A deemed dividend arises under section 84 of the Income Tax Act whenever a corporation pays a shareholder more than the shares’ paid-up capital on a redemption, acquisition, cancellation or reduction of capital — the excess is taxed as a dividend, not a capital gain, no matter what the parties call the payment.
The rule is mechanical: on a redemption, “the corporation shall be deemed to have paid…a dividend…equal to the amount, if any, by which the amount paid by the corporation…exceeds the paid-up capital in respect of those shares”. A parallel reduction-of-capital rule in subsection 84(4) works the same way. A narrower, non-arm’s-length branch in section 84.1 applies specifically to sales of shares to a related purchaser corporation, which is why the family-transfer exception matters so much to succession deals — that mechanism is worth its own read rather than repeating here.
This is exactly why rollover equity structures need care. A founder rolling into the fund’s acquisition vehicle typically receives preferred shares with paid-up capital tied to a nominal original subscription price, while the shares’ real redemption value at exit reflects the deal. That gap between the two numbers is a deemed dividend waiting to happen — taxed at dividend rates, not capital gains rates, which changes both the founder’s after-tax proceeds and what price they will actually accept at the table.
Rollover preferred shares issued to a founder at closing carry $1,000 of paid-up capital, tied to their original nominal subscription, but a $4,000,000 redemption value at the fund’s planned exit. On redemption, the deemed dividend is $4,000,000 − $1,000 = $3,999,999 — taxed entirely as dividend income to the founder, with none of it available as a capital gain even if the shares would otherwise have qualified for the lifetime capital gains exemption.
See also: Paid-up capital · Intergenerational transfer rules · Corporate purification.
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