Principal Issues: 1. In a situation where there are more than one class of shares that are voting, that participate equally in the distribution of the corporation's property upon dissolution and that are entitled to discretionary dividends, would paragraph 55(2.1)(c) apply when a dividend is paid on only one class of shares?
2. In a situation where there is a class of preferred shares that are non-voting, non-participating and that are entitled to discretionary dividends, and there is a class of common shares which are voting and participating, would paragraph 55(2.1)(c) apply when a discretionary dividend is paid on the preferred shares? Would such a dividend reduce the safe income on hand attributable to the common shares?
Situation: 1. In applying paragraph 55(2.1)(c) in such a case, a taxpayer should compare all the safe income on hand of the corporation before the payment of the dividend with the capital gain that could be realized on a disposition of the shares on which the dividend would be paid at fair market value at the time that is immediately before the payment of the dividend, taking into account that such shares are entitled to the dividend that will be paid and declared. Depending on the facts that are particular to a situation, it could be reasonable to consider that the safe income on hand of the corporation contributes to the hypothetical capital gain on the shares.
2. It depends on the valuation of the preferred shares. For example, if the adjusted cost base is equal to the fair market value of the preferred shares immediately before the payment of the dividend, there would be no safe income on hand that can be reasonably considered to contribute to the hypothetical capital gain with respect to the preferred shares. In such a case, the question would be whether the purpose tests of proposed subsection 55(2.1) are met. If one of the purpose tests is met and if the other conditions required for the application of subsection 55(2) are met, such provision will apply with respect to the dividend and the safe income on hand of the corporation would not be reduced. If subsection 55(2) does not apply, the dividend on the preferred shares would reduce the safe income on hand of the corporation.
Reasons: 1. Wording of the proposed legislation.
2. Wording of the proposed legislation. Questions of fact and valuation.
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2015-059394
Sylvie Labarre, CPA, CA
December 3, 2015
Dear Sir,
Subject: Allocation of income earned or realized by a corporation
This is in response to your emails of June 22, 2015 and of September 14, 2015 in which you requested our views as to the amount of safe income earned or realized on hand (hereinafter the "safe income on hand") that relates to the shares held by each shareholder of Opco in the following hypothetical situations.
Unless otherwise stated, all statutory references herein are references to the provisions of the Income Tax Act (hereinafter the "Act").
First Situation
Three unrelated shareholders hold all the shares in the capital stock of Opco. The shareholders are corporations resident in Canada.
Each shareholder holds a separate class of voting and participating shares in the capital stock of Opco (Holdco A holds 100 Class OA shares, Holdco B holds 100 Class OB Shares and Holdco C holds 100 Class OC shares). The shares in the capital stock of Opco carry the right to a discretionary dividend.
The total Opco safe income on hand amounts to $90,000.
The Opco directors determine to pay a dividend of $35,000 on the OA Class A shares held by Holdco A and not on the other two classes of shares.
Second Situation
This is the same situation as that mentioned above except that the shares described in the first situation are non-voting non-participating shares eligible for discretionary dividends, and Opco issues additional voting and participating shares equally to the three corporate shareholders.
Third Situation
Opco is a Canadian-controlled private corporation.
Opco pays annual dividends to its shareholders.
Mr. A holds 39 Class "A" shares in the capital stock of Opco.
Holdco A (held 100% by Mr. A) holds 11 Class "B" shares in the capital stock of Opco.
Mr. B holds 39 Class "A" shares in the capital stock of Opco.
Holdco B (held 100% by Mr. B) holds 11 Class "C" shares in the capital stock of Opco.
Mr. A and Mr. B are unrelated and are Canadian residents for tax purposes.
The Class "A", "B" and "C" shares in the capital stock of Opco are voting and participating, with discretionary dividends.
The safe income on hand for the current year is $100,000 for all the Class "A", "B" and "C" shares in the capital stock of Opco.
Holdco A and Holdco B each receive $50,000 in dividends.
Fourth Situation
Opco is a Canadian-controlled private corporation.
Opco pays annual dividends to its shareholders.
Mr. A holds 49 Class "A" shares in the capital stock of Opco.
Holdco A (held 100% by Mr. A) holds 1 Class "B" share in the capital stock of Opco.
Mr. B holds 49 Class "A" shares in the capital stock of Opco.
Holdco B (100% held by Mr. B) holds 1 Class "C" share in the capital stock of Opco.
Mr. A and Mr. B are brothers and are Canadian residents for tax purposes.
The Class "A" shares in the capital stock of Opco are voting and participating, with discretionary dividends.
The Class "B" and "C" shares in the capital stock of Opco are voting and non-participating, with discretionary dividends.
The safe income in hand for Opco for the current year is $100,000.
Holdco A and Holdco B each receives $50,000 in dividends.
Fifth Situation
Mr A and Mrs A are divorcing.
Mr. A holds 99 Class "A" shares in the capital stock of Opco.
Mrs. A holds 1 Class "B" share in the capital stock of Opco.
Mr A and Mrs A are Canadian residents for tax purposes.
The Class "A" and "B" shares in the capital stock of Opco are voting and participating, with discretionary dividends.
As part of the separation process, it is agreed that Mrs. A will receive 90% of the value of Opco even though she only holds 1% of the participating shares.
Accordingly, the following transactions are implemented:
1- HoldcoMsA is established.
2- Mrs A sells her Class "B" share in the capital stock of Opco to HoldcoMsA. An election under section 85 of the Act is made.
3- Opco pays a dividend on its Class "B" share in an amount equal to 90% of the value of Opco.
4- The Class "B" share in the capital stock of Opco held by HoldcoMsA is repurchased by Opco for the sum of $1.
Questions
In the first two situations, you asked if subsection 55(2) as proposed applies in respect of a portion of the dividend paid to Holdco A.
In the first two situations, you also inquired as to the impact of the dividend on the allocation of safe income on hand to each of the classes of common shares in the capital stock of Opco after the dividend payment.
Regarding the third and fourth situations, you inquired as to the tax impact on Holdco A and Holdco B of the dividends paid to them.
In the fifth situation, you inquired as to the tax impact of this dividend on HoldcoMsA.
Our Comments
This technical interpretation provides general comments on certain of the July 31, 2015 income tax legislative proposals respecting the Act and the Regulations (hereinafter, the “Legislative Proposals") and the provisions of the Act and related legislation, if applicable. It does not confirm the income tax treatment of a particular situation but is intended to assist you in making that determination. The income tax treatment of transactions will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R6, Advance Income Tax Ruling.
All your questions concern the new rules in subsection 55(2) forming part of the Legislative Proposals.
In the Legislative Proposals document, section 55(2.1) was added to enact situations where subsection 55(2) applies. One of these conditions is indicated in paragraph 55(2.1)(c) which reads as follows:
"(c) the amount of the dividend exceeds the amount of the income earned or realized by any corporation -- after 1971 and before the safe-income determination time for the transaction, event or series - that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value, immediately before the dividend, of the share on which the dividend is received."
First Situation
For the current purposes, we have assumed that the fair market value ("FMV") of the shares in the capital stock of Opco is $120,300, their adjusted cost base ("ACB") is $100 for each class of shares and the shares of categories OA, OB and OC would share equally in the remaining Opco property on its winding-up.
Since all shares in the capital stock of Opco are participating, and are entitled to discretionary dividends but are not entitled to a predetermined dividend, it would be reasonable to take into account the global safe income on hand of the corporation for the purpose of determining whether the condition specified in paragraph 55(2.1)(c) was satisfied when a discretionary dividend was paid in respect of shares of one class of shares.
The dividend paid in respect of the Class OA shares ($35,000) is less than the overall safe income on hand of Opco ($90,000). The question is whether it can be concluded that it is reasonable to consider that an amount of safe income on hand equal to the dividend contributed to the capital gain which would be realized on a disposition at FMV, immediately before the dividend, of a share on which the dividend was received (the “hypothetical capital gain”). The amount of the hypothetical capital gain would be a function of the FMV which could be attributed to the share on which the dividend was declared, such FMV being measured immediately before the dividend payment but keeping in mind that such share would have a right to an additional amount equal to the dividend declared thereon.
Based on the assumptions stated above and taking into account an additional value of $35,000 for the Class OA shares, we are of the view that the $35,000 dividend would not be greater than the safe income on hand which it would be reasonable to consider as contributing to the hypothetical capital gain.
Following the $35,000 dividend, the FMV of the corporation would be reduced to an amount of $85,300 and the safe income on hand of Opco would be reduced to $55,000.
If no other dividend was declared, and Opco was liquidated and the residue of its property paid in equal parts to each class of participating shares, the capital gain which would be realized on the shares of each class, if there was a disposition at FMV immediately before the dividend in accordance with subsection 55(2.1)(c), would be $28,333. In such a case, we would consider that the safe income on hand which it would be reasonable to consider as contributing to the capital gain on the shares of each class would be $18,333 ($55,000/3).
Second Situation
Respecting non-voting and non-participating shares with discretionary dividends, it also would be necessary to consider the overall safe income on hand of the corporation in determining the share of that income that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at FMV, immediately before the dividend, of the shares on which the dividend was received (consistently with the wording of paragraph 55(2.1)(c)).
The question is therefore is one of establishing what would this hypothetical capital gain be on such shares and, therefore, what would be the FMV of such shares immediately before the dividend. In this regard, the FMV would be determined immediately before the dividend payment but taking into account that such share will be entitled to an additional amount equal to the dividend declared in respect of that share. Of course, this is a valuation issue on which we cannot comment. However, we can offer the following general comments that you might find helpful.
It could be that for the purposes of paragraph 55(2.1)(c) there would be no hypothetical capital gain if the FMV of the non-participating shares and non-voting shares was equal to their ACB. For example, this could occur if the unpaid dividends represented distinct rights from the shares to which they related.
In such a case, the condition in paragraph 55(2.1)(c), as it reads in the Legislative Proposals, would be satisfied. If no capital gain arises on a disposition at FMV of shares on which the dividend is paid, there indeed is no safe income on hand which contributes to the hypothetical capital gain.
It would then be necessary to consider whether the conditions referred to in paragraphs 55(2.1)(a) and (b) are met. The dividend on the preferred shares would reduce the FMV of the common shares and would also reduce the capital gain which would be realized on a disposition at FMV of the common shares. The question is whether these reductions are significant. There could also be an increase in the cost amount of the property of the dividend recipient. With a dividend in the order of magnitude of $35,000 and taking into account the assumptions above, we could conclude that the reduction is significant or that the increased cost amount is significant. The question then is whether any of the purposes of the $35,000 dividend is to effect such a significant reduction or such a significant increase. This is a question we cannot answer without having all the relevant facts.
If one of the purposes of the payment or receipt of a dividend is as stated in subparagraphs 55(2.1)(b)(i) and (ii), subsection 55(2) could apply to the $35,000 dividend if the other conditions were satisfied. In such a case, the CRA would accept that the amount of the dividend does not reduce the safe income on hand of the corporation. If instead, subsection 55(2) did not apply to the dividend on the preferred shares, the amount of the dividend would reduce the safe income on hand of the corporation.
Moreover, if, in the situation where, given the determination of FMV, there is a hypothetical capital gain in respect of the non-voting and non-participating shares, it could be that the corporation’s overall safe income on hand is sufficient such that we could conclude that the dividend does not exceed the safe income on hand that can reasonably be regarded as contributing to this hypothetical capital gain. For example, if the amount of the hypothetical capital gain for the non-voting and non-participating shares was equal to $35,000, it might be that we would consider that the $35,000 dividend was not greater than the safe income on hand which it was reasonable to consider as contributing to the hypothetical capital gain. If so, subsection 55(2) would not apply. In that case, the safe income on hand of the corporation would be reduced by the amount of the dividend. Furthermore, there may be some situations where the corporation’s overall safe income on hand does not contribute to the hypothetical capital gain on the non-voting and non-participating shares.
Third Situation
The analysis of this situation is similar to that indicated above with respect to the first situation.
For the purposes of the third situation, we have assumed that the FMV of the shares in the capital stock of Opco is $120,100, that their ACB is $1 per share, that all shares in the capital stock of Opco were issued at the same time and the Class A, B and C shares share equally in the remaining Opco property on its winding-up.
Given that all the shares in the capital stock of Opco are participating, are entitled to discretionary dividends and are not entitled to a predetermined dividend, it would be reasonable to take into account the corporation’s overall safe income on hand for the purpose of determining whether the condition specified in paragraph 55(2.1)(c) was satisfied when a discretionary dividend was paid in respect of the shares of one class of shares.
The total dividends paid in respect of the Class "B" and "C" shares ($100,000) would equal Opco’s overall safe income on hand. The question is whether it could be concluded that it is reasonable to consider that an amount of safe income on hand equal to the amount of each of these dividends contributes to the capital gain that would have been realized on a disposition at FMV, immediately before the dividend, of the share on which the dividend is received. The hypothetical capital gain would depend on the FMV that could be attributed to the share on which the dividend is declared and paid, with such FMV being determined immediately before the dividend taking into account that such share will be entitled to receive an additional amount equal to the amount of the dividend that will be declared in respect of this share.
Based on the above assumptions and taking into account the additional value of $50,000 equal to the amount of the dividend which would be paid on the shares of Class "B" and "C", we are of the view that each dividend of $50,000 would not be greater than the safe income on hand which it would be reasonable to consider as contributing to the hypothetical capital gain on each of Classes B and C. Consequently, subsection 55(2) would not apply in these circumstances.
The dividends which were not subject to subsection 55(2) would reduce the safe income on hand for the shares of Opco.
Fourth Situation
In the fourth situation, the Class "B" and "C" shares are not participating. The analysis is similar to that indicated above in relation to the second situation.
In the fourth situation, it is thus possible that the FMV of non-participating shares is equal to their ACB. If that were the case, they would have no hypothetical capital gain. There would therefore be no safe income on hand contributing to this hypothetical capital gain. Accordingly, the dividend paid in respect of such classes of shares would exceed the safe income on hand contributing to the capital gain. The condition in paragraph 55(2.1)(c) would apply.
It would then be necessary to consider whether the conditions referred to in paragraphs 55(2.1)(a) and (b) are satisfied. The dividend in respect of the Class "B" shares would reduce the FMV of all participating classes and also reduce the capital gain that would be realized upon the disposition at FMV of the shares of all participating classes. The question is whether these reductions are significant. There could also be an increase in the cost amount of property of the dividend recipient. With a dividend in the order of magnitude of approximately $50,000, we could conclude that the reduction is significant or that the increase is significant. The question is whether any of the purposes of the dividend of $50,000 was to effect such a significant reduction or such a significant increase. This is a question we cannot answer without having all the relevant facts.
If the conditions for applying subsection 55(2.1) were satisfied, subsection 55(2) could then be applied to the taxable dividend if no tax under Part IV was paid in respect of the dividend or if the latter was refunded as a consequence of the payment of a dividend by the corporation.
It would be necessary to apply the same analysis with respect to the dividend received by Holdco B. The conclusion would probably be the same as for Holdco A subject to there being a payment of Part IV tax.
The CRA accepts that a dividend which is subject to subsection 55(2) does not reduce the safe income on hand for the shares in the capital stock of Opco. A dividend that is not subject to subsection 55(2) reduces the safe income on hand for the shares in the capital stock of Opco.
On the other hand, it is possible that the FMV of the Class "B" and "C" shares in the capital stock of Opco is greater than their ACB. It would then be necessary to consider whether it is reasonable to consider that the safe income on hand contributes to the hypothetical capital gain on such shares. As in the second situation, it could be that paragraph 55(2.1)(c) does not apply in relation to the dividend paid to Holdco A or Holdco B, as the case may be. If that were the case, subsection 55(2) would not apply and the safe income on hand of the corporation would be reduced by the dividend amount not subject to subsection 55(2).
Fifth Situation
The analysis of this situation is similar to that indicated above with respect to the first situation.
We assume that the shares held by Mr A and Mrs A were acquired simultaneously on the formation of Opco and for the same ACB per share. We also assume that the shares in the capital stock of the corporation have a FMV of $120,100 and an ACB of $1 per share. Finally, we have assumed that the corporation's safe income in hand is $100,000.
Since all the shares in the capital stock of Opco are participating, are entitled to discretionary dividends and are not be entitled to a predetermined dividend, it is reasonable to take into account the corporation’s overall safe income on hand for the purpose of determining whether the condition specified in paragraph 55(2.1)(c) is satisfied when a discretionary dividend is paid in respect of shares in the capital stock of Opco. Therefore, it is necessary to compare the dividend paid by HoldcoMsA, being 90% of $120,000 ($108,000) to the safe income on hand of Opco ($100,000).
It follows that the dividend is greater than the safe income on hand of such shares by $8,000. The question is whether the dividend of $108,000 would significantly reduce the FMV of the “A” shares in the capital stock of Opco. If this were the case and one of the purposes was such reduction, the conditions for the application of subsection 55(2.1) would be satisfied. Subsection 55(2) would apply respecting the dividend (subject to the application of paragraph 55(5)(f)) received by HoldcoMsA, unless Part IV tax applied and the tax was not refunded by the payment of a dividend by HoldcoMsA.
We trust that our comments will be of assistance.
Stéphane Charette, CPA, CMA, MBA
for the Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and
Regulatory Affairs Branch