The term “deemed dividend” refers to a dividend that is not actually paid as a dividend but is treated as one for the purposes of taxation under the Internal Revenue Code.
What is the difference between dividend and deemed dividend?
December 27th, 2014 The term “dividend” refers to the real dividend that a corporation declares at its annual general meeting (AGM), as well as interim dividends. However, a presumed dividend occurs when a firm pays an individual with a strong interest in the company an advance, assets, or loans, and the value of those assets is assumed to represent the dividend.
How is a deemed dividend calculated?
The adjusted cost base (ACB) is the tax cost of a shareholder’s stock purchase. When a shareholder sells their stock, the ACB is subtracted from the proceeds of disposition to determine the amount of a capital gain or loss.
The ACB is a shareholder characteristic, while the stated capital and PUC are share attributes. As a result, the ACB of a shareholder for a share does not have to match the share’s stated capital or PUC. The ACB captures a shareholder’s contribution to any vendor for a share, whereas the stated capital and PUC only record a shareholder’s investment to the company for a share.
To illustrate, consider the following scenario: you transfer $100,000 worth of property to a corporation in exchange for a single share. The stated capital and PUC of your share will both be $100,000. Your ACB will be $100,000 as well. You later sell your part for $150,000 to a buyer. This transaction benefits the firm in no way. As a result, the stated capital and PUC of the stock remain at $100,000 each. The buyer, however, paid $150,000 for the stock. As a result, the ACB for the buyer is $150,000.
Deemed Dividend Upon an Increase of PUC: Subsection 84(1)
A corporation is deemed to have paid a dividend on a class of shares for which the corporation has increased PUC under subsection 84(1). As a result, paragraph 53(1)(b) raises the shareholder’s share ACB by the presumed dividend amount. When a shareholder sells the affected shares, the ACB bump ensures that they are not taxed twice.
However, if the increase in PUC was due to any of the following, paragraph 84(1) does not apply, and no presumed dividend will be paid:
- a stock dividend (i.e., a corporation’s retained earnings being capitalized);
- a transaction in which the rise in the PUC corresponds to either an increase in the corporation’s net assets or a drop in its net liabilities;
- a transaction in which the PUC increase is offset by a drop in the PUC for shares in a different class; or
- Contributed surplus is converted into PUC (i.e., a company capitalizes contributed surplus).
For example, in exchange for a $450 debt, a corporation issues shares with a PUC of $500 to a creditor. (No other share class’s PUC was reduced by the corporation.) As a result, the creditor is entitled to a $50 presumed dividend ($500 PUC minus $450 liability reduction). For the shares, the creditor’s ACB is $500 ($450 initial ACB plus $50 declared dividend).
Deemed Dividend Upon Winding Up: Subsection 84(2)
When a company is wound up or liquidated, its assets are sold, liabilities are paid, and the remaining cash is dispersed to shareholders, thus canceling their shares. Any property or cash distributed to a shareholder in excess of a share’s PUC is regarded a dividend under subsection 84(2) upon the corporation’s liquidation or winding up.
However, when calculating the capital gain on the sale of the shares, the shareholder deducts the considered dividend from the liquidation proceeds. This avoids the shareholder’s liquidation proceeds being taxed twice as deemed dividends and capital gains.
The liquidation corporation, for example, pays $800 to its shareholder in cancellation of shares with a PUC of $200 after selling its assets and paying its liabilities. The ACB for the shares is also $200 for the shareholder. As a result, the shareholder is entitled to a $600 considered dividend ($800 distributed minus $200 PUC). And the shareholder has made no profit ($800 distributed minus $600 declared dividend minus $200 ACB).
If: (1) subsection 84(1) applies to the same transaction; or (2) the corporation’s share acquisition for cancellation was an open-market transaction, the deemed-dividend rule in subsection 84(2) does not apply.
What is deemed dividend as per Income Tax Act?
The profits a shareholder receives for investing in a firm are referred to as dividends.
Let’s imagine Company ‘A’ is profitable and wishes to disperse the earnings to its shareholders. The company’s board of directors chooses to pay each shareholder a 3% return on their investment. Each share unit costs Rs. 100, hence the shareholder receives Rs. 30 for each share. This amount is known as the ‘Dividend.’
Whereas a presumed dividend is a specific amount or asset loaned to a shareholder who owns a substantial portion of a firm, the lent amount is regarded a ‘deemed dividend’ for tax purposes. Only the company’s accumulated profits should be used to fund the loan or advancement. It should be highlighted that Deemed Dividends are only available to private limited corporations whose activities are not of significant public interest.
Who will pay tax on deemed dividend?
Previously (prior to April 1, 2018), corporations that paid considered dividends did not have to pay DDT on those payments.
It required such businesses to pay 30% DDT plus any surcharges and cess on transactions completed on or after April 1, 2018.
Because the taxability of a deemed dividend in the hands of the beneficiary made tax collection from the shareholder difficult, this change was enacted. As a result, the shareholder is exempt from paying taxes on such earnings.
The responsibility of paying dividend tax is moved to owners in Budget 2021. Companies are no longer required to pay Dividend Distribution Tax (DDT) when delivering dividends to shareholders, implying that DDT has been repealed.
Who pays deemed dividend?
According to Section 2(22)(e) of the Income Tax Act, considered dividends are loans or advances made by a firm (excluding a closely held company) to the following individuals:
- A shareholder who is the beneficial owner of shares and controls at least 10% of the voting power. It should be highlighted that the shares held in this manner should not be entitled to a fixed dividend rate.
- Any business in which the company’s shareholder is a member or partner with a significant stake.
- To the extent permitted by law, on behalf of, or for the benefit of, such shareholder.
Loans made by a subsidiary firm to a holding company, in addition to the ones listed above, would fall under the scope of this section.
How are deemed dividends treated?
A deemed dividend under Division 7A is usually unfranked. Given this, paying a payment or other benefit to a shareholder or their associate as a regular dividend (with a franking credit if available) and having the shareholder include it in their assessable income is the most effective way to do so.
What causes a deemed dividend?
In some cases, we regard a dividend to be an amount paid by a Canadian corporation and received by a shareholder. The situations can be any of the following in general terms:
- Without a matching gain in net assets or decrease in net liabilities, the corporation’s paid-up capital rises without a corresponding increase in net assets or decrease in net liabilities.
- When a corporation’s business is wound up, dissolved, or reformed, property is dispersed to shareholders.
- any of the company’s own shares are redeemed, purchased, or cancelled in any way other than through an open market transaction
For each of the scenarios listed above, the considered dividend is calculated as follows:
- Include the increase in paid-up capital of the shares in that class in case a). Subtract any gain in the value of net assets (or drop in the value of net liabilities), as well as any decrease in the paid-up capital of any other class of shares.
- Include the entire amount or value of the monies or property distributed in circumstance b). Subtract any reduction in the class of shares for which the distribution was made from the total paid-up capital.
- Include the entire amount paid in situation c). However, for shares that were redeemed, purchased, or cancelled, deduct the paid-up capital.
- Include the amount paid minus any loss in paid-up capital in condition d).
What is a deemed dividend South Africa?
In the South African corporate landscape, loans between corporations and their shareholders, or other group companies, are a popular technique of delivering money. Loans of this sort, on the other hand, may have tax ramifications for both the lender and the recipient, therefore these transactions should be carefully considered.
Up to March 31, 2012, dividends declared by a corporation to its shareholders were subject to a 10% Secondary Tax on Companies (STC). The Income Tax Act, No. 58 of 1962 (the Act) also contains measures aimed at preventing tax avoidance transactions in which a company’s shareholder benefited in some way despite the fact that no cash dividend was declared. Specified sorts of transactions were declared dividends under these regulations, resulting in the payment of STC, subject to certain exemptions.
On dividends paid on or after April 1, 2012, dividends tax is imposed at a rate of 15%, subject to certain exclusions and the application of a lesser rate of dividends tax in certain circumstances. Low-interest loans may be subject to dividends tax since they are treated as a presumed dividend in certain circumstances, resulting in a liability for dividends tax.
In some instances, loans or advances from a firm to a shareholder (or any individual connected to the shareholders) will be automatically considered dividends.
The current deemed dividend provision applies when a debt arises “by virtue of a share held in the company” and the following conditions are met: the debtor is not a company; the debtor is a South African resident; and the debtor is either a connected person in relation to the company or a connected person in relation to that person.
In general, a “connected person” in relation to a company means any company that is part of the same group of companies (where the controlling group company owns at least 70% of the equity shares in a controlled group company), or any person, other than a company, who owns at least 20% of the company’s equity shares or voting rights, directly or indirectly, with any connected person.
If all of these conditions are met, the firm is judged to have paid a dividend in specie equal to the larger of “market related interest” in respect of the loan, less the amount of interest payable to that company for the relevant year of assessment. In other words, the dividend is calculated by adding an interest rate to the loan’s debit balance over the course of the year. The difference between the “officialrate of interest” that applies for fringe benefits tax purposes, as established in paragraph 1 of the Seventh Schedule (currently 6.75 percent per annum), and the actual interest rate imposed on the loan, is used to calculate the presumed dividend. Only the interest effectively forgone is considered a dividend, not the loan’s total value. There would be no considered dividend if the loan bears interest at a reasonable rate. This is in contrast to the STC scheme, which computed the tax on a presumed dividend based on the loan’s principal amount.
The corporation is obligated to pay the resulting dividendstax by the end of the month after its year-end, as the dividend is deemed paid on the final day of the assessment year. The firm (rather than the shareholder) is liable for the tax since the payout is judged to be a dividend in specie.
A shareholder loan must occur “by virtue of” a share owned in the corporation in order to be considered a presumed dividend. The Act does not define the phrase “by virtue of,” however advice can be found in a number of circumstances.
In the case of Stander v CIR59 SATC 212, the court considered the meaning of the phrase “in respect of or by virtue of any employment or the holding of any office,” which was used in the context of employment. The court ruled that the terms “by virtue of” do not have a meaning fundamentally distinct from the words “in respect of” and pointed to ST v Commissioner of Taxes 35 SATC 99, at 100, where Whitaker P remarked at 100:
“Normally, the phrase means ‘by force of’, ‘by authority of’, ‘by reason of’, ‘because of’,’through’, or ‘in pursuance of’ (and this was common cause between counsel). (See ed. 252 of Black’s Law Dictionary.) Each of these criteria implies that the cause and effect are inextricably linked.”
In Stevens v CIR69 SATC1, the Supreme Court of Appeal confirmed the grounds established in the Stander case, holding that there was no material difference between the terms “in respect of” and “by virtue of.” They imply a causal link between the amount received and the taxpayer’s work or services.
In order for a presumed dividend to occur, there must be a direct causal relationship between the holding of the relevant shares and the advance of the loan in question, as shown above. The deeming rule will thus be triggered only when a loan or advance is granted to a South African resident person who is not a business (e.g., a trust or a natural person) and who is a related person to that companyor to the aforementioned person (that isconnected to the person who is connected to the company).
To the extent that a sum owed to a corporation by a shareholder or other qualifying person was regarded to be a dividend that was “subject to STC,” no deemed dividend consequences in terms of the dividends tax regime would emerge. In other words, a loan that was regarded to be a dividend and was subject to STC will not be recognized to be a dividend for the purposes of dividends tax.
The term “subject to tax” is not defined in the Act, and it has never been the subject of a court ruling in South Africa. However, decisions from the United Kingdom (UK) can provide guidance on the expression. The First Tier Tribunal addressed the interpretation of the UK-Israel double tax treaty, particularly the meaning of the phrase “subject to tax” in Paul Weiser v HM Revenue and CustomsUKFTT501. The case revolved around the meaning of the word “subject to tax” and the distinction between this phrase and the phrase “liable to tax” in international tax treaties. The difference between the two phrases, according to HM Revenue and Customs, is that “liable to tax” only requires an abstract liability to tax (i.e., a person is subject to tax regardless of whether the country actually exercises the right to tax) and thus has a much broader meaning than “subject to tax,” which requires that tax is actually levied on the income. The First Tier Tribunal ruled in favor of HM Revenue and Customs, finding that relief under the UK-Israel tax treaty to exempt the pension from UK tax was not available because the pension in question was not taxed in Israel.
If the income in question is exempt from tax due to a statutory exemption from tax, it is not considered “subject to tax.”
Unless STC was paid in respect of the debt in question, any interest-free or low-interest loan would be liable to profits tax. Excess interest on the loan amount would be subject to dividends tax, even though loans of this sort may not have constituted deemed dividends under the STCregime as a result of the application of an exemption.
The question for workers’ tax purposes is whether a “taxable benefit” as defined in paragraph 2(f) of the Act, read with paragraph 11 of the Act, emerges as a result of an interest-free or low-interest loan to a shareholder who is a connectedperson in respect to the lender.
The debt must emerge “in respect of” the employee’s employment with the employer in order to be considered a “taxable benefit.” As previously stated, there is no material difference between the expressions “in respect of” and “by virtue of” in terms of the applicable case law. If there is a “unbroken causal relationship between employment on the one hand and receipt on the other,” payment will be “in respect of services done” in both cases (Stevens v CSARS supra). The same concept, according to the argument, will apply to paragraph 2 of the Act’s Seventh Schedule.
To evaluate whether an interest-free or low-interest loan results in a taxable advantage, the reason orcause for the loan’s issuance must be determined.
It’s vital to remember that an interest-free or low-interest loan to a connected person in the company (or a connected person in connection to a connected person in the firm) will only be liable to one of the two taxes: dividends tax or employees’ tax.
What is a Section 85 rollover?
The section 85 rollover is a provision of the Canadian Income Tax Act that allows a taxpayer to transfer qualifying property to a taxable Canadian corporation on a tax-deferred basis. In a nutshell, depending on the taxpayer’s goals, this decision allows them to defer all or part of the tax repercussions that would otherwise occur from the transfer.
The section 85 rollover is commonly utilized in the following scenarios, but is not limited to them:
To begin, both the transferor and the transferee must be eligible for the section 85 rollover. Any taxpayer, including people, corporations, and trusts, is considered an eligible transferor. A taxable Canadian corporation must be the transferee. This usually necessitates the incorporation of the company in Canada.
- Non-residents’ real estate property was used to conduct business in Canada.
Finally, the transferor’s consideration for the transfer must include shares in the transferee. Non-share consideration, sometimes known as “boot,” may be received by the transferor as part of the consideration. The boot’s fair market value (FMV) must exceed the tax cost of the property transferred; otherwise, a capital gain will result. Cash or a note receivable are two common non-share considerations. The fair market value of the transferred assets must be equal to the fair market value of the entire consideration received.
To complete a section 85 rollover, both the transferor and the transferee must agree on the transfer amount. The chosen amount is the difference between the transferor’s proceeds of disposition and the transferee’s acquisition cost.
If the taxpayer is transferring non-depreciable capital property or inventories, the lower range of the elected amount cannot be less than the lesser of:
If the taxpayer is transferring depreciable property, the elected amount’s lower range cannot be less than the smaller of:
Most of the time, you’d choose at tax cost or ACB, which results in a tax-free rollover. However, there may be times when you want to elect at a larger quantity to intentionally trigger gains (e.g., utilizing loss carryforwards, or crystalizing the capital gains exemption).
You want to swap non-depreciable capital property from your sole proprietorship for common shares in your newly established Canadian corporation. The property has a $100,000 ACB and a $300,000 FMV.
You must record a disposition of the capital property at its FMV if you do not decide to transfer under section 85. This would result in a $200,000 capital gain on your personal tax return ($300,000-$100,000).
Alternatively, you could transfer the capital property at the ACB of $100,000 if you use section 85. (elected amount). There would be no capital gain as a result of the property transfer, thus there would be no immediate tax ramifications. Assuming no boot is taken into account, the ACB of the common shares becomes the elected amount of $100,000. The corporation will own $100,000 worth of capital property. The following is a summary of the transaction.
Keep in mind that this does not relieve the transferor of the obligation to pay tax on the accrued gain. Rather, the tax on the capital gain is deferred until the sale of capital property in the future.
The CRA must be notified of this joint election using Form T2057. This form must be submitted by the earliest of the transferor’s or transferee’s income tax return filing deadlines for the taxation year in which the transfer occurred. The transferor’s tax center should receive the form, which should be lodged separately from any other returns. If numerous transferors are involved in the same property transaction, one designated transferor can file all of the completed election forms, along with a list of the transferors involved, to the corporation’s tax centre on behalf of each transferor.
If this form is filed within three years of its original due date, the CRA will accept it as late as long as the taxpayer provides an estimated payment of the penalty at the time of filing.
In addition to the aforementioned, if the form is filed after the three-year deadline has passed, the taxpayer must provide documented justification for the late submission. The CRA will next use its discretion to decide whether or not to accept the late-filed election.
The Tax group at Fuller Landau is ready to answer your concerns if you are considering transferring capital property to a business and would like to understand the Canadian tax ramifications and planning options available.
During her co-op year in 2021, Jessica Hum worked as a Junior Tax Specialist in our Tax Group. She is now studying at the University of Waterloo for her Bachelor of Accounting and Financial Management.
