26 June 1998 Internal T.I. 9813100 - DISCRETIONARY 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.

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.

STRATEGY INSTITUTE - 1998 Round Table

Question

56(2) - Implications of Neuman v. The Queen

Would the Department apply subsection 56(2) in the following estate freeze situation:

• freezor exchanges common shares of an investment holding company (“Holdco”), under subsection 86(1), for redeemable, retractable preference shares of Holdco having a fair market value and redemption price equal to the fair market value of the common shares of Holdco for which they were exchanged;
• a trust for the adult children of freezor subscribes for new common shares of Holdco;
• some of the “freeze” preference shares are redeemed each year in lieu of paying dividends on the “freeze” shares; and
• each year dividends, which do not impair the redemption value of the outstanding preference shares, are paid on the common shares to the trust.

Response

On May 21, 1998 the Supreme Court of Canada rendered its judgment in the case of Melville Neuman v. Her Majesty the Queen concerning the application of subsection 56(2) to dividends.

Iacobucci, J. speaking for the Court concluded that subsection 56(2) cannot operate to attribute dividend income to a taxpayer unless the taxpayer had a pre-existing entitlement to the dividend income paid to another shareholder. Effectively, the Court confirmed the conclusion reached in McClurg “that, as a general rule, subsection 56(2) does not apply to dividend income since, until a dividend is declared, the profits belong to the corporation as retained earnings. The declaration of a dividend cannot be said, therefore, to be a diversion of a benefit which the taxpayer would have otherwise received.”

The Court also addressed the obiter comments made by Dickson, C.J. in McClurg and clarified that subsection 56(2) will not apply to dividend income where the recipient of the dividend in a non-arm’s length transaction has not made any contribution to the corporation. In this regard, Iacobucci, J. stated that “dividends are paid to shareholders as a return on their investment in the corporation. Since the distribution of the dividend is not determined by the quantum of the shareholder’s contribution to the corporation, it would be illogical to use contribution as the criterion that determines when dividend income will be subject to s. 56(2). The same principles apply in the context of both non-arm’s length relationships such as often exist between small closely held corporations and their shareholders, and arm’s length relationships such as exist between publicly held corporations and their shareholders.”

Consequently, in the example described, provided that the dividends paid on the common shares do not impair the redemption value of the “freeze” preference shares or any other class of fixed-value preferred shares, subsection 56(2) will not apply to the dividends paid to the holders of the common shares. However, the possible application of the attribution rules, including those found in subsection 74.4(2), would have to be considered to any estate freeze situation.

T. Harris
981310
June 10, 1998