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 a situation where the capital stock of a corporation is made up of a number of classes of participating common shares, each class being entitled to dividends at the directors' discretion, how would the safe income on hand be allocated amongst the various classes of shares in a situation where a particular class has preferential rights to a certain portion of the profits?
Position: It depends on the facts and circumstances surrounding the situation. The terms of the issued and outstanding shares and of any relevant provisions of any unanimous shareholders agreement would be part of the relevant facts reviewed to reach a conclusion.
Reasons: Previous position.
Sylvie Labarre, CA
July 3, 2012
Subject: Allocation of safe income
This is in response to your e-mails of May 17 and 22, 2012 in which you requested our opinion regarding the amount of safe income on hand that would be attributable to the shares held by each of Opco's shareholders based on the facts of the following hypothetical situation.
Unless otherwise indicated, any reference to a section of legislation or any of its provisions in this document constitutes a reference to a section of the Act or any of its provisions.
Three unrelated shareholders (Shareholder 1, Shareholder 2 and Shareholder 3) held the shares of the capital of Opco. The shareholders were corporations resident in Canada.
Each of the shareholders held a separate class of shares of the capital stock of Opco (Shareholder 1 holding 100 Class A common shares, Shareholder 2 holding 100 Class B common shares and Shareholder 3 holding 100 Class C common shares).
The three separate classes of shares of the capital stock of Opco were common shares that have an entitlement to a discretionary dividend. However, since Shareholder 1 represents the next generation to continue to operate Opco and given Shareholder 1’s contribution to it, Shareholder 1, Shareholder 2 and Shareholder 3 have signed a unanimous shareholder agreement that provides for the Class A common shares being accorded a right to an exclusive and preferential dividend in the amount of $5,000.
Upon liquidation, the Class A common shares would be entitled to the amount of the $5,000 exclusive dividend if it had not been previously paid. Next, the shareholders would be entitled to receive paid-up capital in respect of the shares they hold in the capital stock of the corporation. Finally, the residual property of the corporation that exceeded the paid-up capital of the classes of shares would be shared equally among each of the common shares of the capital stock of the corporation.
Before any transaction, the paid-up capital and the adjusted cost base ("ACB") of such shares was minimal and the fair market value ("FMV") of the corporation was $21,000 divided equally among the Class A common shares, Class B common shares and Class C common shares.
The corporation increased the paid-up capital of the Class A common shares by $5,000. This increase in paid-up capital resulted in a deemed dividend paid on the Class A common shares under subsection 84(1). This amount increased the ACB of such shares by $5,000.
Prior to the increase of the paid-up capital described above, the corporation's safe income on hand would be $12,000.
Following these transactions, Shareholder 2 and Shareholder 3 withdrew from Opco and the shares they held in the shares of the capital stock of the corporation were redeemed by Opco.
You wish to know what the safe income on hand attributable to each of the common share classes of the capital stock of Opco would be in the hypothetical situation.
The determination of the safe income on hand in respect of shares of a particular corporation is based on the right of those shares to participate in the safe income on hand of the corporation and is dependent on the "holding period" of such shares. The allocation or attributing of safe income on hand between shares of the capital stock of a corporation cannot be made without knowing all the facts and circumstances surrounding a particular situation, particularly where the share capital involved includes "discretionary" dividend shares. Thus, the allocation or attributing of safe income on hand among classes of shares would require inter alia an analysis of all the rights, privileges, conditions and restrictions attached to the issued and outstanding classes of shares, as well as an analysis of relevant provisions of a shareholders' agreement, if any, and the applicable corporate law.
The general position regarding the attributing of safe income on hand to a particular class of shares of the capital stock of a corporation was provided at the 1988 Canadian Tax Foundation Conference, in Question 9 of the session, "Section 55: A Review of Current Issues". This position indicated that the income was attributable to a particular class of shares of the capital stock of a corporation on the basis of the proportion of the profits of the corporation to which that class gave entitlement, if all the profits were distributed on a winding-up of the corporation.
In M.N.R. v. Nassau Walnut Investments Inc.,  F.C.A. no. 1663 (Docket: A-262-95-IT) (Q.L.) (C.A.), Robertson, J.A. quoted the following from H.J. Kellough and P.E. MacQuillan, Taxation of Private Corporations and Their Shareholders, 2nd ed. (Toronto: Canadian Tax Foundation, 1992), at 9:33 and 9:34:
As income is earned it contributes to the value of a share of a particular class to the same extent it contributes to the value of each other share of that class...
Because the safe income is the portion of a gain that is attributable to income, it is necessary, in determining the safe income inherent in shares, to determine in what manner the income which is earned and retained by a corporation contributes to the added value of its different classes of shares. Unallocated income is part of the assets of a corporation. It is therefore necessary to determine how the shares benefit from an increase in the assets of a corporation. This can usually be determined by identifying the rights attached to the shares of the corporation and their relative priorities in the event of liquidation.
In the situation you submitted to us, we have assumed that Shareholder 1, Shareholder 2 and Shareholder 3 all acquired their shares of the capital stock of the corporation at the time of formation of the corporation. In addition, we have assumed that the deemed dividend paid on the Class A shares of the capital stock of Opco forms part of the same series of transactions or events as the redemption of the shares of the capital stock of Opco held by Shareholder 2 and Shareholder 3. Consequently, the safe income would have to be determined in advance of the payment of the deemed dividend of $5,000, as provided for in the definition of "safe-income determination time" in subsection 55(1). On the facts of your situation, that safe income on hand would be equal to $12,000.
However, that amount of $12,000 would no longer represent the amount of safe income on hand following the deemed dividend of $5,000.
As previously stated, the manner of attributing the safe income on hand to each of the classes of shares is dependent on all the rights, privileges, conditions and restrictions attached to each class of common shares.
In this situation, the unanimous shareholders agreement establishes an exclusive and preferential right for the Class A common shares of the capital stock of Opco in respect of a dividend of $5,000. Furthermore, the right to residual property upon liquidation could be different if the paid-up capital of each of the classes of the shares of the capital stock of Opco was not identical. According to our understanding, the corporation's residual property would be used primarily to repay the paid-up capital of the common shares. Subsequently, the residual property that is not distributed as a payment of the paid-up capital would be shared equally among the three classes of common shares.
Under this scenario, it may be possible to argue that the Class A common shares of the capital stock of Opco would have an additional right to the corporation’s income on the liquidation in the amount of $5,000 (which is provided for in the shareholders agreement). Consequently, apportioning the safe income on hand between each of the classes taking into account this additional amount may be reasonable. Thus, taking into account the FMV of the shares of the capital stock of the corporation in the amount of $21,000, we would then consider that the Class A common shares of the capital stock of Opco would give the right to a value of $10,333 ($5,000 + (($21,000 - $5,000)/3)). The Class B common shares and the Class C common shares of the capital stock of Opco would be entitled respectively to $5,333 (($21,000 - 5,000)/3)). The $12,000 safe income on hand would then be allocated to each of the classes of common shares based on that value. Thus, the safe income on hand of the Class A common shares before the deemed dividend would be $5,905 ($12,000 × ($10,333/$21,000)) and the safe income on hand attributable to the other two categories of shares would be $3,047 respectively ($12,000 × ($5,333/$21,000)). Under such a scenario, the deemed dividend of $5,000 would only have an impact on the incomed entitlement of the Class A common shares. It would be reduced by $5,000. Consequently, in that scenario, we are of the view that it would be the safe income on hand attributable to the Class A common shares that would be reduced by the dividend amount of $5,000. Given that, at the time of the payment of the $5,000 dividend, the safe income on hand attributable to the Class A common shares would be greater than the amount of the dividend, that dividend would not be subject to subsection 55(2) at the time of its deemed payment. Thereafter, the safe income on hand attributable to the Class A common shares would be $905 ($5,905 - $905) while the safe income on hand attributable to the other two classes of shares would remain unchanged.
However, the decrease in safe income on hand attributable to the Class A common shares resulting from the increase in the paid-up capital in respect of those shares would be offset by a corresponding increase in the ACB (under paragraph 53(1)(b)) of such Class A common shares.
We understand that in this situation, the attributes of the shares of the capital stock of Opco that you describe as being part of the articles and a unanimous shareholders agreement have been chosen in a corporate succession context. There may be situations where the safe income on hand attributable to each class of common shares would be allocated differently. An example would be a situation where the rights of the three classes of common shares were identical, the residual property of the corporation at the time of the winding-up was equally divided between them and the dividends in respect of each class were truly discretionary (without there being any obligation to declare a dividend to a particular class or a preferential right for a class to receive a dividend).
In closing, it should be noted that, depending on the circumstances, situations of the type described in this letter could result in transfers of value between shareholders or result in an advantage to certain shareholders, which could lead to negative tax consequences. In addition, depending on the circumstances, the CRA may consider the possibility of applying subsection 15(1) or subsection 69(1) because of the issuance of discretionary dividend shares. Finally, the use of discretionary dividend shares could result in the application of subsection 245(2), depending on the facts and circumstances surrounding a particular situation.
We point out that this opinion is not an advance ruling and, as stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it does not bind the CRA with respect to a particular factual situation.
We hope that our comments will be of assistance.
Stéphane Prud'Homme, Notary, M. Fisc.
Reorganizations Section III
Income Tax Rulings Directorate
and Regulatory Affairs Branch
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