Principal Issues: Whether an accounting journal entry recording a dividend as an amount payable to a shareholder is sufficient to consider the dividend received by the shareholder.
Position: No.
Reasons: Existing CRA position.
June 14, 2007
Ms. Samia Nehmé, CGA Corporate Reorganizations and SME Audit Resource Industries Section Montreal TSO 305René-Lévesque Blvd West Marc LeBlond Montreal QC H2Z 1A6 (613) 946-3261
2007-022931
Capital dividend
This is in response to your email of March 29, 2007, in which you asked for our comments on the above subject in relation to the situation described below.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
The situation
1. Mr A is the sole shareholder of a corporation ("Parentco"). Parentco owns all of the outstanding shares of the capital stock of another corporation ("Subco"). Parentco and Subco are "private corporations" as defined in section 89(1).
2. On XXXXXXXXXX, Subco declared a dividend to Parentco of $XXXXXXXXXX equal to the amount in its "capital dividend account" ("CDA"), as defined in subsection 89(1), immediately before the dividend became payable, and made an election pursuant to subsection 83(2), in the prescribed form (T2054) and manner, in respect of the full amount of that dividend to deem it to be a capital dividend ("Subco Capital Dividend").
3. According to Parentco, the dividend declared by Subco of $XXXXXXXXXX was eligible for inclusion in its CDA pursuant to paragraph (b) of the definition of CDA.
4. On XXXXXXXXXX, Parentco declared a dividend to Mr. A of $XXXXXXXXXX which Parentco determined to be equal to the amount of its CDA, immediately before the dividend became payable, and made an election pursuant to subsection 83(2), in prescribed form and manner (T2054), in respect of the full amount of such dividend for it to be deemed to be a capital dividend ("Capital Dividend Election").
5. Following an audit, the Canada Revenue Agency (the "CRA") has determined in respect of the dividend declared by each of Parentco and Subco, respectively, on XXXXXXXXXX that: (i) the dividend declared was not recorded in the books of account of Parentco and Subco; and (ii) the dividend declared did not involve a cash outflow for Parentco and Subco.
6. Having been informed of the above, the representative of Parentco and Subco has amended the financial statements of both corporations to reflect the following accounting entries:
Subco
Dividend $XXXXXXXXXX
Due to parent company $XXXXXXXXXX
Parentco
Due from related parties $XXXXXXXXXX
Due to shareholder $XXXXXXXXXX
7. Your office informed Parentco, by letter, that it had made an Excess Capital Dividend Election of $XXXXXXXXXX and that it should therefore pay Part III tax on that amount pursuant to subsection 184(2).
Your analysis and questions
In your view, "the capital dividend was not paid by the subsidiary [Subco] and was therefore not received by the parent [Parentco]. The parent [Parentco] should not have added the capital dividend declared by the subsidiary [Subco] to its CDA balance since it did not receive it. By paying a capital dividend, Parentco has paid an amount in excess of its CDA balance which makes it subject to Part III tax on the excess paid." [TaxInterpretations translation]
First, you asked whether, in the particular situation, Parentco could add to its CDA the amount of the Subco Capital Dividend that was declared on XXXXXXXXXX. The underlying question is whether the mere recording of the accounting entries referred to in 6 above is sufficient for considering Parentco to have received a Capital Dividend from Subco for the purposes of the definition of CDA.
You then asked whether it is appropriate in the situation presented to subject Parentco to Part III tax in respect of its capital dividend of XXXXXXXXXX. Finally, you asked whether, in the situation you have presented, each of Subco and Parentco may revoke (cancel) the dividend declared, respectively, on XXXXXXXXXX, which remains unpaid, if any.
Response to Question 1
We agree with you that, in the particular situation, Parentco cannot add the amount of the Subco Capital Dividend to its CDA. Our conclusions are based on the following observations.
In calculating the amount of a corporation's CDA at a particular time, paragraph (b) of the definition of CDA requires that account be taken of, inter alia, capital dividends received by the corporation, as follows;
capital dividend account of a corporation at any particular time means the amount, if any, by which the total of
(a) […]
(b) all amounts each of which is an amount in respect of a dividend received by the corporation on a share of the capital stock of another corporation in the period, which amount was, pursuant to subsection 83(2), not included in computing the income of the corporation,
[...]
[emphasis added]
The question of whether an amount constitutes an "amount … received" is a question of fact which must be resolved taking into account all the circumstances and particularities of each case.
In the reasons for the majority of the Supreme Court of Canada in Hickman Motors Ltd. v. The Queen, [1997] S.C.J. No. 62, Docket No. 24994 (DTC citation: 97 DTC 5363, at 5375), L'Heureux-Dubé J. clearly states the ancillary role of book entries, as follows:
¶ 87. ... The law is well established that accounting documents or accounting entries serve only to reflect transactions and that it is the reality of the facts that determines the true nature and substance of transactions: Vander Nurseries Inc. v. The Queen, 95 D.T.C. 91 (T.C.C.); Mountwest Steel Ltd. v. The Queen (1994), 2 G.T.C. 1087 (T.C.C.); Uphill Holdings Ltd. v. M.N.R., 93 D.T.C. 148 (T.C.C.); M.N.R. v. Wardean Drilling Ltd., 69 D.T.C. 5194 (Ex. Ct.); M.N.R. v. Société Coopérative Agricole de la Vallée d’Yamaska, 57 D.T.C. 1078 (Ex. Ct.). …
[Emphasis added]
The CRA states in Income Tax Technical News No. 14 Archived - December 9, 1998, that the mere recording of an amount payable by means of an accounting entry in and of itself is not sufficient for an amount to be "credited" to a person, for the purposes of subsection 212(1), as follows:
It is the Department's position that the mere recording of the payable by way of journal entry, regardless that such amounts are payable on demand and the debtor has the capacity to pay such amount if such payments are demanded, does not constitute "credited" for purposes of subsection 2121(1) of the Act.
[Emphasis added]
In our view, the threshold to be met for an amount payable to be considered "received" is undoubtedly higher than the "credited" test.
Furthermore, in Prosperous Investments Ltd. v. Canada, [1992] A.C.I. No. 6, Court Nos. 86-1338(IT), 83-72(IT), 86-1337(IT) and 86-1336(IT), (DTC citation: Ed Sinclair Construction & Supplies Ltd, and Edward Sinclair v. The Minister of National Revenue, 92 DTC 1163, at 1169), Bowman J. of the TCC had to decide whether the mere fact that an amount was recorded in a loan account by an accounting entry was in itself evidence that it had been received. In doing so, he relied on the comments of Lord Brampton in Gresham Life Society Co. Ltd. v. Bishop, (1902) 4 TC 464, as follows:
A mere bookkeeping entry in a loan account by itself does not constitute a taxable event unless there is something more, such as receipt. In Gresham Life Society Co. Ltd. v Bishop (1902), 4 T.C. 464 at 476, Lord Brampton said:
My Lords 1 agree with the Court of Appeal that a sum of money may be received in more ways than one e.g. by the transfer of a coin or a negotiable instrument or other document which represents and produces coin, and is treated as such by business men. Even a settlement in account may be equivalent to a receipt of a sum of money, although no money may pass; and I am not myself prepared to say that what amongst business men is equivalent to a receipt of a sum of money is not a receipt within the meaning of the Statute which your Lordships have to interpret. But to constitute a receipt of anything there must be a person to receive and a person from whom he receives and something received by the former from the latter, and in this case that something must be a sum of money. A mere entry in an account which does not represent such a transaction does not prove any receipt, whatever else it may be worth.
[emphasis added]
In our view, for the reasons given above, in the situation you have presented to us, the mere making of the accounting entries described in 6 above does not in itself constitute the payment of a dividend of $XXXXXXXXXX by either Subco or Parentco. It follows, therefore, and we agree with you in this regard, that Parentco cannot take such dividend into account in calculating the amount of its CDA immediately before the directors of Parentco declared the $XXXXXXXXXX dividend to Mr. A (on XXXXXXXXXX).
Please note, however, that a dividend can be paid by a corporation and received by its recipient without any monetary movement, for example, by the issuance of a demand note that is accepted as an absolute payment by the recipient.
The CRA's position on this issue is described in paragraph 15 of Interpretation Bulletin IT-109R2 - Unpaid Amounts (April 23, 1993), as follows:
Problems Involving Section 78
¶ 15. Certain problems involving section 78 and the manner in which they are dealt with by the Department are discussed below.
(a) ....
(b) Payment by Promissory Note
For the purposes of section 78, an ordinary promissory note is regarded as a promise to pay a debt at a later date, and not as payment of the debt on the date on which the note was issued. This is so unless the agreement between the parties clearly indicates that the note was accepted as absolute payment.
[Emphasis added]
Furthermore, the following passages from the Federal Court of Appeal decision in Banner Pharmacaps NRO Ltd. v. Canada, [2003] F.C.J. No. 1440, (DTC citation: 2003 DTC 5642, at page 5644) point out, inter alia, that a dividend may also be paid by way of the issuance of a note where the resolution by which the dividend is declared states in clear terms that a dividend was to be paid by way of the issuance of a note, as follows:
[7] Second, we respectfully disagree with the conclusion of the Tax Court Judge that, as a matter of law, a dividend cannot be paid by delivery of a promissory note. The legal effect of delivery of a promissory note depends upon all the relevant facts, the most important fact being the intention of the maker of the note as determined by the evidence. For example, in some circumstances a promissory note may be evidence of a debt to be paid at some future time. In other circumstances, delivery of a promissory note may itself be payment of a particular obligation.
[8] In the context of this case, the most important evidence is the resolution declaring the dividend. That resolution must be presumed to express the intention of Banner Canada because there is no evidence to the contrary. It states in the clearest possible terms that a dividend in the amount of $5,647,775 was to be paid on the date of the resolution, and that the dividend was to be paid by means of delivery of a promissory note in that amount. As the promissory note was in fact delivered as the resolution required, it is impossible to conclude that the dividend was not paid when it was supposed to be paid, on February 15, 1996. It follows that Banner was required to include the amount of the dividend in its income for its 1996 taxation year.
[Emphasis added]
Response to Question 2
We are of the view that Parentco could technically be subject to tax under Part III of the Act in respect of the Capital Dividend Election made in respect of its $XXXXXXXXXX dividend declared on XXXXXXXXXX since the conditions of subsection 184(2) are satisfied.
Section 184(2) reads as follows:
Tax on excessive elections
184 (2) Where a corporation has elected in accordance with subsection 83(2), 130.1(4) or 131(1) in respect of the full amount of any dividend payable by it on shares of any class of its capital stock and the full amount of the dividend exceeds the portion thereof deemed by that subsection to be a capital dividend or capital gains dividend, as the case may be, the corporation shall, at the time of the election, pay a tax under this Part equal to 3/4 of the excess.
[Emphasis added]
In the situation you have presented to us, the conditions of subsection 184(2) are satisfied because Parentco has validly elected pursuant to subsection 83(2) in respect of the total amount of the $XXXXXXXXXX dividend payable by it on XXXXXXXXXX on shares of a class of its capital stock and that amount exceeds the portion of such $XXXXXXXXXX dividend that is deemed pursuant to subsection 83(2) to be a capital dividend. Consequently, Parentco may be subject to a tax of 75% of the amount of the $XXXXXXXXXX dividend pursuant to subsection 184(2).
Naturally, Parentco could avoid tax under Part III of the Act by making the election under subsection 184(3) in the prescribed manner on or before a day that is 90 days after the day of mailing of the notice of assessment in respect of the tax that would otherwise be payable pursuant to Part III of the Act.
In addition, pursuant to paragraph 12(1)(j) and subsection 82(1), in order for Mr. A to be taxed on the deemed separate taxable dividend pursuant to paragraph 184(3)(c), he must have received the dividend in question. As noted above, the mere making of the accounting entries described in 6 above does not in itself constitute the payment by Parentco and receipt by Mr. A of a dividend of XXXXXXXXXX.
In closing, it is understood that the CRA's administrative policies and procedures relating to the application of Part III of the Act should be taken into account when dealing with a case such as the one in this situation.
Response to Question 3
In our view, in the situation you have presented to us, Subco and Parentco cannot revoke (cancel) the dividends that their directors declared, respectively, on XXXXXXXXXX, and which remain unpaid.
The answer to this last question is based on the same observations we made XXXXXXXXXX in a situation virtually identical to yours. A declared dividend cannot be revoked primarily because general principles of corporate dividend law provide that a corporation or its shareholders cannot validly reduce or revoke (cancel) a declared dividend,1 and the declaration of a dividend by a corporation is a matter of administration and within the power of the board of directors, unless there is a by-law adopted by the shareholders limiting that power.2 On the other hand, it appears that the recipient of an unpaid dividend may waive it.3
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope you find our comments of assistance and thank you for bringing these issues to our attention. Should you require any additional information regarding this matter, please do not hesitate to contact us.
Maurice Bisson, CGA
Manager
Corporate Reorganizations and Resource Industries Section
Corporate Reorganizations and Resource Industries Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
ENDNOTES
1 Maurice Martel and Paul Martel, Les aspects juridiques de la compagnie au Québec, 2nd ed., Volume 1, Montreal, Publications les Affaires.
2 Denault v.. Stewart, Denault & Co., (1918) 54 S.C.R. 209.
3 Ludlow v. McMillan, [1990] B.C.J. No 1817 (S.C.), a decision of the British Columbia Provincial Supreme Court.