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 Questions: 1. In a situation where there are two classes of shares in the capital stock of a corporation, the shares were issued to two different taxpayers at the same time and at the same price, and the fair market value (FMV) of the shares of each class is identical to the FMV of the other class, how would the safe income on hand of a corporation be attributed between the two classes of shares immediately before the time the shares of one of the classes are repurchased by the corporation.
2. Whether the answer would be different if a discretionary dividend was paid on the shares that will be purchased by the corporation before the purchase and if that dividend reduced FMV of the shares to be purchased without reducing the FMV of the other class of shares. The discretionary dividend would be equal to the FMV of the shares repurchased.
Position Adopted: 1. In such a situation, the safe income on hand would be attributed equally to each class of shares of the capital stock of the corporation.
2. Based on the facts described in the present situation, the safe income on hand would be attributed equally to each class of shares of the capital stock of the corporation.
Reasons: 1. As the FMV and adjusted cost base of each class of shares of the capital stock of the corporation would be identical, the same amount of safe income on hand could reasonably be considered to contribute to the capital gain that could be realized on a disposition at FMV, immediately before the dividend, of the share on which the dividend would be received (the capital gain being the same for each class held by each taxpayer).
2. If the FMV of the class of shares that would be purchased is equal to the total of the amount of the discretionary dividend plus the purchase price (that would be equal to nil in the present situation) and if such FMV is equal to the FMV of the shares of the other class, the same reason as the reason given in issue 1.
Sylvie Labarre, CPA, CA
April 27, 2016
Subject: Discretionary dividends and safe income
This is in response to your email dated March 21, 2016 in which you asked our view as to the amount of income earned or realized on hand (hereinafter, "safe income on hand") respecting shares held by each Opco shareholder in the following hypothetical situation.
Unless otherwise stated, all statutory references herein are references to the provisions of the Ways and Means Notice of Motion to implement certain provisions of the budget tabled in Parliament on March 22, 2016 and certain other measures (hereinafter, the “Notice of Ways and Means"), which was tabled in Parliament on April 18, 2016.
1. Opco is a corporation with a fair market value of $2M. The overall Opco safe income is $1M.
2. Opco is held by two shareholders, Holdco 1 and Holdco 2.
3. The share capital of Opco consists of two classes of shares (Classes A and B) that are voting, participating and provide for discretionary dividends. 1000 Class A shares are held by Holdco 1 and 1000 Class B shares are held by Holdco 2. Holdco 1 and Holdco 2 held their shares since the incorporation of Opco and the shares have a nominal adjusted cost base.
4. X holds all the shares in the capital of Holdco 1 and Y holds all the shares in the capital of Holdco 2.
5. X and Y are unrelated to each other.
6. Holdco 2 wishes to dispose of its Class B shares in the capital of Opco.
7. We have assumed that each class of shares in the capital of Opco has a value of $1M. This is a valuation question as to which our Directorate does not comment.
Opco purchases for cancellation the Class B shares for the sum of $1M.
Instead of effecting a purchase for cancellation for $1M, Opco pays a discretionary dividend of $1M and purchases the Class B shares for a total of $1. Due to the particular attributes of the Class A and B shares, the fair market value of the Class A shares, before and after the discretionary dividend on the Class B shares, continues at $1M and that of the Class B shares is reduced by the amount of the discretionary dividend.
You wish to know what the impact would be of these alternative transactions respecting the safe income and its attribution to the two categories of shares in the capital of Opco.
This technical interpretation provides general comments about the provisions of the Income Tax Act (the “Act”) and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.
For the purposes of this letter, we assume that the shares of Class A and B were acquired by their current holders on the date of the formation of Opco at a nominal value.
Under the first alternative, there would be a purchase for cancellation of Class B shares in the capital of Opco. Immediately prior to the purchase for cancellation of the Class B shares, each class in the capital of Opco had a value of $1M. This is what Holdco 2 receives for the Class B shares and this is the value to which Holdco 1 would be entitled if the Class A shares were purchased at that time. Therefore, we are of the view that it is reasonable to conclude that the income earned or realized that contributes to the capital gain for each class is equal for each class ($500,000 per class under the above assumptions) given their value and nominal adjusted cost base. The deemed dividend arising on the purchase of Class B shares thus would exceed by approximately $500,000 the income earned or realized that contributed to the hypothetical capital gain on the Class B shares. Under the Notice of Ways and Means tabled in Parliament on April 18, 2016, paragraph 55(5)(f) would apply to deem a $500,000 dividend to be received as a separate taxable dividend. Subsection 55(2) would apply to the separate taxable dividend, which would represent the excess of the discretionary dividend over $500,000.
Following the purchase of the shares for cancellation, the value of shares that Holdco 1 held in the capital of Opco would remain unchanged. Thus, there would be no change in the amount of income earned or realized that contributes to the capital gain on the Class A shares held by Holdco 1. This amount would remain equal to $500,000.
Regarding the alternative for the payment of a discretionary dividend, it would be necessary, before distributing the discretionary dividend of $1M, that the directors ensure that the dividend payment did not breach any applicable solvency tests. They would also need to ensure compliance with the rights of the other classes of shares.
If the attributes of the Class B shares were such that their value decreased upon payment of a discretionary dividend on such shares without the value of the Class A shares being reduced, it would be necessary to consider the value of both classes of shares before the discretionary dividend (taking into account that there would be a discretionary dividend paid on the class B shares). Under this alternative, it may be that we could conclude that the Class B shares had a value equal to the total of the discretionary dividend and the redemption value of $1 and that the Class A shares retained their value of $1M. This is a valuation question on which our Directorate does not comment.
If this were the case, in contrast to the situation where a discretionary dividend reduced the value of all participating shares of a company and the class of shares that received the dividend was entitled to additional value relative to the other class (equal to the amount of the discretionary dividend paid in respect of that class), it would be reasonable to consider in this hypothetical alternative that the income earned or realized that contributed to the hypothetical capital gain on the class B shares was equal to half of the Opco safe income. Thus, the discretionary dividend of $1M would exceed by $500,000 the income earned or realized that contributed to the hypothetical capital gain on the Class B shares. Under the Ways and Means Notice tabled in Parliament on April 18, 2016, paragraph 55(5)(f) would apply to deem a dividend of $500,000 to be a separate taxable dividend. Subsection 55(2) would apply to the separate taxable dividend that represented the excess of the discretionary dividend over the $500,000 amount.
The dividend of $1M would normally reduce the subsequent safe income on hand. However, we accept that the separate taxable dividend that was subject to subsection 55(2) did not reduce the safe income on hand of Opco.
Following the dividend and the purchase of Class B shares for cancellation, Holdco 2 would no longer hold any shares with a value and Holdco 1 would continue to hold the Class A shares having a value of $1M. We are therefore not in a situation where the value of Class A shares had changed. Thus, the safe income on hand following the purchase of shares for cancellation would now be equal to $500,000 (taking into account our administrative position) and there would be no change in the amount of income earned or realized that contributed to a capital gain on the Class A shares held by Holdco 1. That amount would continue to equal $500,000.
As mentioned in the previous paragraph, the result would have been different if the discretionary dividend had produced an additional value of $1M for the holder of the class of shares in respect of which the dividend had been paid in addition to the redemption value of the said shares and if the discretionary dividend had reduced the value of all the shares in the capital of Opco. In such a case, if we considered that the fair market value of the Class B shares relative to the Class A shares was increased by the amount of the discretionary dividend, we would conclude that the income earned or realized that contributed to the hypothetical capital gain on class B shares was equal to the safe income on hand for Opco and that the discretionary dividend would have reduced such safe income on hand of Opco.
Our letter only provides comments on subsection 55(2) and paragraphs 55(2.1)(c) and 55(5)(f).
Our comments are not intended to accord blanket approval for the use of discretionary dividend shares. Indeed, the issuance and holding of discretionary dividend shares could result in other tax consequences that may be adverse to certain taxpayers. For example, there may be situations in which certain provisions of the Act could apply such as subsections 15(1), 56(2), 69(1) and 246(1) of the Act. Similarly, there may be abusive situations where we would consider the application of the general anti-avoidance rule in subsection 245(2) of the Act.
It should also be noted that the use of discretionary dividend shares could have an adverse effect if a butterfly transaction was contemplated in a particular situation. Indeed, given the uncertainty in the valuation of discretionary dividend shares, it could be more difficult to satisfy the conditions for there being a distribution, as defined in subsection 55(1), for purposes of paragraph 55(3)( b) of the Act in such a situation.
We trust that our comments will be of assistance.
Stéphane Charette, CPA, CMA, MBA
For the Director
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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