On August 4, 2023, the Department of Finance released a revised version of its proposed 2% equity buyback tax (“Buyback Tax”) that will apply to relevant transactions that occur on or after January 1, 2024. The draft legislation does not include an exception for equity issued prior to the effective date for the Buyback Tax. Although not strictly speaking an income tax, the Buyback Tax will be included in the Income Tax Act (Canada) (“Tax Act”) as a new Part II.2. The Buyback Tax was first announced in the government’s 2022 fall economic statement, with an initial version of the draft legislation being introduced as part of the 2023 federal budget.

While the rules have been refined since the initial version of them was released this past spring, the scope of the Buyback Tax remains broad in its revised form.^[1] It is expected to apply to a variety of ordinary course capital market transactions including, in particular, normal course issuer bids and substantial issuer bids. Capital markets participants will therefore need to carefully consider the Buyback Tax when evaluating transactions that involve the redemption, repurchase or cancellation of publicly traded equity.

Who Does the Buyback Tax Apply To?

The Buyback Tax will apply to a corporation, trust or partnership that is a “covered entity” – a term which has been defined to include publicly listed Canadian resident corporations, real estate investment trusts, specified investment flow-through (“SIFT”) trusts, and SIFT partnerships. For these purposes, “equity” is defined to mean (i) a share of a corporation, (ii) an income or capital interest in a trust, or (iii) an interest as a member of a partnership.

How is the Buyback Tax Calculated?

In general terms, the amount of the Buyback Tax is equal to 2% of a covered entity’s net equity repurchases in the taxation year, as set out in the following formula:

The Buyback Tax rules contain a de minimis rule such that a covered entity will not be subject to the tax in any taxation year in which the amount determined for it under variable A is less than C$1,000,000.

Exceptions to the Buyback Tax

There are two conceptual exceptions, which, if applicable, will result in equity of a covered entity being excluded from the Buyback Tax formula. These two exceptions are summarized below.

• Substantive debt: While this term is comprehensively defined in the Tax Act, it is intended to capture equity that possesses debt-like characteristics (namely, non-voting, non-convertible or exchangeable, fixed value preferred shares).
• Certain transactions involving equity issuances and repurchases: Conceptually, this exception applies to certain transactions that technically include an equity issuance or repurchase but that do not from a policy perspective warrant being included in the Buyback Tax formula. In most cases, the exception is triggered when the investor does not increase or decrease his/her financial investment in the covered entity (or one or more successor entities). The term “reorganization or acquisition transaction” exception generally includes equity repurchased, redeemed, or cancelled in the course of amalgamations, wind-ups, or equity exchanges whereby a holder receives only equity consideration, as well as so-called “butterfly transactions” covered by subsection 55(3) of the Tax Act.

Anti-avoidance Rules

The Buyback Tax provisions contain specific anti-avoidance rules which, in general terms, prevent the following transactions from reducing the amount of tax payable by a particular covered entity under the rules:

• Equity issuances or repurchases by a covered entity that are part of a transaction or series of transactions the primary purpose of which is to manipulate the Buyback Tax formula.
• Repurchases of equity issued by a covered entity by an affiliated corporation, trust, or partnership where the covered entity controls the affiliate or (ii) owns, directly or indirectly, more than 50% of the equity of the affiliate.

Observations

The Buyback Tax was likely inspired by a similar 1% tax that was implemented in the United States at the beginning of 2023, but the underlying policy rationale for the tax is less clear. According to the Department of Finance, the purpose of the Buyback Tax is

“…to make sure that large corporations pay their fair share [of tax], and to encourage them to reinvest their profits in workers and in Canada.”

While reasonable people can differ as to whether public corporations pay enough tax, it is troubling that the federal government seems to think it is better positioned than a business to determine how its surplus capital ought to be allocated. This mindset also seems to presuppose that the funds received by investors on an equity repurchase transaction will not be reinvested in a productive manner. Perhaps the Department of Finance simply wanted to add to its assortment of revenue tools in order combat the deficit – it has been estimated that the Buyback Tax will raise on average C$500-600 million per year in revenue over its first five years of existence. While this is not an immaterial amount of money, when viewed in the context of the federal government’s total annual revenues of approximately C$457 billion (for its 2023-2024 fiscal year) it is not a significant amount either.

Finally, the federal government may be of the view that equity repurchase transactions provide inappropriate tax advantages to shareholders relative to the payment of dividends. Again, what is and is not inappropriate from a tax policy perspective is a subjective assessment, but we would observe that, at least in the case of a substantial issuer bid, a significant portion of the purchase price is often characterized as a dividend for Canadian income tax purposes.

Conclusion

Capital markets participants will need to carefully consider the Buyback Tax when evaluating transactions that involve the redemption, repurchase or cancellation of equity by publicly traded entities.

[1] The revised proposal is included in this August 2023 release from the Department of Finance, beginning on p. 50.

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