30 May 1989 Income Tax Severed Letter 5-7578 - [Calculation of Safe Income of a Company—Subsection 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.

Dear Sirs:

This letter respond to fours of February 13, 1989 in which you requested our comments on the issues described below relating to the calculation and allocation of safe income of a resource company, for purposes of subsection 55(2) of the Income Tax Act (Canada) (the "Act").

1. It is your position that the safe income on hand for a corporation carrying on a resource business should be:
• (a) decreased by the amount of any "phantom income" inclusions required by paragraph 12(1)(o) and subsections 69(6), (7), (8) and (9) of the Act;
• (b) decreased by the amount of deductions disallowed by paragraphs 18(1)(1.1) and 18(1)(m) of the Act;
• (c) increased by the amount of the additional deductions provided for in paragraph 20(1)(v.1) and section 65 of the Act and the related provisions of the Income Tax Regulations;
• (d) increased by the amount of certain non-taxable incentive grants which were, in the past, received from provincial governments in respect of various types of exploration and development expenses and which did not reduce the amount of such expenses for purposes of the Act; and
• (e) increased by the amount of "incremental oil revenue" which you advised us was, in the past, subject to a special incremental oil revenue tax but excluded from tax under Part I of the Act.
• 2. It is your position that where resource properties (the "Transferred Resource Properties") were transferred by a corporation to another corporation in exchange for preference shares having a low paid-up capital, within the meaning of paragraph 89(1)(c) of the Act, and a high redemption amount (the "Preference Shares"), it is reasonable to attribute safe income to the dividend arising on redemption on the Preference Shares providing it can be established that safe income equal to the amount of the deemed dividend was generated from a sale of or production from the Transferred Resource Properties. Production from the Transferred Resource Properties, for purposes of this example, would have the effect of decreasing the value of such properties over time.
• 3. Is it acceptable under paragraph 55(5)(f) of the Act for a corporation to designate as the portion of a dividend received by it which is deemed to be a separate taxable dividend "the amount of the dividend which is attributable to the safe income of the payer corporation which is estimated to be $X"? In the event that the amount of safe income is less than estimated, Revenue Canada, Taxation (the "Department") would, in your opinion, then be entitled to increase the amount of the recipient corporation's deemed capital gain or proceeds of disposition without necessarily subjecting the entire amount of the taxable dividend to taxation.

Opinions

The Department's views on the principles employed in the calculation of safe income can be found in a paper presented by J. Robertson at the 1981 Tax Conference of the Canadian Tax Foundation. These statements were subsequently updated at the 1984 Corporate Management Tax Conference and the 1988 Tax Conference.

Generally, the Department is of the view that "safe income" with respect to a share of a corporation refers to the income earned by any corporation during the holding period of a particular share of the corporation that can reasonably be considered to be allocable to that share in the particular circumstances. Safe income on hand during the holding period of a share is made up of taxable income plus certain adjustments, less the sum of losses incurred, dividends paid and provincial and federal income taxes paid or payable in respect of that income. The holding period is generally the time from the later of January 1, 1972 or the acquisition of the particular share to the time immediately before the transaction or event or the commencement of the series of transactions or events referred to in paragraph 55(3)(a) of the Act.

It should be noted that for purposes of subsection 55(2), the amount of the capital gain which would have been realized on a disposition at fair market value of a particular share immediately before a dividend payment which is attributable to "income earned or realized ... after 1971" cannot exceed the amount of safe income on hand when the dividend is paid. A dividend paid which exceeds safe income on hand may be subject to the provisions of subsection 55(2) of the Act, as the dividend would reduce the portion of the gain on the shares which is attributable to something other than safe income.

With respect to the first issue mentioned in your letter, we cannot agree unconditionally with your position as there may be additional facts which are relevant to a particular situation. However, generally we agree with your views as to the effects on the calculation of safe income and safe income on hand of the items outlined in your question, subject to the following comments.

First, we do not agree that the amount of non-taxable incentive grants received by a corporation would increase its safe income or safe income on hand. Paragraph 55(5)(b) of the Act establishes as the starting point for the calculation of "income earned or realized by a corporation", i.e. safe income, the income for purposes of the Act of the corporation subject to certain adjustments. As no adjustments are specified in respect of government grants, such grants would only affect the calculation of safe income, and consequently safe income on hand, to the extent the grants were included in the computation of the corporation's income for purposes of the Act. This view was expressed in J. Robertson's paper at page 90 of the 1981 Tax Conference Report (item (xvii)).

Secondly, we agree that incremental oil revenue would be included in the computation of safe income of a corporation but note that incremental oil revenue tax paid or payable would reduce safe income on hand.

In our opinion, the entire inherent gain in respect or the Preference Shares referred to in item 2 above, immediately before their redemption, would be attributable to the transferor's deferred gain on the Transferred Resource Properties, whether such properties are subsequently retained or disposed of by the corporation. Therefore, income attributable to the production from or sale of the Transferred Resource Properties would not attribute to such gain. A similar view was expressed in R. Read's paper on section 55 at the 1988 Canadian Tax Foundation Tax Conference in respect of the transfer of non-depreciable capital property. In our view, it is equally applicable to a transfer of assets which may decline in value after the transfer, such as resource properties or depreciable properties.

Paragraph 13 of Information Circular 88-2 contains the following statement by the Department on the application of subsections 55(2) or 245(2) as a consequence of the redemption of shares issued to a corporate vendor of property by an arm's length corporate purchaser to avoid the consequences to the vendor of a straightforward disposition of property:

If the property transferred is non-depreciable capital property, subsection 55(2) applies and the taxpayer would realize a capital gain equal to the difference between the redemption amount and the adjusted cost base of the redeemable preferred shares. Subsection 245(2) would, therefore, not apply. On the other hand, if the property transferred is depreciable property or property the proceeds of disposition of which would result in the realization of income, subsection 245(2) would apply on the basis that the issue of the preferred shares is undertaken to avoid the consequences of a straightforward disposition of the property.

The Department's position with respect to the designations under paragraph 55(5)(f) of the Act is outlined at page 94 of J. Robertson's paper as follows:

The risks of losing the benefits of having safe income by an improper designation can be reduced as follows:

• First, designate an amount under paragraph 55(5)(f) that is equal to the amount that the taxpayer is confident is safe income.
• Second, make a series of designations on the balance of the dividend with respect to amounts for which the taxpayer has reasonable grounds to believe should be included in safe income but for which there may be some element of doubt or dispute.

In our view, this procedure is still the appropriate one and thus a single designation equal to "the amount of safe income of the corporation attributable to the dividend" would not be acceptable. As noted in R. Read's remarks at the 1988 Tax Conference it is the Department's "... fundamental view that the ability to make a designation under paragraph 55(5)(f) does not relieve the dividend recipient of the onus imposed by the self-assessment system to report as a gain its best estimate of the amount of the dividend in excess of safe income."

The foregoing comments are expressions of opinion provided in accordance with the procedure explained in paragraph 24 of Information Circular 70-6R.