Co-ops to Get Critical Tax Deferral for Dividends | FBC, Canada's Farm & Small Business Tax Specialist

Co-ops to Get Critical Tax Deferral for Dividends

If the finance minister gets his way, members of agricultural co-operatives will no longer have to pay income tax on uncashed patronage dividends. This is great news for co-op businesses looking to attract new members.

The Canadian Cooperative Association is pleased that the federal government will follow through on its 2005 budget commitment to reduce the tax burden of co-op patronage dividends. This should help the co-op model remain a viable option for agribusiness.

The association had lobbied for a tax deferral on patronage dividends paid to co-op members, which would enable agricultural co-operatives to keep more cash in their coffers. True to his word, Finance Minister Ralph Goodale released a draft amendment to the Income Tax Act in August that means ag co-op members would no longer be taxed immediately on patronage dividends received in the form of shares or equity in the co-op. Taxation would occur only at a later date when either the co-op buys back the shares or the member otherwise disposes of them.

Patronage dividends, by definition, are payments a customer receives based on a percentage of the business that customer gives the co-op over a period of time. Such dividends usual relate to co-operatives in which the consumer is a member.

Under the existing legislation, patronage dividends are taxable when the co-op member receives them in whatever form. (The exception is for dividends paid as a result of expenditures for non-business or personal goods and services.) These dividends are usually comprised of 2 components: cash paid out to the member and cash held back from the member in the form of equity in the co-operative. Under the current tax law, all patronage dividends, whether paid in cash or in the form of equity or shares, must be included in the recipient¹s income for the taxation year.

For good reason, many ag co-op members had become reluctant to take patronage dividends in the form of shares. While they had to pay taxes on them in the current year, they would not actually receive cash for the shares until they were able to redeem them several years later. In addition, the shares offered minimal capital appreciation. So members pressured their co-ops to pay dividends in cash.

Paying dividends in cash, however, severely limits a co-op's cash flow and constrains the financial resources for growth. The result was that ag co-op membership declined over time and many co-ops were forced to seek alternative sources of financing because of the difficulty in retaining capital.

The new tax measure proposes to permit eligible members of eligible ag co-ops to defer as income a portion or all of any patronage dividend received as an eligible share until the member disposes of that share. Also, when the agricultural co-op issues an eligible share as a patronage dividend, it will no longer be obligated to withhold tax at 15% on that dividend or issue a T4A tax slip. The co-op will have to withhold tax and issue a T4A only when the share is eventually redeemed.

To be eligible for the new tax deferral measure, ag co-ops must have farming or the provision of goods and services for farming as their principal business activity. Included in the definition of “farming” are the production, processing, storing and wholesale marketing of the products of their members¹ farming activities. As well, the principal business must be carried out in Canada. Co-op members also must meet these same criteria to be eligible for the deferral.

To ensure compliance and to administer and evaluate the impact of this new measure, ag co-ops that make patronage dividends in the form of shares eligible for the tax deferral will have to report the issue of such shares with their income tax returns.

There will be a limit to the amount of deductible patronage dividends an ag co-op will be able to issue as shares. Generally, the co-op will be entitled to deduct the amount of eligible shares issued as patronage dividends in a given taxation year up to a maximum of 85% of the income gained from business with members for that taxation year.

Eligible shares will be those that are issued after 2005 and before 2016. They must not â€" except in cases where the member dies, becomes disabled or ceases to be a co-op member â€" be redeemable or retractable within 5 years of issue. If an eligible share should be pledged as collateral security or if the paid-up capital of the share is reduced by some means other than redemption, a share disposition will be deemed to have occurred.

Over the past century, ag co-ops have played a key role in the Canadian agrifood sector and the life of Canada's rural communities. These co-operatives are involved in the processing and marketing of farm products, as well as the provision of agricultural supplies and services for farm production and marketing. Arguably, they put decision-making into the hands of those who need and use the services. Surplus profits are returned to the members and therefore remain within the community.

But co-op membership is faltering. An annual survey of Canadian co-operatives conducted by the Co-operatives Secretariat showed that between 1986 and 2000 there was an increasing trend in all statistics related to agricultural co-operatives â€" except for membership. This isn't really a surprise given the falling farm population, but the new tax deferral clause is seen as an important step in keeping co-op structured businesses viable. Today, there are about 1,300 ag co-ops in Canada, and they employ more than 35,000 people and generate yearly revenues close to $20 billion.

The proposed change to the Income Tax Act was released in draft form in August, with an opportunity for interested parties to submit comments until September 30. The government is expected to bring the measure to Parliament for Royal Assent as soon as practical after the end of the comment period. In fact, the new amendment may be part of the Income Tax Act before the end of the year.

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