This page summarizes oral remarks made at the 28 November 2023 CTF Conference held in Montreal in the CRA presentation, "CRA Update on Subsection 55(2) and Safe Income - Where Are We Now?" Those remarks summarized a paper on this topic that was being prepared by the CRA. CRA also provided a set of slides, and various of those slides are incorporated in this summary. The presenters were:

Marc Ton-That, Special advisor to the Reorganizations Division

Stéphane Prud'Homme, Director, Reorganizations Division

Full paper released on 22 December 2023.

Introduction

Prud'Homme: The CRA recognizes the need to provide guidance and information to taxpayers and their tax advisors so that they can better fulfill their tax obligations, and the CRA hopes that its position paper on safe income will be a significant contribution towards that goal. Throughout this exercise, the objective has been to take a balanced and reasonable approach.

Refer to the full paper, when published, for more detailed and authoritative coverage.

Purpose of the paper

The CRA thought it was time to write an update on the CRA position on s. 55(2) and safe income. Various fundamental concepts are presented. However, it should be noted that the presentation is not a fresh start: it is not a comprehensive discussion of the safe income concept, and various positions in the paper have already been discussed in recent years. Also discussed are the concept of safe income on hand and the allocation of safe income on corporate reorganizations.

Structure of the Paper

This paper goes through the following topics:

the s. 112(1) deduction and the concept of cost;
the role of s. 55(2);
the operation of s. 55(2) and s. 55(3)(a);
various topics on safe income; and, finally,
the allocation (or split) of safe income on corporate reorganizations.

In arriving at the positions in the paper, we have followed the textual, contextual and purpose approach to interpretation of the provision as mandated by courts. The goal was to come up with a balanced and reasonable approach. However, in some cases, CRA has adopted positions that are based on practical realities.

S. 112(1) deduction and the concept of cost

Prud'Homme: Intercorporate dividends are tax-free because of the deduction provided in s. 112(1). The underlying principle is to eliminate duplication of tax on already-taxed income as it moves through a corporate chain, by exempting the income from additional tax when it was already subject to tax in another corporation.

Turning to cost, the cost that a taxpayer has in a property reflects the price paid to acquire the property with after-tax funds. There are rules in the Act to ensure that cost is not created without incurring tax. The result is that there is no creation of tax-free cost base –this is a fundamental principle under the Act. When a property is received by a corporate shareholder as a dividend, the payment of the dividend is normally made with after-tax money of the corporate payor, and the cost of the property to the dividend recipient would be attributable to after-tax funds. This result is in line with policy.

However, there would be a lack of corporate tax integration where corporate shareholders receive property on the payment of a dividend that is not taxable, and the cost of the property received is greater than the amount of tax which has been paid by either the dividend payor or the dividend recipient. Thus, the concept of cost under s. 55(2) has two common objectives: first, to prevent the duplication of corporate tax; and second, to ensure that tax is paid on the dividend when such dividend is not supported by income that was subject to tax.

The point being made here is that s. 112(1) and s. 55(2) on the concept of cost are pieces of the legislative puzzle that work together in order to achieve a result that is in line with policy.

S. 55(2.1)(c) and the question of “what is safe income”

Prud'Homme: Very briefly, clearly the 2015 legislative amendments have resulted in a renewed focus on s. 55(2) and the notion of safe income. Looking at s. 55(2.1)(c), the entitlement to safe income now hinges on whether the income earned or realized could reasonably be considered to contribute to the accrued gain on the shares, the theory being that the income earned or realized could somehow contribute to the increase in the value of the shares. The concept of safe income is paramount because the proper calculation of safe income would assist two things: the avoidance of double taxation; and the avoidance of non-taxation. Again, the main crux of the safe income notion is in two words in s. 55(2.1)(c) – “reasonably” and “contribute.” The proper interpretation of those two words is crucial.

Ton-That: The legislation is minimalistic. Detailed legislation would be very complex and lengthy, which Finance wished to avoid. The complexity of such legislation would be considered to be unwarranted by Parliament and therefore a reasonable approach is required. It is expected that all parties take a reasonable approach in calculating safe income.

Because the legislation is minimalistic, it would be incorrect to argue that the legislation on safe income is a complete code given its jurisprudential and legislative history. And it would also not be correct to adopt a textual approach that ignored its context within the scheme of s. 55(2).

History of safe income on hand

Ton-That: This is a very complex topic, but this presentation will try to simplify it as much as possible, at the risk of losing some things.

Safe income on hand is income that could reasonably be considered to contribute to the capital gain - one takes an amount of income and an amount of gain and tries to determine whether the income contributes to the gain. The concept of “income” does not always point to “real” income, and is sometimes a tax fiction. The gain is also based on something that is particularly based on a tax fiction – ACB is a tax fiction (although fair market value is real).

Thus, one is trying to fit an amount of income into a gain, which is like trying to fit a square peg into a round hole. The legislation requires the calculation of income that could reasonably be considered to contribute to the capital gain. Again, the two words that are very important here are “reasonably” and “contribute”. In the interpretation of safe income, one must try to bridge the gap between the real and the unreal. It’s not linear. It is necessary to understand what the legislature was trying to do here. Basically, it was trying to give taxpayers the potential to reduce the gain to the extent that the gain is attributable to the income, or to the extent that the income can be viewed as contributing to the gain.

Before the 2015 amendment, s. 55(2) provided that if a dividend was received, and the dividend had the purpose or result of reducing a portion of the gain that could reasonably be considered to be attributable to anything other than income earned or realized, then that portion of the dividend would be taxable under s. 55(2).

Under that legislation, the problem was how to determine that a gain was attributable to income earned or realized. One way that the CRA came up with to facilitate the determination of safe income was to say, look at your income – one dollar of gain is attributable to one dollar of income, and that should be your safe income. But that is not true, because safe income is the income to which the capital gain is attributable. If you have determined that there is $100 of income and there is $20 of “phantom income,” or that $20 of that income will be paid out as a dividend or paid out as taxes, the safe income should be $80, not $100.

CRA came up with the notion of “safe income on hand.” If there is $100 of income but then $20 is spent on something else, what is “on hand” to support the gain is $80.

But speaking in terms of safe income on hand is quite confusing. Before, when one talked about gain that is attributable to income earned or realized, then the safe income would be the amount of the income to which the gain is attributable. But now speaking of “safe income on hand” one has to look at whether the income has been retained, etc. That is unhelpful and lends itself to bad interpretation. After starting with an amount of income, and determining what part of the gain is attributable to that income, one now seemingly had to apply a requirement that such income have been “on hand” in order to support that gain. That means that after the income has already been determined, one must look to see what is on hand. Therefore, one can only modify the amount of income for whatever happens after the declaration of the income. That lends itself to an interpretation that was not desired because the actual test is that for the income to be safe income, it must be the income to which the capital gain is attributable (prior to the 2015 amendment) or it must be income that contributes to the capital gain.

Safe income on hand no longer relevant

Ton-That: The CRA is now saying that the safe income on hand concept is no longer relevant. This is so because under today’s legislation, the amount of gain is not modified to fit with the income. The legislation today states that, if a dividend is paid and that dividend exceeds the amount of income that can reasonably be considered to contribute to the gain, that dividend is taxed. The question to be asked is, what is the amount of income that would be considered to contribute to the gain? There is no more of the two-stage inquiry dictated by Kruco. Income is calculated under s. 3, modified by s. 55(5), and then one is to ask: “which portion of that income can be considered to contribute to the capital gain?”

If there is an amount of income that is calculated under s. 3, and then s. 55(5), that is $100, and $20 of that will be paid as taxes or dividends, or $20 of that is phantom income that does not support at all the gain, then $80 of that $100 would be considered to be the income that is reasonably considered to contribute to the capital gain. Thus, only a portion of that income could constitute the safe income that is considered to contribute to the gain.

Obviously, an amount of income that is no longer available for the purpose of paying a dividend should not be viewed as contributing to the gain. But the question that should be asked now is not whether the income is “on hand” or “available” for the purpose of paying a dividend after its calculation. The question is whether the amount of income that is calculated or a portion of such amount can be viewed as contributing to the gain.

What, then, is the essence of safe income? One must try to see whether the income can represent something that is real, that can support the gain that is real. The safe income should represent tangible assets that will continue to exist to support the value of the shares and therefore the capital gain on the shares.

The fundamental question is still the same: prior to the 2015 amendment, one had to determine the income that was an amount to which the gain was attributable. Today, one still asks the question of whether the income can be used to contribute to that capital gain. The section still tries to bridge the gap between the real and the unreal. The question is still the same, but the approach is different. The approach is no longer to do the two-step inquiry. The inquiry is now one step: there is an amount of income; what is the amount of that income that is contributing to the capital gain?

This is not an easy exercise. That is why one has to exercise judgment, restraint, and be reasonable to be able to arrive at the result that Finance or Parliament intends.

Calculation of safe income

Example 7

Prud'Homme: Here is the first example dealing with the calculation of safe income.

Opco was incorporated with no capital contribution. Opco realized an amount of income of $1,000 during the relevant period. Opco then reinvested that income such that, at the end of the period, the balance sheet shows cash of $200, acquired inventory of $300, and real property of $500. Unfortunately, the real property lost value and its FMV is now $250. For simplicity, assume that Opco has no liabilities. Opco also has intangible assets that are now valued at the end of the period at $400. The Opco shares are worth $1,150.

We can clearly see here that the $1,000 of income earned has not retained its value, because only $750 can reasonably be considered as contributing to the gain. That $750 is essentially reflected in the cash, inventory and real property. The $400 is attributable to the unrealized value linked to the intangibles.

However, where there is a loss on a property that is accrued and not realized, it should not reduce safe income. That is the practical approach that the CRA is taking here. In this situation, the safe income will remain at $1,000 despite the accrued loss. However, if the real estate is sold so that the loss is realized, then the safe income will be reduced by the amount of the deductible capital loss, whether or not that loss is claimed when it is realized. As a technical matter, for private corporations, the non-deductible portion of the capital loss will reduce the CDA and, for non-private corporations, the non-deductible portion of the capital loss would also reduce safe income based on s. 55(5)(b)(ii).

Example 12

Prud'Homme: This example has a favourable end result.

In Year 1, Holdco1 transfers assets to Opco on a rollover basis in consideration for preferred shares. Assume that the transferred assets consisted of goodwill with a value of $500 and nominal cost amount. Holdco2 subscribes for common shares of Opco for a nominal amount and, during the relevant period, Opco earns safe income of $500 that is represented by cash held by Opco. Assume that the value of the common shares is $500 at that point in time, so that the safe income of $500 can reasonably be considered to contribute to the gain on the common shares of Opco held by Holdco2.

Opco redeems the preferred shares held by Holdco1 in consideration for the $500 of cash, such that there are no assets remaining in Opco afterwards except for the goodwill. The question is, how much safe income is there at that point on the Opco common shares? In the CRA’s view, there should still be $500 of safe income on the Opco common shares for the following reasons:

First, a redemption of the preferred shares should not affect the entitlement to the safe income of the common shares, because the preferred shares do not participate in the income earned or realized by Opco. Therefore, no safe income should be considered to have been paid to Holdco1 in the context of the redemption of the preferred shares.

The second point is linked to the value of the common shares. Although the cash was used to redeem the preferred shares, there was no reduction in the value of the common shares because the value of the common shares was supported by the other assets of Opco – here, it is the goodwill. It is important to recognize that Opco could have borrowed money to redeem the preferred shares and, if it had done so, clearly there would be no reduction in the safe income of the Opco common shares. Why should the use of existing cash instead of borrowed money change the result?

Thus, it can be seen that the CRA is not engaged in a strict tracing exercise. The corporation is not static, and the assets that are generated by safe income can also be used to acquire other properties, so ultimately, in this situation, the $500 of safe income earned still contributes to the value of the common shares after the redemption of the preferred shares, because the cash generated by the safe income has been substituted with other assets of Opco.

Changes in position

Prud'Homme: The CRA has three changes in position that are favourable to taxpayers:

Contingent liabilities, reserves, losses, phantom income, non-deductible expenses, and prepaid expenses

The CRA’s previous position was that all contingent liabilities and reserves reduce safe income. Its new position is that the contingent liabilities or reserves reduce safe income only if they reduce or have the potential to reduce the income of the corporation on materialization. There is no immediate effect on safe income if they are capital in nature.

Income taxes paid or accrued

Income taxes paid or accrued reduce safe income because an amount to be set aside to pay taxes cannot reasonably be considered to contribute to the gain on the shares, as the amount of the taxes would result in a discount in the value of the shares.

CRA’s previous position was that refundable taxes were only included in income when received.

Its new position is that the portion of refundable taxes that will be reimbursed due to a payment of a dividend before the end of the taxation year will be considered to be a reduction of such taxes paid or accrued. The refundable taxes that are not reimbursed due to any payment of dividends being after the end of the taxation year will be included in safe income, if and when they are received by the corporation.

Realization of gain accrued at the time of acquisition

Assume a transfer of property with an accrued gain to a corporation on a rollover basis in consideration for preferred shares. When the property is disposed of and the gain is realized, should that gain be included in the income of the preferred shares?

The previous CRA position was: “no way,” i.e., the accrued gain at the time of the property transfer cannot be included in the safe income that contributes to the gain on the preferred shares.

The new position is that the accrued gain at the time of the transfer of the property is considered to contribute to the gain on the preferred shares. Therefore, that gain should be included in the safe income of the preferred shares when realized.

Ton-That: CRA has taken this new favourable position but, by the same token, one should realize that, if there is a gain on the sale of the rollover property (say, after the redemption of the preferred shares), that gain cannot be included in the safe income of the common shares, i.e., they do not participate in that safe income.

Such gain does not at all contribute to the value of the common shares; and the redemption of the preferred shares does not affect the value of the common shares. Thus, the sale of such property does not contribute to the gain on the common shares. CRA recognizes that, in that situation, one has to do some tracing to determine which property has been received on a rollover basis, in exchange for the preferred shares. This is a practical inconvenience that is outweighed by the reasonableness of this approach.

Does the exclusion of “phantom income” from safe income result in double taxation?

Ton-That: There is a misconception that the non-inclusion of phantom income in the computation of safe income results in double taxation.

Phantom income is income for tax purposes that is not supported by any tangible cashflow. For example, an investment tax credit has been added back to income, it is like thin-air income –one has obtained nothing from it. Thus, phantom income cannot be included in the calculation of safe income because it does not contribute to the value of the shares and, hence, to the capital gain on the shares.

Could that non-inclusion result in double taxation? This notion seems to come from the Tax Court in Kruco, which stated that, where phantom income is taxed in a corporation and a corresponding amount is taxed again in the hands of a shareholder, then there has been double taxation.

Note the use of the words “corresponding amount.” What does that mean? The CRA believes that the court in Kruco at the TCC level was following the argument of appellant’s counsel that the essence or basis of the system is that after-tax income is to pass tax-free from one corporation to another, so as to avoid double taxation. Note the words “pass tax-free”. What does it mean for income to “pass” to another corporation? The Benson report, discussing the s. 112 exemption, stated that “If this exemption were not in the law, corporation tax could be collected twice, three times or even more often from the same profits before they are ultimately distributed to individual shareholders.” Double taxation refers to taxes being levied on the same profit at several levels. The technical notes to s. 112(3.1) and s. 112(5.2) stated that “the s. 112(1) deduction is intended to limit the imposition of multiple levels of corporate taxation on earnings distributed from one corporation to another.” Vern Krishna, often quoted by the courts, stated that “The policy underlying the rule that dividends between Canadian corporations should flow through on a tax-free basis is to avoid multiple taxation of income as it passes through a chain of corporations.”

What, then, is necessary to have an income pass through, or be distributed from, one corporation to another? You need tangible assets for this to occur. If the income is not represented by tangible assets, can it pass through to another corporation? The safe income shares the same objective as the s. 112 deduction regarding double taxation, i.e., eliminating duplication of tax on income moving through a corporate chain by exempting the income from additional tax.

Looking further at the words used by the Tax Court, if an amount of income has been taxed in the hands of a corporation and a “corresponding amount” is taxed in the hands of shareholders, that results in double taxation. Is that how our corporate tax system works? Ignore safe income for now. Let us examine how the corporate tax regime works, and see whether, when tax is paid on phantom income in the hands of a corporation, there is some kind of credit when something is distributed to the shareholder. Let’s go through an example where something is distributed to a shareholder.

Example (i)

There is a taxable income of $100 received in cash. Tax of $30 is paid on that income. After-tax income is $70. Of course, in this situation, there is an amount that can be distributed, and that can pass through to another corporation. So if the $70 is distributed, it is safe income, protected from double taxation.

Example (ii)

Consider now the situation where there is income earned but no cash, so it is just fictional income of $100. Tax is paid of $30, with after-tax income of $70 – so that the corporation is in the hole by $30. Nothing can be paid as a dividend. Where is the double taxation?

Example (iii)

Holdco has invested in shares of Aco, having a nil ACB and FMV. Aco has phantom income of $100, which is subject to tax of $30. What would be the tax consequences (dealing just with the corporate tax regime, and not yet looking at safe income) if Holdco sold the shares of Aco for nil, would it realize a loss? If Holdco had been given some kind of credit or compensation corresponding to the amount of the income that had been taxed in the hands of Aco, then, yes, Holdco would have some sort of loss on its sale of Aco. But this example is under a corporate tax regime and not a partnership regime. If Aco were a partnership, the $100 of income would be added to the ACB of Holdco’s partnership interest, because the income of the partnership would be allocated to Holdco and taxed in its hands. This income normally produces an ACB increase - but, for the moment we are working within the corporate tax regime and, in that context, there is no such thing as allocation to increase of the ACB of the shares because some income has been taxed in the hands of the corporation.

In this situation, if Holdco sold its Aco shares for nil, there are no tax consequence. Phantom income of $100 does not result in any loss to Holdco. At most, if Holdco had to inject $30 into Aco to allow it to pay the taxes, then Holdco would realize a loss on the sale of Aco of $30. That is because it lost $30 by giving Aco $30 to pay for the taxes. That is the most that it can obtain.

Example (iv)

In another example, Holdco has shares in Aco with an ACB of 0, and an FMV of $30 because Aco has $30 in intangibles. Now Aco earns phantom income of $100. What would be the tax consequences on the sale of intangibles by Aco for $30? Is there anything in the corporate tax regime that would indicate that the tax paid on the phantom income of $100 would give rise to some kind of credit on the sale of the intangibles? No – there is no such thing.

When Holdco sold the shares of Aco for $30, the $30 is derived from the value of the intangibles. Are we saying now that, if Aco has paid tax on phantom income, a corresponding amount, equal to the phantom income on which Aco has paid tax, should be credited in the hands of Holdco? That would essentially exempt from tax a sale of shares of Aco, the value of which is derived from the intangibles. That is not how the corporate tax regime works. Phantom income has no impact on this.

The next question is, does the safe income regime exist to alter, modify or change the corporate taxation regime here, or to compensate for the lack of recognition for the taxes that have been paid on the phantom income that is not supported by any tangible cash inflow? The answer is an emphatic no. As for the non-inclusion of phantom income in the safe income calculation, the phantom income has been taxed, the non-inclusion of the phantom income in safe income is the right result and it is in accordance with the corporate tax regime and does not result in any double taxation.

Safe income in a corporate chain

Ton-That: Now, for an example illustrating the movement of safe income.

Opco has generated safe income of $300, called direct safe income (DSI).

Holdco3 owns Opco. Because it owns Opco, its indirect safe income (ISI), being the safe income in the hands of Opco, is $300. It has also earned income itself of $200, so that it has DSI of $200, and ISI of $300.

Holdco2, which owns shares of Holdco3, has earned DSI of $100, and its ISI is the sum of the DSIs of Holdco3 and Opco, or $500.

Holdco1 (holding Holdco2) has ISI of $600.

If Holdco3 pays a dividend of $300 to Holdco2, Holdco3 reduces its direct safe income from $200 by $300 so it would be in the negative, with negative direct safe income of $100. That will become direct safe income of Holdco2, and that will also reduce the indirect safe income of Holdco2. When you go through the paper, you will see that sum.

Example 21

This example illustrates another safe income, direct safe income/indirect safe income concept.

Newco has shares in Subco2 with an ACB of 0 and FMV of $500.

Subco2 has earned safe income of $350. When Holdco acquired the shares of Newco, Newco had already earned $200 of safe income. At that time, because Subco2 had already earned $200 of safe income, Holdco acquired the shares of Newco for an ACB of $300. It means that, at that time, the safe income of $200 of Subco2 has somehow found its way into the ACB of the shares of Newco that were held by Holdco.

Safe income of $350 could be paid from Subco2 to Newco. Newco would be entitled to safe income of $350 in Subco2. But if, in turn, Newco paid a dividend of $350 to Holdco, that would be an issue because, when Subco2 paid a dividend of $350 to Newco, it only transferred the indirect safe income of $150 into direct safe income. The rest was gone: the $200 extra, had been capitalized in the ACB of the shares of Newco held by Holdco, so it should not increase safe income. If a dividend of $350 is paid from Newco to Holdco, then s. 55(2) might apply to the amount in excess of $150.

Safe income split on corporate reorg (Examples 15 and subsequent)

Ton-That: This will summarize the main principles driving the CRA’s thinking here. When looking at the basis of the assets downstairs, that basis needs to come from somewhere.

Safe income will contribute to the cost of property, at least in part; capital invested has also contributed to the cost of property; and, finally, liabilities have also contributed to the cost of property. That said, one must be practical here because it is impossible or very difficult to do a tracing exercise. This is why the CRA’s practical approach is saying, let’s ignore capital, and we’ll take liabilities into account by going with net cost amount of assets. So, logically, safe income has to be allocated pro-rata to the net cost amount of assets that have been separated between the corporations.

The general formula for the split of the direct safe income (e.g., a transfer from Opco to Newco) is as follows:

DSI on the shares of Newco: DSI of Opco prior to reorganization X net cost amount of the assets transferred to Newco / total net cost amount of the assets of Opco prior to the reorganization

DSI on the shares of Opco after the reorganization: DSI of Opco prior to the reorganization X net cost amount of the assets retained by Opco / total net cost amount of the assets of Opco prior to the reorganization

Ton-That: If you have an accounting background, this can be easily conceptualized – it is essentially basically a balance-sheet. On the left-hand side are assets, on the right-hand side are liabilities, capital and income/ retained earnings. The left-hand side must equal the right-hand side. We take a holistic approach – we want to look at everything. Look at safe income as capital, because you can capitalize the safe income. Moreover, we don’t want you to be able to generate cost out of thin air.

Prud'Homme: We need to be careful, here. The formula described above is an attempt to simplify the allocation of safe income. It is meant to apply in situations where there is a Holdco that wholly owns a distributing corporation (DC) and assets of DC are spun-out to a transferee corporation (TC) that is also owned by Holdco. In other words, we are talking about a corporate reorganization within the same group and where there is possibility of streaming or swapping ACB between corporations. It’s not a one-size-fits-all formula.

Regarding ACB-streaming, in some cases it could be challenged because the result can be offensive, but it is acceptable if the sole purpose of ABC-streaming is to avoid misalignment of basis.

Situation where DC is wound up

Ton-That: This example illustrates an exception to the use of the proration of safe income.

Parentco has shares in Holdco with a nil ACB and an FMV of $1,000.

Holdco has shares of DC with a nil ACB and an FMV of $1,000.

DC has current safe income of $1,000 which has been used to acquire Property A.

When DC is wound up, Holdco will receive the assets of DC. It is essentially exchanging the shares of DC, adding an ACB of $1,000 if you capitalize the safe income, for property having an ACB of $1,000. In this situation, CRA would consider the safe income of DC to have been paid up to Holdco and, therefore, Holdco would have a direct safe income of $1,000 and an indirect safe income of zero. And Holdco would receive assets having an ACB of $1,000.

Ton-That: This is another example where the formula is not used to prorate safe income.

Parentco has shares of Holdco1 with an ACB of zero, FMV of $1,000, and shares of Holdco2 with an ACB of zero and FMV of $1,000.

Holdco1 invested in DC on Day 1, so that it has an ACB of zero and an FMV of $1,000.

DC earned safe income of $1,000 when it was wholly owned by Holdco1, so that DC has direct safe income of $1,000, and Holdco 1 has indirect safe income of $1,000. Safe income of DC was used to acquire Property A with a cost of $1,000.

Holdco2 itself has earned safe income of $1,000 in the form of Property B (e.g., cash) and transferred Property B to DC with a cost and FMV of $1,000. We can see that, since the beginning, the safe income that was earned by DC belongs to Holdco1. Holdco2 has no safe income in DC.

Suppose that there was a one-winged butterfly of DC to Holdco2, with DC distributing half of Property A to Holdco2, and half of Property B to Holdco2. Half of each property would give Holdco2 an ACB of $1,000, which replaces the ACB that Holdco2 had in the shares of DC. In this situation, CRA is not going to say that the safe income of DC of $1,000 must be split on the assets that are being distributed. It should remain as is. Even though Holdco2 has received half of the cost amount of the assets of DC, the CRA would not want to say that half of the total safe income of DC has moved up to Holdco2 in this situation.

Situation 1: One-wing split-up – arm’s length

This slide illustrates the same thing. The previous example discussed the split up between the related persons, deals with the same facts in an arm’s length context. The same answer is reached – that there is no change.

Prud'Homme: Again, there is again a one-wing split-up, but this time in a related group.

Holdco1 invested in DC on Day 1.

DC earned safe income of $1,000 when it was wholly owned by Holdco1. This safe income was used to acquire Property A with a cost of $1,000.

Holdco2 also earned safe income of $1,000, which is used to invest in Property C. Holdco2 also invested in shares of DC afterwards with an ACB of 0.

DC used the investment by Holdco2 to buy Property B for an ACB of 0. The value of Property B subsequently increased to $1,000.

Now, DC does a one-wing butterfly to Holdco2. Holdco2 receives a pro-rata share of Property A and Property B. Consequently, Holdco2 has received one half of the cost-amount of the assets of DC. Its total cost amount of assets has thus increased to $1,500 at that point.

On the Holdco1 side, the outside ACB would be $1,000 (including capitalization of safe income of $1,000) but the inside ACB is $500 at that point, so there is a misalignment of basis in this situation. There is no allocation of safe income based on the formula discussed previously. What happens when the formula is applied? Essentially, the safe income that Holdco1 has in DC is reduced by one half. This is the right result, because DC has lost one half of its cost amount in the assets after the reorganization.

Turning to Holdco2, it has received one half of the safe income from DC because it has also received one half of the ACB in the assets of DC.

The result effectively shifts ACB from the Holdco1 side to the Holdco2 side. The result is not abusive because there is no misalignment of basis.

Situation 2: One-wing split-up – arm’s length

Prud'Homme: Now, for a very similar fact pattern, but in an arm’s length situation. There is a misalignment of basis. What should be done?

Again, there should be a practical approach. Where the reorganization is a bona fide split-up between arm’s length persons, there is no requirement to allocate safe income based on the formula. The safe income that Parentco2 has in Holdco2 should not change as a result of the split-up. In other words, in an arm’s length split-up, one normally should not bother with a misalignment of basis and with the allocation of safe income – again, a practical approach.

Ton-That: We have to recognize that there is a windfall to Holdco2, which has received half of the cost amount of the assets of DC so its total cost amount of assets goes from $1,000 to $1,500. On the Holdco2 side, the outside ACB is $1,000, whereas the inside ACB is $1,500, and that there is a shortfall for Holdco1.

There is a misalignment of basis because Holdco1 can simply sell the shares of DC without any negative implications and Holdco2 can sell the assets with an increased ACB.

However, because it is an arm’s length situation, the CRA is not going to challenge it.

ACB and allocation of safe income on corporate reorganization (transferring property up a chain of corporations)

Ton-That: Now for a discussion of a transfer of assets up the chain between corporations, and how it affects safe income and how safe income and ACB should be allocated.

Holdco1 has shares in Holdco2 with an ACB of $1,000.

Holdco2 has shares of Opco, also with an ACB of $1,000.

Opco has earned safe income of $4,000.

Thus, the direct safe income of Holdco2 is $4,000 and the indirect safe income of Holdco1 in Holdco2 is $4,000.

With that safe income of $4,000, and the capital invested in Opco by Holdco2 of $1,000, being $5,000, Opco has acquired Asset1 for $3,000 and Asset2 for $2,000 for a total of $5,000. Those assets have now increased in value, so that each is now worth $6,000. In total, Holdco2 would have shares in Opco with an ACB $1,000, and an FMV $12,000; and Holdco1 would have an ACB $1,000 and an FMV of $12,000 for its Holdco2 shares.

In this situation, what would happen if, at each level, each corporation were to dispose of all of its assets separately? Each scenario is different.

Examples (i)

If Holdco1 sold all its assets held by it, i.e., the shares of Holdco2, it would realize a gain of $7,000, being the proceeds of disposition of $12,000 (equal to FMV) and the ACB of $5,000, including capitalized safe income, of $4,000.

If Holdco2 sold the shares of Opco, the result is the same: proceeds of $12,000, an ACB, with capitalized safe income, of $5,000, for a gain $7,000.

If Opco sold its assets, there would be a gain of $3,000 on Asset1 and a gain of $4,000 on Asset2, for a total of $7,000.

Examples (ii)

Now consider a distribution of Asset2 from Opco to Holdco2. One way of doing so is to go through an internal reorganization under which Holdco2 transfers some shares that it held in Opco to Newco, and then Opco transfers Asset2 to Newco for shares of Newco, with a cross-redemption of shares, and Asset2 being held by Newco in the end.

On the transfer of the shares of Opco to Newco, Holdco2 is transferring half of the value of the shares. Traditionally, people would consider that because half the value of the shares was transferred, half of the ACB that they had in the shares of Opco should also be transferred. So Holdco2 would transfer $6,000 in value of shares of Opco to Newco with an ACB of $500. In the end, Newco would be wound up, so that Holdco2 owns the assets directly.

Suppose that there was no allocation of safe income between the corporations, so that Holdco2 decided to retain the safe income of $4,000 in Opco on the basis that there was nothing that told it that such safe income was gone. If Holdco1 sold the shares of Holdco2 with a FMV $12,000, with an ACB, plus capitalized safe income, of $5,000, there would be a $7,000 gain. If instead, Holdco2 sold its assets, being the shares of Opco and Asset2, it would realize proceeds of $6,000 on the shares of Opco and, because its safe income that it retained was $4,000, the total ACB with capitalized safe income would be $4,500. Thus, a gain of $1,500.

Opco sells Asset2 for proceeds of $6,000, with an ACB $2,000, for a gain of $4,000. The total gain now is $5,500. Thus, because it has done this reorganization, and safe income has not been properly allocated, Holdco2 has reduced its gain by $1,500. Opco will have a gain of $3,000 on Asset1. Is that appropriate? You can see that Holdco2 has reduced its gain by $1,500. because it has an increase of cost in Asset2 of $2,000 and it has lost only $500 of ACB in the shares of Opco, so that accounts for the $1,500.

When something like this occurs, safe income should be allocated. According to the formula provided, if safe income is allocated based on the cost amount of assets that are transferred –here, the cost amount of Asset2 is $2,000, and the total cost amount of assets before the transfer is $5,000 — there should be an allocation of $1,600 of safe income. Thus, Holdco2 would lose $1,600 of safe income, which would go into Holdco1. Holdco1 thus exchanges direct safe income of $2,400 for indirect safe income of $2,400.

In this situation, the gain of Holdco2 would be $7,100, which is more than it ought to be. The CRA would say that, when the shares of Opco were transferred to Newco, instead of allocating $500 to the shares transferred to Newco, only $400 could be allocated to those shares. That is a kind of streaming of basis. In the end, one retains shares of Opco with an ACB of $600, and that should be fine. There is a gain of $7,000.

When assets are transferred, let’s say the Opco assets to Holdco1, CRA would treat that as, first, a transfer from Opco to Holdco2, and then from Holdco 2 to Holdco1.

The takeaway should be that, where assets are transferred on a tax-free basis between corporations, the transferee corporation that receives the asset is going to receive an increase in ACB. Because of that increase in ACB, it should lose something to keep the system balanced. It should lose safe income and cost on the shares equal to the increase.

Conclusion

Ton-That: The positions the CRA is taking here were not taken lightly. The CRA made sure that they are simple, logical and reasonable. Of course when you drill down, you will have many questions. If so, please write in, and the CRA will do its best to answer your questions in the most thoughtful, logical and reasonable way within the object and spirit of s. 55(2) and the whole Act with regard to the concept of cost and capital gain.

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28 November 2023 CTF Conference - CRA Update on "S. 55(2) and Safe Income - Where Are We Now?"