Principal Issues: A corporate shareholder would own all of the issued and outstanding shares of the capital stock of a holding corporation ("Holdco"). Holdco would own all of the issued and outstanding shares of the capital stock of an operating corporation ("Opco"). For asset protection purposes, the following transactions would be implemented. First, Opco would pay a dividend to Holdco. The amount of such dividend would be almost equal to the value of the common shares of the capital stock of Opco held by Holdco. Holdco would then loan the funds received as a dividend back to Opco.
Whether subsection 55(2) of the Act would apply in a situation where, after completing those transactions, the corporate shareholder of Holdco would sell some of its shares in the capital stock of Holdco to an arm's-length party for proceeds equal to their fair market value.
Position: No definitive position is taken.
Reasons: In some cases and depending on the facts of a particular situation, it could be argued that the purpose test provided for in subsection 55(2) of the Act is not met where there is no sale of the shares of the capital stock of Opco nor any increase in the direct interest in Opco that are part of the same series of transactions or events that includes the dividend paid to Holdco.
XXXXXXXXXX 2011-042202 Sylvie Labarre, CA October 18, 2011
Dear Sir,
Subject: Subsection 55(2) of the Income Tax Act
This is in response to your email of September 21, 2011 in which you requested our opinion regarding the application of subsection 55(2) of the Income Tax Act (the "Act") upon payment of a dividend in the following hypothetical circumstances.
Hypothetical Situation
A small business corporation, Holdco, held all the shares of the capital stock of another corporation, Opco. Those shares were common shares, voting and participating.
ACO held all the shares of the capital stock of Holdco and the adjusted cost base of those shares for ACO was minimal.
Mr. A held all the shares of the capital stock of ACO.
There was not safe income with respect to the shares of the capital stock of Opco held by Holdco.
As part of a reorganization, the following steps were undertaken:
- Holdco transferred certain assets necessary for the operation of the business (other than capital assets) to Opco. Opco assumed debts and issued other common shares as consideration for those assets. Opco and Holdco made a joint election by virtue of subsection 85(1) with respect to that transfer of assets.
- Opco paid a series of dividends to Holdco over a few days. All dividends represented substantially all of the value of the common shares of the capital stock of Opco. The purpose of those dividends was to secure Opco's assets.
- Holdco lent Opco a sum of money equal to the total amount of dividends and took a mortgage guarantee on all of Opco's assets.
- Opco continued to carry on the business.
- ACO sold 35% of the shares of the capital stock of Holdco that it held to an unrelated third party in a transaction that was part of the same series of transactions as the dividends. That disposition of shares of the capital stock of Holdco was for proceeds of disposition equal to their fair market value. As a result, ACO realized a significant capital gain.
Question
You wish to know if subsection 55(2) would apply to dividends paid by Opco to Holdco because Holdco could not avail itself of the exception in paragraph 55(3)(a) because of the sale by ACO of the shares it held in Holdco to an unrelated third party (a transaction described in subparagraph 55(3)(a)(iv) of the Act).
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, it is the practice of the Canada Revenue Agency (the "CRA") not to issue a written opinion regarding proposed transactions otherwise than by advance rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, the determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments may, however, under certain circumstances, not apply to your particular situation.
Subsection 55(2) of the Act was introduced to limit the improper use of tax-free dividends between two corporations for the purpose of reducing the capital gain, which we could call capital gain stripping. Dividends calculated up to the amount of safe income on hand are not considered to be an inappropriate use of tax-free intercorporate dividends.
Thus, under that subsection, part or all of the dividend, as the case may be, would be taxed in the hands of the recipient corporation as a capital gain rather than as dividends if the conditions set out in the preamble to subsection 55(2) were satisfied and the exemptions in subsection 55(3) did not apply.
If subsection 55(2) applied in respect of a portion or all of a dividend, as the case may be, a capital gain would be taxed in the hands of the dividend recipient corporation even if, furthermore, a shareholder of the recipient corporation was taxed on a capital gain because the shareholder disposed of shares in the capital stock of the recipient corporation to a third party. We do not believe that such a result is unusual. Indeed, whenever a corporation is interposed in a structure, there is a possibility of taxation of income or gains at the level of the corporation and at the level of the shareholder.
In this situation, the payment of the dividend by Opco to Holdco would result in a decrease in the portion of the capital gain that, without the dividend, would have been realized on the disposition of the shares of the capital stock of Opco. However, that alone is not sufficient in itself to conclude that subsection 55(2) applies.
One of the issues with respect to the potential application of subsection 55(2) would be to determine whether the decrease is significant. It is likely that in the present situation that is the case since substantially all of the value of the common shares were paid as dividends.
However, for subsection 55(2) to apply, one of the purposes of the dividend must also have been to make that decrease significant ("purpose test").
You stated that the purpose of the dividend was to protect Opco's assets by making Holdco a secured creditor of Opco. We are of the view that, even if one of the purposes was the protection of Opco's assets, further examination of the facts would be required to determine whether the payment of the dividend to Holdco had any other purpose that would lead to the application of subsection 55(2).
In this situation, you did not indicate any other transaction in the same series of transactions or events as the payment of the dividend that would involve a sale of the shares of the capital stock of Opco or a significant increase in the direct interest in Opco by an unrelated third party. Furthermore, ACO sold shares it held in the capital stock of Holdco to an unrelated third party. As we understand it, the dividend paid by Opco to Holdco did not decrease the value of the shares of the capital stock of Holdco held by ACO. Similarly, the capital gain realized by ACO on the sale of a portion of its interest in Holdco remained the same as if the dividend had not been paid.
Furthermore, prima facie, the objective of the dividend paid by Opco to Holdco would not appear to be the reason for the introduction of subsection 55(2), i.e. the conversion of a capital gain (other than that attributable to the safe income on hand) to tax-free dividends. Indeed, according to the situation described to us and subject to all the facts surrounding the particular situation, it would appear that no sale of shares of the capital stock of Opco, nor any significant increase in the direct interest in Opco, would occur.
In addition, even though we are dealing with a situation described in subparagraph 55(3)(a)(iv), it should be noted that the main purpose of that subparagraph was to prevent a form of purchase butterfly. Subject to additional facts regarding the particular situation, it would seem that we are not in such a circumstance.
Consequently, subject to a review of any other transaction in the same series of transactions or events in which the dividend was paid by Opco to Holdco, it appears to us that Holdco would have arguments in favor of concluding that the purpose test in subsection 55(2) would not be satisfied.
These comments are not advance income tax rulings and are not binding on the CRA with respect to a particular situation.
Best regards,
Stéphane Prud'Homme, notary, M.Fisc.
for the Director
Corporate Reorganizations and Resource Industry Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch