ACC 522 – Chapter 12 Notes: Organization, Capital Structure, and Income Distributions of Corporations

Corporate Capitalization – Debt or Equity Debt to a corporation is referred to as a shareholder loan and equity is additional shares. Shareholder’s perspective, both debt and equity constitutes capital property for tax purposes and

yield a ROI in the form of interest or dividends.o As capital property, both are subject to capital-gains treatment if and when disposed of at

a value different from the initial cost. Value of a shareholder loan may decrease if the assets within the corporation decline and are

insufficient to satisfy the obligation or increase in value if the debt bears a long-term interest rate that is high in relation to current economic conditions.

Value of shares may change as a subject of the following factors: (1) profits earned/losses incurred by the corporation; (2) increase/decrease in the value of assets owned by the corporation such as land, buildings, equipment, goodwill, and other intangibles; and (3) the distribution of profits by corporate dividends.

Corporate Capitalization by Shareholder Debt For tax purposes, a shareholder loan qualifies as debt, regardless of how it may be viewed by the

marketplace.Return on Investment (ROI)

Interest paid by the corporation is deductible for tax purposes; this reduces corporate taxable income and increases the shareholder’s taxable income by an equivalent amount.

If the shareholder loan does not bear interest, corporate taxable income will be higher, the result being increased corporate taxes and a further tax when the corporate retained earnings are distributed as a dividend.

When the corporate tax is 15%, an interest-free loan is preferable because the immediate tax is substantially lower and the overall combined tax is lower. However, when the corporate tax is 25% the preference is less clear.

Loss of Investment If the loan is to a small business corporation, the capital loss becomes a business investment loss. A loss on a loan is recognized for tax purposes in the year in which it is established to be

uncollectible, whereas a loss on share capital is recognized only when the shares are actually sold, the corporation is insolvent and ha ceased operations, or the corporation has become legally bankrupt. A loss on shareholder loans can be recognized before loss on share capital. Advantage:

1. Recognizing the loss earlier, rather than later, diminishes the real loss–in cash-flow terms – on the initial investment.

2. The shareholder loss can be recognized when a corporation is in extreme financial difficulty but is not yet bankrupt and still has a change of survival. The cash flow created for the shareholder from the early loss recognition can be used to strengthen the corporation and increase its chances for survival.

Return on Capital Capital base contributed to a corporation by its shareholders is not permanent. Can return money to shareholders by declaring a dividend or by repaying the loan. Dividend payment is taxable to the shareholder; the loan repayment constitutes a return of capital

and is not taxable.

Corporate Capitalization by Share Capital For tax purposes, a common share is a share that entitles the owner to share in the corporation

assets and earnings beyond the initial share price plus a fixed premium or dividend rate.

Preferred share is a share that entitles tow owner to participate in corporate assets and earnings only up to an amount equal to the initial share price plus a fixed dividend rate, regardless of the extent of corporate earnings.

Return on Investment Dividends are not deductible by the corporation and are taxable to the individual shareholder. Two-tier tax system: the corporation must earn income, pay tax, and use its after-tax earnings to

pay dividends, which the shareholder pays tax on again. If the corporate tax rate is 15%, the combined tax would have been lower and the share capital

option would have been preferred because in such cases, the shareholder can also choose to delay the payment of dividends so that the immediate tax is only 15%.

Loss of Investment A loss incurred on a share capital investment is normally a capital loss, of which ½ is recognized

for tax purposes.o Share capital loss is recognized only in the year in which the shares are disposed of, the

corporation becomes legally bankrupt, or the corporation is insolvent and has ceased operations.

Acquisition of Shares Directly from the Corporation - 1 The receipt of assets in exchange for shares in the corporation has no tax consequences to the

corporation. For tax purposes, the stated value of the shares is referred to as paid-up capital. Shareholder’s perspective, the receipt of shares represents the acquisition of capital property

having an ACB for tax purposes equal to the value of the property exchanged. When a corporation with existing shareholder admits a new shareholder by issuing additional

shares, referred to as treasury shares, there are no tax consequences to the existing shareholders.Acquisition of Shares from Other Shareholders - 2

The original shareholder will have a capital gain/loss on the sale of whatever shares they have sold, whether this involves all their shares or only a fraction of them.

Buyer’s perspective, the shares acquired will have an ACB for tax purposes equal to the purchase price. However, the paid-up capital value of the shares in the corporation remains unchanged, even if the purchaser has acquired the previously issued shares at a different price from the original issued value.

Shareholder can dispose of shares in two ways: (1) Shares are bought by other shareholders and (2) the shares are bought back by the corporation for cancellation.

Sale of Shares to Other Shareholders – 3 Sale of shares creates a capital gain/loss depending on whether the shares have

increased/decreased in value. This allows the shareholder to realize a return on the original investment as well as any share appreciation resulting from corporate earnings.

Sales of Shares Back to the Corporation – 4 The redemption value of corporate shares is the sum of two separate values – the original capital

value of the shares and the change in value resulting from corporate earnings accumulated and attached to those shares.

The tax consequences to the shareholder when a redemption occurs:o To the extent that the redemption price exceed the paid-up capital (original issue price) of

the shares, a dividend is deemed to have been distributed.o Shareholder is deemed to have sold the shares, for the purpose of determining capital

gain/loss, at an amount equal to the paid-up capital of the shares. Share redemption involves both a dividend payment and a sale of shares.

Reduction of Paid-Up Capital – 5 A corporation can return only its paid-up capital to the shareholders without redeeming any of its

shares. Tax treatment of this option varies, depending on whether corporation is private or public.

A private corporation can make a payment to its shareholders that constitute a return on capital. There are no tax consequences for this transaction, provided the payment reduces and does not exceed the paid-up capital value.

Public corporations that execute the same transaction and reduce paid-up capital of any class of shares are normally considered to have paid a taxable dividend for the entire payment.

Transferring Assets to a Corporation The transfer of assets to the corporation constitutes a sale and disposition for the shareholder. To

the extent that those assets appreciated in value before the transfer, there will be tax implications. For tax purposes, an existing or proposed shareholder can transfer an asset to a corporation either

at the FMV or at an elected value, which is normally equal to the asset’s cost for tax purposes.

Transfer of Assets at Fair Market Value Assets transferred at FMV, any gains on the sale are recognized by the shareholder. Depending on the asset, it can be a capital gain, a recapture of CCA, or normal business income. The corporation that acquires the asset at FMV has an increased cost for tax purposes that may, in

turn, reduce the taxes payable by the corporation.

Election to Transfer Assets at Tax Values The shareholder can elect to set the transfer price at the UCC price and create no taxable income

for itself and transfer or roll-over the potential taxable income to the corporation.Election Limitations

Primary limitations of the election procedure relate to the nature of the consideration paid for the asset. In order for the transfer to avoid tax, the consideration must include some shares, although there is no specified amount; as well the non-share consideration cannot be greater than the elected value of the asset transferred.

Applying the Election Option Exceptions to the election option are real estate that is being held for resale and real estate owned

by a non-resident.

Corporate Distributions to ShareholdersStock Dividends

Corporation’s perspective, there are no tax or cash implications, as the transaction simply involves making an accounting entry that reduced retained earnings and increases the share capital.

Shareholder who receives additional shares is deemed, for tax purposes, to have received a normal taxable dividend. Amount is equal to the amount the corporation transfers to paid-up capital from retained earnings.

o Individual shareholder, the dividend must be grossed-up by the appropriate amount.

Special Distribution of CCPC A CCPC is taxed on property income at a high corporate rate (36%-44%) plus a special

refundable tax rate of 623

%.

Certain income earned by corporations is tax-free, such as, life insurance proceeds and one-half of capital gains.

Distributions Other than Cash If the asset distributed has a value greater than the corporation’s tax cost, the corporation is

deemed to have disposed of the asset at FMV, which results in taxable income to the corporation. A taxable dividend is received by the shareholder is equal to the FMV of the asset received.