Short-term and taxable preferred shares: Think before you dividend

9 juin 2022 | Raymond G. Adlington

( Disponible en anglais seulement )


Dividend sits among the group of the most pleasant words in the English language. The crescendo of the single letter syllable in the middle of the word creates a satisfying enunciation when spoken. The connotation of the receipt of money or property from a corporation is always a pleasant thought. The alliterative phrase ‘directors declare a dividend’ is the perfect rhythm for such an auspicious occasion. Truly, dividend is an underutilized word in our collective library of songs, poems, and stories.

Despite the pleasant lilt of the word, unexpectedly painful tax consequences may lurk if the shares upon which a dividend is paid are either “taxable preferred shares” or “short-term preferred shares.” A corporation that receives a dividend on taxable preferred shares it owns faces Part IV.1 tax of 10% under the Income Tax Act (the “Act”).[1] Just like when we were children, the Act allows an annual dividend allowance to paying corporations of $500,000. A taxable Canadian corporation that exceeds the allowance earns the privilege of paying Part VI.1 tax of 25% of the excess if the shares are taxable preferred shares and 40% if the shares are short-term preferred shares.[2]

Let’s dig deeper into definitions and departures to take a Louisville slugger to both Part IV.1 and Part VI.1 tax on our dividend declarations.

What are these fancy shares anyway?

A “taxable preferred share”[3] is one which, based on the terms and conditions of the shares or any agreement to which the corporation or related person is a party:

  • the dividend entitlement is fixed, limited to a maximum, or not less than a minimum;
  • on dissolution, redemption, acquisition or other cancellation of the share the liquidation entitlement is fixed, limited to a maximum, or not less than a minimum;
  • the share is convertible or exchangeable unless the conversion is to another security that would not otherwise be a taxable preferred share; or
  • a person, other than the corporation, is obligated as a result of the transaction or series that included the issuance of the share at some time to ensure any loss incurred by the shareholder in relation to the share is limited or that the shareholder will derive earnings from the ownership of the share.

A “short-term preferred share[4]” is one which, based on the terms and conditions of the shares or any agreement to which the corporation or related person is a party, the corporation may be required to redeem or reduce the paid-up capital of the share within 5 years after the date of its issue.[5]

For the drafting lawyer, falling down the rabbit hole into one of these two definitions is deceptively simple even in circumstances where the shares might otherwise be considered “common shares” [6] for tax and corporate law purposes. Consider as examples:

  • If two classes of discretionary dividend common shares are distinguished by giving one of the classes a nominal preference on the dissolution of the corporation before amounts are paid on the other classes of common shares then that share will be considered a “taxable preferred share” since the dissolution amount is established to be not less than a minimum.
  • If on an estate freeze, the terms and conditions of the preferred shares issued contain a retraction right that allows the holder of the shares to require their redemption at any time to satisfy the Canada Revenue Agency (“CRA”) policy on fair market value to avoid a benefit conferral,[7] then that share will be considered a “short-term preferred share” even if no redemption occurs in the five year period referenced in the definition since the definition is focussed on possibilities rather than actual events.
  • If the shareholders of a corporation, all holding the same class of common shares, enter into a unanimous shareholders agreement with the corporation that contains a dividend policy stating that a fixed percentage of the after-tax income will be declared as dividends to the shareholders with the rest reinvested or used to pay debt then that share will be considered a “taxable preferred share” since the agreement sets a maximum dividend entitlement.
  • In the same circumstances, if the unanimous shareholders agreement instead includes a compulsory acquisition of the share by the corporation upon certain triggering events (other than the death of the shareholder) then that share will be considered a “taxable preferred share” since the agreement fixes the amount to which the shareholder is entitled to receive on the acquisition unless that amount is equal to the fair market value of the share.[8]

Painful Part IV.1 tax or Part VI.1 tax can arise in such varied circumstances as (i) normal annual dividends paid to a retiree following an estate freeze, (ii) a safe income strip prior to a share sale, or (iii) a post-mortem redemption designed to avoid double taxation. Yet the pain is not automatic when you encounter these fancy “short-term preferred shares” or “taxable preferred shares,” under whatever assigned name they may have for corporate law purposes. Let’s keep going in the analysis.

Where are the escape hatches?

Part IV.1 tax comes before Part VI.1 tax in the ordering of the Act, so let’s review this 10% tax imposed on a corporate recipient of a dividend on a taxable preferred share first. Part IV.1 tax is not imposed on individuals, so being human is the first escape hatch. A corporation that claims the inter-corporate dividend deduction is subject to Part IV.1 tax unless either the paying corporation makes the election available under ss. 191.2(1) to increase its Part VI.1 tax rate from 25% to 40% (let’s call that unlikely) or the dividend is an “excepted dividend.” An excepted dividend[9] is one that is (a) received from a foreign affiliate, (b) received from a corporation in which it has a “substantial interest” (more on this later), (c) received from a private corporation, (d) received on a short-term preferred share,[10] or (e) received from a mutual fund corporation. The final type of excepted dividend is a deemed dividend under ss. 84(2) or (3) that is then deemed an excepted dividend by ss. 191(4). More on this later too since it also applies to Part VI.1 tax.

The five escape hatches of the “excepted dividend” definition plus the ability to elect out of Part IV.1 tax leaves only a very narrow sliver of circumstances where Part IV.1 tax applies. This sliver is dividends received from a corporation that is either a public corporation or a subsidiary of a public corporation (which is also not a foreign affiliate or mutual fund corporation) otherwise deductible in which the recipient corporation does not own a substantial interest and where the paying corporation has not made an election to pay more Part VI.1 tax than it would otherwise have to pay and ss. 191(4) does not apply. In other words, Part IV.1 tax is not a major governmental revenue source.

The most common escape hatch from Part VI.1 tax when dividends are declared on short-term preferred shares or taxable preferred shares is the annual dividend allowance. The base annual dividend allowance is set at $500,000,[11] but this is reduced on a dollar for dollar basis if non-excluded dividends[12] are declared on taxable preferred shares in excess of $1,000,000 in the calendar year that precedes the calendar year in which the taxation year ends. Unchanged since 1987, the base annual dividend allowance is not indexed. If the total amount of the dividends declared (or deemed declared) on short-term preferred shares and taxable preferred shares is less than or equal to $500,000 and no grind applies due to prior calendar year dividends then declare away. Even if all other escape hatches are locked, Part VI.1 tax only applies to the excess of the dividend over the available dividend allowance to help manage the pain.

If the dividend allowance escape hatch is locked then the next escape hatch to try is the substantial interest[13] part of the “excluded dividend” definition found in ss. 191(1). Get through this one and no Part VI.1 tax applies to any amount of dividend declared. The shareholder receiving the dividend has a substantial interest in the corporation paying the dividend if:

  • The dividend recipient is related to the corporation;[14] or
  • The dividend recipient owns a total number of shares that exercise 25% of the votes which may be cast at a general meeting of the shareholders and a total number of shares that represent 25% of the value of all shares of the corporation and either shares excluding taxable preferred shares that represent 25% of the value of all such shares of the corporation or 25% of each class of shares of the corporation.

For the purpose of this 25% ownership test, the shareholder is deemed to also own any shares actually owned by a related person.[15] The test to determine whether a substantial interest exists in the context of a deemed dividend arising on a redemption is applied immediately prior to redemption.[16]

The final escape hatch is available solely to a dividend deemed arising on the redemption, acquisition or cancellation of a share to which ss. 84(2) or (3) applies. If at the time the share was issued, terms changed, or an agreement entered into and the terms of the shares specify an amount for which the share is to be redeemed[17] and the specified amount does not exceed the fair market value of the consideration for which the share was issued then the deemed dividend arising on the redemption, acquisition or cancellation is further deemed an “excluded dividend” for the purposes of Part VI.1 tax and an “excepted dividend” for the purposes of Part IV.1 tax. If the amount actually paid on the redemption, acquisition or cancellation of a share exceeds the “specified amount” then the escape hatch slams shut putting the deemed dividend back into the Part IV.1 tax and Part VI.1 tax regimes.[18]

With respect to the specified amount, the CRA has issued administrative statements (untested before the Tax Court) that the terms or conditions of the share or agreement in respect of the share must specify an actual dollar amount, and where no amount has been specified, the specified amount will be the amount for which the share is to be redeemed, acquired or cancelled.[19] Common practice in the context of any estate freeze or other related party transfer of property to a corporation pursuant to ss. 85(1) is to include a price adjustment clause in the terms and conditions of the share. The CRA has also stated acceptance that the shares being the subject to the potential operation of a price adjustment clause will not, in and of itself, negate the amount that was specified for the purposes of ss. 191(4). That said, the CRA went on to state that if a price adjustment clause became operative after the redemption of the shares to increase the redemption proceeds to an amount in excess of the specified amount, the excess would not qualify as an excluded dividend by virtue of the ss. 191(5) limitation.[20] Worse, the CRA also stated that if a price adjustment clause became operative to reduce the redemption amount then the requirement of ss. 191(4) that the specified amount not exceed the fair market value of the consideration for which such shares were issued would not be met leading to the outcome that the entire deemed dividend on the redemption, acquisition, or cancellation of such shares may be subject to Part IV.1 tax and Part VI.1 tax if no other escape hatch is available.

Despite the promise of the opening words of ss. 191(4), the final escape hatch is also unavailable where the share is issued as consideration for another taxable preferred share. This means that on an estate refreeze where preferred shares containing a retraction right issued on the original estate freeze are exchanged for preferred shares having a reduced redemption value due to a decline in the value of the assets of the corporation, the newly issued preferred shares will be subject to Part IV.1 tax and Part VI.1 tax respectively upon redemption, acquisition or cancellation even if a fair market value amount is specified in relation to these shares unless another escape hatch is available due to the application of subpara. 191(4)(d)(i) or (ii).[21]

What about a refund?

Unfortunately not. Neither Part IV.1 tax nor Part VI.1 tax is added to a refundable dividend tax on hand or other similar tax balance that could be recovered through some action taken by the corporation.

Neither Part IV.1 tax nor Part VI.1 tax is directly deductible in calculating the taxable income of a corporation.[22] Instead, for Part VI.1 tax only, a deduction of 3.5 multiplied by the tax payable is available.[23] This deduction is designed to allow a paying corporation to recover Part VI.1 tax payable through a reduction of Part I tax should the paying corporation have sufficient taxable income. The multiple of 3.5 presumes a combined federal and provincial / territorial corporate tax rate of 28.5%. Where the small business tax rate applies or where the combined federal and provincial / territorial corporate tax rate is less than 28.5%, the deduction does not allow a full recovery of Part VI.1 tax when considering the pre-tax income that must be earned to pay the dividend.


Please save a little trouble for the next taxpayer by ensuring that you find an escape hatch from Part IV.1 tax and Part VI.1 tax or that the tax paid can be fully recovered via the enhanced deduction available before hitting send with that dividend declaration resolution attached. Please then declare dividends delightfully traversing the tax traps so we can keep dividend at the top of the English language pile of happy words.

[1] This tax only applies to dividends which are deductible under ss. 112(3) and are not “excepted dividends” as defined in s. 187.1.

[2] Liability for the tax may be transferred by agreement to a related corporation, determined without regard to para. 251(5)(b), by agreement between the corporations pursuant to ss. 191.3(1).

[3] Defined in ss. 248(1).

[4] Defined in ss. 248(1).

[5] Unless the requirement to redeem is only in the event of the death of the shareholder or by reason only of a right to convert or exchange the share.

[6] Defined in ss. 248(1) to be a share where the participation on dissolution or redemption from participating in the assets of the corporation beyond the amount paid up on that share plus a fixed premium and a defined rate of dividend is unrestricted.

[7] CRA Technical Interpretation No. 9500555 (February 2, 1995) and CRA Information Circular 76-19R3, Transfer of Property to a Corporation Under Section 85 at para. 24 (June 17, 1996).

[8] The fair market value exception is found in part (f) of the definition of “taxable preferred share” in ss. 248(1).

[9] As defined in s. 187.1.

[10] This exception makes the list because the Part VI.1 tax rate is automatically the higher 40%.

[11] Set by ss. 191.1(2), the dividend allowance is shared among associated corporations by agreement among them by ss. 191.1(3) or by Minister determination by ss. 191.1(5) should the corporations fail to agree. The dividend allowance is also prorated for short taxation years by application of ss. 191.1(6).

[12] As defined in ss. 191.1(1).

[13] As defined in ss. 191(2) and subject to the specific anti-avoidance rules in ss. 191(3).

[14] Determined without regard to para. 251(5)(b).

[15] Determined without regard to para. 251(5)(b).

[16] CRA Technical Interpretation No. 2005-0118531E5 (March 9, 2005).

[17] Accrued and unpaid dividends may be added if the terms so specify.

[18] See ss. 191(5).

[19] CRA Technical Interpretation 9309585 (April 16, 1993).

[20] CRA Technical Interpretation 2016-0634551E5 (May 4, 2016).

[21] Subpara. (ii) applies where the change is made to the terms and conditions of the share or the agreement in relation to the share is changed at a time when the share is a taxable preferred share.

[22] Due to the limitation in subpara. 18(1)(t)(i).

[23] See para. 110(1)(k). The availability of this deduction is a reason to consider the ss. 191.2(1) election so that a corporate recipient is not subject to the 10% Part IV.1 tax for which no other recovery method exists.

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