This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: In the given situation where (i) two unrelated individual shareholders (M.A and M.B) of a profitable corporation (Société Payante) transfer their shares of Société Payante to their respective newly formed holding corporation (GescoA and GescoB) on a rollover basis (ii) GescoA and GescoB transfer their shares of Société Payante to Société Payante on a rollover basis for redeemable preferred shares of Société Payante and M.A and M.B subscribe to new common shares of Société Payante (iii) Société Payante redeems annually a portion of its preferred shares owned by GescoA and GescoB resulting in deemed dividends ($ 150,000) pursuant to subsection 84(3) (iv) GescoA and GescoB self-assess subsection 55(2) in respect of the deemed dividend in order to report the entire amount of the deemed dividend ($ 150,000) as proceeds of disposition of the redeemed shares pursuant to paragraph 55(2)(b) (and a resulting taxable capital gain) in an attempt to distribute annually to their respective shareholder (M.A and M.B) half ($ 75,000) of what would have been an annual subsection 82(1) dividend in the amount of $ 150,000 as a capital dividend: whether (1) the general anti-avoidance provision (GAAR) under subsection 245(2) may apply? and (2) our answer to question 1 would be different if in (ii) above, instead of M.A and M.B subscribing to the new common shares of Société Payante, a discretionary trust for the benefit of M.A and his family and a discretionary trust for the benefit of M.B and his family subscribed to the new common shares of Société Payante?
Position: (1) Yes, the GAAR may apply. (2) No.
Reasons: (1) and (2) In the particular situation, the GAAR may apply since the result of the avoidance transactions is similar to the situation in a ruling request (2004-009920) that was withdrawn because CRA`s GAAR Committee agreed that the GAAR should apply. In our opinion, the GAAR may very well be applicable whether the capital gain is realized at the corporate level as in the present case or at the individual shareholder level as in the withdrawn ruling request (2004-009920). Notwithstanding the recent decision in Gwartz et al. v. The Queen, 2013 TCC 86, the CRA intends, at the next opportunity, to demonstrate to the Court that there is a specific scheme of the Act for taxing the distribution of surplus of a Canadian corporation as a taxable dividend in the hands of individual shareholders and that there is also an overall scheme of the Act against surplus stripping.
June 18, 2013
Subject: Paragraph 55(5)(f)
This is in response to your e-mail of January 13, 2012 in which you asked us questions regarding the "Technical Interpretation" number 2011-041209 of the Canada Revenue Agency (the "CRA") on the subject of the "Designation" under paragraph 55(5)(f) of the Income Tax Act (the “Act") in the context of the particular situation described below. We apologize for the delay in responding to your request.
Unless otherwise indicated, all statutory references herein are to the provisions of the Act.
It appears to us that the situation described in your letter and hereinafter summarized could constitute an actual situation involving taxpayers. As stated in Information Circular 70-6R5, 2002, it is not the practice of the Directorate to provide comments on proposed transactions involving specific taxpayers otherwise than through advance rulings. However, we are able to offer the following general comments that may be helpful to you.
You wrote to us following the publication of the Technical Interpretation, which provided the response to a question entitled "Late Filed Paragraph 55(5)(f) Designation” posed at the 2011 Conference of l'Association de planification fiscale et financière.
The issues you raised in your email appear to arise from the position of the CRA set out in the summary of the Technical Interpretation, which you quote as follows:
CRA's long standing practice is to apply subsection 55(2) only to the excess of the taxable dividend over the safe income on hand, when issuing an assessment based on subsection 55(2). In a situation where a corporation would refuse to deduct its safe income on hand from the taxable dividend subject to subsection 55(2), for example, in order to convert the safe income on hand into a capital gain as part of a dividend stripping scheme the application of the GAAR could be raised.
You described in your email a situation ("Particular Situation") in which subsection 55(2) could apply, which we have summarized as follows:
- Two brothers ("Mr. A" and "Mr. B") resident in Canada have for several years owned in equal shares all of the common shares (the only outstanding shares) of the capital stock of a corporation ("Dividend Payor"). Dividend Payor is a "small business corporation" as defined in subsection 248(1).
2. The fair market value ("FMV") of the common shares of the capital stock of Dividend Payor is $ 3 million. These shares have a "paid-up capital" ("PUC"), as defined in subsection 89(1), and an "adjusted cost base" ("ACB"), as defined in section 54, of a nominal amount. Dividend Payor does not have "refundable dividend tax on hand", as defined in subsection 129(3) and, without having calculated it, considers that its "safe income on hand" ("SIOH") for purposes of the application of section 55 would be approximately equal to its retained earnings ("RE") of $2 million.
3. Each of Mr. A and Mr. B incorporates a corporation (hereinafter referred to as "HoldcoA" and "HoldcoB", respectively) and subscribes to one common share of the capital stock of the corporation. HoldcoA and HoldcoB are both "Canadian-controlled private corporations" ("CCPC") as defined in subsection 125(7).
4. Each of Mr. A and Mr. B then transfers his common shares of the capital stock of Dividend Payor to HoldcoA and HoldcoB, respectively, on a rollover basis under subsection 85(1). Each of them receives in exchange for the transfer only common shares of the capital stock of HoldcoA and HoldcoB, respectively, having a FMV of $1.5 million and a nominal PUC and ACB.
5. Thereafter, each of HoldcoA and HoldcoB transfers its common shares of the capital stock of Dividend Payor to the latter, on a rollover basis by virtue of subsection 85(1). Each of HoldcoA and HoldcoB receives, in exchange for the transferred shares, preferred shares of the capital stock of Dividend Payor having a FMV and a redemption amount of $1.5 million and a nominal PUC and ACB. Immediately thereafter, each of Mr. A and Mr. B subscribes in equal numbers to common shares of the capital stock of Dividend Payor.
6. Subsequently, Dividend Payor annually redeems preferred shares of its capital stock held by HoldcoA and HoldcoB, in each case, for their redemption amount of $150,000. As a result, each of HoldcoA and HoldcoB would be deemed to have received a taxable dividend (of $150,000) under paragraph 84(3)(b), the amount of which would exceed the amount (say $100,000) of its share of the Dividend Payor’s SIOH attributable to the redeemed shares.
7. You stated that the conditions for subsection 55(2) to apply annually to the dividends deemed to be received by HoldcoA and HoldcoB by virtue of paragraph 84(3)(b) are met. In fact, you stated that the test applicable in this case is a test of result and not a purpose test and that the deemed dividend received by each of them annually is not excluded from the application of subsection 55(2) by virtue of paragraph 55(3)(a). The exception in paragraph 55(3)(a) does not apply to the dividend received, for example, by HoldcoA, because that dividend was received by HoldcoA in a series of transactions in the course of which there has been a significant increase in the total direct interest in HoldcoB of Mr. B, an "unrelated person" as defined in paragraph 55(3.01)(a) to HoldcoA. In addition, this significant increase in ownership would result from a disposition of common shares of the capital stock of Dividend Payor by Mr. B to HoldcoB for proceeds of disposition lower than their fair market value given the election made under subsection 85(1) at a nominal agreed amount. The same reasoning would apply, by analogy, with respect to the deemed dividend received by HoldcoB because of the significant increase in the total direct interest of Mr. A in HoldcoA.
8. Neither HoldcoA nor HoldcoB would, pursuant to paragraph 55(5)(f), designate a portion of the taxable dividend received from Dividend Payor as a separate taxable dividend in its income tax return for the taxation year in which the dividend was received.
9. Each of HoldcoA and HoldcoB would then declare the taxable dividend received by it from Dividend Payor Payante (i.e. $ 150,000) as proceeds of disposition, pursuant to paragraph 55(2)(b). Consequently, each of HoldcoA and HoldcoB would realize a capital gain of $150,000 annually and could pay each year to its shareholder, Mr. A and Mr. B, as the case may be, a portion ($75,000) of the net proceeds of disposition after tax resulting from the repurchase of the preferred shares of the capital stock of Dividend Payor as a capital dividend (non-taxable), pursuant to subsection 83(2), and the remainder as a taxable dividend.
In your email, you also stated that in Step 5 (above), the subscription to common shares of the capital stock of Dividend Payor could be made by two discretionary family trusts for the benefit of Mr. A and his family, as well as for that of Mr. B and his family, rather than as an issue of common shares of the capital stock of Dividend Payor to Mr. A and Mr. B.
Your Questions and Your Comments
In the first place, you asked if the extract from the above Technical Interpretation means that in the particular situation:
1. Must a corporation such as Dividend Payor compute its SIOH?
2. Is it true that if HoldcoA or HoldcoB chooses not to make a Designation in respect of the deemed dividend received by it under paragraph 84(3)(b), subsection 55(2) would necessarily apply to the total amount of the dividend, having the effect of converting the entire dividend into a capital gain?
3. If the answer to question 2 above is negative, you are asking whether each of HoldcoA and HoldcoB must make a Designation in order to split the dividend it is deemed to have received under paragraph 84(3)(b) into separate taxable dividends, for example, an amount equal to its share of the SIOH of the Dividend Payor (often referred to as "Safe Dividend"), which would not be subject to subsection 55(2), and a second of the amount of the deemed dividend that exceeds the deemed Safe Dividend, which would be covered by subsection 55(2)?
Furthermore, you tell us in your email that in a situation like the Particular Situation, you are concerned that the small CCPCs among your clients do not have the financial resources to do the so-called complex calculations of the SIOH. In addition, you mention that small accounting firms like yours do not have enough human resources to do the SIOH calculations on all files. You also acknowledge that in a situation such as the Particular Situation the tax payable is less than if a simple dividend had been paid annually directly to individual shareholders by an operating company, out of its annual profits after tax.
Your last question is whether our answers to the previous questions would be the same if at Step 5 of the Particular Situation the Family Discretionary Trusts subscribed to the common shares of the capital stock of Dividend Payor rather than Mr. A. and Mr. B.
In our view, whether or not HoldcoA and HoldcoB make a Designation, the Particular Situation appears to us to constitute a stratagem for stripping the surplus of Dividend Payor to Mr. A and Mr. B to which the "general anti-avoidance rule" ("GAAR") provided for in section 245 could be applicable. Our opinion is based on the following observations.
Stripping of a Corporation’s Surplus
We are of the view that there is a specific scheme in the Act to tax any distribution or allocation of surplus (after-tax income) of a Canadian corporation as taxable dividends in the hands of its shareholders who are individuals.
That specific scheme of the Act results from paragraphs 12(1)(j), 82(1)(b), section 121, subsections 84(1) to (4) and subsection 15(1).
The taxable dividend gross-up mechanism, provided for in paragraph 82(1)(b), and the dividend tax credit in section 121 play a fundamental role in that specific scheme of the Act and are intended to ensure tax neutrality inter alia between business income earned directly by an individual, or indirectly through a corporation and then distributed to the individual shareholder by means of dividends.
That taxable dividend gross-up and dividend tax credit mechanism for an individual shareholder (the "Integration Principle") is intended to reconstruct, inter alia, business income earned through a corporation and included in the income of a particular shareholder and to give him or her credit for the tax already paid on that income by the corporation.
The Integration Principle provides for two levels of taxation: first at the level of the corporation; and second at the level of the particular shareholder.
In a corporate surplus stripping scheme, the second level of taxation at the individual shareholder level is either avoided or reduced.
It appears to us that the provisions of subsections 84(1) to (4) and subsection 15(1) are intended to counter any direct stripping of the surpluses of a Canadian corporation in favour of its shareholders who are individuals.
It also appears to us that any avoidance transaction resulting in the indirect stripping of the surpluses of a Canadian corporation in favour of an individual shareholder is subject to the possible application, inter alia, of one or another of the following anti-avoidance rules: subsections 84(2), 246(1), 84.1(1) or 245(2).
In the Particular Situation, it appears to us that the surplus of Dividend Payor is annually stripped in favour of Mr. A and Mr. B given that annual taxable dividends of $150,000 which otherwise would be paid by Dividend Payor (namely, its accumulated surplus) directly to each are, through a series of transactions entailing the insertion of Holdco A and Holdco B, converted in form into capital dividends free of tax (in the amounts of $75,000), through utilizing, inter alia, section 55.
In our view, in the Particular Situation, the insertion of Holdco A and Holdco B is part of a surplus-stripping scheme respecting Dividend Payor with a purpose of converting annual taxable dividends paid by Dividend Payor, which dividends would normally be inter-corporate dividends eligible for the subsection 112(1) deduction in the computation of taxable income of HoldcoA and HoldcoB, into proceeds of disposition of shares in a manner that abuses subsections 84(3), 55(2) and 83(2).
As part of a request for advance income tax rulings, the GAAR Committee of the CRA has already confirmed that all conditions for the application of GAAR are met in a corporate surplus stripping situation in which annual taxable dividends that otherwise would be paid to an individual shareholder are converted into a proceeds of disposition of shares giving rise to a capital gain to the individual.
In this regard, we refer you to document 2004-0099201R3 issued by our Directorate.
The situation ("Comparable Situation") in document number 2004-0099201R3 can be illustrated as follows:
1. Mr. A holds all of the common shares of the capital stock of a corporation ("Aco") that have a significant FMV and have a nominal PUC and a ACB. Aco has generated an annual operating profit for several years of more than $100,000.
2. Mr. A incorporates Bco, a corporation in which he owns all the common shares of its capital stock (the only ones outstanding) with a PUC, an ACB and a FMV of a nominal amount.
3. In a particular year, Mr. A transfers to Aco, under subsection 85(1) for an agreed amount of $100,000, a number of common shares of the capital stock of Aco with a FMV of $100,000 in exchange for 100,000 preferred shares of its capital stock with a nominal PUC and a redemption amount and FMV of $100,000. This transaction does not give rise to any dividends to Mr. A but instead a capital gain of $100,000 to him. Mr. A does not claim any capital gains deduction under section 110.6 in computing his taxable income for the particular year.
4. Subsequently and still in the same year, Mr. A transfers to Bco the 100,000 preferred shares of the capital stock of Aco that he owns in exchange for a $100,000 note issued by Bco. This transfer results in the application of section 84.1, but it has no effect since the ACB of the shares transferred having regard to paragraph 84.1(2)(a.1) is $100,000.
5. Subsequently, Aco redeems the 100,000 preferred shares of its capital stock held by Bco for cash consideration of $100,000. Such redemption gives rise to a deemed dividend paid by Aco and received by Bco under subsection 84(3) in the particular year. A deduction of an equivalent amount may be claimed by Bco under subsection 112(1). Subsection 55(2) cannot apply in these circumstances since the dividend in no way reduces the capital gain that would have been realized without the dividend. In fact, the ACB and the FMV of the shares held by Bco amount to the same amount.
6. Bco transfers to Mr. A the $100,000 cash received from the redemption of the preferred shares of the capital stock of Aco in payment of the $100,000 note due to Mr. A.
The purpose of the series of transactions in the Comparable Situation was to convert annually a taxable dividend of $100,000 payable by Aco to Mr. A into a proceeds of disposition of the shares of the capital stock of Aco giving rise to a taxable capital gain to Mr. A of $50,000 (and an equivalent non-taxable capital gain).
We are of the view that in the Particular Situation and in the Comparable Situation the result of the avoidance transactions is the same: the stripping of the surpluses of a corporation to the shareholders who are individuals by converting what should be a taxable dividend into a payment of a capital nature.
In our view and by analogy with the Comparable Situation, the GAAR could apply to a surplus stripping scheme involving the conversion of an annual taxable dividends into a capital gain, regardless of whether the capital gain is realized by a corporation (as in the Particular Situation) or by an individual as in the Comparable Situation. It follows that the GAAR could apply in the Particular Situation regardless of whether or not a Designation under paragraph 55(5)(f) is made by HoldcoA and HoldcoB.
Despite the recent decision in Gwartz et al. v. The Queen, 2013 TCC 86, the CRA proposes, at the first favourable occasion, to demonstrate to the Court that there is a specific scheme under the Act for taxing the distribution of surplus of a Canadian corporation as a taxable dividend in the hands of individual shareholders who are the taxpayers; and that there is also an overall scheme of the Act against surplus stripping.
Our position would be the same if, in the Particular Situation, a discretionary family trust for the benefit of Mr. A and his family and a discretionary family trust for the benefit of Mr. B and his family subscribed to the common shares of the capital stock of Dividend Payor rather than HoldcoA and HoldcoB, respectively. Indeed, in such a situation, the result of the avoidance transactions is the same as in the Particular Situation, namely to strip the surplus of the Dividend Payor annually.
Furthermore, as stated in the Technical Interpretation (number 2011-041209), in a situation other than one of stripping the surplus of a corporation in the course of which a deemed dividend by virtue of subsection 84(3) comes within subsection 55(2), we expect the dividend recipient to make a designation in accordance with our long-standing administrative practice of "applying subsection 55(2) ITA only in respect of the excess of the taxable dividend over the safe income on hand when an assessment is issued."
The administrative practice of the CRA referred to above is consistent with the purpose of paragraph 55(5)(f) as described by the Federal Court of Appeal in Nassau Walnut Investments Inc. v. The Queen (CA),  2 FC 279, 97 DTC 5051, at page 5059, namely:
to prevent the conversion by subsection 55(2) of an entire dividend into taxable capital gain where a portion of that dividend might be attributable to safe income:
Furthermore, the courts have repeatedly emphasized that the SIOH of a corporation should not be subject to double taxation. For example, the Federal Court of Appeal, in paragraph 13 of The Queen v. Brelco Drilling Ltd. (CA),  4 CF 35, 99 DTC 5253, made the following comments:
 Due to the operation of this phrase, to avoid double taxation, section 55(2) does not apply to a dividend (or that portion of the dividend) which can reasonably be considered to be attributed to income earned by the corporation issuing the dividend. That income is referred to colloquially as "safe income." The more "safe income" held by the corporation issuing the dividend, the larger the tax-free dividend which can be issued.
In addition, with regard to your concerns with respect to certain small and medium-sized businesses and certain small accounting offices, we would like to point out as indicated in Information Circular IC 01-01 entitled "Third-Party Civil Penalties” that “[t]he Canadian tax system is based on the principle of self-assessment” and that “[t]axpayers are responsible for filing their tax returns accurately, truthfully, and on time.” In this regard, we generally expect a professional advisor who provides tax advice to a taxpayer or who files an income tax return for the taxpayer, among other things, to reasonably calculate the taxpayer's relevant tax accounts (whether it is SIOH, or a capital dividend account).
We hope that our comments will be of assistance.
Maurice Bisson, CPA, CGA
Income Tax Rulings Directorate
and Regulatory Affairs Branch
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