There is a policy incoherence between Holdco redeeming or selling its Opco shares

The bifurcation rules in s. 55(5)(f) (or s. 55(2.3) for high-low stock dividends) frustrate the creation of capital dividend account to the extent that the built-in capital gain in shares is attributable to safe income on hand of the dividend payer – but only in the context of s. 55. On the other hand, a holding company that realizes a capital gain on a disposition of its shares of an operating company (Opco) by other means, such as a sale, can still increase its CDA respecting its capital gain, irrespective of whether any portion thereof derives from appreciation in the shares caused by after-tax retained earnings.

This policy incoherence can be illustrated by the situation where 1/3 of the shares of Opco, having nominal paid-up capital and adjusted cost base, and safe income on hand of $30 as compared to their fair market value of $100, are held by Holdco A.

If Holdco A sells its shares to another corporation (Holdco B), although there is safe income of $30, the bifurcation rules do not apply because Opco did not pay a taxable dividend to Holdco A. Thus, Holdco A's capital gain increases its CDA by $100. Holdco A can distribute its sale proceeds to A as a capital dividend and an ineligible dividend so as to achieve an effective combined tax rate approximating that applicable to capital gains realized directly by Mr. A.

In contrast, if Opco redeems its shares held by Holdco A, s. 55(5)(f) bifurcates the resulting deemed dividend into a safe income dividend of $30 and a non-safe income dividend of $70 for s. 55 purposes. S. 55(2) recharacterizes the non-safe dividend as a deemed capital gain in the amount of $70. Only this smaller $70 amount increases Holdco A's CDA. As the safe income dividend reduced the quantum of the deemed capital gain, Opco's safe income on hand that is attributable to its redeemed shares cannot be surplus stripped. This is a punitive result.

Finance …sought, through its withdrawn proposed section 246.1, to deny CDA created on an internal reorganization that was not caught by subsection 55(2) but which could have facilitated surplus stripping. Upon the abandonment of that measure, there is no clear tax policy against surplus stripping achieved through realizing the economic value of a corporation's safe income on hand by a sale of shares that does not invoke the bifurcation rules. Further, withdrawal of proposed section 246.1 indicates that there is no abuse from surplus stripping through so-called "mixing-and-matching" distribution.

Neal Armstrong. Summaries of Rick McLean, Jeff Oldewening and Jonas Lau, "Capital Gains Stripping and Surplus Stripping," 2017 Annual CTF Conference draft paper under s. 55(5)(f), s. 89(1) – CDA – (a)(i), s. 52(3)(a)(ii) and s. 53(1)(b)(ii).