D & D Livestock Ltd. v. The Queen, 2013 DTC 1251 [at at 1412], 2013 TCC 318 -- summary under Subsection 55(2)

After a preliminary reorganization, all of the shares of the taxpayer (consisting of Class A common shares and Class D preference shares) were owned by another Canadian corporation ("HLL"), whose safe income on hand ("SIOH") respecting the taxpayer was $1.493M, comprised of safe income earned by the taxpayer of $0.976M and safe income of $0.517M in respect of the taxpayer's 50% shareholding of another Canadian corporation ("RTI"). Then:

1. The taxpayer paid a stock dividend ("Stock Dividend 1") in the amount of $1.465M to HLL by issuing Class A shares to HLL with a stated capital of that amount in satisfaction of the dividend (thereby increasing the adjusted cost base ("ACB") of HLL's Class A shares of the taxpayer to $2.72M.)
2. HLL transferred all its (Class A and D) shares of the taxpayer on a s. 85(1) rollover basis to a newly-incorporated subsidiary (Newco) in consideration for Class A common and Class D preference shares of Newco (so that under s. 85(1)(g) essentially all the ACB of the transferred shares, including the stepped-up ACB of the transferred Class A shares, was allocated to the cost to HLL of the Class D preference shares of Newco, which was $3.47M).
3. HLL transferred its Newco Class D preference shares on a s. 85(1) rollover basis to a newly-incorporated subsidiary (Newco 2) in consideration for Class A common shares of Newco 2 ( having a deemed cost under s. 85(1)(h) of $3.47M.)
4. Newco 2 satisfied a dividend of $3.47M to HLL by transferring its Class D preference shares of Newco to HLL, thereby creating an accrued loss to HLL on its Newco 2 shares.
5. The taxpayer transferred its shares of RTI (with an FMV of $7.05M) on a s. 85(1) rollover basis to a newly-incorporated subsidiary (Newco 3) in consideration for Class A common shares of Newco 3 (having a cost under s. 85(1)(h) of $0.50M.)
6. Newco 3 paid a stock dividend ("Stock Dividend 2") in the amount of $0.52M to the taxpayer by issuing Class A shares to the taxpayer (and made s. 55(5)(f) designations for such dividend to be deemed to be 10 separate taxable dividends), thereby increasing the ACB of the taxpayer's Class A shares of Newco 3 to $1.02M.)
7. HLL transferred its shares of Newco 3 to Newco 2 on a s. 85(1) rollover basis (so that the accrued gain to it on all its shares of Newco 2 was reduced by the accrued loss arising in 4 above.
8. Newco 3 was wound up.
9. HLL transferred its Class A common shares of Newco 2 (reported as having an ACB of $4.48M) on a s. 85(1) rollover basis to a special-purpose wholly-owned subsidiary of HLL (HLAL) in consideration for Class A common shares of HLA.
10. Newco 2's only asset was its 50% shareholding in RTI. HLAL sold its shares of Newco 2 to the other 50% shareholder of RTI for $7.05M, with a capital gain of $2.566M being reported based on the $4.49M ACB in 9 above (i.e., such capital gain was reduced by the amount of both Stock Dividend 1 and 2).

The parties agreed that Stock Dividend 1 (see 1) reduced the SIOH of HLL in its shares of the taxpayer by $1.465M. At issue was whether Stock Dividend 1 also reduced the SIOH of the taxpayer on its shares of RTI, thereby reducing its SIOH in respect of the Newco 3 shares which were substituted therefor (see 5). CRA considered that such reduction occurred, so that virtually none of Stock Dividend 2 came out of SIOH of the taxpayer respecting its shares of Newco 3 (see 6). The capital gain reported by a successor of the taxpayer on a sale (see 10) of shares of a successor of Newco 3 (namely, shares of Newco 2) was reduced by the bump in the adjusted cost base of the shares of Newco 3 for the amount of Stock Dividend 2, as this bump carried over to the adjusted cost base of such shares of Newco 2– see 7). (The adjusted cost base of such shares of Newco 2 already effectively reflected the basis bump from Stock Dividend 1 as a result of the above series of transactions - see 2 and 3.) Accordingly, CRA had assessed the taxpayer on the basis that s. 55(2) applied to Stock Dividend 2.

In rejecting CRA's position, Graham J stated (at para. 31):

The shares in RTI had value because of the income earned by that company after 1971. That income had not been removed from RTI by way of dividend. The fact that a stock dividend (i.e. Stock Dividend 1) was declared by the [taxpayer] did nothing to change the fact that the shares in RTI obtained their value from the income earned by RTI after 1971.