20 July 1994 External T.I. 9408795 - 55(2)

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

safe income calculation

Position TAKEN:

safe income flows through by means of ss.107(2) distribution
safe income on hand reduced in relation to ss.80(3) election
non-deductible losses reduce safe income on hand

Reasons FOR POSITION TAKEN:

see file

XXXXXXXXXX		940879

Attention: XXXXXXXXXX

July 20, 1994

Dear Sirs:

Re: Safe Income Calculation for Purposes of Subsection 55(2) of the Income Tax Act (the "Act")

We are writing in response to your letter of March 30, 1994 wherein you requested our opinion on whether the various hypothetical situations described in your letter would affect the computation of safe income for the purposes of subsection 55(2) of the Act.

The Department's position on the concepts of "safe income", "safe income on hand", "safe dividend", "holding period", etc. can be found in the papers published in various Canadian Tax Foundation conference reports.¹ In particular, it should be noted that a difference between "safe income" and "safe income on hand" exists. "Safe income" with respect to a share of a corporation is equivalent to the "income earned or realized" by the corporation during the relevant holding period. The expression "income earned or realized" by a corporation is deemed to be the amount determined pursuant to paragraph 55(5)(b), (c) or (d) of the Act, as the case may be. Consequently, "safe income" with respect to a share of a corporation refers to the corporation's net income, as determined for purposes of the Act, as adjusted by paragraphs 55(5)(b), (c) or (d), as the case may be, that is attributable to that particular share during the relevant holding period. However, in order to contribute to a gain on a share, income earned or realized must be on hand. Consequently, "safe income on hand" with respect to a share of a corporation at a particular time refers to the portion of the income earned or realized by the corporation during the relevant holding period that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at fair market value of the share at that time. It follows then that income that has been distributed as a dividend or laid out to pay taxes or non-deductible expenses is not on hand and cannot contribute to the fair market value of, or the gain inherent in, a share. A "safe dividend" can be paid only from safe income on hand. Therefore, it should be remembered that it is possible for a computation of safe income based only on income earned in the holding period to result in an amount that is greater than that which is "on hand" and that can be paid as a safe dividend.

With reference to the above, we offer the following general comments on the hypothetical situations outlined in your letter in the order they were written:

.Where a person acquires a share of a corporation from an estate pursuant to subsection 107(2) of the Act such that the cost of the shares to the beneficiary is deemed to be equal to the cost amount of the shares to the estate and the cost amount of the shares to the estate immediately before the distribution is equal to their cost amount at the time the estate first acquired the shares, such a transferred share will retain its portion of the safe income and safe income on hand that could have been paid as a safe dividend immediately before the transfer. In other words, a rollover under subsection 107(2) would be accorded treatment similar to that accorded to rollovers effected under sections 51, 85, 85.1, 86 and 87 of the Act.

.When a portion of the capital gain inherent in the shares of a corporation is crystallized, it is the Department's view that the only reasonable approach is to apportion the safe income and safe income on hand to which the entire gain is in part attributable, proportionally to each part of the gain. Therefore, in the example referred to in your letter, the amount of the safe income on hand that will flow through to Holdco as a result of the transfer of the OPCO shares by the transferor to Holdco should be

Holdco's potential gain x safe income on hand of OPCO
Vendor's accrued gain
immediately before the transfer

= $1,100,000 x $1,300,000 = $953,333
$1,500,000

Consequently, the entire amount of safe income on hand will not be crystallized as part of the adjusted cost base of the shares if the agreed amount in respect of the subsection 85(1) election is less than the fair market value of the shares of OPCO being transferred to Holdco.

.In the third situation outlined in your letter, it is our view that after the winding-up of the 1st Company into the 2nd Company, the safe income on hand of the 2nd Company will be reduced by the amount of the loss realized on the intercompany debt which is deemed to be paid in full by virtue of the subsection 80(3) election. Although for tax purposes subsection 80(3) deems the intercompany debt to have been received in full, the 2nd Company has suffered an economic loss and to the extent of such economic loss, funds of the 2nd Company would not be on hand for distribution to its shareholders. In addition, any other liabilities of the 1st Company assumed by the 2nd Company in excess of the fair market value of the property of the 1st Company distributed to the 2nd Company (the "Excess Liabilities") will also reduce safe income on hand of the 2nd Company because such income could not be said to have contributed to the gain on the sale of the shares of the 2nd Company as it will be used to pay off the Excess Liabilities.

However, we agree with your view that the claiming of the loss carryforward of the 1st Company for tax purposes by the 2nd Company would not affect the computation of safe income on hand of the 2nd Company after the winding-up.

.It is our view that losses (whether they are business, farm or capital losses) incurred in a taxation year but which have not been deducted in computing income under section 3 by the corporation, or by any corporations over which the corporation has significant influence, will generally reduce safe income on hand of the corporation because income of the corporation that has been used to finance such losses is no longer on hand to contribute to the gain inherent in a share of the corporation.² Consequently, capital losses that are not deductible for tax purposes would reduce safe income on hand.

The above comments represent our general views with respect to the subject matter of your letter. These comments do not constitute an advance income tax ruling and therefore, as described in paragraph 21 of Information Circular 70-6R2, are not binding on the Department.

Yours truly,

for Director
Reorganizations and Foreign Division
Rulings Directorate
Policy and Legislation Branch

¹ For examples, see John R. Robertson's paper titled "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55" published in the 1981 Annual Tax Conference Report; Michael A. Hiltz's paper titled "Section 55: An Update" published in the 1984 Corporate Management Tax Conference Report; Robert J.L. Read's paper titled "Section 55: A Review of Current Issues" published in the 1988 Annual Tax Conference Report; and Michael A. Hiltz's paper titled "Income Earned or Realized: Some Reflections" published in the 1991 Annual Tax Conference Report.

² It is our position that only the allowable portion of the capital loss will reduce safe income on hand of a private corporation where the non-deductible portion of the capital loss will reduce the balance of the capital dividend account which was created by the non-taxable portion of any capital gains realized previously. To the extent that such non-deductible portion of the capital loss exceeds the balance of the corporation's capital dividend account it should also reduce safe income on hand of the private corporation.

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