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Principal Issues: What would be the safe income of the common shares under the two scenarios.
Position: Will have to determine what portion of the safe income can reasonably be considered to contribute to the capital gain of the share on which the dividend is received.
Reasons: See below.
FEDERAL TAX ROUNDTABLE OCTOBER 7, 2020
APFF CONFERENCE 2020
3. Taxable dividend paid before 2016 and negative safe income
In 2010, Mr. X was the sole shareholder of a corporation ("Opco"). Mr. X held 100 common shares of the capital stock of Opco. Opco was a corporation carrying on a business.
In 2015, prior to the changes to subsection 55(2), Opco paid a dividend to Mr. X equal to the fair market value ("FMV") of Opco, being $100,000. Mr. X was taxed on the dividend. Prior to the payment of the dividend, the safe income of Opco was $0. At the time, Opco had an intangible asset worth $100,000. Opco had received a loan of $100,000 to enable the dividend to be paid to its shareholder. Following the dividend payment, Opco had an accounting deficit of $100,000.
After the payment of the dividend, Mr. Y subscribed through a corporation ("Holdco Y") for 100 common shares of the capital stock of Opco for $100. Mr. Y was the sole shareholder of Holdco Y.
Mr X and Mr Y dealt at arm's length.
In 2018, Mr. X formed a corporation ("Holdco X"). Mr. X transferred his 100 common shares of the capital stock of Opco to Holdco X on a rollover basis. The agreed amount was equal to the tax cost of the shares, being $100.
Subsequent to the payment of the dividend in 2015, the aggregate safe income generated by Opco was $200,000. At the end of its 2018 taxation year, Opco had $100,000 in cash and a retained earnings balance of $100,000. The value of the intangible held by Opco at that time was still $100,000. The debt incurred by Opco for the 2015 dividend payment was repaid from the $200,000 of income earned. The FMV of all of the shares in the capital stock of Opco at the end of 2018 was $200,000.
Questions to the CRA
(a) If a dividend of $200,000 were paid on the common shares of the capital stock of Opco, what would the safe income be on the 100 common shares of the capital stock of Opco held by Holdco X?
(b) Would the answer be the same if instead of there being a dividend in 2015, Opco repurchased Mr. X's shares and issued 100 new common shares of its capital stock to Mr. X and Holdco Y, respectively?
CRA Response to Question 3(a)
It should be recalled that, at the time of the transfer pursuant to subsection 85(1) by Mr. X of his 100 shares of the capital stock of Opco to Holdco X for an agreed amount equal to the adjusted cost base ("ACB") of those shares, the safe income then accrumulated on those shares was retained upon the transfer. Consequently, the safe income attributable to the common shares of the capital stock of Opco held by Mr. X will be retained for those shares of the capital stock of Opco held by Holdco X.
In determining whether the exception in paragraph 55(2.1)(c) is satisfied to prevent the application of subsection 55(2), the taxpayer must show that the amount of the dividend does not exceed the amount of income earned or realized by any corporation that could reasonably be considered to contribute to the capital gain that would have been realized on a disposition at FMV, immediately before the dividend, of the share on which the dividend was received.
Generally, the income earned or realized that can reasonably be considered to contribute to the capital gain on the share on which the dividend was received is the safe income calculated under subsection 55(5) and adjusted by certain items to take into account the portion of safe income that contributes to the capital gain on the share. Generally, any amount of a dividend paid by a corporation, other than a dividend subject to subsection 55(2), will reduce the corporation's safe income. In addition, on the basis of the facts presented, it should be noted that the repayment of the loan used to finance the payment of the dividend was repaid out of the corporation's earned or realized income. Consequently, that income cannot be viewed as contributing to the unrealized gain on the common shares of the capital stock of Opco.
Thus, the relevant safe income of the 100 common shares of the capital stock of Opco held by Holdco X, based on the facts described above, would be $50,000. Indeed, it would be reasonable to consider that only that portion of the safe income would contribute to the capital gain on the shares of the capital stock of Opco held by Holdco X. It should be noted that the 100 common shares of the capital stock of Opco held by Holdco Y would have the same safe income.
It is of interest to note that, on the facts presented, the capital gain on the common shares of the capital stock of Opco is supported in part by the value of the intangible, being the unrealized gain of $100,000.
CRA Response to Question 3(b)
We have assumed that Opco received a loan to redeem shares of the capital stock of Opco held by Mr. X in 2015 and that such redemption resulted in a deemed taxable dividend to Mr. X. That loan also was repaid at the end of his 2018 taxation year. We also have considered the other facts in Question 3(a) to remain the same.
Our answer would be the same, as we would have to go through the same exercise of determining what portion of the safe income can reasonably be considered to contribute to the capital gain on the shares on which the dividend is received.
October 7, 2020
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