14 February 1992 External T.I. 9127805 F - Safe Income

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.

February 14, 1992

Dear Sirs:

Re:   Income earned or realized after 1971 ("Safe Income")

We are writing in response to your letter dated September 27, 1991 wherein you requested technical interpretations regarding the calculation of Safe Income under subsection 55(2) of the Income Tax Act (Canada) (the "Act") in respect of certain situations that would have an impact on such calculation at a particular time.

In your letter you have outlined what appears to be an actual fact situation related to completed transactions. The review of such transactions falls within the responsibility of District Taxation Offices and it is the practice of this Department not to comment on such transactions when the identities of the taxpayers are not known. However, we can provide you with the following general comments on the situations described in your letter, which we hope will be of assistance to you.

Investment Tax Credits ("ITC's")

You have asked us to review and comment on your interpretation of the effects of ITC's and the resultant "phantom income" on the calculation of Safe Income in the example given in your letter.

In a paper presented by Mr. M. Hiltz of this Directorate at the 43rd Tax Conference of the Canadian Tax Foundation held in Toronto in November 1991, the Department explained its position regarding the effects of investment tax credits on the calculation of Safe Income, which in the context of your example, is as follows:

1.     A corporation has a taxable income of $10,000 in year 1 and a taxable income of $10,000 in year 2 before claiming any capital cost allowance allowed under the Act. In year 1, the corporation purchased a Class 10 asset for $10,000 and the asset was eligible for a 10% ITC. We will assume a combined provincial and federal corporate tax rate of 50%.

2.     The ITC claimed by the particular corporation would result in a reduction of $1,000 of its income tax liability in year 1. In year 2, pursuant to subparagraph 13(21)(f)(vii) of the Act, the undepreciated capital cost of the particular class of property would be reduced by the amount of the ITC claimed by the particular corporation in year 1, thereby reducing the amount of capital cost allowance that could be claimed by $300 ($1,000 x 30%).

3.     The calculation of the corporation's Safe Income in year 1 and year 2 would be as follows:

                                                                  Year 1 Year 2

Revenue from operations                           $10,000       $10,000Less: capital cost allowance  $5,000 x 30% *                                       (1,500)  ($10,000-1,500) x 30%                                                 (2,550) ***Add  $1,000 x 30% **                                                               300 ***Income subject to tax                                     8,500          7,750Taxes (before ITC)                                        4,250         3,875Income after taxes, but before ITC              $ 4,250       $ 3,875Safe Income                                                $ 4,250       $ 8,125

*      - represents application of the half-year rule in subsection 1100(2) of the Income Tax Regulations.

**     - represents realization of a portion of the capital cost reduction applicable to the ITC of $1,000 claimed in the previous year.

***     - in practice, it would not be necessary to make two separate calculations, since UCC in Year 2 would not only be reduced by Year 1 CCA of $1,500, but would also be reduced by the ITC of $1,000 pursuant to subparagraph 13(21)(f)(vii) of the Act. Thus, CCA for Year 2 would be determined as follows:

UCC end of Year 1                     $8,500

ITC claimed in Year 1                  1,000

UCC before CCA 7,500

CCA at 30%                                2,250

UCC end of Year 2                    $5,250

Thus, additions to Safe Income would be automatically phased in over the (tax) depreciable life of the asset.

As may be understood from the above example, we are of the view that the ITC will be included in Safe Income over the period that its income tax effects have been realized through the corporation's operations. In the case of a capital asset, the reduction of a corporation's annual capital cost allowance claim on an after-tax basis would reflect the realization of the ITC.

Stock Options

Based upon the views expressed in the paper "Section 55: A Review of Current Issues", as given by Mr. R.J.L. Read of this Directorate at the 1988 Conference of the Canadian Tax Foundation, you are of the view that Safe Income may accrue to options to acquire shares prior to the exercise of the option. You would like to know whether or not this would also be the case where the exercise of the stock option results in a taxable benefit and an increase in the adjusted cost base of the option shares to an employee of the issuing corporation pursuant to section 7 and paragraph 53(1)(j) of the Act, respectively. In other words, you suggest that a transaction which results in an increase in the adjusted cost base of the shares also results in an addition to Safe Income of the issuing corporation with respect to those shares.

In general terms, we agree that Safe Income may accrue to stock options that have not been exercised in the circumstances discussed in Mr. Read's paper. As also mentioned therein, a portion of a gain inherent in shares acquired on the exercise of the options may be referable to income earned by the corporation before the option was exercised.

We do not understand your concern as it relates to section 7 and paragraph 53(1)(j) of the Act, both of which pertain to individuals, since there is no connection between the operation of these provisions and the application of subsection 55(2) of the Act, which applies to corporations. In this context, if a corporation acquired an option to purchase common shares of another corporation, and prior to the time of its exercise, Safe Income of $10 accrued in respect of the option, then the common shares acquired would inherit that Safe Income entitlement. If for some reason subsection 52(1) of the Act applied to bump up the adjusted cost base of the common shares otherwise determined to their fair market value, the portion of the gain attributable to the Safe Income of $10 and the portion of the gain attributable to something else would be subsumed under the adjusted cost base of the common shares. There would be no Safe Income attributable to those common shares.

Allocation of Safe Income to various classes of shares acquired pursuant to stock options

In a situation where a corporate shareholder acquires a certain percentage of each class of the issued and outstanding shares of another corporation at an option price which is less than their fair market value, you would like our opinion on how Safe Income would be allocated to various classes of shares acquired as a result of the exercise of the option.

In order to determine the amount of Safe Income that may be allocated to the various classes of shares of a corporation, it is essential to know all of the facts in each particular case. Generally, all shares of the corporation will share pro rata in the Safe Income of a corporation in accordance with their holding period and their entitlement to participate in the income of the corporation, which entitlement would, of course, depend upon the terms and conditions of the particular class of shares.

In line with our comments given above, Safe Income in respect of a share may be referable to an option which was exercised to acquire the share. On the date that an option is exercised, any preferred shares acquired on the exercise of the option that have a non-cumulative dividend entitlement would only be entitled to a Safe Income allocation in a case where dividends on those shares were declared but were unpaid at the time that the option is exercised. On the other hand, preferred shares with a cumulative dividend entitlement would be entitled to a Safe Income allocation equal to the amount of any dividends that would have accrued to the preferred shares commencing at the time that the option was issued, which dividends would not have been paid to existing shareholders prior to the exercise of the option.

The balance of the Safe Income earned by the corporation not allocable to a class of preferred shares would be allocated to the common shares of the corporation.

Safe Income Attributable to Preferred Shares

In general, Safe Income of a corporation is allocable to preferred shares in line with the principles discussed above. In the situation where preferred shares have a low paid-up capital and a high redemption amount, the redemption of such shares will result in a deemed dividend under subsection 84(3) of the Act that would be subject to the application of subsection 55(2) of the Act. In this regard, you have asked us to confirm that Safe Income attributable to a deemed dividend on the redemption of high-low preferred shares that were received as consideration for shares which had a Safe Income entitlement is fixed at the point in time that the preferred shares are issued, and does not change over time in relation to changes in the fair market value of the corporation and its shares.

We agree that if a subsection 84(3) deemed dividend exceeds the Safe Income attributable to preferred shares, then the provisions of subsection 55(2) may apply to tax the excess as a capital gain. Here, we would point out that the entire subsection 84(3) deemed dividend would be subject to subsection 55(2) of the Act if a designation is not made pursuant to paragraph 55(5)(f) of the Act. We would also agree that, generally, Safe Income attributable to a preferred share does not vary in relation to changes in the fair market value of a corporation and its issued shares. However, there may be unusual cases where the Safe Income entitlement which was fixed at the time a preferred share was issued might change. We would be prepared to consider these cases as they arise from time to time. Subject to this comment, Safe Income in respect of such a share may be increased by its entitlement to dividends payable by the corporation. We would also point out that any premium included in the redemption amount of preferred shares will always be tainted for the purposes of subsection 55(2) of the Act, and in this connection, we would refer you to page 86 of the paper "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55" that was published in the 1981 Conference Report.

Impact on Safe Income attributable to Common Shares due to insufficient dividends paid on Preferred Shares

You ask that if holders of preferred shares agree to waive their entitlement to dividends in arrears on those shares, would the Department agree that the waived dividends would accrue to Safe Income available to common shares?

Before the Department would agree that dividends waived by holders of preferred shares could accrue to Safe Income in respect of holders of common shares, we would need to examine all of the circumstances under which the dividends would be waived. We would also consider the possible application of subsection 56(2) or 245(2) of the Act.

The foregoing comments represent our general views with respect to the subject matter of your letter. The facts of a particular situation may lead to different conclusions. The foregoing opinions are not rulings and, in accordance with the guidelines set out in Information Circular 70-6R2 dated September 28, 1990, are not binding on the Department.

Yours truly,

for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and IntergovernmentalAffairs Branch