Understanding Paid Up Capital (PUC) of Shares and Section 85 Issues

Introduction

Paid Up Capital (PUC) is a crucial concept in the realm of corporate finance and taxation. It plays a vital role in determining the amount of capital that can be distributed to shareholders as a tax-free return of capital. In this comprehensive guide, we will delve into the general rules and principles surrounding PUC, with a focus on its calculation, reduction, and its significance in tax planning.

‍General Rules for Establishing PUC

Paid Up Capital (PUC) is a critical concept in taxation, and it plays a pivotal role in determining the amount of capital that can be distributed to shareholders as a tax-free return of capital. PUC is primarily determined based on the legal stated capital of shares issued by a corporation under the relevant corporate laws. This legal stated capital typically reflects the fair market value of the consideration received in exchange for the issued shares.

To illustrate this concept further, let's delve into an example:

Example: Establishing PUC with Legal Stated Capital

Suppose a corporation, ABC Inc., decides to issue 1,000 common shares to raise capital. The corporation sets a legal stated capital of $10 per share. When these shares are sold to investors, they receive the shares in exchange for cash. In this scenario, the legal stated capital per share, which is $10, represents the amount attributed to each share under the corporate laws. The total legal stated capital for all 1,000 shares issued would be:

Total Legal Stated Capital = Legal Stated Capital per Share × Number of Shares

Total Legal Stated Capital = $10 × 1,000

Total Legal Stated Capital = $10,000

So, in this case, the PUC of the shares issued by ABC Inc. would be $10,000. This is the amount that can be distributed to the shareholders as a tax-free return of capital.

Now lets look at some situations where PUC calculations require extra attention.

PUC Reduction in Section 85 Rollover Scenario

In certain scenarios, such as transfers of assets under the Income Tax Act (ITA) Section 85 (ITA 85 rollover), the fair market value of the assets transferred is used to establish the PUC of the shares issued. This approach can lead to potential tax-free distributions of deferred gains, which may create tax policy issues.

Let's explore this with an example:

Example: PUC in ITA Section 85 Rollover

John owns a small business and decides to transfer the business assets to a newly formed corporation, XYZ Inc., under the provisions of ITA Section 85. The assets have a combined fair market value of $200,000, but their adjusted cost base (ACB) is only $150,000. Under ITA Section 85, John can elect to transfer these assets to the corporation at a value equal to their ACB ($150,000) to defer capital gains tax.

As consideration for the transfer, John receives common shares with a legal stated capital of $80,000 and $120,000 in cash. The fair market value of the assets transferred ($200,000) is higher than the elected value ($150,000), creating a deferred capital gain of $50,000 ($200,000 - $150,000).

Now, if the PUC of the shares issued were simply based on their legal stated capital of $80,000, John could potentially withdraw this amount from the corporation on a tax-free basis, effectively allowing the capital gain to escape taxation.

To prevent this, ITA Section 85(2.1) requires a reduction in the PUC of the shares issued by an amount equal to the total increase in legal stated capital, less any excess of the elected value over non-share consideration given.

In this case, the PUC reduction would be calculated as follows:

• Increase in Legal Stated Capital: $80,000 (common shares)
• Excess of Total Elected Value over Total Non-Share Consideration: $150,000 (elected value) - $120,000 (cash) = $30,000

• PUC Reduction: $80,000 - $30,000 = $50,000

This PUC reduction ensures that John cannot distribute the deferred gains on a tax-free basis and helps maintain the integrity of the tax system. It aligns the PUC of the shares with the economic reality of the asset transfer.

PUC When More Than One Class of Shares Are Involved

In most Section 85 rollovers, the ITA 85(2.1) formula will reduce the PUC of all shares issued to nil. This happens because non-share consideration typically equals the elected value. However, in cases where non-share consideration is less than the elected value, the PUC reduction must be allocated to different classes of shares based on the relative increases in legal stated capital.

Example: PUC in ITA Section 85 Rollover with lesser elected value

Suppose a transfer involves preferred shares with a fair market value of $250,000 and common shares with a fair market value of $750,000. The PUC reduction would be allocated to these two classes based on their relative legal stated capital increases.

• PUC of Preferred Shares: $250,000 - $75,000 = $175,000
• PUC of Common Shares: $750,000 - $225,000 = $525,000

This allocation ensures that each class of shares retains its proportionate PUC reduction.

Let's look at a comprehensive example below to make it clear.

Example: PUC in ITA Section 85 Rollover with lesser elected value

Mr. John Smith transfers non-depreciable capital property to a corporation at an elected value of $114,000. The property has an adjusted cost base of $114,000 and a fair market value of $234,000. As consideration, he receives a note for $83,000, preferred shares with a fair market value and legal stated capital of $97,000, and common shares with a fair market value and legal stated capital of $54,000.

First, we determine the adjusted cost base of the preferred and common shares:

Elected Value: $114,000

ACB of Note: $31,000 ($114,000 - $83,000)

ACB of Preferred Shares: $31,000 (Balance available as it is less than the fair market value of $97,000)

ACB of Common Shares: Nil (Residual)

Next, we calculate the total PUC reduction:

Increase in Legal Stated Capital: $97,000 + $54,000 = $151,000

Excess of Total Elected Value over Total Non-Share Consideration: $114,000 - $83,000 = $31,000
PUC Reduction: $151,000 - $31,000 = $120,000

Finally, we allocate the PUC reduction based on fair market values:

PUC of Preferred Shares: [($120,000)($97,000 ÷ $151,000)] = $77,086

PUC of Common Shares: [($120,000)($54,000 ÷ $151,000)] = $42,914

This allocation ensures that each class of shares retains its proportionate PUC reduction.

‍Conclusion

Paid Up Capital (PUC) is a fundamental concept in taxation. It determines the amount of capital that can be distributed to shareholders as a tax-free return of capital. Understanding PUC is essential for effective tax planning and compliance with tax regulations. Properly calculating and managing PUC can help individuals and corporations optimize their tax liabilities and ensure compliance with tax laws.

If you’d like to learn more or would need help with a similar tax issue, please reach out to us at help@futurecpa.ca.