SECTION 55 CASE STUDY SALE OF CORPORATION€¦ · 2019 British Columbia Tax Conference & Live Webcast SECTION 55 CASE STUDY: SALE OF CORPORATION Ron Dueck Farris LLP Vancouver Lee-Lynn

2019 British Columbia Tax Conference & Live Webcast

SECTION 55 CASE STUDY:

SALE OF CORPORATION

Ron Dueck

Farris LLP

Vancouver

Lee-Lynn Gan, CPA, CA

Vancouver

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INDEX

1 Introduction............................................................................................................................... 3

2 Analytical Framework for Section 55 ......................................................................................... 3 2.1 Subsection 55(2.1) ............................................................................................................................................... 4 2.2 Safe Income and Safe Income on Hand ........................................................................................................... 5

2.2.1 Safe Income ....................................................................................................................................... 5 2.2.2 Safe Income on Hand (SIOH) ........................................................................................................ 6 2.2.3 The Start of the Relevant Holding Period for Which SIOH Is Computed .............................. 7 2.2.4 Safe Income Determination Time (SIDT) – The End of the Relevant

Holding Period for Which SIOH is Computed ............................................................................ 8 2.2.5 CRA’s Current Approach to the Allocation of SIOH Among Shares ...................................... 9

2.3 Bifurcation of Dividends Exceeding SIOH ..................................................................................................... 9 2.4 Exceptions and Exemptions ............................................................................................................................ 10

2.4.1 Capital Dividend Exception .......................................................................................................... 10 2.4.2 Part IV Tax Exemption.................................................................................................................. 10 2.4.3 Related Party Exception for Deemed Dividends ....................................................................... 10 2.4.4 Divisive Reorganization Exception (Butterfly) ........................................................................... 11

2.5 Purpose and Results Tests ................................................................................................................................ 12 2.5.1 Results Test: 84(3) Deemed Dividends ........................................................................................ 12 2.5.2 Purpose Test: All Other Dividends .............................................................................................. 12

2.6 Stock Dividend Rules ........................................................................................................................................ 15

3 Case Study Facts ...................................................................................................................... 17

4 Case Study Analysis ................................................................................................................. 20 4.1 SIOH Considerations ........................................................................................................................................ 20

4.1.1 Organic Growth .............................................................................................................................. 20 4.1.2 Strategic Acquisition – Start of the Relevant Holding Period for

Acquired Shares ............................................................................................................................... 20 4.1.3 Sale of Assets with Unrealized Gains ........................................................................................... 21 4.1.4 Estate Freeze ................................................................................................................................... 21 4.1.4.1 Allocation of Safe Income to Non-Participating, Voting Common

Shares ................................................................................................................................................ 21 4.1.4.2 Allocation of Safe Income to Crystallized CGE Freeze Preferred Shares .............................. 22 4.1.4.3 Allocation of Safe Income to High – Low Preferred Shares .................................................... 22 4.1.4.4 Allocation of Safe Income to Non-Voting, Participating Common

Shares ................................................................................................................................................ 22 4.1.5 Deemed Separate Dividends ......................................................................................................... 22

4.2 Availability of Exemption and Exceptions .................................................................................................... 23 4.2.1 Use of Capital Dividend ................................................................................................................. 23 4.2.2 Part IV Tax Considerations ........................................................................................................... 23 4.2.3 Related Party Exception ................................................................................................................. 24 4.2.4 Stock Dividend Planning ............................................................................................................... 24

4.3 Purpose Test Considerations ........................................................................................................................... 25 4.3.1 Bifurcated Dividends ...................................................................................................................... 25 4.3.2 Making Saleable ............................................................................................................................... 26 4.3.3 Purification ....................................................................................................................................... 27

4.4 Non-Distribution Strategies ............................................................................................................................. 28

5 Intentionally Triggering 55(2) ................................................................................................. 28

6 Conclusion ................................................................................................................................ 31

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1 Introduction1

Section 55 of the Income Tax Act (Canada)2 (the “Act”)3 is often thought of as a set of anti-avoidance rules that aims to prevent taxpayers from converting capital gains on shares into tax-free intercorporate dividends (capital gains stripping). This is in fact the topic of this paper: to consider the application of subsection 55(2) to a case study involving the extraction of surplus assets from an operating company prior to the sale of its shares to an arm’s length purchaser.

However, the goal of section 55 is broader than that, being: to prevent taxpayers from using dividends to transfer untaxed value in a manner that frustrates the Act’s integration scheme. The application of section 55 in the specific case study of this paper is best understood within this broader policy objective.

Taxpayers are generally required to include the amount of a dividend in income under paragraph 12(1)(j) and may generally deduct the same amount under subsection 112(1). Where the property being transferred by the dividend is something other than cash, such as a dividend-in-kind or stock dividend, subsections 52(2) and (3) ensure that the cost of the transferred property tracks the value of the property that has been taxed, or otherwise ensure that any untaxed portion of its value is taxed upon the dividend being effected. The role of subsection 55(2) is to prevent this scheme from being purposefully thwarted – which taxpayers have historically tried to achieve by paying a dividend in a manner that either reduces the fair market value of a share (and thus the tax payable on its subsequent disposition), or increasing the cost of property received by a the recipient of a dividend on a share (and thus the tax payable on its subsequent disposition). In the CRA’s words:

The role of subsection 55(2) is to question whether one of the purposes of the payment or receipt of such dividend, amongst any other objectives, is to significantly reduce the fair market value of a share or to increase the cost amount of property of the dividend recipient. If so, the scheme of the provision is that such dividend should not be tax-free. The scheme of subsection 55(2), amongst other objectives, is to preserve the integrity of the corporate tax system by prompting an inclusion in income where there is an increase in the cost of property of the dividend recipient when such increase in cost has not been taxed in the hands of the dividend payer or the dividend recipient and when a purpose of effecting such increase exists. Such inclusion results from the recharacterization of the dividend as proceeds of disposition or as a capital gain.4

2 Analytical Framework for Section 55

The operative subsection of section 55 is subsection 55(2). If triggered, subsection 55(2) deems taxable intercorporate dividends to be either proceeds of disposition of a share (if the dividend arose on the disposition of a share, and was not already otherwise included in the proceeds of disposition)5 or (in any other case) a capital gain.6 However the starting point for every analysis is subsection 55(2.1), which sets out the conditions under which subsection 55(2) will apply, subject to certain exceptions.

The authors would like to thank Rebecca Cynader of Farris LLP for her assistance in the writing of this paper. 2 RSC 1985 c.1 5th Supp. All refences to sections, subsections, paragraphs and subparagraphs in this paper are references

to the Act. 3 Unless otherwise specified, all statutory references herein are to the Act. 4 CRA Document 2016-0671501C6. 5 Paragraph 55(2)(b). 6 Paragraph 55(2)(c).

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2.1 Subsection 55(2.1)

Subsection 55(2.1) provides that subsection 55(2) will apply to a dividend if each of the following four conditions are met:

1. A Canadian-resident corporation (referred to as the “dividend recipient”) receives a taxable dividend as part of a transaction or event or series of transactions or events;7

2. The dividend is deductible to the dividend recipient under subsection 112(1) or (2) or subsection 138(6);8

3. One of the following three circumstances exists as part of the transaction or event or series of transactions or events in which the dividend was received:

a. In the case of a subsection 84(3) deemed dividend, one of the results of the dividend is to effect a significant reduction in the inherent capital gain of any share existing immediately prior to the dividend;9

b. In the case of a subsection 84(2) deemed dividend, one of the purposes of the dividend is to effect a significant reduction in the inherent capital gain of any share existing immediately prior to the dividend;10

c. In the case of all other types of dividends:

i. the share on which the dividend was paid was held as capital property by the dividend recipient; and:

ii. one of the purposes of the payment or receipt of the dividend is to effect:

1. a significant reduction in the inherent capital gain of any share existing immediately prior to the dividend;11

2. a significant reduction in the fair market value of any share;12 or

3. a significant increase in the cost of property of the dividend recipient;13 and

4. The amount of the dividend does not exceed the after-tax income of the corporation earned or realized after 1971 and before the “safe-income determination time” (the “safe income”), which safe income contributes to the inherent capital gain of the share on which the dividend was received, at the time immediately prior to the dividend when the dividend was received (is “on-hand”).

A fifth unstated condition also exists:

5. The dividend is not otherwise excepted from the application of subsection 55(2) under another subsection of section 55.

7 Preamble to subsection 55(2.1). 8 Paragraph 55(2.1)(a). 9 Subparagraph 55(2.1)(b)(i). 10 Subparagraph 55(2.1)(b)(i). 11 Subparagraph 55(2.1)(b)(i). 12 Clause 55(2.1)(b)(ii)(A). 13 Clause 55(2.1)(b)(ii)(B).

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Subsection 55(2.5) contains a deeming rule relevant to determining whether there has been a “significant” reduction in fair market value. The deeming rule applies if the amount of the dividend in question exceeds the fair market value of the share, and in such circumstances deems the value of the dividend to have been included in the fair market value of the share immediately prior to the payment of the dividend. In essence, this makes it possible for the purpose test in paragraph 55(2.1)(b) to be satisfied even if the share on which the dividend is paid has nominal value.

In determining whether subsection 55(2) might apply to a distribution of assets by way of dividend, this paper suggests the following analytical approach:

(1) Consider whether there exists sufficient safe income on hand (“SIOH”) to shelter the dividend the dividend;

(2) If there is insufficient SIOH, consider whether there is an available exception or exemption to the application of 55(2) for the portion of the dividend that does not;

(3) If none of the foregoing applies, consider whether the dividend offends the applicable “purpose test” or “results test”.

Where there is a risk that subsection 55(2) might apply, taxpayers should consider whether any non-distribution strategies might be available (as briefly discussed in section 4.4 of this paper).

2.2 Safe Income and Safe Income on Hand

2.2.1 Safe Income

“Safe income” is not defined in the Act; rather, as noted above, “safe income” is a generally accepted abbreviation for the amount referred to in paragraph 55(2.1)(c) as “income earned or realized by any corporation after 1971 and before the safe-income determination time (“SIDT”) that can reasonably be considered to contribute to a hypothetical capital gain on a disposition of the share on which the dividend is received. The definition reveals the base assumption for the safe income exception to the application of subsection 55(2): income earned and retained by a corporation should increase the value of its shares and potentially increases the gain that would arise on their disposition. A corporation that has already been taxed on its income should be permitted to distribute such income via dividends to a corporate shareholder without incurring additional tax. Dividends that exceed “safe income” are, subject to other exceptions, recharacterized as proceeds of disposition or capital gains.

Subsection 55(5) deems the safe income of non-private corporations, private corporations and foreign affiliates to be computed as follows:

• Paragraph 55(5)(b) non-private corporations resident in Canada: net income for tax purposes for the relevant period, adjusted for deductions relating to inventory allowance and certain deductions for scientific research and experimental development (“SRED”), plus the non-taxable portion of capital gains in excess of non-taxable portion of capital losses;

• Paragraph 55(5)(c) private corporations resident in Canada: net income for tax purposes for the relevant period, adjusted for deductions relating to inventory allowance and certain deductions for SRED; and

• Paragraph 55(5)(d) foreign affiliates: the lesser of (a) tax-free surplus balance and (b) the fair market value of the foreign affiliate.

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At first glance, these rules appear relatively straight-forward. Practically, these rules are only the starting point for determining safe income. The calculation of safe income relies on guidance from the Canada Revenue Agency’s (“CRA”) administrative positions. These are primarily based on what tax practitioners refer to as “Robertson Rules”14 which have been periodically updated by the CRA. While not law, tax practitioners typically follow these guidelines when determining safe income to avoid disputes with the CRA. It is beyond the scope of this paper to discuss in detail the practical computation of safe income and SIOH; other authors have written comprehensively on this topic.15 However, particular rules that may apply to the case study being examined in this paper are discussed in our analysis of the case study. We have also discussed three particular aspects of computing SIOH in the following sections:

(a) differentiating between safe income and SIOH; and

(b) the relevant holding period for computing SIOH; and

(c) the CRA’s current approach to allocating SIOH among different shares.

2.2.2 Safe Income on Hand (SIOH)

If the safe income exception is to apply, the safe income must remain “on hand” to contribute to a hypothetical capital gain that could be realized on a disposition of the share on which the dividend is received. The CRA has differentiated between “safe income” and SIOH as follows:

“Safe income” with respect to a share of a corporation is equivalent to the “income earned or realized” by the corporation during the relevant holding period. The expression “income earned or realized” by a corporation is deemed to be the amount determined pursuant to paragraph 55(5)(b), (c), or (d) of the Act, as the case may be. Consequently, safe income with respect to a share of a corporation refers to the corporation’s net income, as determined for purposes of the Act, as adjusted by paragraph 55(5)(b), (c), or (d), as the case may be, that is attributable to that particular share during the relevant holding period.

In order to contribute to a gain on a share, income earned or realized must be on hand. Consequently, “safe income on hand” with respect to a share of a corporation refers to the portion of the income earned or realized by the corporation during the relevant period of time that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at fair market value of the share at that time.

Since “safe income” is computed on the basis of net income as determined for purposes of the Act, amounts that have been distributed as a dividend or amounts laid out or set aside to pay income taxes, charitable donations, or other amounts not currently deductible for tax purposes will not generally reduce a corporation’s safe income. However, since such amounts will not contribute to the gain inherent in the corporation’s shares, they will reduce the corporation’s safe income on hand. In addition, certain contingent liabilities, accrued interest on income

14 John R. Robertson, “Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55,” in Report of

Proceedings of the Thirty‐Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982), 81‐109.

15 Paul Cormack, “A Practical Approach to Calculating Safe Income – Case Study,” in 2017 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2017), 2:1-32; Bryant Frydberg and Shashi B. Malik, “Subsection 55(2) and Safe Income,” in 2018 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2018), 9:1-28; Kenneth Keung, “Selected Safe Income Issues: Relevant Period, Global Computation and Allocation”, in 2017 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2017), 8A:1-20; Mark Brender, “Subsection 55(2): Then and Now,” in Report of Proceedings of the Sixty-Third Tax Conference, 2011 Conference Report (Toronto: Canadian Tax Foundation, 2012), 12:1-35; Janette Pantry and Bill Maclagan, “Issues and Updates – Safe Income,” in 2008 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2008), 4:1-35.

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debentures, and certain accounting provisions that are not currently deductible for income tax purposes are other examples of items that will not affect a corporation’s safe income but will normally reduce its safe income on hand. A liability for dividends payable will not affect the calculation of safe income but will reduce the safe income on hand attributable to other classes of shares of the corporation.16

Income earned or realized that is no longer on hand to reasonably contribute to a hypothetical capital gain cannot protect a dividend from the application of subsection 55(2).

2.2.3 The Start of the Relevant Holding Period for Which SIOH Is Computed

Provided the acquisition date of a share is after 1971, the determination of safe income attributable to that share generally starts on the date on which a shareholder acquires a share because it is impossible for a capital gain to accrue on a share before it is acquired. However, where a shareholder acquires a share as a result of a tax-deferred share exchange, the SIOH of the old share should flow to the new share if the exchange occurs on a fully tax-deferred basis. This result is reasonable as the entire gain on the old share should be transferred to the new share. If multiple classes of shares are received as consideration for the old share, it is the CRA’s view that the SIOH of the old share should be allocated to the new shares based on the proportionate capital gain that would be realized on the disposition of the new shares. The CRA’s formula can be expressed as follows:

A x B / C

where

A is the safe income on hand attributable to the shares exchanged immediately before the exchange;

B is the gain on the shares issued as consideration for the original shares; and

C is the gain on the original shares immediately before the exchange.

The CRA’s rationale for pro-rating the safe income attributable to the original shares is that the shareholder has realized a portion of the gain on the original shares, thus reducing the hypothetical gain.

In contrast, in 2004, the Tax Court of Canada held that safe income need not be pro-rated when applying subsection 55(2) to a similar fact pattern. In the case of 729658 Alberta Ltd. et al. v. The Queen,17 two individuals owned 50% of a corporation (CCorp). The shares held by each taxpayer had fair market value of $12,000,000, nominal adjusted cost base and safe income of $2,000,000. The taxpayers transferred their respective shares of CCorp to their own holding companies and elected to dispose of their shares for $10,000,000. Section 84.1 applied to the dispositions and each individual taxpayer was deemed to receive a taxable dividend.

CCorp then paid safe income dividends of $2,000,000 to each respective holding company. The CRA reassessed the holding companies on the basis that the safe income after the transaction was only 1/6 of the original safe income, i.e., that portion of the safe income that was represented by the remaining unrealized gain on the shares of CCorp. In court, the Minister argued that safe income should be pro-rated based on the gains realized on the CCorp shares.

16 “Revenue Canada Round Table” in Report of the Proceedings of the Forty-Fifth Tax Conference, 1993 Conference Report

(Toronto: Canadian Tax Foundation, 1994), 58:1-76, question 12, at 58:7. 17 2004 DTC 2909 (TCC).

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The court held that the deferred tax related only to the portion of the gain that was attributable to safe income, stating:

In interpreting the phrase “reasonably be attributable,” there has never been any suggestion that an accrued gain should generally be apportioned on a pro rata basis between “income earned or realized” and “unrealized appreciation in the value of underlying assets.” The accepted approach is that gain is first allocated to “income earned or realized” and, only if dividends exceed this amount, is gain allocated to “unrealized appreciation in the value of underlying assets.” There is nothing in the statute that implies this ordering but it is critical in order that subsection 55(2) achieve the legislative purpose.18

The court found that no tax was avoided because the individuals paid tax on the untaxed appreciation in the value of CCorp’s underlying assets when they reported deemed dividends under section 84.1. The dividends received by the holding companies did not exceed safe income. As a result, no pro ration of safe income was required in this case.

In a technical interpretation19 issued after 729658 Alberta Ltd., the CRA was asked to confirm whether safe income should be pro rated where a taxpayer claimed the lifetime capital gains exemption to partially offset the capital gain resulting from a transfer of shares under section 85. The CRA did confirm its historical position, stating that it considered the facts in the case at hand to be different from those in 729658 Alberta Ltd. It is unclear why claiming the capital gains exemption on a partial rollover should make a difference as to the allocation of safe income to the shares received as consideration.

2.2.4 Safe Income Determination Time (SIDT) – The End of the Relevant Holding Period for Which SIOH is Computed

Paragraph 55(2.1)(c) provides that the period for determining SIOH ends before the SIDT which is a defined term. Pursuant to subsection 55(1), the SIDT for a transaction or a series of transactions is the earlier of the time that is:

(a) immediately after the earliest of certain dispositions or increase in interests described in subparagraphs 55(3)(a)(i) through (v) that resulted from the series; and

(b) immediately before the earliest dividend paid as part of the series.

The dispositions or increases in interests described in subparagraphs 55(3)(a)(i) through (v) describe events which involve a party who is not related to the dividend recipient. In essence, if the series of transactions does not include an event that involves a person who is unrelated to the dividend recipient, then the SIDT will be the earliest time at which a dividend is paid in the series of transactions. In planning a series of transactions, practitioners must be careful to examine each transaction and whether such a transaction will trip the SIDT. If so, no income earned or realized after the SIDT can be included in SIOH, even if it clearly contributes to the gain on the shares.

18 Ibid., at para. 19. 19 Technical Interpretation 2005-0112141E5, February 3, 2005.

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2.2.5 CRA’s Current Approach to the Allocation of SIOH Among Shares

On the basis of Robertson’s Rules, SIOH has traditionally been computed on a share-by-share and a shareholder-by-shareholder basis. Income was attributable to a particular class of shares in the same ratio in which each class would be entitled if all earnings of the corporation, but not share capital, were to be distributed. The CRA considered that each share of a corporation represented only its proportionate share of the value of the company and therefore was entitled only to its proportionate share of the safe income of the corporation during the relevant holding period of that share. However, in a technical interpretation released in late 2015,20 the CRA appears to have adopted a new approach in allocating SIOH, particularly in dealing with shares that have discretionary dividend provisions. Very generally, the CRA’s new approach involves calculating the aggregate SIOH of the dividend payor (the “global approach”) and then allocating the SIOH to the outstanding shares based on the relative hypothetical capital gain of the shares.

In cases where a corporation has only one class of shares outstanding, this is a straightforward exercise. One can easily overlay the concept of the relevant safe income holding period for each shareholder of that class of shares. However, where a corporation has multiple classes of shares outstanding, combining the global computation of SIOH and the holding period concepts can be tricky.

Further, in computing the fair market value of shares with discretionary dividends, the CRA has explicitly included the amount of a dividend declared on that share. That inclusion increases the gain on the share and shifts value from one class of shares to another, allowing corporations to “stream” SIOH. The CRA has expressed concern with potential abuses that could arise from this ability to stream SIOH and has stated that it is studying this issue.21 Whether the traditional share-by-share approach to allocating SIOH or the newer global approach is more acceptable or reasonable (and in what circumstances) will likely be a matter ultimately determined by the Courts. In the meantime, practitioners must be prudent in their allocations of safe income where a corporation has multiple classes of dividend sprinkling shares. Mischief in streaming SIOH away from non-resident or tax-exempt entities will clearly be scrutinized by the CRA.

2.3 Bifurcation of Dividends Exceeding SIOH

In circumstances where a dividend is paid which is greater than the SIOH, paragraph 55(5)(f) will apply to bifurcate the “whole dividend” into two separate dividends: the portion that is equal to the SIOH will be deemed to be one separate dividend (the “safe income dividend”) and the portion that exceeds the SIOH will be deemed to be another separate dividend (the “non-safe income dividend”). Note that if the dividend was effected through a stock dividend, the stock dividend would be similarly bifurcated under subsection 55(2.4).

The CRA has stated that, while paragraph 55(5)(f) does not contain an ordering rule for applying safe income to determine the SIOH of the bifurcated dividends, a taxpayer cannot claim that the same safe income will shelter both of the bifurcated dividends – as this would be an absurd duplication of safe-income that is clearly contrary to the object and purpose of section 55.22 The authors agree.

The CRA has further stated that:23

• The "taxable dividend" referred to in the preamble of subsection 55(2.1) is the “whole dividend”;

• The "dividend" referred to in paragraphs 55(2.1)(a) and (b) is the “whole dividend”;

21 2016-0669651C6. 22 CRA Document 2017-0726381C6. 23 CRA Document 2017-0726381C6.

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• The "amount of the dividend" referred to in paragraph 55(2.1)(c) is the “non-safe income dividend”;

• The "taxable dividend" referred to in the preamble of subsection 55(2) is the “whole dividend”; and

• The "amount of the dividend" referred to in the preamble of subsection 55(2) that is deemed not to be a dividend and to be a gain is the amount of the “non-safe income dividend”.

2.4 Exceptions and Exemptions

A dividend will be excepted from the application of 55(2) if it either categorically fails to meet one of the conditions in subsection 55(2.1) or otherwise falls within one of the exceptions set out elsewhere in section 55. A dividend will also be exempted from the application of 55(2) if it is otherwise subject to subsection 55(2) but fits within a safe harbor in subsection 55(2) itself.

2.4.1 Capital Dividend Exception

Capital dividends are not subject to subsection 55(2), because they categorically fail to meet the first requirement under Subsection 55(2.1): they are not deductible under subsection 112(1) or (2) or subsection 138(6). Each of these deduction provisions applies only to “taxable dividends”, which is defined in subsection 89(1) as expressly excluding capital dividends under subsection 83(2). Accordingly, a capital dividend is categorically excepted from the application of subsection 55(2).

2.4.2 Part IV Tax Exemption

The preamble to subsection 55(2) provides that it will not recharacterize the portion of a dividend that is subject to Part IV tax that is not refunded as a consequence of the payment of another dividend by the dividend by the dividend recipient as part of the series of transactions in which the initial dividend was paid. Accordingly, even if the dividend meets the conditions in subsection 55(2.1), it will nonetheless be exempt from the consequences of subsection 55(2) if the forgoing condition is met.

It is important to note that this exemption only requires that the Part IV tax is not refunded to the dividend recipient, regardless of whether the dividend triggering the refund is to an individual such that the dividend is taxed in the hands of the recipient. Accordingly, this exemption could result in double tax on the dividend – as a taxable capital gain in the hands of the initial corporate dividend recipient and as a taxable dividend in the hands of the subsequent individual dividend recipient. This is in sharp contrast to the pre-2015 version of subsection 55(2) which required that the off-side Part IV refund be the result of a dividend paid to a corporation.

2.4.3 Related Party Exception for Deemed Dividends

Paragraph 55(3)(a) provides that a deemed dividend under subsection 84(2) or 84(3) of the Act will be excepted from the application of subsection 55(2) if the related party conditions set out in subparagraphs 55(3)(a)(i)-(v) are met. The related party conditions generally require that persons unrelated to the dividend recipient (and partnerships any member of which are unrelated to the dividend recipient)24 cannot, as part of the series of transaction that includes the deemed dividend, acquire:

(i) Any property for less than its fair market value, other than money on the payment of a dividend or reduction of paid-up capital;

24 Per the definition of “unrelated person” in paragraph 55(3.01)(a). Note that the dividend recipient itself does not

constitute an “unrelated person”.

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(ii) A significant increased direct interest in the payor corporation by any manner;

(iii) A significant increased direct interest in any corporation other than the payor corporation, that is not the result of other shareholders selling their shares for proceeds of disposition not less than fair market value; or

(iv) An interest in shares of the payor corporation or dividend recipient, or property deriving more than 10% of its value from such shares.

It should be noted that the CRA has stated that they may consider the application of the general anti-avoidance rule (GAAR) to situations where, instead of declaring a dividend, a corporation repurchases its shares to access the related party exception and the repurchase price exceeds the SIOH of the repurchased shares.25 This position seems questionable in circumstances where the repurchase neither reduces the fair market value of a share (and thus the tax payable on its subsequent disposition), nor increases the cost of property received by a the recipient of a dividend on a share (and thus the tax payable on its subsequent disposition) – i.e., does not frustrate the Act’s integration scheme. The following statement from the CRA in the same document suggests they may agree: “paragraph 55(3)(a) is intended to facilitate corporate reorganizations made in good faith by related persons, but it is not intended to accommodate the payment or receipt of a dividend or transactions or events which seek to increase, manipulate or manufacture tax basis” (emphasis added).26 Regardless, taxpayers who seek to effect such repurchases should heed the CRA’s advice: “Consequently, in an actual scenario similar to your hypothetical situation, there should be an analysis with respect to a tax benefit, avoidance transaction and abuse of the Act in considering the potential application of subsection 245(2).”27 If the GAAR is applied, the result would presumably be that the dividend recipient would be assessed the tax that would have been assessed had subsection 55(2) applied, but without the benefit of an addition to the dividend recipient’s CDA had subsection 55(2) applied at first instance.

It should also be noted that section 55 contains a number of important modifications to the general related person rules contained in section 251 in respect of siblings and trusts. Subparagraph 55(5)(e)(i) deems siblings to be dealing at arm's length and not to be related to each another, for the purposes of Section 55. Accordingly, the related party exception in paragraph 55(3)(a) will typically not be available in respect of a series of transactions involving transfers between siblings or companies owned by siblings.

Subparagraph 55(5)(e)(iii) deems a person and a trust to not be related to one another unless they are deemed to be related under either paragraph 55(3.2)(d) or subparagraph 55(5)(e)(ii). Paragraph 55(3.2)(d) provides that, for the purposes of divisive reorganization in paragraph 55(3)(b), a person is deemed to be related to a trust where they acquire a share in satisfaction of all or part of their capital interest in the trust. For all other purposes in section 55, including the related party exception in 55(3)(a), subparagraph 55(5)(e)(ii) deems a person and a trust to be related to one another if the person is related to each beneficiary of the trust.

2.4.4 Divisive Reorganization Exception (Butterfly)

Paragraph 55(3)(b) sets out a much narrower exception than paragraph 55(3)(a) applicable to dividends that occur in the course of a divisive reorganization where some or all of its assets are spun out into one or more new corporations owned by the shareholders of the original corporation. The conditions governing butterflies are properly the subject of a paper in and of itself and, in any case, will not be discussed further in this paper.

25 CRA Document 2017-0683511E5. 26 Ibid. 27 Ibid.

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2.5 Purpose and Results Tests

2.5.1 Results Test: 84(3) Deemed Dividends

The results test is narrow, but practically inescapable. Paragraph 55(2.1)(b)(i) will generally cause subsection 55(2) to apply to a subsection 84(3) deemed dividend if the deemed dividend results in a significant reduction in the inherent capital gain of any share existing immediately prior to the dividend. As a deemed dividend will result in a decrease in corporate assets, which will in turn result in a decrease to the net asset value of a company, it will in most circumstances result in a decrease in the fair market value of the common shares in the capital stock of the corporation and thus, as a mathematical certainty, a reduction in the inherent gain on those shares. Accordingly, a subsection 84(3) deemed dividend will in most cases be subject to subsection 55(2) unless there is sufficient SIOH or the related party exception applies.

2.5.2 Purpose Test: All Other Dividends

As discussed in section 2.3 of this paper, in determining whether the bifurcated “non-safe income dividend” offends the purpose test in paragraph 55(2.1)(b), one must look to the purposes for which the whole dividend was paid or received. If it is determined that the whole dividend was declared or received for one of the purposes set out in 55(2.1)(b), then the non-safe income dividend deemed under 55(5)(f) becomes subject to subsection 55(2).

The purpose of a taxpayer is, by definition, subjective. But how can anyone other than the taxpayer know with any certainty what their actual purpose was? Putting aside the epistemological problems involved in this query, there are three possible legal approaches in determining a taxpayer’s purposes: objective, subjective, and objective-subjective.

The distinction between an objective purpose test and a subjective purpose test has been described as follows:

An objective test of purpose will take account of all relevant circumstances including, but not necessarily limited to, the taxpayer’s stated intention, and may result in a finding of purpose that is independent of the taxpayer’s state of mind. An objective purpose test may often be similar to a results test; that is, one looks to what in fact happened and infers that the taxpayer must have had as his purpose the achieving of that result.

A subjective test, on the other hand, looks primarily to the state of mind of the taxpayer in entering into a transaction. The surrounding circumstances may be relevant but only insofar as they confirm or refute the taxpayer’s statement of his purpose. Under a subjective test, the fact that a transaction or series of transactions results in a tax benefit is irrelevant if the taxpayer’s stated intention to achieve some other purpose is established to the satisfaction of the court.28

The leading case in establishing the appropriate manner in which to apply purpose tests in the Act is the 2001 Supreme Court of Canada case Ludco.29 The leading case in establishing how to apply the purpose test in subsection 55(2), as it read prior to the 2015 amendments to section 55 (the “Amendments”) is the 1996 Federal Court of Appeal case Placer Dome.30

28 Thomas E. McDonnell, "Legislative Anti-Avoidance: The Interaction of the New General Rule and Representative

Specific Rules," Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 6:1-34 at 19 to 21.

29 Ludco Enterprises Ltd. v R, 2001 SCC (“Ludco”) 30 The Queen v Placer Dome Inc., 96 DTC 6562 (FCA), (“Placer Dome”) affirming 96 DTC 1787 (TCC).

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In Placer Dome, the taxpayer had decided to dispose of its directly and indirectly held shares of Falconbridge Limited (“Falconbridge”) and solicited bids accordingly. Falconbridge wanted to acquire the shares, but was limited by securities laws in how much it could bid for them. To make its bid more competitive, Falconbridge agreed that if its bid was accepted, it would pay a dividend and then purchase the Falconbridge shares directly and indirectly held by Placer Dome. The court acknowledged that subsections 55(2) to (5) were anti-avoidance provisions aimed at preventing a Canadian-resident corporate shareholder from converting a taxable capital gain into a tax-free dividend. The court further stated that “the dividend must be received as part of a transaction or series of transactions, one of the purposes of which was to effect a reduction of what otherwise would have been a capital gain.”31 The Crown argued that when a dividend is inextricably linked to the disposition of a share, the purpose of the dividend is to effect a significant reduction in the capital gain, and thus it is irrelevant whether one or both of the parties are motivated by tax avoidance considerations. The taxpayer argued that the use of the words “purpose” in the context of regular dividends and “result” in the context of deemed dividends required that different meanings be given to each word. Further, the taxpayer argued that since Parliament had differentiated between the two words and because “result” is a necessarily objective term, “purpose” must be interpreted as intended to be applied in a contrasting subjective manner. The court agreed:

Putting aside these evidential matters, it remains to be decided whether the term "purposes" as employed in subsection 55(2) of the Act is to be understood in an objective sense. Standing alone that term is neutral. It is only when it is placed in a particular context that its meaning can be ascertained. While there may be instances where the term "purposes" is modified by words or phrases suggesting something other than a subjective understanding, that is not the case with respect to subsection 55(2) of the Act . The words of that subsection provide that in certain circumstances the "purpose" of a transaction will determine whether the subsection applies while in another (i.e., where the dividend is deemed to arise under subsection 84(3)) the "result" of a transaction will be determinative. Parenthetically, I note that subsection 55(1), a general anti-avoidance provision (since repealed) is limited to circumstances in which the "result" of a transaction is to artificially or unduly reduce the amount of gain. No one can doubt that the term "result" invites an objective appreciation of the factual circumstances. In this context I do not see how one can argue persuasively that both the words "purpose" and "result" are to be interpreted as embracing an objective criterion. In my opinion, it is clear that the use of the term "purpose" in one context and "result" in another requires that a different meaning be attributed to each that is consistent with their use and context within subsection 55(2).”32 [Emphasis added.]

Further, the court stated that the taxpayer must establish on a subjective basis that none of the purposes was to reduce the capital gain:

Accepting for the moment that subsection 55(2) employs the term "purposes" in its subjective sense, there are three basic propositions relevant to the analysis. First, the onus or burden rests on the taxpayer to establish the inapplicability of subsection 55(2) of the Act. Second, mere denial (without explanation or elaboration) by a taxpayer that his or her purpose was to effect a significant reduction in capital gain is not by itself a sufficient basis on which to discharge that burden. Third, it is not necessary that the taxpayer adduce corroborative or additional evidence which shows or tends to show that his or her testimony is true. On these three points see, respectively, C.P.L. Holdings Limited v. The Queen, supra; R. v. Covertite Ltd., [1981] CTC 464 (F.C.T.D.); and McAllister Drilling Ltd. v. Canada, [1994] 2 CTC 211 (F.C.T.D.).

Practically speaking, it is evident that once it is established that a transaction has the effect of reducing significantly a capital gain it is proper for the Minister to infer that the taxpayer had such a purpose. To rebut that inference the taxpayer (or his advisors) must offer an explanation

31 Placer Dome, supra note 30, at paragraph 5. 32 Ibid, at paragraph 23.

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which reveals the purposes underlying the transaction. That explanation must be neither improbable nor unreasonable. All the while it must be remembered that subsection 55(2) of the Act speaks of "one of the purposes" of the transaction. Consequently, the taxpayer must offer a persuasive explanation that establishes that none of the purposes was to effect a significant reduction in capital gain. It is in this sense that uncorroborated but credible testimony can be sufficient proof of taxpayer intention: see V. Krishna, The Fundamentals of Canadian Income Tax, 5th ed., (Toronto: Carswell 1995) at 1391.33

The take-away from Placer Dome is that (i) the court confirmed that subsection 55(2) is an anti-avoidance provision, (ii) the purpose test is a subjective test, and (iii) the onus is on the taxpayer to establish that none of its purposes is an enumerated offensive purpose.

The CRA acknowledges Placer Dome, but takes the position that Placer Dome is qualified to its unique facts, and that Ludco supports a more objective approach universally. Following the Amendments, the CRA first summarized its views at the 2015 Canadian Tax Foundation Round Table:

The determination of purpose is based on facts that are particular to the situation, including, but not limited to, the actions taken by the parties to the dividend and their motivation. In Ludco (2001 SCC 62), the Court was of the view that "in the interpretation of the Act, as in other areas of law, where purpose or intention behind actions is to be ascertained, courts should objectively determine the nature of the purpose, guided by both subjective and objective manifestations of purpose.” Although a dividend on a share would normally result in a reduction of value of the share, it's not the result that determines the application of new subsection 55(2.1). It’s the purpose and the motivation behind the purpose that could be established by finding the answer to questions such as: What does the taxpayer interest to accomplish with a reduction in value? How would such reduction in value be beneficial to the taxpayer? What actions did the taxpayer take in connection with the reduction in value?34

Since 2015, the CRA has consistently maintained this position, relying on Ludco as establishing that the subjective purposes of a taxpayer under paragraph 55(2.1)(b) are to be objectively determined.35 This is effectively an “objective-subjective” approach. The following, admittedly lengthy, extract from a 2018 CRA ruling is instructive of the CRA’s approach to the purpose tests.

As indicated in document 2015-0610651C6, the correct test to use to determine purpose in respect of subsection 55(2) is the Supreme Court's test in Ludco which is as follows:

"in the interpretation of the Act, as in other areas of law, where purpose or intention behind actions is to be ascertained, courts should objectively determine the nature of the purpose, guided by both subjective and objective manifestations of purpose."

Ludco followed the purpose test in respect of paragraph 18(1)(a) established by the Supreme Court in Elizabeth C. Symes v. The Queen, 1994 DTC 6001 ("Symes"):

"74 As in other areas of law where purpose or intention behind actions is to be ascertained, it must not be supposed that in responding to this question, courts will be guided only by a taxpayer's statements, ex post facto or otherwise, as to the subjective purpose of a particular expenditure. Courts will, instead, look for objective manifestations of purpose, and purpose is ultimately a question of fact to be decided with due regard for all of the circumstances. For these reasons, it is not

33 Ibid, at paragraph 20-21. 34 See CRA Document 2015-0610651C6. 35 CRA Document 2017-0683511E5.

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possible to set forth a fixed list of circumstances which will tend to prove objectively an income gaining or producing purpose."

….

The decision of the Federal Court of Appeal in Placer Dome was in response to the Crown's argument that "purpose" in subsection 55(2), based on some Australian case law, does not embrace the motivation of each of the participants and that term is to be understood in an objective, not a subjective sense, especially when a dividend and a disposition of a share are inextricably linked where the transaction has the effect of reducing substantially a capital gain. The Crown lost the argument and the Court reaffirmed that the "purpose" test in subsection 55(2) is a subjective test. This has to be differentiated from the standard established by Ludco and Symes on the determination of purpose.

At paragraph 20 of the FCA decision in Placer Dome, the Court made the following comment: "it is not necessary that the taxpayer adduce corroborative or additional evidence which shows or tends to show that his or her testimony is true." Such comment was derived from McAllister Drilling, 95 DTC 5001 (FCTD), where the Court made the following comment at paragraph 8 of the decision:

"In the somewhat unusual circumstances of this case where credibility is conceded, if I agree that the taxpayers' evidence is credible, it will not require the bolstering or corroboration afforded by external facts".

In both Placer Dome and McAllister Drilling, the court determined the "purpose" of the taxpayers by not only listening to their testimony but also by examining all the facts and corroborating their testimony with the objective facts and the evidence. The comments made by the courts and quoted above only meant that a court does not need to probe further if the facts and evidence in front of them are sufficient to establish the credibility of the testimony.

The court in Placer Dome and McAllister Drilling did not contradict Ludco and Symes. They followed the standard established in Ludco and Symes that "courts should objectively determine the nature of the purpose, guided by both subjective and objective manifestations of purpose" (see above).

Where a dispute under subsection 55(2) arises, the Crown and the CRA will ensure that all relevant facts and evidence are brought to the court to help it to establish the objective manifestations of purpose and the credibility of the testimony of the taxpayers.

Canadian courts have yet to comment on the proper approach to determining purpose under the new subsection 55(2.1)(b). However, these comments of the CRA, along with the decision in Placer Dome, underscore the reality that taxpayers who pay or receive dividends that have the effect of reducing a capital gain, reducing the fair market value of a share, or increasing the cost of property will have the burden of establishing that these effects did not form one of their purposes.

2.6 Stock Dividend Rules

Section 55 contains a set rules to ensure that stock dividends cannot be used to circumnavigate the application of subsection 55(2).

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Solely for purposes of subsections 55(2), (2.1), (2.3) and (2.4), subsection 55(2.2) deems the amount of a stock dividend to be the greater of the paid-up capital and the fair market value of the shares issued as a stock dividend. Accordingly, to the extent that the conditions in subsection 55(2.1) are otherwise met and no exception applies, it is possible for a stock dividend to be recharacterized in accordance with subsection 55(2) even in the case of “high-low” preferred shares.

Where the fair market value of the stock dividend shares exceeds the paid-up capital thereof, subsections 55(2.3) and (2.4) provide a special deeming rule similar to paragraph 55(5)(f), such that the amount of the stock dividend paid out of safe income is deemed to be a separate safe income dividend that reduces the amount of safe income attributable to the shares on which it is paid, and the remainder of the dividend is deemed to be a separate dividend, which will be subject to subsection 55(2) unless another exception applies.

Where there exists SIOH on the shares on which a stock dividend is declared, one must determine the allocation of the SIOH to the distributed stock dividend shares. In the case of dividends received by corporate shareholders, the rules governing the amount of the dividend and the allocation of SIOH are set out in subsections 55(2.2) to (2.4). However, subsections 55(2.2) to (2.4) do not apply to individuals, as they are not included in the meaning of “dividend recipient” in subsection 55(2.1). The CRA has thus taken the position that, in the case of stock dividend recipients who are individuals, “a corporation's safe income contributes to the stock dividend shares and the shares upon which the stock dividend is paid based on the relative gains inherent in the shares, as determined immediately after the stock dividend is paid.”36

The CRA provided the following illustration of how the safe income allocation would work. If a stock dividend is paid on common shares having a fair market value of $500,000, an adjusted cost base of $5,000 (and therefore an inherent gain of $495,000) and SIOH of $450,000, where the stock dividend is declared in the amount of $350,000 by way of issuance of preferred shares having a redemption amount of $350,000 and paid up capital of $1 (by way of PUC increase by Opco), the following will result:

Holdco Individual

Common Shares - Prior to Stock Dividend

FMV 500,000 500,000

ACB 5,000 5,000

Inherent capital gain 495,000 495,000

SIOH contributing to gain 450,000 450,000

Stock Dividend Declared

Dividend declared 350,000 350,000

Stock Dividend Shares

FMV (redemption amount) 350,000 350,000

PUC 1 1

"amount” of stock dividend (greater of FMV or PUC increase) - 55(2.2) 350,000 -

ACB for corporate shareholder - s. 52(3)(a)(ii) / 55(2.2) 350,000

ACB for individual shareholder - s. 52(3)(a)(i) / 248(1)”amount”(c) 1

Inherent capital gain 0 349,999

SIOH – (SIOH becomes ACB under 55(2.3)(a) for corporations) 0 318,182

Deemed dividend on redemption 350,000 349,999

Capital gain on redemption 0 1

Common Shares - After Stock Dividend

36 CRA Document 2016-0658351E5.

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FMV 150,000 150,000

ACB 5,000 5,000

Inherent capital gain 145,000 145,000

SIOH contributing to gain – 55(2.3)(b) 100,000 131,818

In the above circumstances, if the individual were to roll their stock dividend shares into a corporation prior to their redemption, then, absent the related party exception in subsection 55(3)(a), the resulting deemed dividend would have a safe income shortfall of $31,817 as compared to the same stock dividend share being issued directly to the corporation prior to its redemption.

The CRA has also recently provided their views as to how the cost of distributed stock dividend shares should be calculated:

The calculation of cost of a stock dividend is governed by subsection 52(3). Finance's intent is to give cost to the portion of the stock dividend that is protected by safe income and the portion of stock dividend that was subject to the application of subsection 55(2). Furthermore, the preamble to paragraph 52(3)(a) makes it obvious that a stock dividend that was subject to the application of subsection 55(2) remains a dividend for purposes of application of subsection 52(3) and cost should be recognized on an amount of stock dividend that was subject to the application of subsection 55(2)…. the views expressed in document #9830665 are no longer valid.37

3 Case Study Facts

John Jay Strip is a resident of Canada. In Year 1, John incorporated JJ Hardware Ltd. (JJ Hardware), a taxable Canadian corporation through which he owned and operated a hardware store located in Vancouver. John subscribed for 100 Class A common shares for a nominal amount. The Class A common shares of JJ Hardware were participating, voting and entitled to discretionary dividends.

John opened seven more stores in the next 10 years: three stores in the Vancouver area, one store in Victoria, and three stores in the BC Interior. Each store was owned in a separate corporation to accommodate additional management shareholders. Each successive store within a shareholder group became a lineal subsidiary of the previous store in the chain. In Year 7, John allowed the managers of his Vancouver Island store and his Interior stores to acquire shares of their respective stores by granting them stock options. The shares acquired by both managers amounted to a 10% interest in their respect regional stores. At the time the stock options were exercised for a nominal exercise price, JJH Victoria was worth approximately $200,000 and its SIOH was $75,000. JJH Kelowna and its subsidiary corporations were worth about $300,000 and their consolidated SIOH was $250,000.

37 CRA Document 2018-0780071C6.

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Figure 1: Organic Growth

At the beginning of Year 10, JJH Victoria Ltd. (JJH Victoria) purchased 100% of the shares of Acme Hardware Ltd. for $250,000 from an arm’s length party. John immediately changed the name of the company to JJH Nanaimo Ltd. (JJH Nanaimo). Although JJH Nanaimo operated two stores in Nanaimo, John decided to sell the second store less than one year after acquiring the shares of JJH Nanaimo. He was able to sell the store’s assets and lease at the beginning of Year 11 for proceeds of $110,000. JJH Nanaimo realized a capital gain of $10,000 on the disposition. John believed that the company would have realized the same gain if he had sold the second store immediately upon acquiring JJH Nanaimo.

Figure 2: Strategic Acquisition and Sale

In Year 25, John froze his interests in JJ Hardware and crystallized his lifetime capital gains deduction. At the time of the freeze, the fair market value of JJ Hardware was $3,000,000 and the safe income on hand was

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$2,400,000, all attributable to John’s 100 Class A Common shares. The following share transactions were executed:

1. John exchanged his 100 Class A Common shares of JJ Hardware for two classes of newly authorized preferred shares under subsection 85(1) and one class of skinny-voting shares. John received the following shares of JJ Hardware in exchange for his original 50 Class A Common shares:

a. 1,000 Class A Preferred shares of JJ Hardware with redemption value of $750,000; and

b. 1,000 Class B Preferred shares of JJ Hardware with redemption value of $2,250,000; and

c. 1,000 Class C Voting Common Shares of JJ Hardware entitled to vote, but without dividend or participation rights.

John and JJ Hardware jointly elected for the exchange to occur at $750,000 so that John could fully use his lifetime capital gains exemption.

All of the preferred shares of JJ Hardware are entitled to a discretionary dividend up to a maximum annual amount equal to 5% of the redemption amount. The preferred shares were both redeemable and retractable.

2. Immediately after the freeze, a new family trust (Family Trust) settled by a close friend subscribed for 100 Class B Common shares of JJ Hardware for $100. The beneficiaries of the family trust included John, his spouse Jane, their adult daughter Rosemary, Rosemary’s yet-to-be-born children, and a newly incorporated family holding company (Investco). The trustee of the family trust is John. The Class B Common shares of JJ Hardware are non-voting but entitled to dividends at the discretion of the directors. All of the shares of Investco are held by John.

Figure 3: Estate Freeze

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Now, in Year 35, John has decided to sell the shares of JJ Hardware to an arm’s length purchaser. In the course of preparing the company for sale with his accountant, John has determined that the JJH group of companies need to remove approximately $2,000,000 of passive assets to meet the 90% active business asset test to qualify as a “small business corporation” for purposes of paragraph (a) of the definition of “qualified small business corporation shares” (QSBCS) in subsection 110.6(1).

In the course of preparing the company for sale with his investment banker, John has further determined that the company and its various subsidiaries have approximately $2,000,000 of cash in excess of a reasonable amount of working capital that a prospective purchaser would want to acquire, and JJ Hardware would need to further divest itself of its short-term investment instruments which currently have a fair market value of $1,500,000 and a cost of approximately $750,000. John wants to find a way to distribute these $3,500,000 of “Surplus Assets” in a way that results in the least amount of tax. This will simultaneously solve his QSBCS problem.

JJ Hardware’s accountant is in the process of determining the safe income on hand available to shelter the distribution of these amounts for purposes of subsection 55, but has indicated that he suspects the company’s safe income is less than $3,000,000. Unfortunately, JJ Hardware does not have a “well established dividend policy” consistent with the amount of the Surplus Assets. All of the shareholders of JJ Hardware hold their shares on capital account.

4 Case Study Analysis

4.1 SIOH Considerations

4.1.1 Organic Growth

On acquiring shares of JJH Victoria and JJH Kelowna via stock options, both management shareholders were subject to tax on the stock option benefit, although the inclusion of that benefit would have been deferred to the year of disposition pursuant to subsection 7(1.1) as both JJH Victoria and JJH Kelowna were, at all relevant times, CCPCs. Despite the deferral of the income inclusion, the stock option benefit would be calculated as the amount by which the fair market value of the shares at the time of acquisition exceeded the exercise price paid to acquire the shares. The amount of the stock option benefit would be added to the adjusted cost base of the managers’ shares pursuant to paragraph 53(1)(j). Accordingly, the cost of the shares to the management shareholders would have reflected the corporate earnings retained by the companies and which contributed to the gain inherent in those shares at the time of acquisition. As such, the safe income to be allocated to the management shareholders would only reflect their share (10% in both cases) of the safe income earned by the companies after the Year 7 acquisition date.

Any safe income earned prior to the Year 7 acquisition date should be attributable solely to the shares of JJH Victoria and JJH Kelowna owned by JJ Hardware. After the managers had exercised their stock options, safe income would be allocated 90% to JJ Hardware and 10% to the management shareholders.

4.1.2 Strategic Acquisition – Start of the Relevant Holding Period for Acquired Shares

The acquisition of shares of JJH Nanaimo by JJH Victoria initiates the start of the holding period for the shares of JJH Nanaimo. Any safe income earned by JJH Nanaimo up to the date of acquisition would be reflected in the purchase price for its shares, i.e., the adjusted cost base of the shares to JJH Victoria. As a consequence, the safe income of JJH Nanaimo on the date of acquisition should be nil.

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4.1.3 Sale of Assets with Unrealized Gains

The CRA has stated that while the safe income realized by an acquired company subsequent to the acquisition of control would be increased by the amounts included in its net income as a result of the sale of appreciated assets, those realized amounts would not increase any capital gain inherent in the shares of the acquired company after the acquisition of control to the extent that they had accrued prior to that time and should, therefore, be deducted from safe income in the calculation of SIOH.38 In accordance with this administrative position, amounts included in JJH Nanaimo’s net income as a result of the sale of its second store would increase JJH Nanaimo’s safe income. However, the taxable capital gain should be deducted when calculating JJH Nanaimo’s SIOH. Any taxes paid by JJH Nanaimo on the resulting capital gain should also be added back as such taxes should not reduce JJH Nanaimo’s safe income on hand if the income is not also includable.

It has been suggested that the CRA’s position on this issue may not be supported by the Federal Court of Appeal’s decision in R. v Kruco Inc.39 In this case, the CRA attempted to argue that the company’s safe income must be reduced by two amounts: (1) the amount by which capital cost allowance was reduced for investment tax credits claimed and (2) the amount required to be included in income under paragraph 12(1)(t) for investment tax credits received. The CRA argued that such income was “phantom income” and could not represent income that could contribute to a hypothetical capital gain on the shares of the company. Both the Tax Court of Canada and the Federal Court of Appeal dismissed the Minister’s arguments. The courts found that safe income for a private corporation must be determined under paragraph 55(5)(c). This rule provides that calculating safe income starts with income as determined under the Act (with certain adjustments required under paragraph 55(5)(c)). As such, one author has posited that safe income should include all taxable income or gains realized during the holding period, whether or not those gains can be attributed to a time prior to the holding period.40 Nevertheless, the same author comments that a practitioner may be at “peril to deviate from CRA’s position on this issue”.

4.1.4 Estate Freeze

4.1.4.1 Allocation of Safe Income to Non-Participating, Voting Common Shares

The Class C Common shares of JJ Hardware are what are colloquially referred to as “skinny” voting shares. This type of share is normally issued for a nominal amount, and it is generally intended that the skinny shares will never appreciate in value. The CRA has previously argued that these skinny voting shares may hold a voting control premium.41 The CRA later updated its position, stating:

The question arises in the context of estate freezes of private corporations, where the freezer desires additional security for the value of the freeze shares taken back. Provided that the owners of all the shares of the corporation act in a manner consistent with the assumption that no value attaches to the voting rights, and the rights are eventually extinguished for no consideration, the CRA will generally not attribute value to the rights. If the holder of the rights uses them to run the corporation in conflict with the common shareholders or seeks or is offered consideration for them, it would be difficult for the CRA to ignore this evidence of value.42

38 Technical interpretation 2000-0053165, December 11, 2000. 39 2003 FCA 284. 40 Supra, note 2. 41 Dustan v R., docket no. 2009-1152(IT)G (TCC) (discontinued). 42 Income Tax Technical News No. 44, April 13, 2011 (archived).

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While the issue has not yet been resolved, we have assumed for purposes of our analysis that the Class C Common shares would have nominal value as a result of their inability to participate in the profits of JJ Hardware. As such, no hypothetical capital gain could accrue on these Class C Common shares and hence, no safe income may be allocated to these shares.

4.1.4.2 Allocation of Safe Income to Crystallized CGE Freeze Preferred Shares

John’s Class A Preferred shares of JJ Hardware did not have any safe income attributable to them because no capital gain can be realized on the disposition of these shares. John’s use of his lifetime capital gains exemption should result in these shares having an adjusted cost base equal to their fair market value.

4.1.4.3 Allocation of Safe Income to High – Low Preferred Shares

According to the CRA’s formula (see Section 2.2) the safe income attributable to John’s Class B Preferred shares should be $1,800,000, calculated as follows:

$2,400,000 of safe income on hand attributable to John’s Class A Common shares of JJ Hardware

multiplied by

$2,250,000, the gain on the Class B Preferred shares issued as partial consideration for the original Class A Common shares

divided by

$3,000,000, the gain on the original Class A common shares.

4.1.4.4 Allocation of Safe Income to Non-Voting, Participating Common Shares

At the time of issue, the Class B Common shares will not have any safe income allocated to them as there is no hypothetical capital gain on these shares. They should be worth exactly what was paid for them by the Family Trust. However, 100% of JJ Hardware’s future safe income should be allocated to these shares.

4.1.5 Deemed Separate Dividends

For the purposes of this section, it will be assumed that the Surplus Assets that are not distributed by way of a capital dividend will be distributed by way of an ordinary taxable dividend on the Class B Common shares held by the Trust, and allocated by the Trust to the individual family member beneficiaries. It will also be assumed that the amount of this dividend will be greater than the SIOH contributing to the gain on the Class B Common shares.

Paragraph 55(5)(f) will bifurcate the “whole dividend”: the portion that is equal to the SIOH of the Class B Common shares will be deemed to be one separate dividend (the “safe income dividend”) and the portion that exceeds the SIOH will be deemed to be another separate dividend (the “non-safe income dividend”). If the dividend was effected through a stock dividend, the stock dividend would be similarly bifurcated under subsection 55(2.4).

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4.2 Availability of Exemption and Exceptions

4.2.1 Use of Capital Dividend

If JJ Hardware has a capital dividend account balance, all or a portion of the Surplus Assets could be distributed by way of a capital dividend which is excluded from subsection 55(2).

The company should also consider whether it would be prudent to undertake a series of transactions to increase its capital dividend account by way of a related party sale of the Surplus Assets. For example, if JJ Hardware’s short-term investment Surplus Assets are held on capital account, JJ Hardware could liquidate some or all of these assets, which would give rise to a capital gain in the hands of JJ Hardware, one half of which would be immediately added to the company’s capital dividend account. JJ Hardware could then distribute a portion of the Surplus Assets by way of a capital dividend equal to the resulting addition to the capital dividend account outside of the application of section 55.

This or similar strategies may be a prudent step to take in many circumstances where a target company is distributing assets with an accrued gain prior to a share sale, to ensure that the vendors retain the benefit of the capital dividend account addition created on the distribution.

4.2.2 Part IV Tax Considerations

The Part IV tax exception will likely be of limited assistance in planning for a tax-deferred distribution of the Surplus Assets.

At first instance, it may appear that Part IV tax would not apply to a dividend paid by JJ Hardware to the Trust, which is then allocated by the Trust to Investco. As John holds all of the voting shares of both JJ Hardware and Investco, JJ Hardware and Invesco will be related under paragraph 251(2)(c)(i), deemed not to deal at arm’s length under paragraph 251(1)(a), and thus deemed to be “connected” for purposes of Part IV tax under subsection 186(2) and paragraph 186(4)(a). As such, Part IV tax would not ordinarily apply to dividends received by the Trust and designated to Investco.43

However, the CRA’s position is that under subsection 104(19), a trust cannot designate a dividend to its beneficiaries until the end of its taxation year in which the dividend was received, with the result that where a dividend is received by a trust in a taxation year when it is connected to a corporate beneficiary to which it designates the dividend, Part IV tax will apply to the dividend in the hands of the corporate beneficiary if it is not connected to the payor corporation at the end of the trust's taxation year in which the dividend was received.44

In our sale situation, the Trust would not own the shares of JJ Hardware at the end of its taxation year. Accordingly, at the end of the Trust’s taxation year, subsection 186(4) would not deem Investco to control JJ Hardware, with the result that they would not be connected under Part IV, such that the CRA would consider Part IV tax to apply to the dividend designated to Investco.

However, the application of Part IV tax to the dividend would likely not be viewed as a planning opportunity, as Part IV tax eliminates the sought corporate tax deferral. Moreover, if, at the time the dividend is paid, it is contemplated that Investco would then pay a dividend in the future to receive a refund of the Part IV tax, there is a risk that this future dividend would be considered to be paid as part of a series of transactions that

43 Paragraph 186(1)(a) does not impose Part IV tax on dividends received from “connected” corporations. 44 CRA Documents 2016-0647621E5 and2018-0757591I7.

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included the Surplus Asset dividend, with the potential punitive result that Investco would be subject to both Part IV tax and a table capital gain on the Surplus Asset dividend.

4.2.3 Related Party Exception

The most common method of ensuring that subsection 55(2) does not apply to a non safe-income dividend is arguably the related party exception, whereby the Surplus Assets could be distributed by way of a share redemption or repurchase to NewCo such that the deemed dividend is exempted from the application of subsection 55(2) under paragraph 55(3)(a).

To repeat what was discussed above, paragraph 55(3)(a) will generally apply where the dividend payor corporation pays redeems or cancels shares issued by it such that a dividend is deemed to occur under subsection 84(2) or 84(3) of the Act, provided that the conditions is subparagraphs 55(3)(a)(i)-(v) are met.

In this case, the dividend itself would seem to meet these conditions.

Accordingly, it would be tempting to have JJ Hardware repurchase such number of its common shares as equal the fair market value of the Surplus Assets and distribute the Surplus Assets to the Trust in consideration for the repurchased shares. The fair market value of the distributed assets would constitute a deemed dividend under subsection 84(3) of the Act, which the Trust would then allocate to Investco under the terms of the trust instrument in the year the dividend was received. As the allocated dividend retains its character as a dividend when received by Investco, Investco would then be entitled to deduct the dividend under subsection 112(1) of the Act.

However, while the dividend itself may meet the relevant conditions, the series of transactions of which it is a part will likely not. Pursuant to the decision of the Supreme Court of Canada in Copthorne,45 for the deemed dividend and a subsequent disposition to be part of the same series of transactions, there needs to be something more than the “mere possibility” of a disposition. However, Copthorne made clear that deemed dividend and a subsequent disposition to be part of the same series of transactions where a subsequent disposition was contemplated at the time the dividend was paid, even if only generally without identifying a specific purchaser. In this case, the shareholders of JJ Hardware are clearly contemplating selling their shares on which the deemed dividend would be paid, and are in fact contemplating paying the dividend to accommodate such a sale; accordingly, the dividend and subsequent sale would likely be considered to be part of a series of transactions. Subparagraph 55(3)(a)(iii) provides that 55(3)(a) will not exempt a deemed dividend from 55(2) if, as part of a series of transactions or events as a part of which the dividend was received, there was a disposition of the shares on which the dividend was paid to a person or partnership that is unrelated to the dividend payor immediately prior to the disposition. Accordingly, subparagraph 55(3)(a)(iii) will likely prevent the deemed dividend from being sheltered from the application of subsection 55(2) under paragraph 55(3)(a).

4.2.4 Stock Dividend Planning

While perhaps obvious, it should be noted that the use of stock dividends to manage the application of subsection 55 will not be available in this case. Subsection 55(2.2) will deem the amount of a stock dividend of “high-low” preferred shares to be the fair market value of the shares issued as a stock dividend – generally their redemption amount. Accordingly, the redemption amount would be subject to the same 55(2.1) analysis as a cash dividend.

45 Copthorne Holdings Ltd. v The Queen, 2012 DTC 5007 (SCC) (“Copthorne”).

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Even if the stock dividend itself escapes the application of subsection 55(2), any subsequent redemption of the issued stock dividend shares will almost certainly offend the results test in subparagraph 55(2.1)(b)(i). A subsequent redemption of the distributed stock dividend shares will reduce the value of the assets of JJ Hardware which will generally be considered to reduce the fair market value of the Class B Common shares, which will thus have the result of reducing the portion of the capital gain on the Class B Common shares that would otherwise been realized on their disposition at their fair market value.

Accordingly, the issuance of a stock dividend would require that the related party exception be available to except the resulting deemed dividend from the application of subsection 55(2). As discussed in the above section of this paper, the related party exception is not available. Consequently, the issuance and redemption of high-low preferred stock dividend shares would almost certainly trigger the application of subsection 55(2). Moreover, as only a portion of the SIOH of the shares on which the stock dividend was declared will follow and attach to the stock dividend preferred shares, the resulting deemed dividend may exceed the SIOH by a greater amount than if a cash dividend had simply been declared.

4.3 Purpose Test Considerations

If none of the exceptions and exemptions are available to shelter the portion of the Surplus Assets that exceeds the SIOH from the application of subsection 55(2), it becomes necessary to assess whether a distribution of the excess amount by way of a cash or in-kind dividend would fall within the purpose test in paragraph 55(2.1)(b), namely whether one of the purposes of the payment or receipt of the dividend is to effect:

(a) a significant reduction in the inherent capital gain of any share existing immediately prior to the dividend;

(b) a significant reduction in the fair market value of any share; or

(c) a significant increase in the cost of property of the dividend recipient.

Based on the facts of this case study, the dividend declared on the Class B Common shares was paid and received for the purposes of (1) making the company saleable, per the instructions and advice of John’s investment banker, and (2) enabling the beneficiaries of the Trust to access their lifetime capital gains deduction in respect of the gain realized on the Class C Common shares upon the contemplated sale.

The effects of the dividend will be to (a) significantly reduce the inherent capital gain of the Class C Shares, (b) significantly reduce the fair market value of the Class C Shares, and (c) significantly increase the cost of property of the family members who received the dividend (as allocated from the Trust). As discussed in section 2.5 of this paper, the CRA recognizes that the effects of a dividend are not conclusive of the purposes of a dividend, but are merely one consideration to be taken into account when determining the purposes of the dividend. However, where such effects exist, the CRA is free to assess on the grounds that a taxpayer had the purpose of effecting such results, whereupon the taxpayer will have the onus to rebut the CRA’s assumption.

4.3.1 Bifurcated Dividends

The CRA’s view is that in determining whether the bifurcated “non-safe income dividend” meets the purpose test, one must look to the purposes for which the whole dividend on the Class B Common shares was paid or received. If it is determined that the whole dividend was declared or received for one of the purposes set out in 55(2.1)(b), then the non-safe income dividend deemed under 55(5)(f) becomes subject to subsection 55(2).

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Accordingly, despite the application of 55(5)(f), the question remains whether the whole dividend declared on the Class B Common shares was paid or received for one of the purposes enumerate in 55(2.1)(b).

4.3.2 Making Saleable

In this case, the investment banker advised John that if he wanted to sell the company, the $3.5 million of Surplus Assets would exceed the working capital that any prospective buyer would want to pay for – and thus to make the company more attractive to sell, he should remove these assets. Does the purpose of making the company saleable, per the instructions and advice of John’s investment banker, offend the purpose tests in paragraph 55(2.1)(b)? As a starting point, it is a near certainty that the dividend will form part of the series of transactions that includes the dividend based on the fact that it will be paid in contemplation of a future sale of the shares of the company.

Taking assets out of a company to make it saleable is not unusual. It is often the case that a company must distribute surplus assets to make a company saleable to arm’s length purchasers who do not wish to expend capital on non-revenue generating non-depreciable assets such as an investment portfolio, redundant or obsolete assets, and excess cash. In these situations, the buyer will either be:

(a) not willing to purchase the corporation with the non-business assets in it,

(b) willing to purchase the corporation with the non-business assets in it, but only for a price equal to the fair market value of the shares without the non-business assets,

(c) willing to purchase the corporation with the non-business assets in it but only for an amount that reflects a discount from the fair market value of the non-business assets, or

(d) willing to purchase the corporation with the non-business assets in it for an amount that reflects the fair market value of the non-business assets.

In the case of (a), it cannot be said that the purpose of the dividend would be to reduce the fair market value of the shares, as there would be no willing buyer of the shares with the non-business assets in the corporation, and no fair market value of the shares could be arrived at unless the purification dividend was paid. In the case of (b), it also cannot be said that the purpose of the dividend would be to reduce the fair market value of the shares, as the fair market value would not have changed. In the case of (c), it is unlikely that the purpose of the dividend would be to reduce the fair market value of the shares, as the purpose would more likely simply be to enable the shareholders to better realize on the value of the non-business assets by way of a separate asset sale in the future. Accordingly, the only situation in which the application of subsection 55(2) would generally be of concern is the scenario in (d), where a buyer exists who is willing to purchase the targetco shares at a price reflecting the fair market value of the non-business assets. Note that in a situation like (a), (b) or (c), it would be prudent for the vendors to obtain written documentation from the purchaser evidencing the fact that they are not willing to purchase the shares for a price that includes the value of the non-business assets, to avoid any question of the application of subsection 55(2).

Accordingly, in the authors’ view, none of the offensive purposes in paragraph 55(2.1)(b) should be considered to exist where a dividend is paid out for the purpose of making a company saleable in circumstances where an arm’s length buyer is either (a) not willing to purchase the corporation with the non-business assets in it, (b) willing to purchase the corporation with the non-business assets in it, but only for a price equal to the fair market value of the shares without the non-business assets, or (c) willing to purchase the corporation with the non-business assets in it but only for an amount that reflects a discount of the fair market value of the non-business assets. However, where the buyer has demonstrated that they are willing to purchase the corporation with the non-business assets in it for an amount that reflects the fair market value of the non-business assets in circumstances where a founder or controlling block of shareholders does not

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have access to the lifetime capital gains deduction, it will generally be reasonable to assume that one of the purposes of an inter-corporate purification dividend was to reduce either the capital gain on, or fair market value of, some of the shares of the corporation. In that case, it would be up to the taxpayer to, on the facts, refute that they in fact had such a motivation.

In this case, no prospective purchaser had yet been identified. As such, the investment banker and John likely assumed that the presence of the Surplus Assets would likely result in one of the scenarios in (a) to (c) – and wanted to protect against this eventuality. In the authors’ view, this purpose does not offend the purposes set out in 55(2.1)(b).

4.3.3 Purification

In addition to the investment banker’s advice, John’s accountant also advised John that if he wanted his family members to be able to access their lifetime capital gains deduction on the gain from the sale of the Class C Shares allocated by the Trust, he would need to cause JJ Hardware to distribute at least $2,000,000 of the Surplus Assets prior to the sale – i.e., a “purification dividend”. Does the purpose of enabling shareholders to access their lifetime capital gains deduction under subsection 110.6(2.1) of the Act offend the purpose tests in paragraph 55(2.1)(b)?

As above, it is a near certainty that the purification dividend will form part of the series of transactions that includes the dividend based on the fact that it will be paid in contemplation of a future sale of the shares of the company.

At first glance, the purpose of paying a dividend in order to enable shareholders to realize a tax-free capital gain might seem to be “to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share or capital stock immediately before the dividend”, in which case the dividend would clearly offend subparagraph 55(2.1)(b)(i).

This would ultimately be a question of fact. However, an examination of the capital gains and lifetime capital gains deduction mechanics in the Act demonstrates that this will generally not be the case. “Capital gain” is generally defined for purposes of the Act in paragraph 39(1)(a) as a taxpayer’s gain from the disposition of property for the year determined under subdivision c of Part I, Division B of the Act. A taxpayer’s gain from the disposition of property is calculated under section 40, and in particular paragraph 40(1)(a), as the amount by which the taxpayer’s proceeds of disposition less reasonable costs of disposition exceed the adjusted cost base of the property, less the amount of any reserves the taxpayer is entitled to deduct in respect of the disposition. A taxpayer’s lifetime capital gains deduction does not factor into the calculation of their gain, and thus does not impact their capital gain for purposes of the Act. Instead, any deduction that a taxpayer may be entitled to under subsection 110.6(2.1) in respect of their lifetime capital gains deduction is deducted when computing the taxpayer’s taxable income under Part I, Division C of the Act – which effectively serves as a reduction of their “taxable capital gain” as would otherwise be calculated under paragraph 38(a).

The next question that needs to be addressed is whether the dividend could be said to be paid for the purpose of reducing the fair market value of any shares as prohibited under clause 55(2.1)(b)(ii)(A). Again, this would ultimately be a question of fact. However, the same considerations would apply here as under subparagraph 55(2.1)(b)(i). The fair market value of the shares of Opco has no relevance to their qualification as a “qualifying small business corporation share” under subsection 110.6(1) or the deduction claimed under subsection 110.6(2.1). Accordingly, the purpose of accessing the lifetime capital gains deduction does not include as a constituent the purpose of reducing the fair market value of the share.

Based on the above, in the authors’ view, paying a dividend for the purpose of purifying a company to enable certain shareholders to claim their lifetime capital gains deduction does not, in and of itself, offend the purpose tests in paragraph 55(2.1)(b).

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The CRA appears to agree with this conclusion, but have suggested that they will generally look past this “purification purpose” to see if other offending purposes simultaneously exist:

Subsection 55(2) could apply where any one of the purposes described in paragraph 55(2.1)(b) is present and, therefore, it is important to demonstrate that the payment or receipt of the dividend has no purpose described in paragraph 55(2.1)(b).

Whether a purpose of maintaining QSBCS status cannot be divorced from other purposes such that a payment of a dividend can be viewed as having only the purpose of maintaining QSBCS status but has no purpose of reducing the accrued gain or value of the shares or increasing the cost of property of the dividend recipient can only be made in light of all the relevant facts and circumstances.

As indicated in the above-mentioned interpretation, where the dividend is paid with assets other than surplus assets, this might be a sign that the payment of the dividend could have a purpose referred to in paragraph 55(2.1)(b). Or, if the removal of the surplus assets from the corporation through the payment of a dividend is made in contemplation of a possible disposition of the shares of the corporation, it may also indicate that there is a purpose referred to in paragraph 55(2.1)(b).

The above are only examples of questions that could be asked to help determine whether a purpose referred to in paragraph 55(2.1)(b) could be present in respect of a dividend paid to qualify as QSBCS. They do not represent the only guidelines to use to determine such purpose in that context.

We also question why the payment of a dividend to remove surplus assets is not covered by safe income since the generation of surplus assets or a disposition of such assets would generally result in a realization of income.46

4.4 Non-Distribution Strategies

In many share sale situations, it may be possible to use non-distribution strategies to accomplish the objectives of (1) making the company saleable, per the instructions and advice of John’s investment banker, and (2) enabling shareholders to access their lifetime capital gains deduction. The opportunities to do so will of course depend on the unique circumstances of each corporation. However, it will often be the case that a corporation will have short and long-term liabilities that are reflected in the fair market value of its shares. Instead of distributing its excess cash, a corporation may instead choose to pay down its liabilities with its excess cash, thereby increasing the fair market value of its shares. By doing so, the corporation has effectively converted its surplus assets into capital gains.

5 Intentionally Triggering 55(2)

Often overlooked is the fact that the tax arising on the application of subsection 55(2), on a fully integrated basis, is significantly less than the tax arising on taxable dividends, whether ordinary or eligible. Table 1, below, sets out the tax savings that would occur if paragraph 55(2)(c) applied to deem a dividend received by a BC resident corporation to be a capital gain, and the corporation distributed the amount received to a BC resident individual shareholder by way of a capital dividend and ordinary dividend in the same year it was received.

46 CRA Document 2017-0724021C6.

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Note that the CRA has taken the position that the addition to a dividend recipient’s capital dividend account from the gain that is deemed to occur on the application of 55(2)(c) is deemed to be realized at the time of payment of the dividend for the purposes of inclusion in income and the definition of "capital dividend account" in subsection 89(1), and thus a capital dividend can be declared immediately after.47

Table 1

55(2) Does Not Apply 55(2) Applies

Ordinary Dividend

Eligible Dividend

Capital Gain

CCPC Level

Dividend received 1,000,000 1,000,000 1,000,000

Corporate tax (net RDTOH) - - (100,000)

Amount distributed 1,000,000 1,000,000 900,000

Individual Level

Capital dividend - - 500,000

Ordinary dividend 1,000,000 - 400,000

Tax (44.64%) (446,400) - (178,560)

Eligible dividend - 1,000,000 -

Tax (31.44%) - (314,400) -

After-Tax Cash 553,600 685,600 721,440

It is often assumed that the tax savings illustrated in Table 1 will soon disappear where the corporation takes advantage of the available tax deferral by retaining and investing a tax-free 112(1) dividend. However, that may not be the case in many circumstances. As the Table 2, below, illustrates, a dividend to which section 55(2) applies can still result in an individual shareholder being better off even when accounting for the corporate investment returns over the deferral period. For example, if we assume that in circumstances where subsection 55(2) does not apply to a dividend and the corporation earns an annual compounded non-capital gain investment return of 10%, which is earned and taxed annually over a five year deferral period, but also assume that in circumstances where subsection 55(2) does apply and the corporation distributes the after-tax amount to an individual shareholder who invests their after-tax income and receives the same rate of return as the corporation, we see that an individual can still come out ahead if subsection 55(2) applies.

Table 2

55(2) Does Not Apply 55(2) Applies

Ordinary Dividend

Eligible Dividend

Capital Gain

CCPC Level

Dividend received 1,000,000 1,000,000 1,000,000

47 Stéphane Charette and Stéphane Prud'Homme, "Canada Revenue Agency Round Table," in Report of the Proceedings

of the 69th Tax Conference, 2017 Conference Report (Toronto: Canadian Tax Foundation, 2018), 3:1-29.

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Corporate tax (net RDTOH) - - (100,000)

Years of tax deferral 5 5 n/a

ROI (annual) 10% 10% n/a

After-tax investment income (net RDTOH) 402,832 402,832 n/a

Amount distributed 1,402,832 1,402,832 900,000

Individual Level

Capital dividend - - 500,000

Ordinary dividend 1,402,832 402,832 400,000

Tax (44.64%) (626,224) (179,824) (178,560)

Eligible dividend - 1,000,000 -

Tax (31.44%) - (314,400) -

After tax amount invested n/a n/a 721,440

Years invested n/a n/a 5

ROI (annual) n/a n/a 10%

After-tax investment income (top bracket) n/a n/a 200,198

After-Tax Cash 776,608 908,608 921,638

Given the above, taxpayers may find themselves motivated to plan to have subsection 55(2) apply instead of not apply.

The question becomes, in light of the fact that subsection 55(2) is intended to operate as an anti-avoidance provision, can a taxpayer plan to avail themselves of its application for their benefit?

From a technical perspective, the answer would seem to be yes. The Act does not contain any prohibition against undergoing a series of transactions to cause a dividend to be deemed to be a capital gain under subsection 55(2).

From a policy perspective, the answer would also seem to be, yes. The intentional use of subsection 55(2) to convert taxable dividends into capital gains results in a lower effective tax rate than the straightforward distribution of profits by taxable dividends, but yields less tax benefits than internally triggering capital gains on existing corporate assets. As such, the tax benefit of intentionally triggering 55(2) is less than when compared to comparable transactions. The CRA appears to have reached the same conclusion, stating that they have considered whether the general anti-avoidance rule (GAAR) would apply to the intentional use of subsection 55(2) and have reported that they do not believe it would.48 The authors agree with this conclusion. However, the CRA has maintained that it has concerns, stating:

Although the GAAR Committee considered that the Transactions circumvented the integration principle, it recommended that the GAAR not be applied. The GAAR Committee was of the view that it would be unlikely that the GAAR could be successfully applied to the Transactions given the current state of the jurisprudence.

It was also recognized that results similar to those obtained from the Transactions could be achieved in a variety of ways. For example, in a corporate structure similar to that in the Transactions, instead of using subsection 55(2), HOLDCO A could realize a capital gain by

48 CRA Document 2015-0610701C6.

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selling its OPCO shares to a new sister corporation or by transferring its OPCO shares to OPCO in exchange for new OPCO shares.

The CRA is nevertheless concerned with the type of surplus stripping arrangement described above and has expressed those concerns to the Department of Finance.

The CRA will still maintain its position of applying the GAAR and/or subsection 84(2) to cases like The Queen v. Macdonald…where a taxpayer uses losses or other tax shelter to reduce a capital gain realized as part of a surplus stripping scheme.49

It is worth noting that after the CRA expressed these concerns, paragraph 55(5)(f) was amended to automatically bifurcate a declared dividend into a separate “safe income dividend” and “non-safe income dividend” such that subsection 55(2) only applies to the “non-safe income dividend”. This automatic mechanism limits the ability of taxpayers to intentionally trigger subsection 55(2).

If the GAAR is applied, the result would presumably be that the dividend recipient would be assessed the tax that would have been assessed had subsection 55(2) applied, but without the benefit of an addition to the dividend recipient’s CDA had subsection 55(2) applied at first instance.

In circumstances where the related party exception does not apply (such as in the case study discussed in this paper), the easiest way to attempt to intentionally trigger subsection 55(2) is arguably to cause a deemed dividend to be paid by repurchasing or redeeming a share under subsection 84(3) that results in a significant reduction of a capital gain that would have been realized on a share under subparagraph 55(2.1)(b)(i). This is a bright line test with minimal subjectivity or uncertainty.

Alternatively, a taxpayer might try to pay a dividend in a manner that offends one of the purpose tests: (1) a significant reduction of the capital gain that otherwise would have been realized on a disposition of a share, (2) a significant reduction in the FMV of any share, or (3) a significant increase in the cost of property of the dividend recipient. Some commentators have noted that it could be difficult to intentionally meet one of the purpose tests, as the intention to meet the purpose would become the taxpayer’s purpose instead of the abusive purposes enumerated in subsection 55(2.1) that the taxpayer is attempting to possess.50 This could certainly be the case in some circumstances. For example, the CRA has stated that the purpose test will not be met if dividends are paid to effect inter-corporate loss utilization strategies in a related or affiliated group.51 However, in the case of a capital gains stripping transaction, this seems less certain given that the test only requires that one of the purposes be the enumerated 55(2.1) purposes – and a taxpayer can arguably have one of those purposes while still trying to achieve it in a tax efficient manner by triggering subsection 55(2).

6 Conclusion

It remains to be seen how courts will interpret the application of section 55 to distributions of surplus assets in connection with a share sale. However, careful planning should provide a number of ways to navigate the application of 55(2).

49 2015-0610701C6 50 Félix Turcot, "Key Reminders About the Deliberate Triggering of Subsection 55(2)" (2017) 7:2 Canadian Tax Focus 5-

6. 51 2015-0610671C6