Authored by the McCarthy Tétrault National Tax Group 

On August 4, 2023, the Canadian federal government released a package of legislative proposals, including updated draft legislation on the proposed tax on certain equity repurchases by publicly listed companies, partnerships and trusts. Previously released as part of the 2023 federal budget,[1] new Part II.2 of the Income Tax Act (Canada)[2] applies as of January 1, 2024. 

The measure strives to deter buybacks in order to “encourage firms to re-invest in their workers and businesses”. The revisions address some deficiencies with the initial proposal. Still, the tax remains broad. It deliberately catches normal course issuer bids and substantial issuer bids, but may catch other transactions unexpectedly.

Inspired by a similar tax measure implemented in the United States, the Canadian proposals would tax “equity” repurchases by certain publicly listed entities that qualify as “covered entities”. “Equity” is a defined term that means: shares of a corporation, income or capital interests in a trust, or interests as a member of a partnership, as the case may be. “Covered entities” is defined to include:

• Canadian-resident corporations (other than mutual fund corporations) whose shares are listed on a designated stock exchange (which currently includes the TSE and NYSE),
• real estate investment trusts (REITs), and
• specified investment flow-through (SIFT) trusts and SIFT partnerships.[3]

The tax is levied based on changes to the issuer’s equity over a taxation year. The covered entity (or, for a partnership, a member of the partnership that has authority to act for the partnership) must file an annual return in prescribed form to report the tax payable under Part II.2 as computed under these rules.[4]

The tax payable is equal to 2% of the excess of the fair market value (“FMV”) of equity that is redeemed, acquired or cancelled over the FMV of certain equity issued by the covered entity. More specifically, Part II.2 tax is calculated for a taxation year of the covered entity in an amount that is equal to 2% of the difference between variables “A” and “B”, each of which is described in turn below.

Variable A – Increases to the tax base for equity repurchases

Variable A measures the total FMV of equity of the covered entity that is redeemed, acquired or cancelled by the covered entity in the taxation year. Under a deeming rule, if a “specified affiliate” acquires equity of the covered entity, the covered entity will be deemed to have acquired its own equity.^[5] This rule blocks a strategy to avoid the tax where a subsidiary buys-back the equity of the covered entity, rather than the covered entity doing so itself.

Variable A is subject to three relieving exceptions and a de minimis rule. The first exclusion applies to repurchases of equity that is “substantive debt”. This concept refers to equity that possesses debt-like characteristics.[6]

The second exclusion is a reorganization exception. From a policy perspective, the exclusion exempts a repurchase of equity by a covered entity where shareholders of the covered entity maintain their interest in the covered entity or its assets, merely changing the form of the shareholder’s investment. The revised proposals expand the breadth of the reorganization exception. 

The amended rule can apply where the holder exchanges its equity for equity of (i) the covered entity, (ii) certain entities that are related to the covered entity, and (iii) certain entities that control the covered entity. The exception may also apply to transactions involving certain specified amalgamations, liquidations, share-for-share exchanges, and butterfly transactions.[7] The revised proposals respond to concerns that Part II.2 tax would otherwise apply in unintended circumstances.

In particular, the revised rules exempt a taxable spin-off of a subsidiary of a public corporation (“Spinco”) provided that the Spinco shares become listed on a designated stock exchange immediately after the exchange.[8] Further, they exempt acquisitions structured as a triangular amalgamation whereby a wholly-owned subsidiary of the public company amalgamates with the target company, and former target company shareholders receive shares of the public company.

The third exclusion addresses repurchases of equity previously acquired by a “specified affiliate” under the deeming rule described above. This exception prevents double-counting where the deeming rule previously applied. 

The de minimis exception provides that no Part II.2 tax is payable where the amount determined in the taxation year under variable A is less than $1 million. The de minimis amount of $1 million is pro-rated for short taxation years.

Variable B: Reductions to the tax base for equity issuances

Variable B is relieving in nature. Subject to two exclusions, it is determined for a taxation year as the total FMV of three specific types of issuances of equity by the covered entity: subscriptions for cash, issuances for employment remuneration, and issuances to settle a convertible debt originally issued for cash.[9] In this way, the covered entity may reduce its tax base for equity issuances that increase share capital under one of those permitted categories.

Two exclusions to variable B strive to provide symmetry with the computation of variable A. The first prevents a reduction to the tax base solely for issuances of “substantive debt”, which is also excluded in computing repurchases. The second exclusion is for equity issued in the course of[10] a “reorganization or acquisition transaction”. This denies a reduction in the tax base for issuances of equity in the same circumstances as where the reorganization exception would prevent an increase in the tax base for equity repurchases.

Specific anti-avoidance rules

The tax on repurchases of equity are protected by anti-avoidance rules. If a covered entity repurchases equity as a transaction or as part of a series and the primary purpose of the transaction or series is to reduce the Part II.2 tax base, the transaction will be included in variable A or excluded from variable B, as necessary to prevent the intended reduction of the tax base.

In addition, if it is reasonable to consider that one of the main purposes of a transaction or a series is to cause a person or partnership to acquire equity of a covered entity in order to avoid the tax otherwise payable under Part II.2, the person or partnership is deemed to be a “specified affiliate” of the covered entity for the duration of the entire transaction or series of transactions. This causes the deeming rule (described above) to include the repurchased equity in the tax base under variable A.

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[1] For a description of the Part II.2 legislative proposal from Budget 2023, see our 2023 Canadian Federal Budget Commentary.

[2] RSC, 1985, c 1 (5th Supp) (the “Tax Act”).

[3] A partnership or a trust that would be a SIFT if its assets were located in Canada is also treated as a covered entity. The reach of the proposal may be overbroad, as it could cover exchange traded funds that invest in foreign issuers that derive most of their value from real estate.

[4] Proposed subsection 183.4(1).

[5] The deeming rule does not affect two situations. First, it does not apply to a registered securities dealer that acquires equity as an agent in the ordinary course of business and disposes of the equity to customers within a reasonable period of time. Second, it excludes a qualifying employee trust, a trust governed by an employee profit sharing plan or deferred profit sharing plan.

[6] E.g., non-voting, fixed value, and non-convertible equity that has a fixed return. The August 4 proposals expand the scope of “substantive debt” to include, among other things, certain instruments with a variable rate of distribution determined by reference to a market rate of interest (in addition to fixed-rate instruments), certain non-viability contingent capital instruments, and certain securities that entitle holders to an early redemption premium.

[7] The exception may also apply to a “qualifying disposition” to a trust and 107.4(1) or to a “qualifying exchange” by a mutual fund under 132.2(1). Subparagraphs (b)(ii) through (vi) of the definition of “reorganization or acquisition transaction” in proposed subsection 183.3(1).

[8] Section 86 of the Tax Act. Under this structure, public shareholders of a public corporation exchange all of their shares of the corporation for shares of a subsidiary and new shares of the corporation.

[9] The budget measure did not refer to equity issued on the conversion of convertible debt instruments that were issued solely for cash consideration.

[10] We note the “reorganization or acquisition transaction” exception for equity issuances is in the course of a “reorganization or acquisition transaction” but the exception for equity redemptions, acquisitions or cancellations is by a “reorganization or acquisition transaction”. The proposed legislation appears to be drafted to make it more difficult to rely on the exception in the case of equity repurchases and easier to capture equity issuances.