15 November 2016 Roundtable, 2016-0672321C6 - Guidance on determination of 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.

Principal Issues: Various questions raised regarding the calculation of safe income - see document

Position: see document

Reasons: see document

TEI – CRA Liaison Meeting – November 15, 2016

Question B3: Subsection 55(2) guidance on determination of safe income

a. Given the historical records required to prepare safe income calculations, what type of practical approaches and assumptions are accepted by the CRA when it comes to relying on the amounts established as a starting point to support the opening balance of income earned or realized after 1971 and before the applicable safe income determination time” as determined under paragraphs 55(5)(b) and (c) (“safe income”) (e.g. accounting retained earnings)?

b. Could the CRA provide a copy of previous tax returns, assessments, and reassessments dating back to the incorporation of the entities that have to compute the safe income that contributes to the capital gain on a share?

c. What type of audit practices can taxpayers expect in respect of supporting documentation used to calculate safe income that contributes to the capital gain on a share?

d. Safe income is computed in reference to a share over a period that begins when a taxpayer acquires the share and ends at the safe-income determination time. Under subsection 55(1), the safe-income determination time is the earlier of: (i) the time that is immediately after a transaction with an unrelated person as described in subsection 55(3)(a) as part of a series; and (ii) immediately before the earliest dividend paid as part of a series. Could the CRA provide additional guidance on the safe-income determination time where a company pays a regular dividend, either on a monthly, quarterly, or annual basis, but does not enter into a transaction with an unrelated person under subsection 55(3)(a)?

e. The CRA’s position had been that contingent liabilities and accounting reserves, such as future employee benefits and pension obligations, reduce the safe income that can reasonably be considered to contribute to the capital gain on a share. In Kruco v. The Queen, 2003 FCA 284, the court held that safe income should be reduced by cash outflows. Has CRA’s position changed in light of Kruco?

Responses

a. In determining whether a dividend meets the exception in paragraph 55(2.1)(c) of the Income Tax Act, the onus is on the taxpayer to provide support for the calculation of the income earned or realized by any corporation after 1971 and before the safe-income determination time.

Previous positions from the CRA and the Courts have used the expression “safe income on hand”. It appears that the concept of safe income on hand might not have been used consistently in different publications and cases.

For the purposes of this answer, we refer to “safe income” to describe the “income earned or realized after 1971 and before the applicable safe income determination time” as determined under paragraphs 55(5)(b) and (c). In order to avoid possible confusion, we will refer to “safe income that can reasonably be considered to contribute to the capital gain on a share” to describe the portion of the safe income that was sometimes referred to as “safe income on hand” in previous positions and jurisprudence.

The onus is on the taxpayer to provide support for the calculation of safe income that can reasonably be viewed as contributing to the capital gain on a share. The CRA expects the supporting documentation to be organized as an accumulation of year-by-year computations. Safe income has to be determined following the requirements of paragraphs 55(5)(b) and (c) (starting with net income for income tax purposes) and adjusted to reflect the portion of the safe income that can reasonably be considered to contribute to the capital gain on a share.

In the course of a compliance audit where a detailed computation of the safe income that can reasonably be considered to contribute to the capital gain on a share is not provided by the taxpayer and the taxpayer offers an alternative proxy such as the accounting retained earnings or adjusted retained earnings balance, the CRA would proceed as it would in any circumstance in the course of an audit where optimum audit evidence has not been provided by the taxpayer. The CRA auditor would determine if what was provided is a reasonable effort to compute an accurate estimate. In some very rare cases, the CRA auditor might conclude that retained earnings is a fair proxy for safe income on hand but only after a very stringent validation process.

The calculation of safe income has a purpose of substantiating the claim that a dividend is not subject to the application of subsection 55(2). We should note that an incorrect claim could be subject to the application of subsections 152(4), 163(2) or 239(1), depending on the circumstances.

b. As it stands now, when a taxpayer makes a request to the CRA to obtain a copy of income tax returns and/or notices of assessment, the CRA will attempt, in regards to available resources, to provide the requested documentation. However, the CRA is not under the obligation of providing such documents and it is not in a position to provide assurances that these requests will be actioned in all cases.

c. The audit practices that a CRA auditor typically carries out to verify the calculation of safe income that can reasonably be considered to contribute to the capital gain on a share are similar to audit steps on any other audit issue.

Each component of the calculation will be validated utilizing appropriate documentation provided by the taxpayer. That includes a verification of the portion of the safe income that can reasonably be considered to contribute to the capital gain on each share of the corporation in any given year. This typically involves a validation that a detailed analysis was done using share registers and minute books provided by the taxpayer. The analysis should be carried out for each year and the adjustments should take into consideration any changes in the shareholdings.

d. In a recent ruling, the CRA took the view that regular, recurring annual dividends would not, in the circumstances of the ruling request, be part of a series of transactions. Accordingly, a ruling confirmed that the safe income determination time in respect of the first and second annual dividends will be immediately before each such dividend.

In addition, in a recent technical interpretation (2016-0633961E5), the CRA considered the situation where a corporation sold its depreciable properties and its eligible capital property before the end of a taxation year and paid a dividend after the sale of the assets but before the end of the year of the sale. We were asked to confirm whether the amounts computed pursuant to subsections 13(1) and 14(1) at the end of the taxation year would be added to the safe income before the safe income determination time with respect to the dividend.

Applying the textual, contextual and purposive approach, the CRA indicated that it would accept that the safe income immediately before the safe income determination time would include the income computed pursuant to subsections 13(1) and 14(1) if the sale of the assets occurred before that safe income determination time. However, the CRA would also take the position that the portion of the safe income that can reasonably be viewed as contributing to the capital gain on a share would be reduced by the amount of income taxes payable with respect to the income inclusion resulting from that sale.

e. As discussed in ITTN-37, dated February 18, 2008, the FCA's decision in Kruco requires a second stage inquiry in respect of the calculation of a corporation's safe income to determine whether the income earned or realized was kept on hand (i.e., whether such income can reasonably be viewed as contributing to the capital gain on a share). The decision supports the notion that the safe income should be reduced by actual or potential cash outflows such as non-deductible expenses, contingent liabilities and accounting reserves in the determination of the amount of safe income that can be viewed as contributing to the capital gain on a share.

We welcome any additional questions on interpretative issues.

Marc Ton-That
2016-067232
November 15, 2016