4 September 1984 Income Tax Severed Letter 7-3490 - [Dividends paid by a Corporation that is in a deficit position]

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.

September 4, 1984

TO/À SYDNEY DISTRICT OFFICE

FROM/DE HEAD OFFICE
        Corporate Rulings Directorate
        S. Shinerock
        993-6937

ATTENTION G.A. Chiasson
          Audit Section

RE: Dividends paid by a Corporation that is in a deficit position

We refer to your memorandum of July 5, 1984 pertaining to the payment of dividends by a corporation that is in a deficit position at the time of payment. Since you do not have a specific case with its attendant set of facts, our views that follow are of necessity based on general principles of law and should be read as such.

The term "dividend" is not defined in the Act. Accordingly, one must look to its generally accepted meaning, which in broad terms is "a portion of the profits of a company which is distributed pro rata among its shareholders". One cannot, however, stop there. It is necessary to look to the relevant company law as well as to what the courts have said on the meaning of "profits available for distribution".

As a general rule, a company may not pay a dividend if the payment would render the company insolvent or would diminish or impair its capital, and directors of a company who vote for, or consent to the payment of a dividend in such circumstances are jointly and severally liable to the company to make good any loss or damage suffered by the company as a result.

There are no hard or fast rules as to when a company is insolvent or would he made insolvent by a particular dividend payment made at a particular time. Insolvency would exist, we suggest, if a company could not meet its debts as they become due. Therefore, the existence of an accounting deficit, in and by itself, is not a test of insolvency. A company could have an accounting deficit and yet have positive working capital. Even the existence of both accounting and working capital deficits at a particular point in time does not mean that a company is insolvent as long as the company can meet its obligations as they become due.

The present position of company law regarding the payment of dividends may be found in "Fraser's Handbook on Canadian Company Law (Sixth Edition)- Chapter 13", wherein it is stated that:

"The propriety of declaring a dividend and its amount, apart from questions of legality, will be a matter for the discretion of the directors. If the directors do not act illegally or fraudulently or in bad faith, their discretion will not be interfered with by the courts."

Even where dividends are paid out of capital such that the company's capital is impaired contrary to the law of the Incorporation Act, shareholders who have received the dividend with knowledge that it has come out of capital, though bound to indemnify the directors against their liability in respect of the payment, would still appear to have received a dividend. That is, a dividend declared and paid pursuant to a resolution of the board of directors, even though it constitutes an improper dividend, would still appear to be a dividend for tax purposes.

The payment of dividends that actually impair capital would, we think, be a relatively rare occurrence. However, the payment of a dividend when the company has an accounting deficit may not be an infrequent event.

The question then arises as to whether the dividends giving rise to the accounting deficit may be said to "come from profit"? Unfortunately, there are as yet no clear pronouncements by the courts as to the meaning of profit for this purpose. Profit may, however, be viewed as arising from two sources:

i) Profit that represents the credit balance on revenue account arising from the company's ordinary business, and

ii) Profit realized by dealing with the fixed capital and forming accretions to capital i.e. where fixed assets of a company are sold for profit.

The English courts have also held that even unrealized capital profits (i.e. appraisal surplus). may be distributed by way of a dividend. If, of course, the Articles of a company provide that dividends may only be paid out of profit arising from the business of the company, then such a provision will apparently preclude payment of dividends except out of revenue account as opposed to profit arising from the sale of fixed assets or profit inherent in appraisal surplus, though as mentioned above, such an improper dividend may very well constitute a dividend for tax purposes.

Therefore, until company law in Canada adopts a more rigid definition of "profit" for the purpose of paying dividends (as may have already occurred with respect to companies doing business within the framework of the European Common Market), the only test to be applied in Canada in determining the legality and thus the nature of a payment as a dividend would appear to lie in the Articles of the Company and in the actions of the board of directors. If the payments of a dividend is not restricted in any way, then even the payment of a dividend made when the company is insolvent or which renders the company insolvent would not appear to change the nature of the payment as a dividend for tax purposes.

We would again stress the general nature of the above discussion. If you have an actual situation that you would like us to review, we would be pleased to do so.

Chief Finance, Insurance & Leasing Section Specialty Corporations Rulings Division Corporate Rulings Directorate Legislation Branch