Class B common shares to be “taxable preferred shares.” Notably, the ruling did not rely on the special carve-out, suggesting that the bonus payment did not make the repurchase price subject to a floor or, in the words of the definition, an amount not less than a minimum. It may have been the uncertain nature of the increased payment that the CRA found persuasive.
What should businesses and advisors do?
The definition of “taxable preferred share” is broad, and the potential consequences can be significant. Even ordinary common shares may be caught if shareholder arrangements are not carefully drafted. If you are reviewing shareholders’ agreements or planning corporate structuring, our Corporate Tax Group can help you navigate the complexities of Part VI.1 and avoid costly surprises.
Connect with us today to discuss your specific situation and subscribe to our newsletters to receive timely insights on legislative updates.
