Prior to July 2015, many corporate groups gave little thought to the possible application of subsection 55(2) of the Income Tax Act (the act) when paying inter-corporate dividends. While the rules in subsection 55(2) had the potential to re-characterize tax-free inter-corporate dividends as proceeds of dispositions that would result in the creation of taxable capital gains, the limited scope of the purpose test found in this subsection—combined with the ability to rely on the exceptions found in paragraph 55(3)(a) for payments made within a related group—made it unlikely that the provisions would apply to most dividends.
That was then. The new subsection 55(2) rules, released by the Department of Finance in 2015 and enacted into law in 2016, greatly narrowed the circumstances in which the exceptions found in paragraph 55(3)(a) could apply; moreover, they expanded the number of purpose tests that could result in the application of subsection 55(2) on inter-corporate dividends.
The changes to the subsection 55(2) rules have already been discussed capably and at great length in a number of publications, so this article will focus instead on specific examples of common situations in which the recipients of inter-corporate dividends should consider the potential application of subsection 55(2). Where possible, the article will also identify ways to avoid the application of subsection 55(2) when such avoidance would be advantageous. It is worth noting that when considering the effective tax rate to a shareholder on a fully integrated basis, it is often less expensive to an individual taxpayer to have subsection 55(2) apply to a dividend paid than to have the dividend retain its character as a dividend.
A common transaction used to “creditor-proof” an operating company (such as an asset protection plan) involves the declaration of a large cash dividend by the operating company to its holding company; the holding company then lends the cash back to the operating company and takes security against the operating company’s assets. The purpose of this type of planning is to ensure that the shareholder can access their capital if any unexpected liabilities arise in relation to the business. These creditor-proofing dividends can often exceed an operating company’s “safe income on hand” (more on safe income later in this article).
The Canada Revenue Agency (CRA) has commented that the apparent purpose of the payment of a creditor-proofing dividend is to reduce the value of an operating company’s shares. Accordingly, the CRA suggests that subsection 55(2) should apply to the dividend, as per the expanded purpose tests now found therein. In the CRA’s view, the fact that the payment of the dividend is also designed to achieve creditor-proofing, with no plans to sell the operating company’s shares, does not alter its conclusion.
To avoid the application of subsection 55(2) to creditor-proofing dividends, taxpayers may want to consider limiting creditor-proofing dividends to the operating company’s safe income on hand (of course, this will require taxpayers to regularly update the safe income on hand associated with the shares of the operating company).
Another alternative would be to establish a policy of paying dividends on a regular basis. The operating company would then make corresponding draws on a secured credit facility with the holding company. The CRA has stated that subsection 55(2) should not apply where a dividend is paid pursuant to a well-established policy of regularly paid dividends. However, the amount of the dividend must not exceed the amount a shareholder would normally expect to receive as a reasonable dividend return on a comparable listed share issued by a comparable payer corporation in the same industry. For some taxpayers, this requirement to benchmark against a comparable listed share may be prohibitive.
Dividends paid on discretionary dividend shares
Non-participating (aka “skinny”) shares are discretionary dividend shares that are issued for nominal consideration with a discretionary dividend entitlement. These shares are used to distribute income to a particular shareholder without entitling that shareholder to any growth in the value of the business. Because skinny shares are not entitled to participate in liquidation proceeds, they do not accrue gains; additionally, they can be redeemed at any time for a nominal amount without triggering a gain or loss.
“Safe income” is income that contributes to the capital gain that could be realized on the disposition of a share. Accordingly, in order for safe income to accrue to a particular share, there must be a capital gain on that share. The CRA has suggested that safe income may be allocated to non-participating shares only if these shares have value. Whether such shares have value is a question of fact.
If skinny shares do not have value, the safe income exception will not apply to any dividends paid on them. Under the old subsection 55(2) rules, taxpayers could rely on the related-party exception to avoid a re-characterization of a dividend paid on skinny shares; under the new rules, however, taxpayers will have to rely on failing to meet the expanded number of purpose tests.
The upshot? Under the new subsection 55(2) rules, care should be taken when paying inter-corporate dividends on skinny shares.
The safe income attributable to discretionary dividend shares is analyzed differently when such shares participate in the growth of the company’s value (unlike the skinny shares described earlier).
According to the CRA, in determining the safe income on hand attributable to a particular class of participating discretionary dividend shares, the amount of the contemplated but not yet paid discretionary dividend is to be included in the fair market value of the share for the purposes of allocating the payer corporation’s safe income to that share. This approach should allow for disproportionate sharing of safe income between multiple classes of participating discretionary dividend shares.
This is best illustrated with an example. Assume that a corporation has two classes of participating shares with discretionary dividend rights—Class A and Class B—and 50 shares of each class have been issued. Assume that no other shares are outstanding, and the corporation’s safe income on hand is $100,000. If a discretionary dividend of $75,000 is paid on the Class B shares, then—even though this dividend exceeds 50% of the corporation’s safe income on hand—the CRA will accept that the entire $75,000 dividend comes out of the corporation’s safe income, with the result that subsection 55(2) should not apply.
Conclusions and recommendations
As these few examples illustrate, there are significant traps to be circumnavigated now that the new subsection 55(2) rules for inter-corporate dividends are in place.
Each time an inter-corporate dividend is paid (or a deemed dividend is triggered), the possible application and implications of subsection 55(2) should be considered. And in certain instances where the application of subsection 55(2) on the payment of a dividend is unavoidable, alternative means of transferring capital between corporations should be considered (for example, transferring capital by way of loan or the merger of the dividend payer and the recipient).
Additionally, because one of the few safe harbours for inter-corporate dividends under the new subsection 55(2) rules is a corporation’s safe income on hand, corporations that anticipate paying inter-corporate dividends should make a point of calculating the safe income on hand attributable to each of their share classes, and updating these calculations regularly for all subsequent transactions.
For taxpayers who are paying significant inter-corporate dividends, it is generally advisable to have a tax specialist consider the possible application of the new subsection 55(2) rules prior to the payment of the dividends.
All this being said, there are opportunities for informed taxpayers and their advisors despite the complexities of the new rules.
Hayley Brown is a senior manager in tax services at KPMG LLP in Vancouver. She specializes in Canadian corporate tax, with a focus on mining and industrial markets.
Shane Onufrechuk is a partner in tax services at KPMG LLP in Vancouver and the chair of both the CPABC Taxation Forum and the CPABC Professional Development Tax Advisory Group.
- For example: Michael Welters, Cathie Brayley, Chris Speakman, and Riley Burr, “When is an Inter-Corporate Dividend Not Tax Free?” 2015 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2015), 6: 1-36.
- TI 2015-0623551C6, 2015 CTF Annual Tax Conference, CRA Roundtable, Q.6(e), Creditor Proofing (taxinterpretations.com/cra/severed-letters/2015-0623551c6).
- TI 2015-0613821C6, Tax Executive Institute Liaison Meeting, November 17, 2015. Question on section 55 of the Income Tax Act (taxinterpretations.com/cra/severed-letters/2015-0613821c6).