19 August 1988 Income Tax Severed Letter 7-2870 - Safe Income Calculation—Subsection 55(2) of the Income Tax Act

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

MEMORANDUM

AUG 19 1988

TO Toronto District Office G.A. Troy, Chief of Audit

M.T. Liwanpo Business Enquiries Croup 148-2-1

FROM Specialty Rulings Directorate R.H. Joyce (613) 957-2092

Subject: Safe Income Calculation Subsection 55(2) of the Income Tax Act (the "Act")

This is in reply to your memorandum of May 12, 1988, wherein you requested our opinion on the calculation of income earned or realized for the purposes of subsection 55(2) of the Act ("safe income"). For this purpose, certain examples were provided in your memorandum, along with an example contained in a copy of a letter dated March 22, 1988, from XXXX.

As you have noted, the Department's views on the principles employed in the calculation of safe income can be found in a paper by J.R. Robertson presented at the 1981 Canadian Tax Foundation. This position was subsequently updated at the 1984 Corporate Management Tax Conference.

Generally, the Department is of the view that safe income during the holding period of a share is made up of taxable income plus certain adjustments, less the sum of losses incurred, dividends paid and provincial and federal income taxes paid or payable in respect of that income. The holding period is generally the time from the later of January 1, 1972 or the acquisition of the particular share to the time immediately before the transaction or event or the commencement of the series of transactions or events referred to in paragraph 55(3)(a) of the Act.

It should be noted that the amount of safe income must be on hand when a "safe dividend" is paid. As mentioned in Mr. Robertson's paper, there could be cases where a computation of safe income results in an amount greater than that which could be paid as a safe dividend. It is necessary, therefore, to calculate not only the amount of safe income, but also to determine the amount of "safe income on hand" out of which a safe dividend may be paid. A dividend paid which exceeds this latter amount may be subject to the provisions of subsection 55(2) of the Act, as the dividend would reduce the portion of the gain on the shares which is attributable to something other than safe income.

The fundamental question raised in your memorandum concerns the extent, if any, of required adjustments to the calculation of safe income to reflect Investment Tax Credits (ITC's), Refundable Investment Tax Credits (RITC's) and Scientific Research Tax Credits (SRTC's) earned and claimed by the taxpayer during the holding period.

We respond to your question using the examples provided in your memorandum.

XXXX Example

The taxpayer acquired a "quick flip" SRTC note for $4,000,000, which entitled the taxpayer to a $2,000,000 SRTC under paragraph 127.3(2)(a) of the Act. The note was redeemed for $2,300,000.

Calculation of safe income on hand:

Operating income           $10,000,000
Taxable capital gain           150,000
$10,150,000
Tax thereon (net of $2,000,000 tax credit)        (2,872,000)
7,278,000
Untaxed portion of capital gain                      150,000
7,428,000

Net outlay for SRTC note not deducted in computing income:

Cost           4,000,000
Proceeds      (2,300,000)
               1,700,000
Gain included above      300,000        2,000,000
Safe income on hand                   $ 5,428,000

Reconciliation

Operating income                  $10,000,000 
Cost of investment                 (4,000,000) 
Proceeds on sale of investment      2,300,000 
Income taxes paid                  (2,872,000)
Safe income on hand                $5,428,000

The analysis provided by XXXX refers to a difference between safe income and safe income on hand. The deduction in computing safe income for the net outlay for the SRTC note is in accordance with paragraph (xviii) on page 90 of the 1981 Conference report, which, while referring to deductions in computing safe income, includes items which would be deducted from safe income in arriving at safe income on hand (e.g. taxes, dividends, etc).

One of the components of the safe income calculation is the amount of provincial and federal income taxes paid or payable. Thus, in situations where income taxes payable have been reduced by an ITC claimed in the year, the actual amount of the tax liability (i.e. net of the ITC) will be included in the safe income computation. This can be illustrated by the first example provided in your memorandum.

a) We assume, for the purposes of this example, that the taxpayer has earned an ITC of $350 which is to be included in his income by virtue of paragraph 12(1)(t) of the Act.

Taxable income before ITC        $3,000 
Add ITC (paragraph 12(1)(t))        350
Taxable income                   $3,350

Tax thereon at 50%               $1,675 
Less ITC                            350 
Tax payable                      $1,325

It is our view that safe income on hand would be calculated as follows:

Taxable income                   $3,350
Tax payable                      (1,325)
                                  2,025

ITC (phantom income)               (350)
Safe income                      $1 675

Reconciliation

Operating income (assuming no difference in
calculation of income for tax and accounting)    $3,000
Tax payable                                      (1,325)
Safe income on hand                              $1,675

This result is consistent with the guidelines established in Mr. Robertson's paper. While the calculation of safe income would reflect the taxed retained earnings of the taxpayer, paragraph (xx) of the guidelines provides for a reduction of amounts which represent phantom income.

b) The second example provided in your memorandum involved a taxpayer which, due to a loss for tax purposes, had no income tax payable. Accordingly, the taxpayer was able to claim a refund of $350 generated by ITC earned in the year under subsection 127.1(1) of the Act. As this amount is deemed by subsection 127.1(3) of the Act to have been deducted under subsection 127(5) from tax otherwise payable, it is brought into income under paragraph 12(1)(t) to the extent that it has not otherwise been included in an amount determined under paragraph 13(7.1)(e), subparagraph 13(21)(f)(vii), paragraph 37(1)(e) or subparagraphs 53(2)(c)(vi), 53(2)(h)(ii) or 66.1(6)(b)(xi) of the Act.

Net income (loss) before ITC        $(450) 
Add RITC                              350 
(Negative) Safe income on hand       (100)

Since the calculation of safe income is cumulative throughout the holding period, the negative amount calculated above would reduce the amount out of which a safe dividend could be paid in the future.

c) In your final example, the taxpayer earned an ITC in the amount of $7,000 in respect of the acquisition of an asset described in Class 29 of Schedule II of the Regulations. The full amount of the ITC was applied to reduce the capital cost and UCC of the asset under paragraph 13(7.1)(e) and subparagraph 13(21)(f)(vii) of the Act respectively. No amount is therefore required to be included in income by virtue of paragraph 12(1)(t) of the Act. Of the ITC earned, $1,500 is applied to reduce tax otherwise payable. Although the remaining $5,500 would not be totally refundable in the year, by virtue of the definition of "refundable investment tax credit" contained in subsection 127.1(2) of the Act, we will assume that this is the case in order to conform with the figures supplied in your example. The depreciable asset was sold during the year for $93,000 resulting in no gain or loss to the taxpayer.

Taxable income         $3,000

Tax thereon at 50%     $1,500
Less ITC                1,500
Tax payable               NIL 

RITC                  $(5 500)

Safe income on hand would be calculated as follows:

Taxable income          3,000
Tax payable               NIL 
                        3,000

Net outlay not deducted in computing income:

Cost                 $100,000
Proceeds              (93,000)
                       $7,000
RITC                   $5,500   $1,500
Safe income on hand             $1,500

Reconciliation

Operating income (assuming no difference in
calculation of income for tax and accounting)    $3,000
Proceeds from sale of asset                      93,000
RITC                                              5,500

                                               $101,500
Cost of asset                                  (100,000) 
Safe income on hand                             $ 1,500

The above comments represent our interpretation of the guidelines as they would apply to the examples provided. Caution should be exercised in other situations as the facts of each case are unique and the principles applied in these examples may not be appropriate in every case.

Director Reorganizations and Non-Resident Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs-Branch