21 November 2017 CTF Roundtable Q. 6, 2017-0724071C6 - Circular calculations Part IV tax

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether a circular calculation can be made that results in a reduction or elimination of the amount of taxable dividend received and Part IV tax payable.

Position: No.

Reasons: The scheme of 55(2) does not support such circular calculation. The circular calculation is flawed and does not reflect reality. The Part IV tax is the real Part IV tax paid in the first tax return and remains the same in the second tax return. See response.

2017 CTF Annual Conference
CRA Roundtable

Question 6: Circular calculations with respect to Part IV tax

Holdco receives a dividend of $400,000 that is subject to Part IV tax because the connected payer corporation has received a dividend refund. The Part IV tax payable by Holdco is $153,333 (38.33% of $400,000).

Holdco pays a dividend to its shareholders which results in a refund of the Part IV tax. The dividend received by Holdco would therefore be subject to the application of subsection 55(2).

If the dividend received by Holdco was originally taxed as a capital gain to Holdco, the refundable tax on the capital gain would be $61,333 ($400,000 x 50% x 30.66%).

Instead of having to pay the whole amount of $400,000 as a taxable dividend so that it can be established that the Part IV tax of $153,333 is fully refunded for subsection 55(2) to apply, Holdco would only need to pay an amount of $160,000 as a taxable dividend ($61,333 / 38.33%). Therefore, a capital dividend of $200,000 can be paid at the same time as the taxable dividend to the shareholders of Holdco.

This result can be achieved because of circular calculations where the dividend received is deemed to be reduced by the application of subsection 55(2) after each calculation, resulting in a reduced Part IV tax whereas the amount of tax refund remains the same at each calculation.

Does the CRA agree with such circular calculation? Note that all numbers provided in this example are hypothetical.

CRA Response

The scheme of subsection 55(2) does not support such circular calculation.

This is quite different from situations where shares held between 2 corporations are cross-redeemed. The circular calculation in such circumstances is strictly caused by the Part IV tax and dividend refund where Part IV tax payable by one corporation changes every time the tax refund obtained by the other corporation is changed.

It is proposed in the above example that the circular calculation causes the amount of dividend received to be reduced at each calculation by virtue of the application of subsection 55(2) and therefore reduces the amount of Part IV that is payable on the dividend on each calculation such that, at the last iteration, the amount of dividend received is reduced to nil and no Part IV tax is payable. On that basis, it is proposed in that example that there is only a capital gain of $400,000 to be included in the tax return and that the refundable tax on such capital gain is $61,333 which is fully refunded by a payment of a taxable dividend of $160,000.

That suggested circular calculation is flawed and does not reflect the reality.

As explained in document 2016-0671491C6, for a dividend to be subject to subsection 55(2), the Part IV tax payable has to be refunded. The Part IV tax in that situation is the real Part IV tax paid and the refund has to be a real refund. As per Ottawa Air Cargo v. The Queen, 2008 DTC 6177 (FCA) (footnote 1) (“Ottawa Air Cargo”) both amounts cannot be theoretical.

The Court also said the following in Ottawa Air Cargo, at paragraph 33:

This is also a reasonable conclusion in the context of a purposive analysis. The purpose of the provision is to address avoidance. The parenthetical clause sets out an exemption: the subsection does not apply where the taxpayer has not received a refund of Part IV tax. This is a reasonable exemption, because if the refund of Part IV tax is not received, then tax has been paid, not avoided; hence subsection 55(2) need not be applied.

The wording in subsection 55(2) indicates that it does not apply if the Part IV tax has been paid and it applies only where the Part IV tax paid has been refunded. Therefore, as confirmed by the Court, the Part IV tax has priority over subsection 55(2). The circular calculation that operates to eliminate the Part IV tax in order for subsection 55(2) to apply to the whole dividend is contrary to the scheme of subsection 55(2).

In the application of subsection 55(2), the question to be asked first is whether Part IV tax is payable on a dividend received. If no, subsection 55(2) applies. If yes, then subsection 55(2) does not apply unless there is a refund of Part IV tax. If there is a refund of Part IV tax, then subsection 55(2) applies to the portion on which the Part IV tax has been refunded. The application of subsection 55(2) does not eliminate the dividend that was originally subject to Part IV tax and has no effect on the Part IV tax that was paid on the dividend, otherwise it results in a circular calculation that is not in accordance with the scheme of subsection 55(2) as explained in the previous paragraph.

In the above situation and using the numbers that have been provided, if a Part IV tax of $153,333 is paid or payable as declared in the income tax return that reports the inclusion of the full $400,000 in income as a dividend, that Part IV tax is the Part IV tax paid or payable for the taxation year. In the second return mentioned in document 2016-0671491C6, the Part IV tax paid for the taxation year remains $153,333 even though the amount of dividend has been reduced to reflect the application of subsection 55(2).

Therefore, if a dividend of $400,000 has been received by Holdco that is subject to Part IV tax of $153,333 and it paid a dividend of $160,000 that results in a refund of Part IV tax of $61,333, the first return should include exactly those amounts, i.e.:

Taxable dividend received
(before the application of 55(2)) = 	$400,000
Part IV tax paid =				$153,333
RDTOH = 						$153,333
Taxable dividend paid =			$160,000
Dividend refund = lesser of: 		RDTOH ($153,333); and
38. 33% of $160,000 ($61,333)
						Refund = $61,333

Since only a portion of $160,000 of dividend has been subject to Part IV tax that has been refunded, an amount of $160,000 becomes a capital gain. The remaining amount of dividend received is $240,000.

In the second return, the following will have to be reported:

Taxable dividend received
(after the application of 55(2)) =  		$240,000
Capital gain = 					 	$160,000
Part IV tax paid = 					$153,333
RDTOH = total of:			Part IV tax paid = $153,333; and
Part I refundable tax on capital gain = $24,533 (160,000 x 50% x 30.66%)
  Total RDTOH = $177,866
Dividend paid = 						$160,000
Dividend refund = lesser of: 		  RDTOH ($177,866); and
38. 33% of $160,000 ($61,333)
							  Refund = $61,333

Note that 2 returns, not more, are needed to be filed to reflect the application of 55(2) and that there is no circular calculation involved.

Even though the second return indicates that the dividend received is only $240,000, a “manual” adjustment would have to be made to the return to indicate that the Part IV tax paid is $153,333 and not a lower amount.

Of course, in this situation, a CDA dividend of $80,000 ($160,000 x 50%) could be paid after the receipt of the dividend of $400,000 due to the application of subsection 55(2), but the RDTOH has not been fully refunded.

M. Ton-That
2017-072407
November 21, 2017

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Affirming the decision at the TCC level (see Ottawa Air Cargo, 2007 DTC 661 (TCC)).