Paid-up capital is a fundamental concept in the Canadian tax system. It is the "tax" equivalent of legal capital, i.e., issued and paid-up share capital (federally declared capital), which represents the consideration received by the corporation for the shares issued. We provide a basic overview of the concept of paid-up capital.
The general principle is that a shareholder is entitled to get back the paid-up capital of his shares tax-free. Thus, in the event of the liquidation of a company or a share buy-back by the company, for example, the shareholder is entitled to recover his capital outlay without being taxed on this amount.
The excess amount received by a shareholder on a corporate redemption of shares or on the winding-up of a corporation will be deemed to be a taxable dividend for tax purposes. For example, if a shareholder subscribed for 100 common shares for $100 consideration, and on the winding up of the corporation receives $100,000, the shareholder will be deemed to have received a taxable dividend of $99,900 ($100,000 minus the paid-up capital).
The legal capital is the starting point for calculating the paid-up capital for tax purposes. The legal capital is the issued and paid-up share capital for provincial purposes and the stated capital for federal purposes. It is the consideration received, by class of shares, by the corporation for share issues.
The legal capital is not necessarily equal to the paid-up capital, but it is the starting point. The tax laws provide for certain adjustments to determine the paid-up capital for tax purposes.
Paid-up capital is calculated on a class basis, not on a per share basis. For example, if a shareholder subscribes to 100 Class "A" shares for $100, and then an investor subscribes to 100 new shares for $100,000, the paid-up capital will be divided equally among the shares of the class. In this case, each Class "A" share will have a paid-up capital of $500.50 ($100,100 / 200 shares). The second share subscriber could be prejudiced in this situation, as he or she would not be able to recover his or her tax-free investment.
One way to address the paid-up capital allocation problem is to create a new class of shares for the subscription of shares by the second shareholder. Under provincial law, this class of shares may have identical rights and restrictions to the first class of shares, and thus be considered separate for the purposes of calculating paid-up capital. Under the federal system, the law does not expressly provide that two classes may be identical.
Paid-up capital and ACB (adjusted cost base) are different concepts, although often they can be the same amount. Paid-up capital is attached to the company and is not affected by share purchases/sales. A shareholder holding 100 common shares with $100 paid-up capital can sell his shares for $100,000, and the paid-up capital of those shares will remain at $100. The purpose of paid-up capital is to calculate the amount a shareholder can get back tax-free.
Unlike paid-up capital, the ACB of shares is attached to the individual shareholder. It is the cost of his shares and is used to determine the amount of capital gain or loss arising on the disposition of his shares. A single shareholder who subscribed to 100 shares for $100 will have an ACB of $100 on those shares, the same amount as the paid-up capital. If he sells those same shares for $100,000, the buyer will have an ACB of $100,000 on the shares, but the paid-up capital remains $100.