Last month, the Canadian federal government introduced a draft legislation package known as the August Proposals.
These proposals encompass a range of revisions to amend the Income Tax Act, with a key focus on the introduction of a novel equity repurchase tax.
Set to take effect on 1 January 2024, this tax is poised to impact numerous publicly traded entities, subjecting them to a 2% levy on the "net value" of specific equity repurchases.
Canada’s new Equity Repurchase Tax – key points
The equity repurchase tax applies to a broad array of publicly traded entities. This includes Canadian-resident corporations (excluding mutual fund corporations), as well as certain trusts and partnerships, collectively referred to as Covered Entities.
Key points to understand about the equity repurchase tax:
- The tax is calculated annually using a netting rule, typically amounting to 2% of the total value of equity repurchases made by a Covered Entity in a taxation year. This calculation subtracts the total value of equity issued by the same entity from its treasury during the year.
- Notably, the definition of equity for tax purposes excludes equity with debt-like characteristics.
- Acquisitions of equity by specific affiliates of a Covered Entity are deemed to be equity repurchases and are considered in the netting rule.
- Exceptions are made for certain corporate reorganizations and acquisitions. In most cases, all equity repurchases by a Covered Entity are factored into the netting rule, including those within the context of normal course issuer bids, substantial issuer bids, and specific reorganizations.
- The netting rule includes only cash consideration, equity issuances to employees in the course of employment, and the exchange of a debt instrument issued solely for cash consideration.
- Covered Entities repurchasing less than $1 million of equity in a taxation year, calculated on a gross basis, are exempt from the tax.
- The tax applies to repurchases and issuances of equity occurring on or after 1 January 2024.
The genesis of the new tax
The origins of this equity repurchase tax can be traced back to the 2022 Fall Economic Statement. It was here that the Canadian government initially revealed its intention to introduce a 2% corporate-level tax on the net value of share buybacks by Canadian public corporations.
This tax bears similarity to the 1% share buyback tax enacted in the United States under the Inflation Reduction Act of 2022.
Budget 2023 provided more comprehensive legislative proposals, extending the tax's scope to encompass specific publicly traded trusts and partnerships, thus expanding its reach.
It also clarified that normal course issuer bids and substantial issuer bids would be considered equity repurchases for tax purposes.
Understanding the Tax Calculation
The equity repurchase tax relies on a netting rule formula: 0.02 x (A - B), where:
- Variable A represents the total fair market value of equity repurchased by the Covered Entity (or deemed repurchased) in the taxation year.
- Variable B represents the total fair market value of equity issued by the Covered Entity in the same taxation year.
This netting rule applies annually, corresponding to the Covered Entity's fiscal year, for repurchases and issuances occurring after 1 January 2024.
Importantly, there are no grandfathering rules, meaning that equity outstanding prior to this date, but repurchased afterward, remains subject to the tax.
Moreover, any excess in Variable B over Variable A cannot offset repurchases included in Variable A in subsequent years.
Equity Definition for Tax Calculation
To determine the equity repurchase tax, the calculation considers repurchases and issuances of equity by a Covered Entity.
However, not all equity is included; the tax excludes equity that exhibits "substantive debt" characteristics. Substantive debt equity is defined as:
- Non-convertible or non-exchangeable except for specific circumstances.
- Having a periodic rate of dividend expressed as a percentage of fair market value.
- Entitling holders to receive specific amounts upon redemption, cancellation, or acquisition by the Covered Entity.
Many preferred shares may not meet the criteria for substantive debt, such as convertible preferred shares and voting preferred shares.
Since there are no grandfathering rules, Covered Entities with issued and outstanding preferred shares must evaluate whether their shares qualify as substantive debt for tax purposes.
Variable A includes the fair market value of equity (excluding substantive debt) repurchased by the Covered Entity in a taxation year.
Certain equity acquisitions by specified affiliates of a Covered Entity are also included.
However, the deeming rule does not apply to specified affiliates that are registered securities dealers acting as agents for customers or certain employee benefit trusts.
Exceptions to Variable A include specific reorganization transactions, such as share-for-share exchanges and tax-deferred amalgamations, winding-up of the Covered Entity, and other tax-deferred transactions.
Variable B includes the fair market value of equity (excluding substantive debt) issued by a Covered Entity. Equity issuances are included only if:
- Solely for cash consideration.
- Issued to an employee in the course of employment.
- In exchange for a bond, debenture, or note of the Covered Entity issued solely for cash consideration and allowing the holder to make the exchange.
An anti-avoidance rule applies to prevent transactions aimed at decreasing the total value of equity repurchased or increasing the total value of equity issued, primarily for tax avoidance purposes.
De Minimis Threshold
The August Proposals introduce a de minimis threshold of $1 million. The tax is not applicable if Variable A is less than $1 million in a taxation year. This threshold is calculated on a gross basis without considering the netting rule and the value of equity issuances in Variable B.
Filing and Payment Obligations
Covered Entities repurchasing equity in a taxation year must file a return and, if applicable, pay the equity repurchase tax.
Filing and payment deadlines vary for corporations, trusts, and partnerships, with specific timelines outlined for each entity.
In summary, the introduction of Canada's new equity repurchase tax marks a significant development in the country's tax landscape.
Understanding its intricacies and ensuring compliance is crucial for publicly traded entities, as non-compliance can result in financial penalties.
If you have any queries about this article on Canada’s new Equity Repurchase Tax, or Canadian tax matters in general, then please get in touch.
The content of this article is provided for educational and information purposes only. It is not intended, and should not be construed, as tax or legal advice. We recommend you seek formal tax and legal advice before taking, or refraining from, any action based on the contents of this article.