14 August 1990 Internal T.I. 901579 F - Redemption of Shares Subsection 84(3) Deemed Dividends

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.

August 14, 1990

Dear Sirs:

Re:  Subsection 55(2) and Paragraph 55(5)(f) of the Income Tax Act (the "Act")

We refer to your letter of July 10, 1990, in which you requested a technical interpretation of the provisions of subsection 55(2) and paragraph 55(5)(f) of the Act as they would apply to the following hypothetical situation.

A Co., a Canadian-controlled private corporation ("CCPC") within the meaning of paragraph 125(7)(b) of the Act, subscribed for 30% of B Co.'s authorized but unissued common shares on July 1, 1985 for a total subscription price of $100,000.  Prior to the subscription, A Co. did not own any share of B Co.  B Co. is also a CCPC.  The taxation year of both A Co. and B Co. ends on December 31.  A Co. and B Co. deal at are arm's length with one another.

Immediately before the time A Co. acquired its shares of B Co., and on the assumption that the taxation year of B Co. would have ended at that time, B Co. would have incurred a loss for tax purposes of $10,000.  From July 1 to December 31, 1985 ( a "stub period"), B Co. earned income of $100,000.  Consequently, for its taxation year ended December 31, 1985, B Co. would have neither a loss nor any income for tax purposes.

In its 1986, 1987 and 1988 taxation years, B Co. earned a significant amount of income on which it paid tax.  On May 30, 1989, B Co. redeemed its common shares owned by A Co. for $300,000.  Since the subscription price of $100,000 referred to above represented both the paid-up capital and adjusted cost base to A Co. of its common shares held in B Co., B Co. would be deemed to have paid and A Co. would be deemed to have received a taxable dividend of $200,000 pursuant to subsection 84(3) of the Act.  For the period January 1 to May 30, 1959 (a "stub period"), B Co. earned $200,000 of income before income takes.

Income is earned by B Co. evenly throughout the year.

You ask the following questions relating to the above situation:

1.     Based on your understanding of the Department's position as  set out on page 87 of the 1981 Conference Report, the stub period incomes of $10,000 in 1985 and of $200,000 in 1989 would be included in computing "income earned or realized by B Co. after 1971" ("Safe Income") with respect to the common shares of B Co. held by A Co.  You ask whether it would be   necessary, in determining the Safe Income of B Co. in respect of A Co. for the 1985 stub period, to take into account accrued income taxes payable on the $10,000 of income earned therein.  You also ask the sage question with regard to the 1989 stub period income of $200,000, and whether the small business deduction provided for under subsection 125(1) of the Act could, in part, be applied to reduce income taxes otherwise payable on the $200,000.

2.     If B Co. had previously declared bonuses at its year end based on year end results, you ask whether this should be taken into account in respect of the 1989 stub period income of $200,000.  You note that there would be no assurance that such bonuses would be declared in respect of its 1989 taxation year at the time Co. would redeem its common shares from A Co., as described above.

3.     In the 1984 Corporate Management Tax Conference Report, the Department indicated that it would allow more than one designation to be made under paragraph 55(5)(f) of the Act.  You ask whether it is acceptable for a corporation receiving a taxable dividend that would be subject to the provisions of subsection 55(2) of the Act to make multiple designations in order to obtain maximum protection from the application of the subsection.

     You also wish to know if it is still acceptable to include a separate letter with the corporate tax return wherein these designations may be set forth.

Comments

It appears that your request relates to a specific situation in respect of which no proposed transactions are contemplated.  Since the responsibility for determining the tax consequences arising from completed transactions rests with the district taxation offices, the appropriate district taxation office may, upon disclosure of all relevant facts, be able to assist you in clarifying the tax consequences pertaining thereto.

Although we cannot comment directly on your situation, we are prepared to offer the following general comments on your questions in the order that you raised them.

1.     As stated on page 87 of the 1981 conference Report and pages 18: 5 and 6 of the 1988 Conference Report, in the Department's view, the computation of Safe Income in respect of stub periods must be reasonable in the circumstances and should be computed in a manner consistent with other periods in the holding period.  The responsibility for supporting the reasonableness of a particular computation is on the taxpayer.  In this regard, and with respect to the 1985 stub period income of $10,000, if as a question of fact no income taxes were payable in respect of B Co.'s 1985 taxation year ended December 31, it is our view that it would have been          reasonable not to have taken any income taxes into account in determining what portion of the 1985 stub period income of $10,000 constituted Safe Income of B Co. in respect of A Co.  Similarly, given that 1989 stub period income of $200,000 existed on May 30, 1989, it is our view that it would be reasonable to take income taxes into account in determining the portion of such income that constituted Safe Income of B Co. in respect of the shares held by A Co.  In this connection, we agree that it would also be reasonable to reduce the income taxes on the $200,000 as otherwise determined by a pro rated portion (based on the number of days in the 1989 stub period as a proportion of the total number of days in Co.'s 1989 taxation year of 16% of the least of the amounts referred to in subsection 125(1) of the Act, but subject to subsections 125(2) and (3) of the Act.

2.     As indicated in our response in 1 above, the computation of  Safe Income must be computed in a manner consistent with other periods in the holding period.  It may very well be reasonable to accrue a portion of a bonus that would likely be declared at year end based on mid term results.  If no bonus were to be declared, the taxpayer must justify its exclusion in the computation of Safe Income for the relevant period.

3.     It is the Department's position that multiple designations under paragraph 55(5)(f) of the Act cannot be made as a matter of course.  The Department dealt with this topic on page 94 of the 1981 Conference Report, and as indicated therein, more than one designation may be made if the taxpayer has reasonable grounds to believe that certain aspects of the computation of Safe Income are truly doubtful.  This does not, however, absolve the taxpayer from its duty to report an obvious gain with respect to that portion of a subsection 84(3) deemed dividend (or a dividend declared and paid) which is attributable to something other than Safe Income (i.e. goodwill or unrealized appreciation in assets).

     A taxpayer may still notify the Department by a separate letter attached to its corporate tax return that it has made a separate designation (or designations) under paragraph 55(5)(f) of the Act with respect to the payment of, or a     deemed payment of, a taxable dividend that is subject to the application of the provisions of subsection 55(2) of the Act.

It is also important to note that it is possible that a computation of Safe Income could result in an amount which is greater than that which could be paid as a "safe dividend". Subsection 55(2) of the Act discourages the payment of any dividend which would result in a significant reduction in the portion of the capital gain attributable to anything other than income earned or realized by any corporation after 1971. Therefore, it is necessary to determine the portion of the gain which reflects the income earned or realized during the holding period and the portion of the gain which is attributable to anything else, such as goodwill or unrealized appreciation in assets.  If the amount of Safe Income computed is greater than the gain attributable to Safe Income, the payment of a dividend to the full extent of Safe Income will reduce the gain attributable to something else, and subsection 55(2) of the Act may apply to the dividend.

As stated in paragraph 24 of Information Circular 70-6R dated December 18, 1978, the opinions expressed in this letter are not rulings and are consequently not binding on the Department.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch