Loss on Redemption of Pref Shares?

Tax Topics
1

We did a surplus strip for a corporate group last year, and I’m having an issue with the accounting I hope someone can help me with.

Essentially, we have Corporation A that holds pref shares of Corporation B. The shares have a PUC of $1 and a redemption value of $800,000.

Corp A purchased them for $800,000.

Corp B then redeems them triggering a deemed dividend of $799,999.

What is the entry for Corp A? My best guess is the following:

Dividend Income ($799,999)
Investment in Corp B ($800,000)
Cash $800,000
Loss on redemption of Corp B $799,999

The loss on redemption makes the most sense. But on the T2, would I just add it back and record a Schedule 6 disposition of $1 ACB and $1 proceeds?

2

I will take a stab at it;

I don’t think you need to do anything special in the accounting books of A.

Dr cash: 800,000
Cr: Investment in Corp B: 800,000

The deemed dividend is an income tax entry, not an accounting entry.

On the T2 return, you would complete Part 1 of Schedule 3 with the relevant data. Name of payer, connected?, BN, tax year end and the deemed Dividend amount likely under section 112. You don’t need to do anything with Schedule 125 as far as the deemed dividend goes, as long as you reported it in part 1 of S3. Unlike “dividends paid” I don’t think TaxCycle kicks out a diagnostic if you receive dividends on S3 but not on S125.

Are the corporations connected? ie the deemed dividend is not taxable to A?

On Schedule 6 you could complete Part 1 for the disposition of the shares. You could indicate $1.00 as the Proceeds and $8,000,000 as the ACB. The schedule will calculate a loss of 7,999,999.

The stop loss rules at 40(3.6) or 112(3) will likely kick in to deny the capital loss loss. You can enter 7,999,999 on the line 160 (Adjustment to losses under 112(3) related to Canadian (or foreign) sourced income). That will bring your capital gain down to zero.

I don’t know enough about the specific situation, but thought I’d add some comments.

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3

Thanks for the reply. I think you’re right. They are connected so there is no tax (Corp B did have a small dividend refund that Corp A will have to pay).

The Schedule 6 part I’m not 100% on. Would I even need to report anything?

4

You probably don’t need to, but I have in the past when encountering this situation. It technically is a capital loss then the loss is denied. TaxCycle has a neat way of handling it.

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6

My emphasis is on reorganization and restructure. I plan and execute these regularly.

If you’re still working on this, let me know and I’ll give you clarity on treatment.

This is not a surplus strip (section 55), but a simple redemption (section 84). Firstly, corporations can only redeem specified classes of shares given there is enough safe income to do so (for purposes of Section 84, redemptions are deemed dividends). Otherwise, a corporation can redeem a specified class of shares on liquation of the company above it’s safe income.

You CANNOT have a company simply subscribe to a specified share class and then have the counter-party redeem that share class, you are subjecting yourself to GAAR attributions and CRA may, and will, disallow the redemption completely.

However, for knowledge purposes, assuming this was done in a more correct manner, you would have the redemption as recorded on S3 of the company B as a regular dividend (make sure to account for the applicable part 4 taxes if necessary), with the corresponding entry on gifi 100 affecting RE. For accounting purposes, you record the Dr. ($799,999) as an equity distribution account (dividend / redemption of shares) on your RE lead sheet and close it out in the subsequent year as a equity.

For company A, you record the redemption as a return on your ACB when the cash is paid. If the company returned the full $800k, you wouldn’t realize a loss. This goes to your schedule 3 and deductible pursuant to subsection 112. you don’t need to record it as dividend income for accounting purposes, but you need to record it as a deemed dividend for tax purposes.

Company A (bookkeeping entry):
Dr. Cash or due form Company B - $800,000
Cr. Investment in Company B - $800,000

Company B (Accounting entry):
Dr. Share capital - $1
Dr. Redemption of shares - $799,999
Dr. Cash or due to Company A - $800,000

Note that new legislation was introduced for 2024 that replaces the surplus scheme with a “test of economic substance”, essentially disallowing a surplus strip where the transaction has no application of economic benefit to the company or individual shareholders primary activities.

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7

If you want to actually initiate a surplus strip, you need have an individual, or non individual dispose of a specified share class to a holding company and then have the holding company exchange that class for another class, and have OPCO redeem the exchanged class… as this would be outlined initially in your articles as such to allow for a redemption. The individual would report the disposition on his T1 Schedule 3 as a capital gain.

In practicality, surplus strips are performed for higher net worth individuals who want to make draws to their shareholder accounts for large personal acquisitions, or for the benefit of family trust beneficiaries (where a LCGE is being utilized).

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8

I only wrote the final step of a number of transactions whereby the originally holder of the preferred shares was an individual, and they traded hands a couple times to land in Corp A’s hands. We executed a correct surplus strip. And yes, the new 2024 legislation is what mainly spurred the maneuver in 2023.

Thanks for the accounting entries.

9

Fair enough.

If you did a subsection 51 swap and/or 85 exchange , you shouldn’t have any cash involved, just assign promissory notes to each other and pick up the transactions on the T2.

10

Great work!

I have done a handful of these and have always sub’d out the surplus strip work to a larger firm with deeper pockets. Even prior to them closing that door I had always been jittery about using the surplus strip loophole… essentially converting deemed dividends into a capital gain at the individual level. I always figured the bigger named firms would have a much better chance at pushing back on the CRA to defend the strategy than would a little guy like me. :wink:

Not sure I actually even agreed with the strategy.

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11

What’s funny is that there still isn’t any permanent solution to the surplus, even with the new legislation. The economic substance test is imposed by CRA directly and not actually defined into legislation… there was some pushback (a good friend of mine is a senior partner at big 4) on this because having to actually amend the legislation to remove the loophole would also capture the purification scheme that holdco’s use to strip passive assets (a similar methodology is used when executing the transactions here) … so in that manner, it roots itself deeper, diving into individual taxation, affecting LCGE and all that good stuff. The result was CRA saying “ok, we’ll just have to review the substance of it on an individual basis and disallow it from there” … that and the 100% capital gains AMT inclusion (which is basically just the first wall of defense)!

12

Hey - I am actually working on a situation that you are describing here and am fairly new on the whole tax planning/surplus stripping component.

Do you mind helping me - below is the situation I am facing.

I have an individual shareholder who owns 100% of Corporation A and 100% of Corporation B. The PUC of Corporation A Shares is $50.00 and FMV is $400,000.00.

There is an arms length purchaser who is looking to purchase the Assets of Corporation A.

Here is what I am proposing:

Individual takes the Common Shares Class A of Corporation A and transfers them to Corporation A using a S85 rollover in exchange for Common Shares Class B. Individual elects to do the transfer at FMV of 400K and recognizes a Capital Gain on this transfer. Therefore after this transaction he gets preferred shares of Corp A with FMV of 400K and PUC of $50.00.

Individual takes the newly acquired Common Shares Class B of Corporation A and undertakes a transaction with Corporation B (not sure if S85 or another rollover needs to be used here), whereby the Individual gives the Class B Shares with FMV of $400K in exchange for Note Payable equal to $400K.

Now Corporation A is Wholly-Owned by Corporation B & are connected Corps.

The Arms length purchaser purchases the assets of Corporation A and provides proceeds equal to $400K. There are no assets left in Corporation A.

Corporation A redeems its Class B Shares from Corporation B - triggering a deemed dividend as per 84(2) and distributes the proceeds of $400K to Corporation B.

Corporation B repays the notes payable to Individual - allowing the individual to recoup the proceeds.

The issues I am running into are:

  1. How do I prove the GAAR “test of economic substance surplus” → the points i have going for me is that (a) the Arms length purchaser is ONLY interested in purchasing the assets, therefore the shareholder has some economic substance due to their weaker position in this transaction to accompany the asset sale, she is undertaking the series of transactions. She had previously tried to sell this business but was met with difficult due to certain conditions, and therefore knowing these conditions she is in a weaker negotiation position and has to accept an asset sale. Thus to minimize her loss on this transaction shows some aspect of economic substance? (b) The income tax allows for Capital Gains to be applied on Share Sale & given the point explained in (a) for the shareholder to circumvent the massive loss and agree to the provision of this deal with the arms length purchaser - the shareholder has to undertake this reorg, which effectively, when the transaction is looked at holistically - it constitute a share sale, with extra steps?

  2. If the above is actually feasible meeting GAAR - can the individual claim LTCGE on the Capital Gains?

Does this sound about right, or am I missing something here?

13

If the shareholder has Class A common voting shares with FMV of $400k and PUC of $50, why bother exchanging them for Class B common voting shares with FMV of $400k and PUC of $50? He could simply sell the Class A shares to Corp B, then subscribe for a nominal amount of Class B shares (if he wanted to maintain a personal stake in Corp A).

Either way the shareholder ends up with a note payable from Corp B and a capital gain on the sale of shares of Corp A. It’s not going to matter whether he sold Class A shares or Class B shares to Corp B, the whole thing still gets caught under 84.1 (for purposes of 84.1 ACB is reduced as a result of the CG…I think…?).

14

The idea is to avoid 84.1 under the individual shareholder. When a 85 is performed with Corporation A and the Shareholder, there is no 84.1 triggered and no PUC increase.

Hence why its necessary to recognize a Capital Gain without triggering a 84.1 - which occurs when 1. Non-Share Consideration is exchanged with an arms length party 2. PUC is increased. In the situation I explained there is 1. No non-share consideration 2. PUC isnt increased, but rather the ACB.

ACB can increase but not PUC.

15

See your inbox.

16

Not true. But, hopefully @Deepinthemoneycall has set you straight privately, or provided an alternative that works.

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