CRA indicates that dividend income that has not been subject to tax should not constitute safe income, and double taxation can be avoided with proper structuring

The starting structure in Example 30 of “CRA Update on Subsection 55(2) and Safe Income” is that Holdco owned the shares of Opco with an FMV, ACB and safe income of $500, 0 and 0; and Opco owned Subco1 (whose shares also had an FMV, ACB and safe income of $500, 0 and 0) and Subco2 (whose shares had no value, ACB or safe income). Then:

1. Subco1 transfers its assets with an FMV and ACB of $500 and 0 on an s. 85(1) rollover basis to Subco2 for Subco2 shares.
2. A third-party purchaser subscribes $500 for Opco shares.
3. Subco2 redeems the shares of Subco1, Subco1 repurchases the shares of Opco, then Opco repurchases the shares of Holdco, in each case generating a $500 deemed dividend.

CRA indicated that although the deemed dividend from Subco2 to Subco1 is exempted under s. 55(3)(a) by virtue of s. 55(3.01)(g), the deemed dividend from Subco1 to Opco, and from Opco to Holdco, is subject to s. 55(2). In particular, the dividend from Subco2 is not subject to tax in the hands of Subco1 and none of the accrued gain on the assets has been realized, so that such dividend does not result in safe income to Subco1.

In response to a follow-up question, CRA indicated that the purpose of this example was merely “to illustrate the concept that a dividend income that has not been subject to tax should not constitute safe income for the benefit of a shareholder,” and stated:

The order of transactions described in the example would unlikely be implemented as such in the real world (for example, Subco1 does not need to redeem its shares held by Opco to achieve the results sought by Holdco) and a discussion on possible double-taxation in the scenario described is fruitless.

The double taxation issue was that, although “the capital gain realized by Opco on the redemption of shares of Subco1 would be included in the safe income of Opco and would not result in any double-taxation” (presumably because it would be there for potential future use), “[u]nfortunately, the deemed capital gain under subsection 55(2) would not be part of the safe income computed before the safe income determination time if all the transactions described are part of the same series of transactions” so that both Opco and Holdco would realize a capital gain. CRA further stated:

[W]e understand that transactions can be successfully implemented in a way to attract only one level of taxation if the ordering of transactions is carefully thought out … .

Neal Armstrong. Summary of 30 January 2024 External T.I. 2024-1005011E5 under s. 55(2.1)(c).