Changes to subsection 55(2) of the Income Tax Act
Proposed amendments to subsection 55(2) of the Income Tax Act (Canada) (“ITA”) add an additional level of complexity to transactions using intercorporate dividends.
This material is for information purposes only and should not be construed as providing legal or tax advice. Reasonable efforts have been made to ensure its accuracy, but errors and omissions are possible. All comments related to taxation are general in nature and are based on current Canadian tax legislation and interpretations for Canadian residents, which is subject to change. For individual circumstances, consult with your legal or tax professional. This information is provided by The Great-West Life Assurance Company and is current as of December, 2015.
The proposed rules expand the potential application of subsection 55(2), a notoriously complex anti- avoidance rule that generally aims to prevent transactions of which one of the purposes is to use tax-free intercorporate dividends to significantly reduce a realized capital gain.1 If subsection 55(2) applies, it converts an otherwise tax-free intercorporate dividend into a capital gain. The 2015 Federal Budget introduced the amendments to subsection 55(2) which, if enacted, would apply retroactively to intercorporate dividends received after April 20, 2015. As a result, tax practitioners are treating the proposed rules as law.
1Or in the case of a subsection 84(3) deemed dividend, where one of its result is to significantly reduce a capital gain.
The main concerns with the proposed amendments are that they both broaden subsection 55(2)’s purpose test and restrict the rule’s related-party exception as it applies to ordinary dividends. This adds a new level of complexity to common intercorporate transactions, like where an operating company pays a dividend to a holding company for:
- protecting assets from potential creditors;
- maintaining capital gains exemption eligibility; and/or
- tax efficient ownership of life insurance.
This article addresses the key proposed changes to subsection 55(2) and highlights how they affect intercorporate dividends paid within common corporate structures.
Subsection 55(2) – then and now
Under the enacted version of subsection 55(2), business owners were generally able to move cash within their corporate groups through intercorporate dividends without paying much attention to subsection 55(2). They were typically able to rely on either one or a combination of three safeguards from subsection 55(2): the purpose test, the related-party exception and having sufficient safe income – each of which is modified under the proposed amendments.
Purpose test on ordinary dividends
Enacted Rules – Subsection 55(2) does not apply unless one of the purposes of the dividend is to significantly reduce a capital gain that would have been realized on a disposition of any share.
Proposed Rules – The amendments create a new additional purpose test that looks to whether one of the purposes of the payment or receipt of the dividend is to effect (1) a significant reduction of the FMV of any share, or (2) a significant increase in the cost of property in the hands of the dividend recipient. Many tax practitioners are concerned that this additional test is too overarching which makes it difficult to advise clients with any certainty that their intercorporate dividends are not caught by subsection 55(2) when other exceptions discussed below are unavailable.
Safe income test
Enacted Rules – Subsection 55(2) does not apply where the gain reduced by the intercorporate dividend is attributable to the share’s portion of after- tax retained earnings – called “safe income”. Safe income attributable to a share is generally income that has been subject to corporate tax and, as a result, the CRA is not concerned when it is paid to another corporation as an intercorporate dividend.
Proposed Rules – The safe income exception would be available only where the safe income on a share could reasonably be regarded to contribute to a capital gain on the share. This will affect holding companies that own discretionary dividend shares of nominal value.
Related-party exception on ordinary dividends
Enacted Rules – Subsection 55(2) does not apply as a result of the paragraph 55(3)(a) related-party exception where the intercorporate dividend is not part of a transaction (or series of transactions or events) that involved an unrelated party. This exception is often relied on since it even applies where the intercorporate dividend significantly reduces a capital gain and is not attributable to safe income.
Proposed Rules – The amendments significantly restrict the scope of the paragraph 55(3)(a) related- party exception by limiting its application to subsection 84(3) deemed dividends, meaning those arising from a redemption, acquisition or cancelation of shares.
Impact on ordinary dividends paid in common corporate structures
Based on the forgoing, it is likely that tax practitioners will start using share redemptions whenever possible to fit within the related-party exception. Where this is not practical, they will need to place greater reliance on both the purpose test and the safe income test for safeguarding intercorporate dividends from the effects of subsection 55(2).
This situation is generally negative because 1) as noted, relying on not being caught by purpose tests casts uncertainty in tax planning and 2) calculating safe income is difficult for tax accountants to do as it examines a taxpayer’s taxation years from 1972 and its rules are derived from a patchwork of CRA statements and court decisions. As a result, business owners are faced with increased tax compliance costs by having to document the purpose(s) of paying a dividend and maintaining current safe income calculations.
The following examines how the proposed subsection 55(2) will affect ordinary intercorporate dividends, including those which facilitate corporate ownership of life insurance.
Cash dividends paid from an operating company to a holding company
This is the common situation where an operating company with one class of shares pays a tax-free cash dividend to its parent holding company. The purpose of moving cash may be to fund a life insurance policy owned by the holding company. This type of transaction will still be commonplace; however, tax practitioners now need to ensure that the intercorporate dividend either passes the purpose test or is attributable to safe income (the related-party exception no longer applies).
Dividends paid on discretionary dividend shares
This situation is seen where an operating company pays a cash dividend to a holding company on shares that have dividend rights, but a nominal fair market value. The purpose of the dividend may be to fund the premium of a life insurance policy owned by the holding company. This type of transaction may be materially affected by the proposed subsection 55(2) because the related-party exception will not apply and the shares may not have any safe income. As a result, satisfying the purpose test will be necessary in these cases.
Cash dividends paid on new common shares issued after an estate freeze
This situation is commonly seen where new common shares are issued to a trust after an estate freeze and a holding company is a beneficiary of the trust. In many cases the trust can flow the dividend income to the holding company tax-free, which makes the holding company an ideal place to own a life insurance policy. Paying a dividend to the holding company via the trust will be more complicated under the proposed rules as the related-party exception will not apply. As a result, tax practitioners will need to either consider the purpose of the dividend or
calculate whether the new common shares have sufficient safe income to safeguard the dividend.
Intercorporate insured share redemptions
This situation is most commonly seen where an operating company owns life insurance to facilitate an insured buyout of a corporate shareholder. On death, the operating company redeems its shares using the life insurance proceeds, which generally results in a deemed dividend that it may elect to be a capital dividend to the extent of its capital dividend account (“CDA”) balance. Life insurance proceeds received by a corporation credits its CDA by the amount that the death benefit exceeds the policy’s adjusted cost basis. Fortunately, subsection 55(2) does not to apply to intercorporate capital dividends. As a result, the operating company should whenever possible obtain sufficient insurance coverage (and corresponding CDA credit) to cover the full purchase price of a buyout using an intercorporate share redemption.
Public comment and business owner action
The Department of Finance invited the public to comment on the proposals. Hopefully the consultations will result in changes to these proposed rules which will give business owners more certainty that subsection 55(2) will not apply when carrying out routine transactions within their corporate groups. Nevertheless, because these proposed rules could be passed into law in their existing form, business owners should seek guidance from their tax advisors before paying intercorporate dividends or moving assets within their corporate groups.