Subsection 55(2.3)

The 100 common shares of Opco, having an aggregate fair market value (FMV) of $1,000,000 and an aggregate paid-up capital (PUC), and aggregate adjusted cost base (ACB) to their holders, of $100 are held as to 25% and 25% by two unrelated holding companies (Holdco A and Holdco B) each wholly-owned by Mr. A and Mr. B and as to a further 25% and 25% by two discretionary family trusts for the families of A and B (Trust A and Trust B). The common shares (being all of the issued and outstanding shares) have an aggregate safe income of $400,000 ($100,000 each).

Opco now pays a $400 stock dividend (valued at $400,000) of high-low preferred shares so that each shareholder receives 100 preferred shares with a PUC of $100 and a redemption amount of $100,000.

How is the safe income allocated; and where Trust A is taxable on the $100 stock dividend and makes an immediate capital distribution of those preferred shares to Holdco A, what safe income will be attributable to those preferred shares received by Holdco A?

CRA first noted that for the purposes of inter alia ss. 55(2) to (2.4), s. 55(2.2) deems the amount of the stock dividend received by Holdco A and Holdco B and their s. 112(1) deductible amount to be $100,000. CRA then noted that since the accrued capital gain on the 25 common shares of OPCO held by Holdco A and B immediately before the stock dividend exceeded the $100,000 stock dividend amount and this $100,000 amount, in turn, did not exceed the amount of income earned or realized that could reasonably be considered to contribute to the capital gain that could be realized on the 25 common shares immediately before the stock dividend, then by virtue of s. 55(2.3)(a), the amount of the $100,000 stock dividend received by Holdco A and Holdco B would will be deemed to be a separate dividend for the purposes of subsection 55(2), and by virtue of s. 55(2.3)(b), OPCO's safe income that contributed to the capital gain on the 25 common shares of the capital stock of OPCO held respectively by Holdco A and Holdco B would be reduced by $100,000.

By virtue of s. 52(3)(a)(ii), the 100 high-low preferred shares of each of Holdco A and B (with a FMV of $100,000) will have an ACB of $100,000, their 25 common shares (with an FMV of $150,000) will have an ACB of $25; and those 25 shares would no longer have any safe income. By virtue of s. 52(3), the safe income of $100,000 contributing to the capital gain on the 25 common shares of the capital stock of OPCO held respectively by Holdco A and Holdco B before the payment of the stock dividend is now reflected in the ACB of the 100 high-low preferred shares received as a stock dividend by Holdco A and Holdco B.

As for Trust A and Trust B, immediately after the stock dividend, each of them will hold 100 high-low preferred shares having a redemption amount of $100,000 and, by virtue of s. 52(3)(a)(i) and para. (c) of s. 248(1) –amount, an ACB of $100. OPCO's safe income contributing to the capital gain on the 25 common shares held by Trust A and Trust B, respectively, will be reduced by only $100, being the stock dividend received by Trust A and Trust B. However, that amount of safe income will be split between the two classes of shares held by Trust A and Trust B based on the unrealized gain on each class.

The safe income reasonably contributing to the capital gain on the 25 common shares of the capital stock of OPCO held by Trust A and Trust B is $59,940 (149,975 / 249,875 X 99,900) and the safe income reasonably contributing to the capital gain on the 100 preferred shares held by Trust A and Trust B is $39,960 (99,900 / 249 875 X 99,900).

CRA then stated:

As for the high-low preferred shares distributed by Trust A to Holdco A as a capital distribution, and assuming that Trust A was able to make such a distribution with no tax consequences by virtue of subsection 107(2), the safe income contributing to the capital gain of those shares would be the same as that determined in Question 4(a), namely $39,960.

Opco pays a stock dividend to Holdco of shares with a paid-up capital of nil and a fair market value of $1,000 (and whose amount is deemed to be the greater of those two amounts). As the safe income that can reasonably be viewed as contributing to gain on Opco shares was $900, does the bifurcation of the dividend into two dividends under s. 55(2.3) mean that the $900 is exempt as not exceeding safe income, and the $100 is exempt if its purpose is not to significantly reduce the gain or the value of the shares?

CRA indicated that the $1000 dividend is first subject to tests under s. 55(2.1)(a) and (b) and, if those provisions apply, the stock dividend is segregated into two dividends under s. 55(2.3), and the amount of the stock dividend in excess of safe income ($100) becomes the amount referred to in s. 55(2.1)(c) - and it is that amount that is subject to the application of s. 55(2).

Opco has two resident shareholders (Holdco and Ms. X) each owning a bloc of 50 common shares with an adjusted cost base (“ACB”) of $5,000, a fair market value (“FMV”) of $500,000 and safe income on hand of $450,000. Opco paid a $700,000 stock dividend in the form of 1,000 preferred shares with a redemption amount and FMV of $700 per share and aggregate paid-up capital (“PUC”) of $1. How does the Opco safe income of $900,000 contribute to gains on the (stock dividend) preferred shares and the common shares in light of ss. 55(2.3) and 52(3)(a)? CRA responded:

[T]he amount of the stock dividend… deemed to be a separate dividend for the purpose of applying subsection 55(2) is $350,000, and this amount is deemed to reduce Opco’s safe income that contributes to the gain on the 50 common shares, pursuant to paragraph 55(2.3)(b). Immediately after the stock dividend is paid, Holdco will own (i) 500 preferred shares with a FMV and an ACB of $350,000, pursuant to paragraph 52(3)(a) and (ii) 50 common shares with a FMV of $150,000 and an ACB of $5,000, resulting in an inherent capital gain of $145,000. At that time, Opco has $100,000 of safe income that contributes to the inherent capital gain on Holdco’s original 50 common shares. The other $350,000 of safe income is now reflected in the ACB of the 500 preferred shares…pursuant to paragraph 52(3)(a).

…Ms. X, immediately after the stock dividend… will own (i) 500 preferred shares of Opco with a FMV of $350,000 and an ACB of $0.50 (footnote 1), resulting in an inherent gain of $349,999.50 and (ii) 50 common shares of Opco with a FMV of $150,000 and an ACB of $5,000, resulting in an inherent gain of $145,000. Opco’s safe income that contributes to the gain on the 50 common shares held by Ms. X is not reduced by the stock dividend paid… . This safe income of $450,000 will be apportioned between Ms. X’s 500 preferred shares issued as a stock dividend and her original 50 common shares based on their respective gains, as determined after the payment of the stock dividend. …[T] he safe income that reasonably contributes to the $350,000 inherent capital gain on Ms. X’s 500 preferred shares is therefore $318,182 …= $350,000/$495,000…X $450,000… and the safe income that reasonably contributes to the $145,000 inherent capital gain on Ms. X’s original 50 common shares is $131,818… = $145,000/$495,000 X $450,000… .