8 June 2016 CTF Technical Seminar: Update on s. 55(2)
The Canadian Tax Foundation hosted a technical seminar in Ottawa on June 8, 2016 on recent developments in the taxation of private corporations, which was to include an update from Yves Moreno and Annie Mailhot-Gamelin (both with the Income Tax Rulings Directorate) on the proposed amendments to s. 55(2). A giant sinkhole interrupted the conference before they had a chance to present, and their remarks instead were recorded two weeks later. This is an edited transcript of their remarks, with their slides inserted in sequence (and with our own subtitles also inserted).
CRA providing responses on new rules
Yves Moreno. Since the introduction of the changes to subsection 55(2) and other changes in July 2015 and the introduction in April 2016 of the Notice of Ways and Means motion, the tax community has been expressing concerns about the administration of the changes. The CRA has been proactive in providing a number of positions on those proposed changes, back in the fall of 2015 at the annual APFF and CTF Roundtables as well as at an event organized by the TEI. The CRA has provided a number of responses to questions about the purpose test and its administration, loss consolidations, discretionary dividends and safe income allocation, s. 84(3) dividends and the s. 55(3)(a) exceptions, and creditor proofing. In addition to those Roundtable responses, the CRA has also issued about 9 or 10 technical interpretations and rulings on loss consolidations.
Expanding on McLean/Bell presentation
Annie Mailhot-Gamelin. This presentation follows two presentations that were given by Mr. McLean and Mr. Bell at this technical seminar two weeks ago that provided a very good overview of section 55 and the proposed changes, including on safe income. They also touched on some of the positions that were taken by CRA, and we will take this opportunity to revisit, expand and clarify some of these positions and also to comment on the application of proposed subsection 55(2).
Informed by policy purpose
Yves Moreno. Before we do that, I would like to talk about the role of subsection 55(2). I would like to step back, because, in the end, all the CRA positions I was referring to are interpretive positions on the new changes, and the Supreme Court dictates that we should be using the textual, contextual and purposive approach in interpreting positions including on subsection 55(2). So what is the context and purpose of s. 55(2)? I think it is important to address that because it informs a number of things: the evolution of the provision on the one hand; its interpretation; and, more generally, the scheme of the Act overall and the object, spirit and purpose of the provision.
When thinking about s. 55(2), the first thing that comes to mind is the exceptions because they are complex. So the first thing that comes to mind often is butterflies, related party transactions, safe income computations and allocations. I would like to leave that aside for now, and to focus on the more fundamental role of s. 55(2), which is basically about integration. Integration is about the payment of corporate tax and avoiding duplication of corporate tax. Those two elements are important. The integration principle provides that the income should not be taxed twice in a corporate chain, so that once it is taxed, it can move in that chain tax free through an inclusion and offsetting deduction mechanism.
A dividend has two effects. It will increase the income of the recipient, and it will reduce the capital gain on the participating shares of the payer held by its shareholders. If the purpose, or the result in the case of some deemed dividends, is to reduce the capital gain, s. 55(2) will not apply even if that purpose or result is there, to the extent that the dividend is supported by safe income. That safe income element is one of the keys to making sure that there is no duplication of corporate taxes. If the dividend is supported by safe income, then the dividend would be deductible by the corporate recipient, and the other leg of taxation would be when the dividend moves out of the corporate chain.
Potential abuse of integration principle
However, the D & D Livestock case illustrates how s. 55(2) can be instrumental in not only preventing the duplication of taxes, but might also be instrumental in generating ACB that is unsupported by taxed corporate income.
Respecting the reduction of the capital gain, the two components of the capital gain are basically the value of an asset and its excess over the ACB. The safe income role is to prevent duplication of taxes and preserve integration, the role of ACB is similar. ACB would normally be supported by after-tax earnings, and there is a cost component to ACB. Where ACB in generated and is not supported by safe income, in the context of a dividend that is instrumental in increasing the ACB, the new iteration of the provision will extend to capture those circumstances. This is an extension of its role which, again, is to ensure that corporate tax is paid, but that at the same time that there is no duplication of corporate taxes.
Expanded scope of s. 55(2)
Not just capital gain reduction
So the new proposed wording of s. 55(2) will now address situations where the purpose of a dividend is to increase the cost base of the properties held by the dividend recipient, and that would be the case where the dividend recipient receives additional property on the payment of the dividend.
So before I move on to the next slide, maybe I can sum up the context and purpose of s. 55(2). The result of a dividend will be to increase the income of the recipient, it might reduce the capital gain on payer shares, it might also reduce the fair market value of those shares and/or increase the cost base of the property of the recipient. Those circumstances are now within the extended scope of subsection 55(2). If the purpose or result is to achieve one of those four results, then the safe income exception would apply to avoid the duplication of tax. In addition, if the purpose or result, depending on the circumstances and the nature of the dividend, is to generate unsupported ACB, new s. 55(2) might also apply to that dividend.
D & D Livestock addressed
We will not go over the facts of D & D Livestock in detail. The slides of the June 8th presentation summarize in simplified form the way the taxpayer in that case was able to generate an additional dollar of ACB which was not supported by safe income. In a nutshell, that example describes a situation where Parent owns shares of Opco, those shares have a fair market value of $10 and ACB of $0, and Opco has $1 of safe income. Opco pays a stock dividend to Parent by issuing preferred shares that have a FMV and ACB of $1, and s. 55(2) does not apply. Even if it did otherwise, the safe income exception would apply. And that would be fine.
The next step though is that Parent incorporates Newco and transfers the preferred shares that it received as a stock dividend to Newco. Now Parent owns shares of Opco and Newco, and through a stock dividend Newco transfers back the shares to Parent. So there’s some back and forth with the preferred shares from Parent to Newco and back to Parent, back to Newco, so that at the end of those transactions, Parent owns shares of Newco having an ACB of $2 that it can sell at a reduced capital gain of $8—the value of the shares at $10 minus the new ACB now at $2. Whereas had the ACB not aggregated in the way it did, Parent would have realized the capital gain of $9 on the shares of either Newco or Opco. So there is a reduction of the capital gain of $1 in that case.
Again, the changes to new s. 55(2) are meant to address that kind of circumstance, and what we see happening in that example is the value of the shares of Newco drops on the payment of the second stock dividend that transfers the preferred shares back to Parent, the value of the shares of Newco drops from $1 to zero, while it preserves an ACB of a dollar, and so that there is a $1 potential loss there. S. 112(3) did not apply there as the loss was not realized, and s. 55(2) did not apply because there was no gain to reduce, as those shares of Newco had a fair market value and ACB of $1 before the second stock dividend was paid.
The changes in new s. 55(2) now would address circumstances where the purpose of the dividend is to either reduce the value of a share (going back to that example, the drop in the value of shares of Newco from $1 to zero dollars) or to increase the cost of the property in the hands of the dividend recipient (in this case, Parent ends up with an additional dollar of ACB). The safe income exception would only apply in respect of the first dividend of $1. The second dividend was not subject to the application of s. 55(2), but not because of the safe income exception, just because there was no gain on the share, and the current version only contemplates situations where the intention or the result, depending on the type of dividend, is to reduce a capital gain.
Expanded scope analogous to boot rules
Under the proposed version, the tax result would be the same as before. If s. 55(2) applies, a capital gain is deemed to have been realized, or proceeds of disposition are deemed to have been realized, depending on the circumstances, and that is consistent with other provisions of the Act. The first that come to mind are the rollover provisions where if ACB is generated, there is an immediate income inclusion, so under section 85 for example, if property is transferred and non-share consideration is received in excess of the ACB of the transferred property, that would prompt an income inclusion - so: a similar result.
Some people have been wondering about the fact that in D & D, there was a sale that was contemplated and whether the changes to proposed s. 55(2) would be limited to circumstances where a potential buyer has been identified or where there is a potential sale as part of a series in the traditional sense or in the extended sense under s. 248(10). Again, similar to the rollover provisions, the fact that whether a buyer has been identified or not, or whether there is an intention to use the increased ACB or not, does not really limit the application of subsection 55(2) (the application of the provision is not conditional on that). Again, that is no different from rollover situations where ACB is generated and there is immediate taxation no matter when the property received on the rollover is sold.
Annie Mailhot-Gamelin. This slide provides an example of a situation in which the CRA said that it would not consider that one of the purposes of a dividend is described in proposed s. 55(2.1)(b). That response was repeated at a TEI Liaison Meeting that was held last November and was published. The example basically describes a dividend that is paid by a public corporation to its shareholders as part of its standard practice of paying quarterly or annual dividends on its listed shares. It is just an example that should be taken at face value for what it is. Subsection 55(2) would not normally apply to dividends which are paid in these circumstances. The example was extended to dividends paid by a comparable private corporation that would follow the same practice, because that makes sense. We have seen references to that example as being a safe harbour or even suggestions that everything outside that would be subject to s. 55(2). But that would be ignoring that the tests in proposed in s. 55(2.1)(b) are not results tests, they are purpose tests.
There are two built-in limitations to the application of s. 55(2). The first one is that the reduction of fair market value or capital gain, or the increase in cost, has to be significant. Consistent with the way that concept has been interpreted historically, “significance” will be determined based on the relative or dollar basis.
The second one is that the facts and circumstances have to support that one of the purposes of the dividend is to reduce the gain or fair market value or to increase the cost of property of the dividend recipient. In the example that is described on the slide, it is doubtful that the dividend would significantly reduce the fair market value or the gain on shares. However, it might, in certain circumstances, increase the cost base of the assets of the recipient. But even then, it is difficult to imagine that one of the purposes of the dividends would be to achieve that. So, essentially the relevance of that example is to illustrate a clear and fairly universal set of circumstances. The analysis of every dividend will involve its own set of facts and circumstances which will have to be taken into account in determining whether a dividend has one of the purposes that are described in proposed s. 55(2.1)(b). It would be misleading to dissect the various components of that example as if it were a section of the Act or an administrative position.
No blanket exceptions
The proposed amendments have also prompted questions as to whether certain categories of dividends should be devoid of the purposes described in proposed paragraph 55(2.1((b) and therefore be automatically exempted from the application of subsection 55(2). For example, it has been suggested in the past that normal course or ordinary course dividends should not be considered to have a purpose described in proposed s. 55(2.1)(b). As we have previously indicated, the determination of purpose is based on facts that are particular to a situation that would include, but are not limited to, the actions that are taken by the parties to the dividend and their motivation. The CRA statement about well-established dividend policy that was referred to in the previous slide was meant to provide a sense of comfort in some very low threshold scenarios. It is not meant to create a class of blanket exceptions for proposed paragraph 55(2.1)(b).
Will rule on purpose if enough facts
Guidelines providing a greater level of comfort could be developed in the context of a ruling request with all the relevant facts. For instance, the Rulings Directorate has given favourable opinions on the proposed amendments in the context of loss consolidation arrangements, and we will consider requests for rulings that involve the determination of purpose in other contexts as long as we are provided with detailed and complete facts. Over time, such rulings will provide additional guidance on the application of the new provisions.
Three potential bad purposes
In terms of the factors that will be considered in determining the purpose of a dividend, we would like to reiterate what we said at the 2015 CTF Roundtable that, in a sense, the purpose test is a purpose test, it is not a results test. The purpose will be examined in light of all the circumstances, looking at the perspective of both the payer of the dividend, and the recipient, to determine: what does the taxpayer intend to accomplish with a reduction in value or an increase in cost; how would such reduction or increase in cost be beneficial to the taxpayer; and what actions did the taxpayer take in connection with such reduction in value or increase in costs.
There are three separate purposes that might prompt the application of proposed s. 55(2): a significant reduction of a capital gain; a significant reduction in value; and a significant increase in the cost of property. It is important to remember that each test must be applied separately. Even if there is no accrued gain on the share that is reduced by a dividend, the significant reduction in fair market value test might still apply. The new rule in s. 55(2.5) is clear that even if a share has nominal fair market value and potentially no accrued gain, a dividend might significantly reduce its fair market value since the value of the share must be adjusted to take into account the value of the dividend. Also, it is not necessary for the fair market value reduction to create a loss to meet the purpose test. So as Yves mentioned, the focus of new s. 55(2) has changed. It now applies where people set the table. Therefore, it is not relevant whether the sheltering of a gain is made in the distant future or not.
No type-of-dividend exception
At the TEI meeting of last November, we were asked to consider whether the purpose tests would be met when the dividends paid up a corporate chain in various scenarios that included funding the payment of dividends or funding the general current expenses of a parent corporation or settling intragroup debt that resulted from cash pooling arrangements. Continuing what we said earlier, there is no type of automatic exemption that is based on the type of dividend paid up a corporate chain.
Under proposed paragraph 55(2.1)(b), we need to look at the purpose, and the purpose of the payment and receipt of each particular dividend. There is no consolidated approach in determining if the purpose test is met. Although the use of the funds by the parent corporation is an indication of purpose, it is not determinative by itself. It does not inform on purpose regarding the reduction of fair market value or capital gain or an increase in cost of property.
With respect to creditor proofing, as we said earlier, tests in proposed s. 55(2.1)(b) are not limited to actual dispositions but they also apply to cost creations or reduction in fair market value without a disposition. The purpose of creditor proofing is to reduce the fair market value of a share or to increase the cost base of property by the creation of a note, which is squarely within the provision. We can presume that the reduction or increase will be significant. If the dividend is paid for one of those purposes, the fact that there is also an intention to protect the assets of the corporation against its creditors does not change that conclusion. In fact there will always be another intention behind the payment of a dividend.
No reversal of incentive deductions
We have also heard the argument that low safe income that results from accelerated depreciation or favourable tax rules for some business activities should not prevent the distribution of retained earnings. In such case, the tax break is provided at the corporate level. The application of s. 55(2) to a distribution of cash surplus to another corporation in the form of a dividend where one of the purposes of such dividend is described in s. 55(2.1)(b) is not incompatible with that scheme. The policy that applies to the earnings of a corporation does not normally extend to the shareholder.
No blanket public corp exemptions
Finally, we were surprised to see that the example on the public corporation paying dividends became a focal point in discussions about purpose. In our view, trying to come up with a broad category of exemptions would not only be impossible because every set of circumstances is different, but it would result in confusion due to misinterpretation and unintended application.
Finally, just a few words on loss consolidation arrangements. At the 2015 Roundtable at the CTF annual conference, we stated that loss consolidation arrangements that are only designed to move losses between related or affiliated corporations and on which we have ruled favourably in the past would not be considered to have a purpose described in proposed s. 55(2.1). As we have said before, since the release of our proposed amendments, we have issued several favourable rulings for conventional loss consolidation arrangements. These are situations where we were provided with all the relevant facts and assurance that the sole purpose of the dividend is to provide a reasonable return on the preferred shares and to accommodate the loss consolidation arrangement, that the spread between the interest rate and the dividend rate was within an acceptable range and also assurance that any cost that would be created as part of the arrangement would be eliminated as a result of the unwind of the structure.
S. 55(3)(a) transactions
No basis bump
Yves Moreno. The main change in proposed s. 55(3)(a) is that it is now restricted to some types of dividends, basically deemed dividends under s. 84(2) or (3), partly because in those circumstances the cost base of the share that gets cancelled is thereby eliminated.
Undue preservation of ACB
There is still a possibility of abuse even under the new provision as it is proposed to read. As was mentioned by the CRA in a previous Roundtable back in 2015 (and a technical interpretation also was issued on the point), if the result is not consistent with the intent of the provision as it is to be amended, the CRA might consider the application of GAAR in those circumstances. I would also like to reiterate the CRA’s concern about shifting or streaming transactions where ACB is unduly preserved, and in those circumstances the current concern of the CRA remains.
Timing/discretionary dividend issue
Safe income determination time
There is a timing element in the definition of safe income determination time that might cause issues (and concerns were expressed in the past). It deals with the fact that the determination time ends immediately before the dividend that is part of a series is paid. There might be timing issues in some circumstances, for example, where property is sold resulting in an income inclusion for the corporation, but the income inclusion occurs after the safe income determination time. A recent technical interpretation mentions that the CRA will consider in those circumstances that the proceeds of disposition that are distributed as part of a dividend would be considered to be protected by safe income to the extent that there is corresponding income inclusion as recapture or under section 14.
There was some discussion about the CRA’s position on the June 8th seminar. The slides summarize the CRA’s positions and we would like to refer you to that material. We do not have time to go over that as part of this presentation.
We would just like to emphasize two elements. Discretionary dividends might give rise to two sets of issues. The first one is a valuation issue. It goes to a number of things. But the valuation concern is that once the dividend is declared on the share, what is the value of the share? On the declaration of the dividend, does the value of the share increase to reflect that additional dividend that the shareholder is entitled to receive. The terms of the shares would have to be considered (which might be on a case by case determination), and the Income Tax Rulings Directorate is not in a position to provide valuation issues in those circumstances, so that the various positions that we are taking were based on different hypotheses.
It might be a bit involved to consider the different variations as part of this presentation, but the valuation issue would be of concern in two respects. The first one is the allocation of the safe income to that share, so that such allocation would have to be done - and the words of the provision are that the safe income exception applies to the extent that it could reasonably be considered to contribute to the gain on the share. If the value of the share goes up, the gain would go up, and would it be reasonable to allocate safe income to that share? Again, there are a number of positions on that. The CRA in those positions has been describing approaches that it would view as being a reasonable allocation under the terms of the Act. The CRA has also been trying to preserve the objective of s. 55(2) which, again, is to prevent the duplication of taxes. So in some circumstances the safe income adjustments of different accounts would be done on that basis.
So valuation is one concern. Value shifting would be another concern. If the value of a share goes up, or if property of the corporation on the payment of a dividend goes to the holder of the discretionary share, other shareholders or other classes of shares might drop in value. That would have some bearing on the safe income allocation. Again, it would require a case by case determination. In some circumstances it might also give rise to other concerns that have been expressed by the CRA, respecting subsection 15(1) or 69(1) or the implications of the GAAR.
One last comment on discretionary shares: in the context of butterflies, because of the valuation issues I was describing, the Income Tax Rulings Directorate will not be in a position to confirm in the context of a butterfly that the pro-rata requirement in s. 55(1) is met where the shares issued are discretionary. The CRA might ask that the terms of those shares be changed in order to be able to issue a favourable ruling under s. 55(3)(b).
Purpose, not results, test
Annie Mailhot-Gamelin. In conclusion, we would like to emphasize a couple of points that were discussed during this presentation. First, the purpose test is not a results test. In determining whether the purpose test is met, we will follow the guidelines that were established in Ludco. That purpose has to be objectively determined guided by both subjective and objective manifestations of purpose.
Pillar of integration
Yves Moreno. We encourage the taxpayer to compute their safe income. As we mentioned, the concept of safe income is one of the pillars of integration, along with s. 55(2), s. 112(1) and the concept of ACB. There have been some concerns expressed about the fact that the corporation might have some tax benefit that reduces its income, hence reducing the safe income of the corporation that can be passed on to its shareholders and whether those results are consistent – but, in the CRA’s view, safe income appropriately reflects the fact that the benefit of the lower income of the corporation is its benefit and does not extend to the shareholders.
No blanket safe harbours
Annie Mailhot-Gamelin. Also, trying to come up with a broad category of exemptions for certain types of dividends would not only be impossible, because every set of circumstances is different, but it would also result in confusion due to misinterpretation and unintended applications.
Open to ruling requests
Yves Moreno. Perhaps we can conclude by saying that we are open to considering ruling requests involving the application of proposed s. 55(2). We have issued opinions in that respect already, subject to the requirement that we should be provided with ample information: enough information to be able to make that determination whether the facts support the lack of purpose as alleged by the taxpayer.