SECTION 84.1: THE DEEMED DIVIDEND TRAP
When you sell shares in a corporation that are capital property to you, any gain is normally considered a capital gain and only half of that gain is included in your income as a taxable capital gain. Furthermore, if the shares are QSBC shares (qualified small business corporation), some or all of the gain may be effectively exempt from tax under the lifetime capital gains exemption.
However, the situation may be different if you sell shares in a corporation (the “subject corporation”) to another corporation (the “purchaser corporation”) with which you are non-arm’s length, generally if the purchaser corporation then controls the subject corporation or owns more than 10% of the shares of the subject corporation on a fair market value and votes basis. A non-arm’s length purchaser corporation can include a corporation that you control, and a corporation that a related person (such as your spouse, child, or parent) controls, among others.
In such a case, if you receive non-share consideration from the purchaser corporation as part or whole consideration for the sale of the subject shares, you may have a deemed dividend instead of a capital gain. Generally, instead of a capital gain, you will have a deemed dividend to the extent that the fair market value of the non-share consideration exceeds the paid-up capital in respect of the subject shares that you transferred. (There may be other calculations involved.) The paid-up capital is the income tax version of the stated capital of the shares − it is based on the legal stated capital but with various adjustments made for income tax purposes to generally reflect the after-tax amounts paid on the original issuance of the shares.
This deemed-dividend rule creates at least two potential problems for you. First, the marginal tax rates applicable to dividends are generally higher than the tax rates on capital gains. Second, the deemed dividend is not eligible for the capital gains exemption.
Even if you have a deemed dividend, the sale of the subject shares still reflects a disposition for capital gains purposes. To avoid double taxation, the amount of the dividend is subtracted from the proceeds of disposition for capital gains purposes.
You sell shares in a subject corporation to a purchaser corporation that you control. The shares had an adjusted cost base to you and paid-up capital of $10,000 and fair market value of $100,000.
As consideration, you receive shares in the purchaser corporation plus a $100,000 promissory note. The note is the non-share consideration.
Due to section 84.1, you will have a deemed dividend of $100,000 minus- $10,000, or $90,000. You will also have a disposition of the subject shares for capital gains purposes, but the proceeds of disposition are reduced from $100,000 to $10,000. Therefore, in this example, there is no capital gain.
Note that if the adjusted cost base is higher that the paid-up capital of the subject shares, you could have a capital loss along with the deemed dividend. However, the capital loss cannot serve to offset the inclusion of the dividend, because capital losses can be offset only against capital gains.