9 February 2004 Internal T.I. 2004-0059891I7 - safe income - intercorporate dividends

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 dividends paid on preferred shares within a corporate group are included in safe income where the payor did not earn any net income during the period that the shares were outstanding

Position: based on the facts of this case such dividends could be included in safe income of the recipient

Reasons: when the dividends were paid they would reduce the safe income attributable to the common shareholders, therefore, it is not inappropriate for them to be included in the recipient's safe income

February 9, 2004

Technical Applications and Valuations Division	Reorganizations and Compliance Programs Branch	Resources Division
Place de Ville, Tower B	Ted Harris
112 Kent Street, 13th Floor	(613) 957-2114

Attention: Rob Ferrari
Corporate Section 2004-005989

Income Earned or Realized

We are writing in response to your request for our views as to whether "income earned or realized" within the meaning of paragraph 55(5)(b) or (c) of the Income Tax Act (the "Act") refers to income for a taxation year as computed under Division B of Part I of the Act or taxable income determined under subsection 2(2).

You have described a situation where a corporation (Aco) that is a member of a related corporate group held non-voting, non-participating preferred shares of two other corporations (Bco and Cco) that are also members of the same corporate group. The preferred shares of Bco and Cco owned by Aco entitled Aco to receive cumulative annual dividends at a pre-determined rate. Each of Bco and Cco paid dividends on their preferred shares held by Aco. These preferred shares of Bco and Cco were redeemed in XXXXXXXXXX. In XXXXXXXXXX, the common shares of Aco were sold to an arm's length purchaser; however, before the sale Aco paid a substantial dividend to its corporate shareholder. The amount of this dividend did not exceed the aggregate dividends received by Aco on the preferred shares of Bco and Cco.

Based on discussions with the auditor, we understand that during the period that these preferred shares were held, Bco earned sufficient safe income to cover the dividends paid to Aco but Cco did not earn any net income. The TSO auditor, however, believed that Cco had "income earned or realized" which was earned prior to the issue of the non-participating preferred shares to Aco.

As we understand your question, the issue is whether, in the circumstances described above, the dividends received by Aco would be included in its safe income such that the dividend paid by Aco would be attributable to Aco's safe income on hand.

Our Comments

It has always been the position of the CRA that the expression "income earned or realized after 1971" (i.e. "safe income") refers to a corporation's net income determined pursuant to the provisions of division B of Part I of the Act, as adjusted by paragraph 55(5)(b) or (c), as the case may be, that is attributable to the particular share during the relevant holding period.¹ This position was confirmed in 454538 Ontario Ltd. v. M.N.R., 93 DTC 427, where Judge Sarchuk, stated at page 435 that "income earned or realized' is income determined pursuant to the provisions found in Division B of Part I of the Act". Both the Tax Court and Federal Court of Appeal cited this passage with approval in their respective reasons for judgment in the case of Kruco Inc. (2001 DTC 668 [TCC]; 2003 DTC 5506 [FCA]).

In addition, with respect to dividends paid within a corporate group, it is the Agency's position that safe income cannot be created through the payment of intercorporate dividends, i.e. that a dividend would only be included in the recipient's safe income calculation if it were paid out of safe income on hand of the payor.²

The Agency has taken the position that the computation of safe income with respect to a share is generally confined to the holding period of the share as it is only income earned during this period that can contribute to the gain on the share i.e. any income earned prior to the holding period will be reflected in the fair market value of the share at the time of its acquisition and should thus be included in its adjusted cost base at the time of acquisition.³ However, in the case of a preferred share that is issued for a cash subscription price that is equal to its redemption amount, the entitlement to participate in the safe income of the issuer is restricted to the dividend entitlement of the share.⁴

During our telephone conversation, the auditor indicated that Cco earned no income during the period that Aco owned the preferred shares of Cco; however, he believes that Cco had income earned or realized in periods preceding the issue of the preferred shares to Aco. If this were the case, the dividends paid by Cco on the preferred shares owned by Aco would reduce the safe income available to the common shareholder of Cco.⁵ In such circumstances, we do not think it would be unreasonable to permit such dividends to be included in the safe income of Aco and, in our view, such a conclusion would not be inconsistent with the Agency's position that safe income can not be created by the payment of dividends in a corporate chain. The payment of dividends on the Cco preferred shares does not create safe income but merely reallocates it from the holder of the common shares of Cco to Aco, the holder of Cco's preferred shares. Also, this position would seem to be supported by the Agency's response to question 25 of the Round Table on Federal Taxation at the 2003 APFF Conference which made the following comments on the subject of intercorporate dividends,

"...the CCRA's position has always been that, with respect to a corporate group, where it would be considered that the safe income of the subsidiary would be reduced because of the intercorporate dividend, the parent company's safe income would be increased by an equivalent amount."

If you would like to discuss this matter further, please contact Ted Harris at 957-2114.

We trust that our comments will be of assistance.

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Planning Branch
ENDNOTES

¹ See John R. Robertson, "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55" in the 1981 Canadian Tax Foundation Conference Report, pages 81 - 109, at page 83; also question 12 of the 1993 Revenue Canada Round Table in the 1993 Canadian Tax Foundation Conference Report at page 58:7.

² See Robertson supra at page 87.

³ See Robertson supra at page 84.

⁴ See Robertson supra at page 85 - 86.

⁵ See Robertson supra at subparagraph (ii) on page 88

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