Navigating Income Tax Act Sections s.88(2) and s.15(1): Potential Costs of Failing to Minimize Shareholder Benefits

Written by Zach Kennedy
JD Candidate 2024 | UCalgary Law

In the unpredictable entrepreneurship landscape, not every startup embarks on a journey to success. Amidst the exhilarating pursuit of innovation, founders must also prepare for possible setbacks and losses. Effective tax planning emerges as a crucial strategy in this context, offering founders avenues to mitigate potential financial losses. By strategically navigating tax regulations, founders can safeguard their assets, optimize deductions, and minimize tax liabilities, even in the face of business challenges. Section 88(2) of the Income Tax Act (“ITA”) is one of those tax planning tools that can assist in minimizing the possible tax consequences for founders who wish to wind up their operations. "Winding-up" is used in connection with the winding-up of a business and the winding-up of a corporation's existence, whether voluntary or otherwise.[1]

Imagine Bill having started such a business; as it stands the total value of the corporation's assets is $100,000, but Bill just doesn’t see a future for the business, so they wish to wind it up. Bill is the sole shareholder. In winding it up, Bill decides that they will just take back the assets from the corporation and begin winding it down. A few different things might happen to those amounts distributed back to them.

1. The amount might be a s.15 Shareholder Benefit;
2. The amount might be seen as a taxable dividend under s.84(2);
3. The amount might be seen as a taxable dividend under s.84(2), but it will be considered a wind-up under s.88(2).

 
Possible Dangers of S.15

S.15 states that at any time a benefit is conferred by a corporation on a shareholder, the amount or value of the benefit is included in the shareholder's income.[2] In this case, the $100,000 of assets might simply be included back into Bill’s income, as they consist of a benefit given to them. This can represent a massive tax liability on wind-up, as the assets that may have been transferred into the corporation by the founder (who may be the sole shareholder) would be transferred back to them as a shareholder benefit. Their whole value would be taxed back as regular income. Based on top rates in Alberta, that might result in an additional $48,000 in taxes to be paid.[3]

Deemed Dividends on Windup per S.84(2)

Luckily, s.15 makes an exception and excludes the amounts which are deemed dividends by operation of s.84.[4] However, The language in both s.15(1) and s.84 are substantially similar – both referencing distributions for the benefit of the shareholder – it must be clear where one is operating within the ITA. Subsection 84(2) applies to either the winding-up of a business or the winding-up of a corporation.[5]

On a typical wind-up of a corporation’s business, the assets in a corporation are distributed back out to the shareholders by way of deemed dividend per s.84(2). A dividend paid on a winding-up will be taxable, and such an amount must be included in the shareholder’s income.[6] This differs from s.15 in that it allows for a reduction of the value of the property distributed by the amount of the paid-up capital of the shares. This can be directly contrasted with how s.15 treats these distributions. For example, if Bill originally paid $50,000 for their shares of the corporation (and took nothing back but shares) then the shares would have a paid-up capital equal to $50,000. On the operation of s.84(2), the amount of the deemed dividend would reduce by $50,000, resulting in an income inclusion of only $50,000; half of what would be included under s.15.

Easing of Taxation Under s.88(2)

Finally, it may be the case that s.88(2) applies. Section 88(2) only applies where the appropriate corporate procedures are followed to bring a corporation's existence to an end.[7] Specifically, S.88(2) applies where a Canadian corporation is wound up after 1978, and throughout the winding-up, all or substantially all of the property owned by the corporation immediately before that time was distributed to the shareholders of the corporation.[8] The main benefit of s.88(2) applying is that it ensures that a corporation’s “capital dividend account,” “capital gains dividend account,” and “pre-1972 capital surplus on hand” reflect the disposition of funds or property by the corporation on the winding-up.[9]

By giving access to accounts like the Capital Dividend Account (CDA), a reduction in the total amount of taxable dividends (and consequently taxable liability) can be reduced. Specifically, s. S.88(2)(a) allows the inclusion of any capital gains existing before the final distribution in the CDA.[10] The amounts in the CDA can then be declared as capital dividends and are excluded from the recipient's income.[11]For example, if a property in the corporation realized a capital gain of $25,000, half of that amount could be added to the CDA and distributed as a capital dividend. This would result in $12,500 being distributed out to Bill tax-free.

Conclusion

Navigating the intricacies of tax law, particularly concerning sections 88(2), s.84(2) and s.15 of the Income Tax Act, requires a nuanced understanding of applicable provisions and careful strategic planning. For any wind-up to avail oneself of the benefits under s.88(2), they may wish to take care to ensure that proper formalities are observed (such as director’s resolutions with very clear minutes) to provide evidence that a wind-up is being performed. If this isn’t done, then it may be the case that s.15 shareholder benefit provision may apply, which will result in the complete inclusion of the fair market value of the assets into taxable income. Businesses can optimize their tax positions and minimize exposure to unintended tax liabilities by leveraging the benefits of s.88(2) on wind-up while implementing prudent measures to mitigate shareholder benefits under s.15.


[1] Canada Revenue Agency (CRA), Interpretation Bulletin IT-126R2 – Meaning of “Winding Up”

[2] Income Tax Act, RSC 1985, c 1 (5th Supp), s.15(1).

[3] Canada Revenue Agency (CRA). (2024, January 23). Income tax rates for individuals. https://www.canada.ca/en/revenue-agency/services/tax/individuals/frequently-asked-questions-individuals/canadian-income-tax-rates-individuals-current-previous-years.html

[4] Income Tax Act, RSC 1985, c 1 (5th Supp), s.15(1)

[5] Supra note 3.

[6] Income Tax Act, RSC 1985, c 1 (5th Supp), s.84(2)

[7] Canada Revenue Agency (CRA), Interpretation Bulletin IT-126R2 – Meaning of “Winding Up”

[8] Income Tax Act, RSC 1985, c 1 (5th Supp), s.88(2)

[9] Canada Revenue Agency (CRA), Interpretation Bulletin IT-126R2 – Meaning of “Winding Up”

[10] Income Tax Act, RSC 1985, c 1 (5th Supp), 88(2)(a)

[11] Income Tax Act, RSC 1985, c 1 (5th Supp), 83(2)(b)