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Attention: XXXXXXXXXX
Dear Sirs:
RE: Section 55 of the Income Tax Act (the "Act")
Your file XXXXXXXXXX
We are writing in response to your letter of October 21, 1992 wherein you requested our confirmation and comments as to whether the following amounts described in your letter constitute "safe income" for the purposes of section 55 of the Act. The amounts are as follows:
A. Amounts actually expended but not deductible for tax purposes (for example, 20% of entertainment expenses pursuant to section 67.1 of the Act);
B. Amounts actually expended but their deductibility was deferred or they were capitalized for tax purposes (for example, employer's contribution to an employee benefit plan pursuant to 18(1)(o) of the Act or amounts capitalized under subsection 18(2) of the Act); and
C. Amounts not yet expended but deducted for accounting purposes (but not for tax purposes) (for example, accrued compound interest not deductible under paragraph 20(1)(d) of the Act, provisions for unfunded future employee pension obligations, and provisions for future warranty obligations).
Our Comments:
Pursuant to subsection 55(2) of the Act, the capital gain referred to therein must be attributable to "income earned or realized" ("safe income") in order that the dividend referred to therein not be subject to that subsection. However, it is the Department's position that safe income can contribute to the fair market value of, or the gain inherent in, a share only if such safe income is on hand and available for distribution to the corporation's shareholders ("safe income on hand"). Consequently, a dividend will be considered to be attributable to a corporation's income earned or realized after 1971 (i.e. a "safe dividend") only where it is reasonable to consider that such dividend has been paid out of the corporation's safe income on hand.
As the amounts in A above are no longer on hand, they cannot contribute to the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of a share of the capital stock of a corporation immediately before the dividend. Consequently, the amounts would not be included in the computation of safe income on hand out of which a safe dividend can be paid.
The analysis in the preceding paragraph can also apply to the amounts referred to in B above. Since the amounts have been expended, regardless whether they were deductible or not for tax purposes, they are no longer on hand to contribute to the fair market value of, or the gain inherent in, a share. Consequently, they do not form part of the safe income on hand attributable to that share. When these amounts are deducted for tax purposes in the future, they will reduce safe income but will not, generally, affect safe income on hand.
As stated in Robert J.L. Read's paper titled "Section 55: A Review of Current Issues" at page 18:4 of the 1988 Conference Report of the Canadian Tax Foundation, the general principle is that if safe income has been used or otherwise set aside to pay amounts not currently deductible for tax purposes, it cannot contribute to the gain inherent in the shares and would not be included in the calculation of the safe income on hand. Consequently, amounts of the type described in C above, such as accrued compound interest and provisions for future warranty and pension obligations, will 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 above comments represent our general views with respect to the subject matter of your letter and are provided in accordance with the practice described in paragraph 21 of Information Circular 70-6R2, dated September 28, 1990, issued by Revenue Canada, Taxation.
Yours truly,
for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch