Subsection 55(2)

Suppose that Holdco has eligible refundable dividend tax on hand (“ERDTOH”) and non-eligible refundable dividend tax on hand (“NERDTOH”) both of nil, and a general rate income pool (“GRIP”) of $1,000,000, and that its wholly-owned subsidiary, Opco, has ERDTOH, NERDTOH and GRIP of nil, $383,333 and $2,000,000, respectively. There is no safe income attributable to the Opco shares held by Holdco. Opco pays a non-eligible dividend of $1,000,000 to Holdco, and Holdco then pays a $1,000,000 dividend.

On the payment of the Opco dividend, it generates a dividend refund of $383,333, which results in Pt. IV tax payable by Holdco of the same amount, which is added to Holdco’s NERDTOH account. When Holdco in turn pays an eligible dividend of $1,000,000, no dividend refund is generated.

In confirming that even though there is no safe income for the shares held by Holdco, s. 55(2) does not apply, CRA stated:

Opco will, by virtue of paragraph 129(1)(a), be entitled to a dividend refund of its NERDTOH balance of $383,333. Considering that, Holdco will therefore be liable for Part IV tax of $383,333. Consequently, the entirety of that dividend received by Holdco would be subject to Part IV tax and may not be subject to subsection 55(2) by virtue of the exclusion provided for in the preamble to subsection 55(2) to the extent that such Part IV tax is not refunded by reason of the payment of a dividend by Holdco where such payment forms part of the series referred to in subsection 55(2.1).

9711005 indicated, before the bifurcation of RDTOH into the eligible refundable dividend tax on hand (“ERDTOH”) and non-eligible refundable dividend tax on hand (“NERDTOH”) accounts, that it was not possible to use both the Part IV tax exception to s. 55(2) and the safe income exclusion.

Holdco holds all the shares of Opco having attributable safe income of $1,000,000 and a fair market value of $5,000,000. Opco has a general rate income pool (GRIP) of $1,000,000 and a NERDTOH balance of $70,000. Before Holdco’s sale of the Opco shares, Opco first pays a $1,000,000 dividend (designated as an eligible dividend) - and then pays a non-eligible dividend of $182,608, which generates a refund of the $70,000 of NERDTOH, so that Holdco is subject to Part IV tax on that dividend.

Can Holdco take advantage of both the $1,000,000 safe income exclusion and of the Part IV tax exclusion regarding the dividend of $182,608, given that the $1,000,000 dividend is not subject to Part IV tax?

CRA noted that no dividend refund arises to Opco on the $1,000,000 eligible dividend, so that there is no Part IV tax payable by Holdco thereon under s. 186(1)(b) – and that such dividend also is not subject to s. 55(2) as it does not exceed the $1,000,000 of safe income.

Since Opco is entitled to a dividend refund of its $70,000 NERDTOH, Holdco is liable for $70,000 of Part IV tax on that dividend, so that such dividend is not subject to s. 55(2) under the Part IV tax exclusion in the s. 55(2) preamble, to the extent that such Part IV tax is not refunded by reason of the payment of a dividend by Holdco where such payment forms part of the series referred to in s. 55(2.1).

Example 1, Scenario 1 is summarized as follows:

Opco, which had refundable dividend tax on hand ("RDTOH") of $383,333 and no safe income paid a $1M dividend to which s. 55(2.1)(b) applied to Holdco (which also had a calendar year). At the time of preparing its original return, the Part IV tax liability and RTDOH of Holdco would be $383,333. An amended return for Holdco would then be prepared to give effect to its deemed capital gain under s. 55(2), but with the Part IV tax paid of Holdco remaining at $383,333. Holdco pays the refundable portion of the Part I tax ("RPPT") on the capital gain in the amount of $153,333, increasing its RDTOH to $536,666. On payment of a $1M dividend, Holdco would receive a DR (38 1/3%) of $383,333, reducing its RDTOH to $153,333 (RDTOH: $536,666 and DR: $383,333). The result in the amended return for Holdco would be that there would be federal tax payable in respect of the application of subsection 55(2) of $193,333 ($1,000,000 * 50% * 38 2/3% , of which $153,333 could be recovered in the event of a possible dividend payment by Holdco of at least $399,999).

CRA then provided two variants of Scenario 1 (in which a smaller or no dividend is paid by Holdco), and two versions of Example 2, under which the starting RDTOH of Opco is smaller.

Respecting the scenarios where smaller Holdco dividends were paid, CRA stated:

[A]ny future payment of a taxable dividend by Holdco that resulted in a refund of Part IV tax could result in the potential application of subsection 55(2) to the extent that this payment was part of the same series of transactions. The CRA would consider any future DR as a result of the payment of a dividend by a corporation, where the payment was part of the same series of transactions, as coming first from the Part IV tax paid on the taxable dividend.

Respecting when the amended return should be filed, CRA stated:

[T]he Act does not provide specific rules as to when the amended T2 return must be filed. However, it would be administratively preferable to wait for the initial notice of assessment to be issued before requesting an amendment to the original T2 return to take into account subsection 55(2).

However, regardless of the filing date of the amended T2, it is possible to avoid interest expenses by paying, by the balance due date that is applicable to the corporation, the tax based on the higher amount the corporation may owe in computing its income based on the application of subsection 55(2) on the amended T2 return. However, there are certain administrative rules that must be followed to ensure that the additional amount is allocated by the Minister to the correct taxation year and not refunded by the Minister on the initial notice of assessment [with such rules then being summarized].

Holdco receives a dividend of $400,000 that is subject to Part IV tax of $153,333 (38.33% of $400,000) equalling the connected payer’s dividend refund and, in turn, pays a dividend to its shareholders resulting in a refund of the Part IV tax – so that the dividend received by Holdco is subject to s. 55(2).

If the dividend received by Holdco was originally taxed as a capital gain to Holdco, the refundable tax on the capital gain would be $61,333 ($400,000 x 50% x 30.66%).

Instead of having to pay the whole amount of $400,000 as a taxable dividend to established that the Part IV tax of $153,333 is fully refunded so that s. 55(2) applies, Holdco would only need to pay an amount of $160,000 as a taxable dividend ($61,333/38.33%) so that, at the same time, a capital dividend of $200,000 can be paid. This result is achieved because of circular calculations whereby the dividend received is deemed to be reduced by the application of s. 55(2) after each calculation, resulting in reduced Part IV tax - whereas the amount of the tax refund remains the same in each calculation. Does CRA agree?

Before concluding that the scheme of s. 55(2) does not support such circular calculations, CRA first noted that the example proposes that there is only a capital gain of $400,000 to be included in the tax return of Holdco, and that the refundable tax on such capital gain is fully refunded by the payment of a taxable dividend by Holdco of $160,000, and indicated that for a dividend to be subject to s. 55(2) based on a Part IV tax refund, such refund must be a real refund of real tax (as per Ottawa Air Cargo). Thus, the application of s. 55(2) does not eliminate the subjecting of the dividend to Part IV tax.

Using the numbers in the example, if Part IV tax of $153,333 is paid or payable, as declared in the initial tax return of Holdco, that Part IV tax is paid or payable for the taxation year. In the second return filed by Holdco, the Part IV tax paid for the taxation year remains unchanged, even though the amount of the dividend received has been reduced by the application of s. 55(2).

A capital dividend of $80,000 could be paid by Holdco after the receipt of the $400,000 dividend, due to the application of s. 55(2).

A dividend is received by Holdco from an Opco, which under the new s. 55(2) rules is no longer exempted from s. 55(2) even though the Part IV tax to which it was subjected is refunded on on-payment as a dividend to the individual shareholder. The high rate of resulting combined tax cannot be alleviated by treating such s. 55(2) application as permitting an election to treat the applicable portion of the individual shareholder’s dividend as a capital dividend. Instead, such capital gain only generates capital dividend account for use for future dividends.

Less overall tax is paid if, rather than Opco paying a taxable dividend to one of its shareholders (A, an individual), A rolls his shares into a new Holdco, Opco redeems the shares now held by Holdco (but without any s. 55(5)(f) designation being made by Holdco so that all of the redemption proceeds are subject to capital gains treatment under s. 55(2)), and then Holdco pays a capital dividend to A. CRA commented:

[T]he GAAR committee…recommended that the GAAR not be applied [in a similar file] having regard to the current state of the jurisprudence.

Nonetheless, the CRA is concerned by this type of tax planning, which in particular, is contrary to the integration principle. Accordingly, we have brought our concerns…to…Finance.

[See also 16 June 2014 STEP Roundtable Q. 7, 2014-0522991C6.]

Holdco holds shares of Opco with a nominal ACB and no safe income. In a corporate reorganization "aimed at protecting the assets of Opco, whose purpose is to reduce the fair market value (FMV) of Holdco’s shares in Opco," Holdco lends money to Opco equal to the accrued gain on the shares (of $1M), and receives that money back as an actual $1M dividend. It does not matter if this transaction has no capital gains avoidance purpose. CRA accepted that since the purpose of the creditor-proofing is to reduce the fair market value of the Opco shares, the full amount of the dividend is deemed to be a capital gain. Furthermore, there is no relief if the dividend from Opco is subject to Part IV tax, but this tax is refunded as a result of payment of an equivalent dividend to the individual shareholder of Opco. Under the new rules, it does not matter that the individual is not a corporation eligible for the s. 112(1) deduction, so that the dividend amount will still be deemed to be a capital gain.

Prior to a sale by Holdco of all the shares of Opco to an arm's length purchaser for $1,000,000, Opco will transfer its interest in the Policy on the life of Mr. X (the sole shareholder of Holdco) to Holdco as a dividend-in-kind. The Policy has a nil ACB, $200,000 FMV, $100,000 CSV and $1,000,000 death benefit. What will be the impact of the dividend-in-kind on the computation of safe income on hand?

Timing of addition to SIOH

After noting that Opco would be deemed by ss. 148(7) and (9) to receive proceeds of disposition equal to the Policy's CSV rather than FMV, CRA stated:

[T]he safe-income determination time for the Dividend-in-Kind… is the time that is immediately before the time that the Dividend-in-Kind is paid to Holdco. Because the income inclusion resulting from the disposition of Opco's interest in the Policy…will be added to Opco's safe income after the Dividend-in-Kind is paid to Holdco, it will not contribute to the capital gain that could be realized on a disposition at fair market value of an Opco share immediately before the time the Dividend-in-Kind is paid.

Effect of non-deductible policy premium on SIOH

After noting that "premiums payable by a taxpayer under a life insurance policy are generally considered to be on account of capital" and referencing "the payment of premiums on the Policy over the period throughout which Opco was a private corporation," CRA stated:

The portion of such premiums that contributes to the increase of the cash surrender value of the Policy would be considered to be on hand at the safe income determination time to the extent that it contributes to the accrued capital gain on a share of the capital stock of Opco at that time. … However, the portion of such premiums that does not contribute to the increase of the cash surrender value of the Policy at that time will not be on hand at the safe income determination time and would therefore reduce the amount of safe income that could reasonably be considered to contribute, immediately before the Dividend-in-Kind, to the accrued capital gain on the Opco shares on which that dividend is received.

A discretionary trust (the "Trust"), whose beneficiaries were A, A's spouse, their children and a corporation ("Holdco") all of whose participating and voting shares were held by A, received a dividend on its shareholding (being all the non-voting common shares) in Opco, and distributed that dividend to Holdco, making a s. 104(19) designation, and with Holdco claiming a s. 112(1) deduction for its income inclusion under s. 104(13). The Opco dividend amount equalled the safe income on hand respecting the Trust's shares, and no Part IV tax was payable (by virtue inter alia of A being the sole voting shareholder of Opco).

Should the dividend be recognized in the calculation of Holdco's safe income? After noting the availability and making of the s. 104(19) designation in respect of the dividend which was included in Holdco's income under s. 104(13), CRA stated (TaxInterpretations translation):

[I]t would be reasonable to consider that the amount of the dividend allocated to Holdco by virtue of subsection 104(19) which was included in the computation of its income, would increase its safe income by an equivalent amount.

On a cross-share redemption between two connected Canadian-controlled private corporations, neither of which has a refundable dividend tax on hand account account immediately before the redemption, each corporation is deemed to receive a dividend from the other. Does the application of s. 55(2) to the deemed dividend received by each corporation, which generates an addition to its RDTOH account and, therefore, generates a dividend refund to it and associated Part IV tax on the deemed dividend paid by it to the other corporation, engage the exclusion from s. 55(2) for dividends which are subject to Part IV tax – or does the Part IV tax exclusion not apply so that s. 55(2) applies to the full amount of the deemed dividend received by each corporation? CRA stated (TaxInterpretations translation):

[I]n accordance with sections 129 and 186, it is provided that the dividend refund, the RDTOH account and thus the Part IV tax of a given corporation are calculated as a function of all relevant amounts in this regard for the whole taxation year.

Furthermore … in … 943963 Ontario Inc. … the parties … and the Court accepted that there was a given amount subject to Part IV tax by the appellant, the dividend recipient, notwithstanding that a part of the deemed dividend…was deemed to not be a dividend received, by virtue of subsection 55(2). In other words, the part of the dividend giving rise to a capital gain by virtue of subsection 55(2) did not affect the amount of the "assessable dividend" taken into account for calculating the Part IV tax payable… . The application of subsection 55(2) in that case did not engage any circular calculation. …

Moreover, the fact of calculating the RDTOH account at the end of a taxation year of each corporation in such a situation…involving cross redemptions and thus cross dividends, entails circular calculations by them of their respective RDTOH, dividend refunds and Part IV tax. In policy terms, it does not appear acceptable to us that circular calculations could result in a complete reimbursement of the total RDTOH of each corporation in such a situation.

A corporation has insufficient safe income in respect of its shares and, rather than making a s. 55(5)(f) designation, self-assesses itself for a capital gain to the extent of the insufficient safe income on hand? Is it permissible for it to self-assess the dividend received by it as proceeds of disposition?

CRA referred to Nassau Walnut, which found that a s. 55(5)(f) designation is not an election (and "is, in some respects, no different than the deduction provided under subsection 112(1)") and, more generally, referred to Brelco, Lamont and Kruco for the principle "that the safe income of a corporation should not be subject to double taxation when distributed as a dividend to another corporation." CRA then stated:

CRA's long standing practice is to apply subsection 55(2) only to the excess of the taxable dividend paid on a share over the safe income on hand attributable to that share, when issuing an assessment based on subsection 55(2).

Vendor sold blocks of shares in the capital of a corporation (the “Purchaser”) to the Purchaser, with the purchase price being payable over a following number of years based a percentage in each year of the annual consolidated after-tax profits of the Purchaser. The deemed dividend arising in the year of the repurchase under s. 84(3) was deemed by s. 55(2) to be proceeds of disposition. Was the reserve under s. 40(1)(a)(iii) available as a deduction from this capital gain?

After the Directorate confirmed that 1999-0009295 (respecting the availability of a reserve under s. 40(1)(a)(iii) to a capital gain under s. 55(2) where the capital gain arose on the receipt of a promissory note made as a conditional payment) still was valid, and went on to indicate that essentially the same positon applied to the above facts where the unpaid purchase price was not evidenced by a promissory note and was payable on an earnout basis with a prepayment right which had not yet been exercised.

Following a preliminary reorganization (including an amalgamation of predecessors of Amalco so as to "consolidate the tax attributes"), all the shares of Amalco are held by Foreignco3 (resident in the U.S.) which, in turn, is an indirect wholly-owned subsidiary of Foreign Parent, a listed company. Amalco has various direct or indirect (mostly Canadian) subsidiaries carrying on the XYZ Business and also holds the "Keep Assets," which mostly are non-resident or resident subsidiaries. The following transactions occur in order to accomplish an indirect sale of the XYZ Business by Foreignco3 to Buyer (an arm's length purchaser) after a spin-off of the other "Keep Assets" to a newly-incorporated Canadian spinco whose initial common share is held by Foreignco3 ("Canco"):

1. On a s. 86 reorganization Foreignco3 will receive "Keep Shares" (non-voting redeemable retractable preferred shares) and New Common Shares in exchange for its old common shares of Amalco (which are taxable Canadian property).
2. Foreignco3 will transfer the Keep Shares to Canco in exchange for additional Canco Shares, electing under s. 85(1) at fair market value.
3. Amalco will transfer the Keep Assets to Canco in exchange for the Canco Note and the assumption of the Assumed Debts, with a net taxable capital gain resulting.
4. Amalco will purchase the Keep Shares from Canco for cancellation (giving rise to an obligation, but with no note issued).
5. The obligations arising in 3 and 4 and other obligations are set-off.
6. Foreignco3 will sell the New Common Shares (which now derive their value from the XYZ Assets) to the Buyer for cash.

Rulings include:

• the gain realized by Foreignco3 on the transfer of the Keep Shares to Canco in 2 and on the sale in 6 will be exempt from tax under Art. 13 of the Treaty.
• 55(2) will not apply to the deemed dividends arising in 4.

An indirect wholly-owned foreign affiliate ("FA") of Canco made an arm's length purchase of all the shares of "US Holdco," whose wholly-owned subsidiaries ("US-Opcos") had accrued gains inherent in the appreciated assets of their active businesses including capital property, depreciable property and intangible property such as goodwill.

After noting (para. 33) that the income realized ("Intangible Property Safe Income") by the US-Opcos under former s. 55(5)(d) on the disposition of the intangible properties was in respect of gains that accrued on those intangible properties in the period before FA acquired the US Holdco shares (the "Pre-acquisition period") and that "the Intangible Property Safe Income was reflected in the purchase price and, therefore, the ACB, of the US Holdco shares that FA acquired," and before concluding (para. 36) that "the Intangible Property Safe Income did not contribute to the gains that accrued on FA's US Holdco shares in the Post-acquisition period and, therefore, did not contribute to the gains that accrued on PrivateCo's… Canco common shares immediately before their redemption," CRA stated (at para. 34):

[A]llocating the Intangible Property Safe Income to the gains that accrued on FA's US Holdco shares in the Post-acquisition period would offend the object and spirit of subsection 55(2) because such an allocation would result in "capital gains stripping" which is what subsection 55(2) is designed to prevent. This is because such an allocation would give rise to a "double counting" of FA's ACB of the US Holdco shares as safe income which could then be allocated to a gain that accrued on the US Holdco shares in the Post-acquisition period and that is attributable to the unrealized appreciation in the value of the underlying assets of the US-Opcos.

See also the summary under Reg. 5907(2)(f).

The fiscal period of a partnership ends on June 30, 2013 but the taxation year-end of the private corporation which is a member is December 31, 2013, which is also its "safe-income determination time." Should a negative adjustment be made in computing the "safe income on hand" if the corporate partner has an income inclusion under s. 34.2(2) but there is a loss in the partnership for the stub period from July 1, 2013 to December 31, 2013?

After noting that "an adjustment to carve out from 'safe income' any amounts included in income under subsections 34.2(2) and (12) and any amounts claimed under subsections 34.2(4) and (11) would be contrary to the wording of [s. 55(5)(c)]," CRA went on to state that:

a negative adjustment in respect of the loss should be made in determining the "safe income on hand" of the corporation on the basis that the [s. 34.2(2)] amount would not be on hand to contribute to the fair market value or the gain inherent in the shares of the corporation.

An individual wholly-owned Holdco, which held all of the preferred shares of Opco (also, with a calendar year end), whereas Opco’s common shares were held by others. In 2008, Opco paid dividends of $2,199,995 and $143,915 to the common shareholders and Holdco, respectively; and also redeemed a portion of Holdco’s preferred shares (which had a nominal PUC and ACB), resulting in a s. 84(3) deemed dividend of $529,785 - so that the 2008 dividends totalled $2,873,695 and Opco received a dividend refund (the "DR") of $131,400. Only the preferred share redemption engaged s. 55(2) (the safe income on hand attributable to the preferred shares was nil). No s. 55(5)(f) designation was made.

How is the Part IV tax payable by Holdco and the portion of the dividend subject to s. 55(2) computed?

After discussion the 943963 Ontario, CRA stated:

It follows, therefore, that the amount of the assessable dividend received for the purposes of subparagraph 186(1)(b)(i) remains the same despite the fact that a portion of the dividend may be deemed not to be a dividend under paragraph 55(2)(a).

In light of that decision, we are of the view that no circular calculation is required to be made to determine the Part IV tax payable by Holdco and the portion of the dividend received that is subject to paragraph 55(2)(a) in the Particular Situation.

Accordingly, s. 55(2) would apply to $457,112. This figure is the s. 84(3) dividend of $529,785 minus $72,673, being the portion of the taxable dividend received from Opco that was computed as being subject to Part IV tax under s. 186(1)(b). This reduction is computed as the pro rata portion of the $131,400 dividend refund applicable to the $529,785 s. 84(3) dividend (i.e., $673,700/$2,873,695 * $131,400 = $30,805), multiplied by the 3X dividend refund rate (to produce $92,415) multiplied in turn by the ratio of the s. 84(3) dividend received (of $529,785) to the total dividends received by Holdco (of $673,700).

An amount designated by a personal trust in respect of its corporate beneficiary under s. 104(13.1) would not be included in determining the corporate beneficiary's safe income or safe income on hand.

The safe income on hand of a corporation, is not reduced by non-capital losses of a corporation within the group that is acquired by it, although the amount paid to acquire such loss company will reduce the safe income on hand attributable to its shares as the shares of the loss company disappear on the subsequent amalgamation.

If Holdco purchases Opco at a time when Opco has unrealized appreciation in certain assets such as inventory or capital property, gain from a subsequent sale of such asset will not increase the safe income attributable to the shares of Opco held by Holdco. However "notwithstanding the above, and as a practical matter, normally we do not require a detailed analysis of all the elements making up the capital gain on a share as long as safe income on hand is computed pursuant to our published guidelines".

Where a share is exchanged for a second share on a rollover basis, the full safe income on hand attributable to the first share owned by the transferor immediately before the exchange will flow through to the second share on the exchange provided that the fair market value of the second share received on the exchange is not less than the fair market value of the transferred share immediately before the exchange.

Discussion of allocation of safe income when shares of a corporation are exchanged on a rollover basis for more than one class of shares.

The safe income attributable to shares of a corporation that were sold to an arm's length purchaser included gain arising from an s. 111(4)(e) designation given that no election was made under s. 256(9).

Where a corporate shareholder transferred public company shares to a new holding company pursuant to s. 85(1), the safe income on hand of the shares of the new holding company would ordinarily include the safe income on hand attributable to the public corporation's shares even if no significant influence is exercised over the public corporation.

The fact that a dividend refund has been received by the payor of a dividend is not normally relevant to consideration of the following expression: "that is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of the series of transactions or events".

Where a wholly-owned subsidiary owns shares in the capital of its parent company, an allocation of safe income must be made to the shares of the parent corporation held by the subsidiary.

Any dividend paid by a payer corporation is considered to be paid first out of the safe income on hand attributable to the recipient corporation's shares of the payer corporation. Accordingly, the amount of the dividend to which s. 55(2) will not apply is the aggregate of the amount of the dividend subject to Part IV tax and the amount, if any, by which the amount of safe income on hand exceeds the amount of the income subject to Part IV tax. Conversely, the recipient corporation would not have to designate any amount under s. 55(5)(f) in any situation where the portion of the taxable dividend that is subject to Part IV tax exceeds the safe income on hand of the corporation.

Discussion of the safe income entitlement of alphabet shares.

Where preferred shares issued by Newco on the roll-in to Newco of shares of Opco, have a dividend entitlement equal to dividends received by Newco on the shares of Opco, and to proceeds received by Newco on the sale of shares of Opco to the extent of the gain realized by Newco, but with the redemption amount of the shares being reduced on a dollar-for-dollar basis by the amount of the dividends paid out of such gain. RC will not consider the preferred shares to have a dividend entitlement in respect of the gain because of the corresponding reduction in redemption amount. Accordingly, the safe income attributable to the gain could not be attributed to the preference shares.

A write- down in the carrying value of a capital asset to reflect an accrued loss inherent in the property, will not reduce safe income on hand because the write-down does not represent an amount of safe income that has been set aside to pay an amount not currently deductible for tax purposes.

Discussion of a situation where a Canadian-controlled private corporation ("Holdco") transfers an asset on a rollover basis to a newly-incorporated subsidiary ("Newco"), following which Newco sells the assets to an unrelated third party and pays the after-tax profit to Holdco giving rise to dividend refund to it and Part IV tax to Holdco, with Holdco paying corresponding taxable dividends to its shareholders that are not liable to Part IV tax.

Discussion of proration formula for determining safe income where an individual realizes a capital gain of $100,000 in connection with bumping the ACB of her shares, then rolls her shares into a holding company in whose hands the shares are redeemed.

"Generally, when a portion of the capital gain inherent in the shares of a corporation is crystallized, the Department's approach ... is to apportion the safe income to which the entire gain is attributable proportionately to each part of the gain. A transferee's safe income attributable to the shares received would be computed by multiplying the safe income attributable to the transferred shares immediately before the transfer by the proportion that the transferee's potential gain (immediately after the transfer) is of the transferor's potential gain (immediately before the transfer)."

When computing exempt or taxable surplus of a foreign affiliate for the purpose of determining safe income of a Canadian corporation with a wholly owned U.S. foreign affiliate, the relevant time is that at which the safe income is to be computed (i.e., immediately before the transaction or event, or the commencement of the series of transactions or events).

General discussion of computation of safe income in the context of a foreign affiliate.

Safe income on hand will flow through on an s. 107(2) rollover in a similar manner to rollovers effected under ss.51, 85, 85.1, 86 and 87.

Where X owns 20% of the shares of Opco having a safe income of $100 and a fair market value of $125, and transfers all of such shares to a new corporation ("Newco") on a rollover basis in exchange for shares of Newco, and Opco then redeems the shares held by Newco for $125 giving rise to a deemed dividend of $125, Newco will not be able to treat itself as having received a safe income dividend of $100 (assuming the appropriate designation under s. 55(5)(f)), and a further separate dividend of$25 subject to Part IV tax, if the payment of the deemed dividend by Opco triggers Part IV tax on $25 of that dividend deemed to be received by Newco:

"It is our view that to the extent that a dividend refund arises in respect of tax paid on the investment income earned by a corporation which pays a dividend (the "payer corporation"), such income would, on an after tax basis, have been included in the calculation of the safe income of the payer corporation. Consequently, when a dividend that gives rise to the dividend refund is paid by the payer corporation, that portion of the dividend [that is sufficient to give rise to the dividend refund would be considered to be paid out of the safe income of the payer corporation ... . Since an amount of $100 (including the $25 dividend subject to tax under Part IV of the Act) which is equal to the total safe income of Opco, is designated as a separate taxable dividend, subsection 55(2) will not apply to this dividend. However, subsection 55(2) will, in our view, apply to the other separate taxable dividend of $25."

The rollover under s. 107(2) is accorded the same treatment for safe income purposes as the rollover under s. 85.

On a wind-up of one company into a second company, the safe income on hand of the second company will be reduced by the amount of the loss realized on the intercompany debt which is deemed to be paid in full by virtue of an s. 80(3) election. In addition, any other liabilities of the first company assumed by the second company that are in excess of the fair market value of the property of the first company distributed to the second company, will also reduce the safe income on hand of the second company.

Losses incurred in a taxation year that have not been deducted in computing income under s. 3 by the corporation, or by any corporation over which it has significant influence, will generally reduce safe income on hand of the corporation.

Current SR & ED expenses must be deducted in computing the corporation's safe income on hand even if such expenses have not yet been deducted for tax purposes. However, SR & ED capital expenditures do not reduce the corporation's safe income on hand until the year that such amounts are claimed as a deduction for tax purposes.

Amounts actually expended but not deductible for tax purposes (e.g., 20% of entertainment expenses), and amounts actually expended but deferred or capitalized for tax purposes (e.g., contributions of an employer to an employee benefit plan pursuant to s. 18(1)(o) or amounts capitalized under s. 18(2)) cannot be included in safe income on hand until such time, if any, as they are deducted for tax purposes.

Amounts not yet expended but deducted for accounting purposes but not for tax purposes (e.g., accrued compound interest, provisions for unfunded future employee pension obligations and provisions for future warranty obligations) reduce safe income on hand if safe income has been set aside to pay these amounts or if the future obligations have reduced a gain that would otherwise be realized on a disposition at fair market value of a share of any corporation.

The deduction under s. 110(1)(k) has no effect on safe income.

Where A and B, who are two of the three individual shareholders of OPCO, transfer their common shares of OPCO to separate newly-incorporated holding companies and later, following a conversion of the common shares of OPCO held by the holding companies into preferred shares, have their holding companies receive redemption proceeds of the preference shares out of the capital dividend account of OPCO, the safe income attributable to the common shares of OPCO transferred to their holding companies cannot be attributed to the shares of OPCO held by the third shareholder, even though the subsequent deemed dividend paid out of the capital dividend account of OPCO does not affect its safe income.

Where an amount, otherwise deemed to be a dividend under s. 84(3), is deemed instead to be a capital gain under s. 55(2), it also will not reduce the safe income attributable to the other shares of the corporation.

Where a corporation pays a dividend in kind comprising part of its assets, its safe income must be pro-rated rather than being allocated fully to the dividend.

Where shares of Opco are redeemed by Holdco giving rise to a deemed dividend of $2.2 million at a time that the safe income of Opco is $1.8 million, Holdco designates $1.8 million as a separate taxable dividend under s. 55(5)(f) and Opco receives a dividend refund of tax of $100,000, the $400,000 of income earned by Opco on which it paid refundable tax will be considered to be part of the safe income of Opco. Consequently, s. 55(2) will apply to the dividend of $400,000 because it would not be considered to have been paid out of safe income.

S.55(2) generally will not apply to a deemed dividend which deliberately has been made subject to Part IV tax in order to avoid the application of s. 55(2).

Crown royalties and other amounts representing cash outlays which are non-deductible under s. 18(1)(m) should be included in computing safe income. However, the resource allowance which does not represent an actual outlay, should be excluded.

Safe income effectively is transferred on an s. 85 rollover or an interspousal rollover under s. 73(1).

Where the individual shareholders of Opco transfer their common shares of Opco to Holdco on a share-for-share exchange, the common shares held by Holdco are changed into preferred shares under an s. 86 reorganization and a dividend and deemed dividend are paid on the preferred shares held by Holdco, Holdco will receive only a proportionate share of the safe income of Opco. Holdco may avail itself of the election under s. 55(5)(f).

Employees of Opco, who own all its issued shares, transfer those shares to Newco in exchange for shares of Newco, thereby realizing a capital gain. Immediately thereafter, Opco pays a taxable dividend to Newco equal to the full amount of its safe income on hand prior to the share-for-share exchange. Assuming that the full amount of the unrealized gain on the shares of Opco is greater than Opco's safe income, and a portion of that gain is realized, then a proportionate part of this portion is attributable to safe income and the remaining part may be reasonably considered to be attributable to something else. Accordingly, a portion of the supposed safe income dividend also would be attributable to something other than safe income, and s. 55(2) will apply.

In response to a proposal that entailed purifying a corporation for purposes of the exemption for sales of qualified small business corporation shares by paying a large dividend on special shares which had been issued for a nominal amount, RC noted that the provisions of s. 55(2) are always of concern where a class of shares attracts an inordinately large dividend, whether that dividend is paid periodically or arises on the redemption of shares. Because s. 55(2) can apply where a large dividend of one class of shares reduces the accrued capital gain on another class of shares, no comfort can be drawn from the absence of any reduction of a capital gain on the special shares.

If it is known, at the beginning of a series of transactions, that there will be an acquisition of control of the corporation resulting in a deemed capital loss under s. 111(4), the deemed capital loss should be applied to reduce taxable capital gains realized prior to the commencement of the series for the purpose of computing the corporation's safe income.

A sale of an operating division by Opco followed by the payment of a dividend to Holdco equal to the net after tax proceeds of the sale likely would not be regarded as having been carried out for the prohibited purpose.

Where Opco pays a stock dividend of $500,000 in high-low preferred shares, only a pro-rata portion of its safe income is attributable to the preferred shares on the subsequent redemption thereof.

One corporation ("S1") transfers a capital property under s. 85(1) to a sister corporation ("S2") in consideration for redeemable preference shares which are then redeemed following the sale by S2 of the property to an arm's length purchaser. The safe income attributable to the preferred shares is nil because the entire gain on those shares is attributable to the capital gain on the transferred property, and no dividend entitlement accrued on the preferred shares prior to the commencement of the series of transactions.

A corporation ("Opco") is owned by siblings who wish to transfer their shares to their children. Each sibling would form a holding company into which he would transfer his common shares of Opco pursuant to s. 85(1) in exchange for preference shares having a redemption amount equal to the fair market value of the transferred common shares, and the children would receive common shares from treasury such that they would have an equity percentage equivalent to what the parents had. S.55(2) would apply on the redemption of the preferred shares. S.55(3)(a) would not apply because nephews and nieces do not deal at arm's length with their uncles and aunts.