The Purpose of Parts IV.1 and VI.1
The tax-free nature of most intercorporate dividends makes equity financing a more attractive avenue for investors to deploy their capital than acquiring debt, as debt would give rise to interest income that would be subject to tax.
Part IV.1 tax and Part VI.1 tax was introduced to mitigate this inequity and prevent the avoidance of tax through the use of tax-free intercorporate dividends. Parts IV.1 and Part VI.1 are generally applicable in situations where preferred shares have been issued with terms that closely resemble the terms commonly found in debt instruments. The applicable sections do this by applying a tax to what would otherwise be tax-free intercorporate dividends.
Part IV.1 of the Income Tax Act levies a tax on dividends that are received on certain types of preferred shares while Part VI.1 levies a tax on dividends paid on certain preferred shares.
In essence, Parts IV.1 and VI.1 of the Act attempt to provide a tax-neutral landscape between debt financing and equity financing.
Who Pays the Tax? Part IV.1
The tax is payable by any corporation that has received a dividend, other than an excepted dividend, on a taxable preferred share, to the extent that the dividend was deductible under section 112 or 113, or subsection 115(1) or 138(6) of the Act.
Part VI.1
The tax is payable by a taxable Canadian corporation that pays dividends, other than excluded dividends, on short-term preferred shares and on taxable preferred shares.
Note the difference between the two taxes; Part IV.1 applies to any corporation, while Part VI.1 only applies to taxable Canadian corporations, which are defined in the Act.
How Much is the Tax?
Part IV.1
Corporations in receipt of dividends subject to Part IV.1 tax are liable to pay 10% of the dividends received to the extent the dividends were deductible under Section 112 or 113, or Subsection 138(6).
Part VI.1
For taxation years ending after 2011, taxable Canadian corporations that pay dividends subject to Part VI.1 tax are liable to pay 40% of the dividends paid to the extent the dividends exceeded the corporation’s dividend allowance for the year.
What Preferred Shares are Impacted?
Short-term Preferred Shares and Taxable Preferred Shares are potentially subject to Parts IV.1 and VI.1. Both types of shares are defined in the Act. A Short-term Preferred Share is a share that is:
(a) A share, the terms of which require, or may require at any time within 5 years of issue, the corporation to redeem, acquire, or cancel the share, unless the requirement is only in the event of the death of a shareholder or because of a conversion right, or
(b) A share that is convertible or exchangeable at any time within 5 years from the date of issue, unless:
- a. It is convertible into or exchangeable for a share that would not be a short-term preferred share, or for a right or warrant that is exercisable for a share that would not be a short-term preferred share, and
- b. The only consideration received on the conversion or exchange is the share, right or warrant, or consideration in lieu of a partial share, right, or warrant.
Any share that is retractable solely at the option of the holder will fall into (a) above as it only requires that the corporation may be required to redeem the share within 5 years. These terms are prevalent in the characteristics of most classes of preferred shares, including freeze shares.
A Taxable Preferred Share is defined as either a Short-term Preferred Share, or a share, the terms of which:
- a. Limit the number of dividends that may be paid to a fixed amount, a maximum amount, or a minimum amount
- b. Limit the amount to which the shareholder is entitled to receive upon the dissolution, liquidation, or winding up of the corporation, or upon the redemption, acquisition, or cancellation of the share, or on a reduction of the PUC of the share, to a fixed amount, a maximum amount, or a minimum amount
- c. Provide that the share is convertible or exchangeable at any time (unless convertible or exchangeable only into a share that would not be a taxable preferred share), or
- d. Obligate any person, other than the corporation, to provide guarantees that either limit losses sustained by the shareholder, or guarantee some level of earnings to the shareholder
In the case of both definitions, the share must only meet one of the criteria to be a Taxable Preferred Share, which makes it incredibly easy for many private corporations to unknowingly issue Short-term and Taxable Preferred Shares and fall into these rules.
Because of the prevalence of Short-term Preferred Shares and Taxable Preferred Shares in the authorized share capital of private corporations, it is important to understand the exceptions to Parts IV.1 and VI.1 and how to ensure your clients are not inadvertently subject to either tax.
Excepted Dividends
There is a carveout from the application of Part IV.1 tax for Excepted Dividends. Although there are several types of dividends included in the definition of Excepted Dividend, we will focus on three common scenarios. Pursuant to Section 187.1, an Excepted Dividend for purposes of Part IV.1 is:
- (a) A dividend received by a corporation on a share of the capital stock of a foreign affiliate,
- (b) A dividend received by a corporation from another corporation in which it has a substantial interest, or
- (c) A dividend received by a corporation that is a private corporation or a financial intermediary corporation,
Paragraph 187.1(c) excepts many corporations from Part IV.1 tax simply by virtue of being a private corporation or a financial intermediary corporation. A financial intermediary corporation is defined to include certain Prescribed Venture Capital Corporations. This key exception provides private corporations and certain venture capital organizations with more freedom in how they invest funds.
Excluded Dividends
Similar to Excepted Dividends, there is a carveout from the application of Part VI.1 tax for Excluded Dividends. There are several parts to the definition of Excluded Dividend in Subsection 191(1), but we will focus on the most relied upon carveout for private corporations. An Excluded Dividend is:
(a) A dividend paid by a corporation to a shareholder that had a substantial interest in the corporation at the time the dividend was paid.
Unfortunately, unlike the definition of Excepted Dividends for purposes of Part IV.1
tax, there is no exception for being a private corporation in the definition of Excluded Dividends for purposes of Part VI.1 tax. Therefore, it is crucial to focus on what amounts to a Substantial Interest for the purposes of the definition of an Excluded Dividend.
Substantial Interest
The Substantial Interest test has two ways to meet it as set out in Subsection 191(2). The first test relies on the shareholder being related to the dividend payer. This is most often achieved by the shareholder controlling the dividend payer or being related to a person that controls the dividend payer. In many closely held structures, this is easily achieved between spouses, children, and parents.
The second test relies on the shareholder crossing certain thresholds with their holdings if the related test isn’t met. The shareholder is required to own, at the time the dividend is paid, shares with at least 25% of the total votes of the corporation plus shares with a fair market value of at least 25% of the fair market value of all issued shares of the corporation. In addition to that, the shareholder must also own either:
- (a) Shares that would not be taxable preferred shares with a fair market value of at least 25% of all such issued shares, or
- (b) In respect of each class of shares, shares with a fair market value of at least 25% of that class
There is also a deeming rule Subsection 191(2) that deems a shareholder to own any shares that are owned by a related person which counts towards meeting the 25% thresholds.
If either test is met at the time the dividend is paid, the dividend will be an Excluded Dividend and won’t be subject to Part VI.1 tax.
Dividend Allowance
If a dividend isn’t an Excluded Dividend for purposes of Part VI.1 tax, there may still be no tax owing if the amount of dividends paid is below the corporation’s Dividend Allowance amount.
A taxable Canadian corporation’s maximum Dividend Allowance is $500,000 per year. A group of associated corporations must share the same $500,000 Dividend Allowance and must file an annual agreement to allocate the allowance between members of the group.
The $500,000 Dividend Allowance is ground down, on a dollar-for-dollar basis, where non-excluded dividends paid on taxable preferred shares in the prior calendar year exceed $1,000,000. Once the prior year dividends equal or exceed $1,500,000, the Dividend Allowance for the current year will be fully ground to nil.
Other Special Rules
Taxpayers who are subject to tax under Part IV.1 or VI.1 are required to file an information return with their corporate income tax returns and is due to be filed by the taxpayer’s regular income tax filing deadline.
Paragraph 110(1)(k) provides a deduction from net income equal to 3.5 times the amount of Part VI.1 tax paid by a corporation. This deduction is intended to ensure that overall no excess tax is paid but rather the Part VI.1 tax payment is treated as an advance of tax. A corporation paying Part VI.1 tax that has no other taxable income will however be subject to additional taxes as it cannot make use of the deduction under Paragraph 110(1)(k).
Subsection 191.3(1) allows two corporations to file an agreement with the CRA to transfer the Part VI.1 tax liability of a dividend payer to the dividend recipient. This may be a useful tool where the dividend payer cannot make use of the deduction under Paragraph 110(1)(k) but the dividend recipient can. It should be noted that there is an anti-avoidance rule that prevents the transfer of liability (and thereby the transfer of the deduction) where the principal purpose for the two corporations becoming related was to make use of the deduction under Paragraph 110(1)(k).
Examples
Example 1:
Assume Opco has only one class of common shares and one class of preferred shares. The percentages below represent the same percentage owned in both common shares and preferred shares and represent the share of votes and fair market value.
C Co has a substantial interest in Opco because it is related to Opco by virtue of control. Dividends paid on taxable preferred shares to C Co will be excluded dividends.
Initially it does not appear that H Co and W Co have substantial interests in Opco because neither is related to Opco as they don’t control Opco and Husband/Wife are not related to Cousin for purposes of the Act. As Husband and Wife are related, however, the deeming rule in 191(2) deems H Co to own shares owned by the related W Co, and vice versa. This results in both H Co and W Co owning shares with 25% of the Opco votes, 25% of the fair market value of Opco, and 25% of each class of Opco shares. As a result, now both H Co and W Co have a substantial interest in Opco.
As seen above, caution should be exercised when establishing corporate structures between family members that are unrelated for purposes of the Act. Structures between aunts/uncles and nieces/nephews or structures that include cousins require extra scrutiny to ensure the shareholdings align with the substantial interest tests.
Example 2:
The same assumptions apply from Example 1.
C Co still controls Opco and therefore is still related to Opco and has a substantial interest in Opco.
Husband is still not related to Cousin for purposes of the Act. As such, H Co is still not related to Opco, and H Co has no related person to make use of the deeming rules to meet the 25% thresholds. H Co therefore does not have a substantial interest in Opco and any dividends paid by Opco to H Co on taxable preferred shares will be subject to Part VI.1 tax to the extent they any dividend allowance allocated to H Co.
Example 3:
Assume a taxable Canadian corporation has no dividend allowance available and has paid $1,000,000 of non-excluded dividends on a taxable preferred share.
The deduction available under Paragraph 110(1)(k) will mostly offset the Part VI.1 tax paid to ensure the dividend payer is not paying additional taxes, but just prepaying tax on behalf of the dividend recipient.
Summary
Parts IV.1 and VI.1 can be a costly surprise for unexpecting taxpayers if attention is not paid to the ownership structure when involving unrelated parties. Consideration should be given to Part VI.1 tax when ownership is divided between traditionally related family members that may not be related for tax purposes. Uncles, aunts, nieces, and nephews may all create situations where a corporation is inadvertently subject to Part VI.1 tax. Where unrelated parties own shares, tax advice should be obtained to ensure the structure is appropriate and meets the Substantial Interest requirements to pay Excluded Dividends.
Taxpayers subject to Part IV.1 or Part VI.1 must remember to file the appropriate information return with their corporate tax returns. Taxpayers may face unexpected late filing penalties on top of the tax if this is not filed. If a group of associated corporations is subject to Part VI.1 tax, it is important to remember that the group must also file an annual allocation of the Dividend Allowance between dividend payers.
It is also important to remember that a dividend payer and dividend recipient must file an agreement with the Minister of Finance when transferring Part VI.1 tax liability to the dividend recipient as the Act deems the transfer not to have been made if the agreement has not been filed. This will have adverse consequences where the pair of corporations are relying on transferring the deduction under Paragraph 110(1)(k) and will result in actual additional taxes if the dividend payer cannot make use of the deduction.
Article written by: John Pollock, CPA, CA, MAccw