Loi de l’impôt sur le revenu – Simplifions en abrogeant la partie VI.1

Trevor McGowan
Sous-ministre adjoint associé
Direction générale de la politique fiscale
Ministère des Finances Canada
90, rue Elgin, Ottawa (ON) K1A 0G5
Courriel : Trevor.McGowan@fin.gc.ca

Objet : Mémoire du Comité mixte concernant la partie VI.1

Monsieur McGowan,

Le présent mémoire (disponible uniquement en anglais) présente les observations du Comité mixte sur la fiscalité de l’Association du Barreau canadien et des Comptables professionnels agréés du Canada (le « Comité mixte ») en faveur de l’abrogation de la partie VI.1 de la Loi de l’impôt sur le revenu. Le mémoire s’appuie sur la recommandation formulée en avril 2025 par le Comité mixte, selon laquelle la partie VI.1 devrait être modifiée de manière à ne pas s’appliquer aux placements effectués par des non-résidents et qu’il faudrait envisager son abrogation, notamment à la lumière des initiatives du ministère des Finances visant à simplifier le régime fiscal.

Des membres du Comité mixte et d’autres membres de la communauté fiscale ont participé à la discussion concernant ce mémoire et ont contribué à sa préparation, notamment :

• Christopher Anderson – Davies Ward Phillips & Vineberg S.E.N.C.R.L., s.r.l.
• Alexander Demner – Thorsteinssons LLP
• Kenneth Saddington – Goodmans LLP
• Carrie Smit – Goodmans LLP
• Gwen Watson – Torys S.E.N.C.R.L.
• Jerald Wortsman – Torys S.E.N.C.R.L.

Nous serions ravis de discuter plus en détail de cette proposition avec vous à votre convenance.

Cordialement,

Joint Committee on Taxation of The Canadian Bar Association and CPA Canada
Submission to the Department of Finance Regarding Part VI.1

Introduction

Nearly 40 years have passed since Part VI.1 was introduced in 1987. At that time, certain corporations with losses or other tax attributes were perceived as using preferred share structures in lieu of debt financing to permit certain investors to receive returns as tax-free dividends. The Part VI.1 regime was introduced as a targeted anti-avoidance measure to address those structures and eliminate the perceived tax advantage. However, Part VI.1 has wide-reaching effects far beyond its intended focus and is negatively impacting investments into Canadian corporations. In April 2025, the Joint Committee made submissions on various technical issues, which included our recommendation that Part VI.1 be amended so that it does not apply to investments by non-residents and that consideration be given to the repeal of Part VI.1. In light of the concerns with Part VI.1 and the Department of Finance’s initiatives surrounding simplification of the tax system, we are writing with more detailed submissions supporting the repeal of Part VI.1.

The STEP Canada Tax Technical Committee made a submission (the “STEP Submission”) to the Department of Finance on August 13, 2026 also recommending the repeal of Part VI.1. The STEP Submission included a detailed discussion of many of the underlying problems with Part VI.1; although we will not repeat all of those issues in this submission, the Joint Committee expresses its agreement with the STEP Submission.

All section references herein are to the Income Tax Act (Canada), as amended (the “Tax Act”).

Brief History of the Rules

The tax policy issue addressed by the Part VI.1 tax regime was first addressed in 1978 through rules that denied the inter-corporate dividend deduction in certain circumstances. The target of the rules was a transaction whereby a lending institution would advance financing through a debt substitute to a corporation that had available losses or other tax attributes (and which was therefore unable to immediately benefit from an interest deduction). In effect, the lending institution converted what would otherwise have been interest income into tax-deductible dividends. The problem was described at the time as follows:

… corporations which were unable to utilize an interest deduction because of losses, deductible dividends, capital cost allowance or resource write-offs would issue either a retractable preference share or an income debenture to a bank or other financial institution. Although any dividend or interest paid on such securities was not deductible to the payor, it was also not taxable to the recipient because a deduction was provided under section 112 or subsection 138(6) of the Income Tax Act. Consequently, lenders were prepared to offer a rate which was substantially less than the normal interest cost (often 1 per cent or 2 per cent above 1/2 of prime). This not only increased the lender’s rate of return; at the same time, it improved the borrower’s cash flow. Therefore, on the face of the transaction, everyone benefited with the possible exception of the Department of National Revenue.¹

At that time, the Tax Act contained other provisions which addressed, in part, this tax policy concern by precluding a corporation from claiming an inter-corporate dividend deduction in certain circumstances. The main provision was subsection 112(2.1), which denied the inter-corporate dividend deduction where a specified financial institution (“SFI”) received a dividend on a “term preferred share” (other than a dividend on a share acquired outside the ordinary course of the business carried on by the institution, certain listed shares where certain ownership thresholds were met, and shares issued by a corporation in financial distress). The inter-corporate dividend deduction was also denied under subsection 112(2.2) where a corporation received a dividend on a “guaranteed share” (subject to an exception for listed shares where all guarantees were given by the issuer or a related corporation), and under subsection 112(2.4) in respect of “collateralized preferred shares”. These provisions all continue to exist today, although they have been amended over the years.²

The 1987 White Paper on tax reform considered that the problem of after-tax financing had not been fully addressed through the existing rules restricting the inter-corporate dividend deduction and proposed the introduction of the Part VI.1 tax regime.³ The White Paper suggests that the tax policy problem remained the same in 1987 as it was in 1978 – i.e., the raising of financing through a debt-substitute by a borrower which was indifferent to the availability of an interest deduction (because of losses or other tax attributes) and a lender seeking to convert taxable interest into tax-deductible dividends. The White Paper states:

It is proposed to reduce the tax advantage for non-taxpaying companies of financing through the use of preferred shares.

Based on the principle of integration, the Canadian income tax system provides relief from taxation for dividends received by corporations (through the inter-corporate dividend deduction) and by individuals (through the dividend tax credit). This recognizes that the dividends are generally paid out of income that has already been subject to tax. However, the accelerated deductions and tax credits provided in the Canadian tax system over the last decade have resulted in many profitable corporations not paying tax, although they were in a position to pay dividends. In such situations a corporation may use preferred share financing and thus take advantage of the tax relief provided to the dividend recipient even though no tax has been paid on the underlying income.⁴

The literature at the time suggested that certain gaps in the dividend-deduction denial regime existed, and that the Part VI.1 tax was introduced to fill those gaps. One example cited was the exemption from the dividend deductibility restriction for publicly-listed preferred shares. As Douglas Ewens wrote:

Despite these four limitations on the deductibility of intercorporate dividends [those addressing term preferred share, guaranteed shares, collateralized preferred shares and short-term preferred shares], extensive use has been made in recent years of after-tax financing through publicly listed term preferred shares. SFIs continue to have a hearty appetite for dividend income on listed preferred shares, adopting internal controls to ensure that they never own, on any dividend payment date, more than 10 percent of any class or series of term preferred shares. Although the practice of banks’ guaranteeing preferred shares issued by unrelated corporations was terminated by the guaranteed share rules, a large number of non-taxable issuers have discovered that the definition of “specified financial institution” is broad, learned that they have an SFI in their associated corporate group, and issued publicly listed shares that are guaranteed by a corporation associated with the issuer. In this situation, dividends are deductible by all corporate shareholders, including SFIs.⁵

Part VI.1 is No Longer Warranted

Although Part VI.1 tax was introduced to address certain relatively narrow gaps, its broad application has been problematic in practice. Given the many issues with the Part VI.1 tax regime (as set out below), we recommend that the regime be eliminated.

Currently, the dividend deduction rules in subsections 112(2.01), 112(2.1), 112(2.2) and 112(2.4) (the “Dividend Deduction Denial Rules”) address (and curtail) substantially all after-tax financing arrangements. To the extent there is a belief that gaps may arise following the repeal of Part VI.1, we suggest that they could more appropriately be dealt with through amendments to the Dividend Deduction Denial Rules.

In addition, to the extent that the Part VI.1 tax regime once served a broader purpose, that purpose may no longer exist to the same degree as it did when the regime was introduced in 1987. In particular, the Tax Act has been dramatically transformed since 1987 through numerous legislative amendments. Many of these amendments address the ability of corporations to realize or utilize losses, and therefore the issue of corporations using losses or other tax attributes to raise after-tax financing is more attenuated today.

For example, the foreign affiliate dumping rules have restricted the ability of a corporation resident in Canada (controlled by a foreign parent corporation) to invest in its foreign affiliates in a manner that generates deductions for the Canadian corporation. The EIFEL rules further restrict the ability of a corporation to shelter income or create losses through interest and other financing expense; for example, a Canadian public corporation with significant foreign operations that borrows to fund those operations cannot generate shelter against Canadian income. The ability of a Canadian corporation to create shelter through double-dip structures has been addressed by the changes to treaties and the hybrid mismatch arrangement rules. The ability of a Canadian corporation to acquire/trade losses has been addressed through attribute trading and loss restriction rules. In addition, the strengthening of the General Anti-Avoidance Rule since 1987 has curtailed the ability of Canadian corporations to generate/accelerate losses. Although the recently announced Productivity Mega Deduction may result in certain Canadian corporations realizing losses earlier than they otherwise would, this is only a timing issue; as capital assets are fully depreciated in the year of acquisition, no depreciation can be claimed on those assets in later years. Furthermore, imposing Part VI.1 tax on a Canadian corporation which issues equity in order to invest in capital assets and is thereby entitled to the Productivity Mega Deduction would negate the benefits (and policy rationale) of that deduction. In addition, in 2004, the period for carrying forward non-capital losses was changed from seven years to ten years and then in 2006 to twenty years. Corporations now place significantly more value on their non-capital loss carryforward balances because they have a much lower risk of expiring unutilized. Thus, corporations are less incentivized to pass on the benefits of their non-capital losses to another party.

Any perceived gaps or planning opportunities in the context of the current rules, particularly the Dividend Deduction Denial Rules, cannot justify all of the issues with Part VI.1 tax, including its enormous complexity and over-reach, its interference with wholly commercial transactions, and its detrimental effect on capital investments.

Issues with Part VI.1

(i) Part VI.1 is Extremely Complex

Part VI.1 is one of the most technically complex set of rules in the Tax Act. It is extremely dense, incorporates dozens of definitions (many of which are themselves highly technical), and requires multiple overlapping sets of calculations. As the 1987 Canadian Tax Report analyzing the introduction of Part VI.1 quipped: “The proposed legislation is an almost impenetrable jungle with layer upon layer of definitions, exceptions and exclusions.”⁶

Such complexity has a real, negative impact on Canadian businesses. Private equity vehicles and other taxpayers may constrain their financing offerings based on concerns over Part VI.1 applying to the borrower. Even if a path through its shoals and traps can be found, doing so typically requires time-consuming and expensive advice from the most qualified practitioners; non-tax practitioners have effectively no chance of navigating Part VI.1.

In concept, Part VI.1 tax is intended to apply to large dividends on preferred shares. In reality, determining whether that tax applies requires a complex multi-step analysis involving determinations of:

• whether the underlying shares are short-term preferred shares (“STPS”) or taxable preferred shares (“TPS”), which demands close scrutiny of the definitions underlying those terms, as well as all relevant corporate documents (articles, by-laws, memoranda, contracts etc.) and shareholders’ agreements (“USAs”);
• whether any dividend constitutes an “excluded dividend”, requiring an analysis of several other terms with ambiguous components (e.g., “financial intermediary corporation” and “private holding corporation”), purpose tests, and concepts such as control (through the “substantial interest” definition);
• whether the “specified amount” exclusion in subsection 191(4) applies and to what extent;
• the dividend payer’s dividend allowance, having regard to dividends paid in previous years and by associated corporations;
• whether a deduction against taxable income under paragraph 110(1)(k) is available to offset the Part VI.1 tax cost;⁷ and
• whether any election or agreement (e.g., in section 191.3) can, and should, be filed to shift or reduce Part VI.1 tax exposure.

All of those points are buttressed by various inclusions, exclusions, deeming rules, anti-avoidance provisions, proration provisions, and re-allocation rules. In practice, the Part VI.1 tax maze can only be navigated by the largest corporations in Canada, such as financial institutions and publicly traded entities. These issuers also generally generate material taxable income within the corporate group and are therefore generally able to claim a paragraph 110(1)(k) deduction to largely neutralize any revenue-raising effects of Part VI.1.

The result is an intricate web of provisions which impede commerce, necessitate heightened legal and accounting fees, and ultimately exacerbate the complexity of an already-complex taxing statute. Compared to its policy objectives, Part VI.1 imposes a grossly disproportionate compliance and professional cost burden on taxpayers.

(ii) Rules are Overly Broad and Exemptions are Overly Narrow

Part VI.1 suffers from extreme overbreadth. Its provisions capture a large array of transactions (far beyond its policy intent) while exempting too few. The result is that an excessive number of taxpayers of all sizes need to navigate overly complex rules.

Several components of Part VI.1 demonstrate such overbreadth. First and foremost, too many shares – well beyond the intended focus of the Part VI.1 regime – are caught by the STPS and TPS definitions (and, thus, Part VI.1). Dividends which Parliament could not have intended to be subject to Part VI.1 tax include dividends on:

• common shares subject to customary put/call or buy/sell rights under a USA;
• common shares with immaterial economic differences to distinguish share classes;
• “tracking” shares that provide economic exposure to a particular business or asset of the issuer;
• common shares of a corporation where bona fide third-party agreements may restrict the amount of dividends that may be paid from time-to-time;
• shares potentially convertible or callable into special stock on a defined event (e.g., third-party takeover); and
• shares under an exchangeable share structure.⁸

The exemptions in Part VI.1 – including the “excluded dividend” and “specified amount” exclusions – are also far too narrow. Standard corporate reorganizations (butterfly transactions, purifications, estate freezes, etc.) can involve the inter-corporate payment of dividends which trigger Part VI.1 tax in entirely inappropriate circumstances. For example, shares held through a family trust (especially one with multiple trustees), freeze preferred shares without control-level voting rights, or shares held through multiple classes with immaterial economic differences can easily cause the “substantial interest” test (and thus “excluded dividend” definition) not to be met. Similarly, failing to expressly stipulate a “specified amount” – or specifying an amount that is even $1 too high – will wholly prevent the safe harbour rule in subsection 191(4) from applying. Several other examples of normal-course situations where Part VI.1 tax can unexpectedly (and inappropriately) apply are outlined in the STEP Submission.

Finally, even when Part VI.1 applies (appropriately or otherwise), it is often rendered superfluous or moot by other, overlapping regimes in the Tax Act. Of particular note, the Dividend Deduction Denial Rules often apply – with a much more severe result – to dividends which are also subject to Part VI.1.

In sum, the scope of Part VI.1 reaches far beyond its policy concerns. Far too many ordinary circumstances are subject to a complex regime, with exceptions which are far too narrow (and complex in their own right), which ordinary Canadians are incapable of successfully navigating.

(iii) Other Tax Provisions Protect the Tax Base

From the outset, the Part VI.1 tax rules were needlessly overbroad. The mischief targeted by the rules – after-tax financing that relies on the subsection 112(1) deduction in order for the holder to receive dividends on a tax-free basis – does not apply to the ownership of shares by individuals, tax-exempts or non-residents. Part VI.1 tax has no basis applying to dividends paid to such shareholders. However, even in the case of Canadian corporate shareholders, the need for Part VI.1 tax is often no longer present and would be more appropriately dealt with through other more targeted measures.

Individual shareholders. Dividends received by Canadian-resident individuals are taxable. Eligible dividends attract combined top marginal rates ranging from roughly 28.33% to 46.2% depending on the province, and non-eligible dividends are taxed more heavily still (up to 49.9% in Nova Scotia). The gross-up and dividend tax credit is calibrated on the assumption that corporate tax has been paid on the underlying earnings at an approximate tax rate of 25%.

Where the payer is subject to Part VI.1 tax on the dividend, that assumption fails. The combined tax paid – by the individual shareholder on the dividend received, and by the corporation under Part VI.1 – significantly exceeds the tax that would be paid by the individual had they received the amount as interest.

For example, assume a corporation (in a loss position) earns $100 and pays that amount as an eligible dividend on a STPS to an individual resident in Newfoundland and Labrador who is subject to tax at the top marginal rate. The corporation would be subject to Part VI.1 tax of $40 on the dividend, and the individual would pay federal and provincial income tax of approximately $46.20. The total tax burden of the dividend is $86.20 (assuming the paragraph 110(1)(k) deduction is not usable). If instead, the corporation had paid $100 of interest to the Canadian individual, the individual would be subject to tax of $54.80, but the corporation would have no incremental Part VI.1 tax liability. Part VI.1 tax results in a disproportionately higher tax burden.

Moreover, in the case of an issuer which is a Canadian-controlled private corporation, if it has insufficient taxable income it is also likely to have nominal general rate income pool (“GRIP”). Therefore, any dividends paid on the preferred shares would likely be treated as non-eligible dividends (and taxed at a higher rate only slightly less than the regular income tax rate). Even where the corporation has sufficient GRIP and dividends are taxed as eligible dividends, the combined personal and corporate tax burden of paying dividends on TPS significantly exceeds the tax burden of an equivalent interest payment.

Practically, individuals are not beneficiaries of the after-tax financing planning which Part VI.1 targets.

Non-Resident Shareholders. As set out in the Joint Committee submission to the Department of Finance on April 15, 2025, the policy behind Part VI.1 does not apply where the investor is a non-resident of Canada.

Interest paid by a Canadian resident to an arm’s length non-resident lender is generally exempt from withholding tax under paragraph 212(1)(b). An arm’s length non-resident can accordingly lend to a Canadian company and receive the return free of Canadian tax. A dividend paid to the same non-resident is subject to withholding tax at 25%, potentially reduced by an applicable tax treaty. Even at the most favourable treaty rate, the dividend bears more Canadian withholding tax than arm’s length interest, and for a portfolio holder the differential is often 15 percentage points or more. A non-resident investor who does not deal at arm’s length with the Canadian corporation and who is entitled to the benefits of the Canada-U.S. Income Tax Convention (the “Treaty”) is similarly not subject to Canadian withholding tax on interest.⁹ Conversely, dividends on preferred shares to such an investor will always be subject to Canadian withholding tax.

Therefore, in the context of non-resident shareholders, there is generally no Canadian tax benefit to investing in equity as opposed to debt.

Tax-Exempt Shareholders. There is no tax policy reason to impose Part VI.1 tax on dividends paid to tax-exempt shareholders. These shareholders derive no tax benefit in receiving a dividend compared to interest. Moreover, imposing Part VI.1 tax on dividends to Canadian pension plans directly contradicts the stated objective of encouraging Canadian pension plans to increase Canadian investment, and the goals of the Canada Strong Fund and other government-investment vehicles. Part VI.1 tax imposes a needless burden on corporations seeking preferred share investments from these investors.

Financial Institutions. As noted above, the Dividend Deduction Denial Rules deny the inter-corporate dividend deduction to an SFI on a dividend received on a term preferred share (with some limited exceptions). These rules attack the original arrangement by eliminating the tax benefit to the SFI; if an SFI cannot exclude the dividend from income, there is no benefit to a share investment and no reason to prefer a preferred share structure over a loan. Part VI.1 adds a second charge to the same conduct, which is unnecessary (and punitive) where the Dividend Deduction Denial Rules have covered the same ground.

In 2023, Parliament added an additional Dividend Deduction Denial Rule in subsection 112(2.01), which denies a dividend deduction to a financial institution on a share which is mark-to-market property. However, a TPS is generally deemed not to be mark-to-market property for purposes of this rule, as the holding of TPS was not within the mischief targeted by subsection 112(2.01).

“Unconnected” Canadian corporations. The concern around after-tax financing was the assumption that dividends move between Canadian corporations free of tax. However, this is often not the case. In particular, Canadian private corporations receiving dividends on preferred shares will be subject to Part IV tax where the payer company is not “connected” with the shareholder.¹⁰ This is often the case where a Canadian corporation owns preferred shares of another corporation in which it does not have a substantial interest (and, if it had a substantial interest, Part VI.1 tax would not apply).

This Part IV tax cost is only refunded where dividends are (ultimately) paid to individual, tax-exempt or non-resident shareholders. For the same reason that dividends paid directly to such shareholders should not be caught by Part VI.1, dividends subject to Part IV tax should not either. Practically, it is also not expected that Canadian corporations undertake the after-tax financing planning which Part VI.1 targets.

The Dividend Deduction Denial Rules apply to the recipient to the extent they would otherwise enjoy a tax benefit. Part VI.1 makes no such inquiry; it applies to the payer regardless of who holds the share, and regardless of whether the holder obtains any benefit. Dividends paid to an individual, non-resident, pension fund or other tax-exempt holder, or taxable corporation subject to either Part IV tax or the Dividend Deduction Denial Rules all attract the same charge. There is no revenue leakage to recover, and yet the tax applies at the same rate.

We acknowledge that Part VI.1 tax may serve as a penalty to ensure after-tax financing does not occur. However, the current regime overcompensates for a concern that is already well-addressed in most situations.

(iv) Part VI.1 Discourages Investments in Canadian Companies

(A) Rules Create Uncertainty in the Cost of Financing

A Canadian corporation may wish to raise capital through the issuance of preferred shares to unrelated investors, understanding that Part VI.1 tax would apply to any dividends paid on those shares. The issuer may currently be in a taxable position and therefore expect to fully recover the Part VI.1 tax through the paragraph 110(1)(k) deduction. However, any number of events could occur after the share issuance which would impact the ability of the issuer to recover the Part VI.1 tax; for example, the issuer’s taxable income could be unexpectedly and negatively affected by factors like Covid, changes in technology or consumer behaviour, trade uncertainty or an increase in business expenses (e.g., fuel costs, wages, rent, tariffs). This possibility causes uncertainty for the issuer at the time of the financing as to the long-term cost of the financing and may adversely impact the issuer’s willingness or ability to raise capital. As discussed below, it may also not be possible to issue additional debt instead. As a result, the decision may be made to forgo the capital raise and the potential investments it would have funded.

(B) Rules may Limit Access to Non-Resident Capital

As set out in the Joint Committee submission to the Department of Finance on April 15, 2025 and discussed above, there is no tax incentive for a non-resident investor to structure an investment in a Canadian corporation as preferred shares instead of debt. A non-resident investor in preferred shares does not acquire the benefit of the Canadian tax losses, deductions or tax credits of the Canadian corporation, which is the mischief targeted by the Part VI.1 regime.

Despite there being no policy reason to apply Part VI.1 to preferred share dividends paid to non-resident investors, its potential application deters non-resident investments in unrelated Canadian corporations. Where the investment is structured as preferred shares, the cost (or the risk of the cost) of unrecoverable Part VI.1 tax may make the preferred share investment uneconomical for the parties. This may force the non-resident investor to instead invest through debt which is not what the parties desire and paradoxically results in less Canadian tax being payable as compared to a preferred share investment because the debt now results in a deduction to the Canadian borrower and no withholding tax on the interest paid to the non-resident of Canada. If it was as simple as replacing the preferred shares with debt that may be an acceptable compromise, but it is often the case that a debt investment is unattractive or unavailable for commercial reasons, which then limits the Canadian corporation’s access to non-resident capital.

(C) Part VI.1 Deters Venture Capital Investments in Start-Ups through Convertible Preferred Shares

Part VI.1 tax may also act as a deterrent to venture capital investments in Canadian start-ups. Convertible preferred shares are the standard equity instrument used by venture capital and other investors in start-ups. This investment structure is nearly universal in the space and is reflected in the Canadian Venture Capital and Private Equity Association model documents, which are themselves based on the U.S. National Venture Capital Association model documents. These convertible preferred shares are not properly viewed as debt substitute: they have common share growth and distribution participation, subject only to downside protection intended to mitigate the risk of investing in early-stage companies. The use of these convertible preferred shares is not motivated by the loss sharing or after-tax financing mischief that Part VI.1 seeks to address.

Unfortunately, the risk of unrecoverable Part VI.1 tax may make a preferred share investment too costly for the Canadian corporation, and debt financing may not be an available or commercially acceptable alternative (particularly for start-ups). A company’s balance sheet or existing debt covenants may not permit an additional amount of leverage. In addition, many early-stage and tech businesses may not have sufficient “hard assets” to provide the security often required under typical debt financings. In either case, even if debt financing is available, these considerations may also result in an unacceptable increased cost of capital. In addition, where the investment is not expected to pay a current return (but rather the return will accrue over time and be paid at a later point), the investors may be unwilling to incur an annual income inclusion respecting interest accrual. These factors unfairly limit the Canadian start-ups’ access to capital.

(D) Private Equity Investors are Discouraged from Investing in Canada

Part VI.1 tax may also act as a deterrent to preferred share investments by private equity funds in unrelated Canadian corporations. This is the case even though the imposition of Part VI.1 tax on preferred share dividends paid to private equity funds is often unwarranted. Private equity funds are primarily structured as partnerships, and their investor base is predominately comprised of non-residents, tax-exempts or investors who would not benefit from a subsection 112(1) deduction without the imposition of Part IV tax. As discussed above, these classes of investors do not engage the mischief that Part VI.1 is intended to address.

Part VI.1 tax can even apply where the private equity fund has a majority or controlling interest in the preferred share issuer. A partnership is deemed not to have a “substantial interest” in a Canadian corporation unless all of its partners are related. A fund may own a controlling interest in a Canadian corporation and want to hold a portion of this interest through preferred shares in order to maintain priority over other investors. Because it does not have a substantial interest, Part VI.1 tax can apply to the dividends paid to that fund. This can compel the fund to structure its investment (wholly or partially) as debt or common equity (which may not be commercially available or desirable in many circumstances).

(E) Multinational Enterprises May Still Issue Preferred Shares – Outside Canada

A multinational enterprise that has decided to raise capital through the issuance of preferred equity often has the choice of whether to raise that capital in Canada or through a non-Canadian entity in the group. Part VI.1 tax may serve as a deterrent to raising this equity within Canada and push the group to issue the preferred equity outside of Canada. Other things being equal, this could distort investment decisions of the group away from Canadian projects towards non-Canadian projects that can be financed through preferred equity without the associated Part VI.1 tax cost.

(v) Part VI.1 and the Distortion of Investment Decisions

Part VI.1 tax is a factor which can impact a Canadian corporation’s decision to raise capital through equity or debt. The tax incentivizes issuers to incur debt in lieu of issuing preferred shares where unrecoverable Part VI.1 tax is a possibility.¹¹ The issuance of additional debt can be financially disadvantageous – it can result in excessive leverage and an undesirable balance sheet, increase the risk of insolvency, and preclude corporate transactions such as dividends and redemptions due to the corporate solvency tests. It may also be the case that the issuer is precluded from issuing additional debt due to restrictions under senior debt terms. A corporation’s capital structure, and its debt-to-equity ratios, should be based on economic factors not the uncertain possibility of a punitive tax.

Comparison to Other Countries

We are not aware of any other jurisdiction that imposes a tax similar to Part VI.1. Other jurisdictions that have confronted the same debt and equity boundary have solved it by characterizing a share with debt-like characteristics as debt for tax purposes, not by imposing a separate corporate-level charge on the issuer. In broad terms:

• The United States has no payer-level tax on preferred dividends. It relies on recipient-level limitations, including the reduction of the dividends received deduction for debt-financed portfolio stock under section 246A, the extraordinary dividend rules in section 1059, and the debt and equity classification regime under section 385.
• The United Kingdom taxes shares accounted for as liabilities under the loan relationship rules, so the return is treated in a manner consistent with interest for both parties.
• Australia’s Division 974 debt and equity rules recharacterize debt-like equity as debt, with the result that distributions are deductible to the issuer and are not frankable in the hands of the holder.

Canada, through the Dividend Deduction Denial Rules, has enacted rules that treat dividends paid to financial institutions (and other holders) on debt-like preferred shares akin to interest. These rules are clearly within the scope of the international norms, and should be sufficient to address the perceived mischief of after-tax financing. The Part VI.1 tax rules are a clear outlier, as the tax is imposed on the issuer of preferred shares based on their choice of capital structure, rather than on the investor that receives the dividend on their investment.

Recommendations

Based on the above, we submit that Part VI.1 extends far beyond its intended scope, introduces unintended and inappropriate results in many circumstances, distorts and interferes with wholly commercial transactions, and deters capital investments. Therefore, it is recommended that Part VI.1¹² be repealed.

Alternatively, if Finance decides to retain Part VI.1 in the Tax Act, the definition of “excluded dividends” should be amended such that Part VI.1 tax will not apply to dividends received, whether directly or indirectly through one or more Canadian resident trusts or partnerships, by individuals (including trusts and estates), tax-exempt entities, non-residents, unconnected Canadian corporations, and any corporation which is not entitled to claim a deduction in respect of the dividend.

Notes de fin