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: 1. Whether the purpose tests of paragraph 55(2.1)(b) are met when a dividend is paid to purify a corporation for capital gain exemption purpose.
2. Each Class AA and Class X share of the capital stock of a corporation entitles the owner of the particular share of one of this class to participate each year in the annual profits of the corporation in proportion of the number of shares of the Class AA and Class X shares issued at the end of the year. A dividend is paid on the Class X shares equal to the amount of the profit to which it is entitled. No dividend is paid on the Class AA shares. The dividend paid on the Class X shares decreases the value of the Class X share but do not decrease the value of the Class AA shares. How would the safe income be allocated between the two classes of shares?
3. If, in a year, the increase in the value of Class AA shares is higher than the increase in the value of Class X shares because of an unrealised increase of the value of one of the assets, how would the safe income be allocated between the two classes of shares?
4. Whether it is possible to isolate the safe income in one class of shares considering all the assumptions in the example.
Position: 1. No position taken.
2. We would apply the position issued in 1981 (part of the "Robertson Rules") stating the income will be attributable to a particular class of shares in the same ratio in which each class would be entitled if all earnings of the corporation, but not share capital, were to be distributed. Furthermore, the safe income is allocated to each class with respect to the holding period of the shares by the shareholder. In the particular situation, the dividend paid with respect to Class X shares would not reduce the safe income on hand in respect of the Class AA shares considering that the value of the Class AA shares is not reduced by such dividend.
3. In the particular situation, same position as the position taken in question 2.
4. In the particular situation, no.
Reasons: 1. The CRA would review all the pertinent facts with respect to a particular situation. The purpose of purification would be one relevant factor.
2. In the particular situation, the previous position taken in 1981 would satisfy the test that the safe income contributes to the capital gain that could be realized on a disposition at fair market value, immediately before the dividend, of the share on which the dividend is received.
3. In the particular situation, as the increase in the value of the assets of the corporation is unrealized and do not form part of the safe income, the safe income would not contribute in that year in that part of the hypothetical capital gain of the Class AA shares.
4. In the particular situation, we should take the same position as mentioned with respect to question 2.
Sylvie Labarre, CPA, CA
April 6, 2017
Subject: Application of subsections 55(2) and 55(2.1)
This is in response to your e-mail of July 21, 2016, in which you requested our views on a continuing asset purification and protection strategy in relation to subsections 55(2) and 55(2.1) of the Income Tax Act (Canada) (the "Act").
Unless otherwise indicated, all legislative references herein are to the provisions of the Act.
1- A private corporation carrying on an active business (Opco) was held by Mr. A and Mr. B, two unrelated persons. Mr. A and Mr. B held equally the participating and non-voting shares (Class AA shares) in the capital of Opco. As of January 1, 2016, immediately after the end of the fiscal year of December 31, 2015, Class AA shares were worth $500,000 and had a safe income of $300,000. The shareholders had each paid $50 for 50 Class AA shares.
2- A holding company (Holdco) was held equally by Mr. A and Mr. B, each holding 50 voting and participating shares in the capital stock of Holdco (“A” shares).
3- Holdco held 100 shares, which were voting, non-participating and redeemable for their paid-up capital, in the capital stock of Opco for which it had subscribed $100. Holdco therefore held 100% of Opco's voting rights.
4- On January 1, 2016, Holdco also subscribed for 100 Class X shares in the capital stock of Opco for $100. The Class X Shares were entitled to participate annually in the corporation's profits proportionately with the number of issued and outstanding AA and X shares. The holders of the Class X Shares had an entitlement to dividends equal to the cumulative earnings from the time of their issuance and the redemption value of the shares was reduced by the amount of dividends paid. The Class X Shares did not have additional rights to the remaining property or dividends and did not have voting rights. Their redemption value was determined solely on the basis of the net after-tax profits accumulated in the year by the corporation on the aforementioned pro rata basis plus their issued and paid-up capital (all calculated in accordance with current accounting principles). Upon each release of the annual financial statements, management determined and confirmed in a letter the share of the corporation’s after-tax accounting profit attributable to the Class X Shares.
5- On December 31, 2016, Opco had accumulated $100,000 in after-tax profits. We assume that the accumulated safe income for 2016 was also $100,000. As there were 200 issued and outstanding AA and X shares, the X class shares had a redemption value on January 1, 2017 of $50,100 (($100,000 x 100/200) + $100 of paid-up capital). Your view was that the appreciation in the Class X shares of $50,000 was entirely attributable to the cumulative earnings in the fiscal year and that the safe income of the Class X shares was also $50,000. The total value of the shares was $600,000 on December 31, 2016.
6- On January 1, 2017, Opco paid a dividend of $50,000 to Holdco pursuant to a strategy developed with the responsible tax planners of not maintaining excess liquidity in Opco in order to qualify the Class AA shares at all times for the capital gains deduction ("CGD") and also for asset protection purposes. After this dividend, the redemption value of the Class X Shares was reduced to $100.
1- You wished to know whether we would consider that the purpose of the transactions was to reduce a capital gain or reduce the market value of a share as described in paragraph 55(2.1)(b).
2- If so, you wish to know our position as to whether the dividend is subject to subsection 55(2) considering the safe income available on the X class shares in the capital stock of Opco.
3- The assumption in paragraph 5 above is modified so that the cumulative safe income in the year was $90,000 instead of $100,000. The after-tax net profits remained at $100,000, but the safe income attributable to the Class X shares was $45,000. With respect to the payment of the dividend referred to in paragraph 6 above, the dividend of $50,000 was paid in two consecutive tranches of $45,000 and $5,000. After such dividends, the redemption value of the Class X Shares decreased to $100. You would like to know if the safe income attributable to Class X Shares was sufficient for subsection 55(2) to not apply to the first dividend of $45,000. Similarly, you wish our view as to the application of subsection 55(2) respecting the second dividend of $5,000.
4- You have the same queries as those in question 3, but taking into account modified assumptions. The profits at December 31, 2016 instead were $200,000, the cumulative safe income in that year was $190,000, and the total market value of the shares in the capital of Opco was currently valued at $800,000 (the value having increased by an amount equal to the profits for the year and the increase in the value of intangibles). Class X shares had a redemption value of $100,100 (50% of the profits plus the paid-up capital). On January 1, 2017, OPCO paid a dividend of $95,000, followed by a second of $5,000, to Holdco. After such dividends, the redemption value of the Class X Shares decreased to $100.
5- In addition, you inquired whether our conclusions would be the same in the event that the value of the Class X Shares was instead based on 50% of Opco’s cumulative safe income during the year rather than the net after-tax profits.
This technical interpretation provides general comments on the provisions of 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 particular transactions 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 paragraph 55(2.1)(b) not to apply, it must be concluded that none of the purposes of an actual dividend comes within that paragraph. The determination of the purposes of a dividend is a question of fact.
In Ludco Enterprises Ltd v Canada, 2001 SCC 62, the Supreme Court of Canada indicated the following:
“…In the interpretation of the Act, as in other areas of law, where purpose or intention behind actions is to be ascertained, courts should objectively determine the nature of the purpose, guided by both subjective and objective manifestations of purpose. …”
Thus, the determination of the purposes of the dividend must be assessed in the light of objective and subjective factors.
Even if a dividend would normally entail a reduction in the value of a share, the reduction of the capital gain on a share or an increase in the cost amount of the recipient’s property, this is the result of the dividend. For an actual dividend, paragraph 55(2.1)(b) requires that the purpose of the dividend be examined and not the result. Thus, it is necessary to establish the goal and motivation hidden behind this purpose by answering questions such as these:
• What did the taxpayer intend to accomplish by reducing the value of the shares?
• How would the reduction in value benefit the taxpayer?
• What actions did the taxpayer take in relation to this reduction in value?
In this situation, paying a dividend with the goal of purifying the corporation so that the shares in the capital stock of that corporation are qualified small business corporation shares within the meaning of subsection 110.6(1) would certainly be a relevant factor that should be taken into account. However, it also should be ensured that the dividend has no other purpose described in paragraph 55(2.1)(b). For example, if the dividend paid to the corporation exceeds the amount that would be required to transfer the surplus assets, this could be a sign that the dividend has another purpose, which was one of those referred to in paragraph 55(2.1)(b).
Questions 2 to 4
For the purposes of questions 2 to 4 and according to the assumptions stated herein, the dividend paid on Class X shares in the capital stock of Opco would reduce only the redemption value of the Class X shares. As a result, the dividend on the Class X shares would not reduce the value of Class AA shares, that would benefit from their portion of the after-tax profits earned or realized annually.
We are of the view that, in such a situation, we would take the position which was set out in 1981 by Mr. Robertson and which is as follows:
"The Department follows the concept that income will be attributable to a particular class of shares in the same ratio in which each class would be entitled if all earnings of the corporation, but not share capital, were to be distributed."
In this regard, given that, in the situation provided, the Class X and AA shares were entitled to an equal share of Opco’s profits following the issuance of the Class X shares and that the value of the shares of each class would increase due to this share of profits, we are of the view that the safe income earned or realized annually following the issuance of the Class X Shares could be proportionately allocated based on the number of shares of each class. The safe income on hand for the Class X Shares was reduced by any portion of the dividend paid on such Class X Shares that was not subject to subsection 55(2).
Accordingly, based on the assumptions stated under question 2, we agree that the share of Opco’s safe income contributing to the hypothetical capital gain on the Class X shares would be $50,000. Accordingly, paragraph 55(2.1)(c) would not apply and no part of the $50,000 dividend would be subject to subsection 55(2).
Taking into account the assumptions in question 3, it would be reasonable to consider that half of the safe income earned during the year would contribute to the hypothetical capital gain on the Class X Shares and half of the safe income would contribute to the hypothetical capital gain on the Class AA, Shares if a dividend was paid on those shares. Thus, the first payment of the dividend in the amount of $45,000 would not exceed the amount of safe income on hand and would therefore not be covered by subsection 55(2). With respect to the second dividend payment, it would be a separate dividend under subsection 55(5)(f) and would be greater than the amount referred to in paragraph 55(2.1)(c). If all other conditions for the application of subsection 55(2) were met, it would apply to the $5,000 dividend.
With respect to the situation in question 4, we are of the view that the safe income would also be allocated in accordance with the proportion of the number of shares of each class of shares in the capital of Opco, and that it would still be reasonable to conclude that half of the safe income would contribute to the hypothetical capital gain on the Class X shares. The increase in the value of the Class AA Shares would result from an unrealized capital gain for tax purposes and therefore would not be included in the safe income for the year. Consequently, the dividend of $95,000 would not be greater than the amount of safe income on hand and, therefore, would not come within subsection 55(2). Furthermore, the additional dividend of $5,000 could be subject to subsection 55(2) if all other conditions for the application of that subsection were met.
Based on our understanding of Question 5, the accounting earnings would be split between the Class AA and X Class shares: an amount representing 50% of the corporation’s safe income during the holding of the Class X shares would be allocated to Class X shares and the rest of the accounting profits, if any, would be allocated to the Class AA shares. Assuming an aggregate safe income of $90,000 subsequent to the holding of the Class X shares and accounting profits of $100,000, if there were a distribution of all the accounting profits, the Class X shares would be entitled to $45,000 and the Class AA Shares would be entitled to $55,000.
In our view, the increase in the corporation's safe income (during the holding of the Class X shares) for that year should be allocated based on the amounts to which each Class would be entitled. For example, 45/100 of $90,000 (i.e., the total safe income during the holding of the Class X shares) would be allocated to the Class X shares, or $40,500.
Therefore, it would not be possible to isolate the safe income of the corporation or a portion thereof in a particular class of shares if the corporation's safe income was less than the accounting profits because a portion of the increase in value of the Class X shares would not be covered by the safe income (in this example, $45,000 - $40,500 of safe income = $4,500), even though the amount of this increase is computed on the basis of the corporation’s safe income.
We hope that our comments are of assistance.
Urszula Chalupa, LL.B, M. Fisc.
for the Director
Income Tax Rulings Directorate
and Regulatory Affairs Branch
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