Canada: Subsection 55(2) – The Road Ahead

Subsection 55(2) of the Act2 was introduced on December 11, 1979, and until now, this provision of the Act has, by and large, remained the same. On April 21, 2015, the Department of Finance ("Finance") proposed a dramatic proposed overhaul to these rules as part of the 2015 federal Budget. The proposals went through certain minor revisions when Finance released draft legislation on July 31, 2015. Despite criticism and suggestions from the tax practitioner community, the draft legislation was largely unchanged when it was introduced to Parliament in 2016 as Bill C-15 which received first reading on April 2016.3 For ease of reference, the provisions contained in the draft legislation are referred to as the "new" section 55 rules in this paper.

With these new rules, the ability to pay tax-free dividends amongst related taxable Canadian corporations, once a foundational concept of the Canadian tax system, can no longer be taken for granted for dividends received after April 20, 2015. This paper will not attempt to cover all of the implications that the new section 55 rules entail as doing so is beyond the scope of one paper. Instead this paper will focus on the implications that these new rules have on commercial transactions commonly encountered by advisors of private enterprises, and to present practical planning ideas for dealing with these proposed rules going forward. The paper will also briefly review the concept of safe income on hand since the new rules make the safe income exception much more important than before.

Overview Of New Versus Old Section 55

In order to not tax corporate earnings more than once, subsections 112(1) and (2) generally enable corporations to receive taxable dividends from another taxable Canadian corporation, Canadian-resident corporation, or certain Canadian branches of non-resident corporations free of additional corporate tax to the extent they are "connected" for Part IV tax purposes. These include all types of taxable dividends: actual cash or in-kind dividends, deemed dividends on share redemption or repurchase, stock dividends and stated capital increase deemed dividends, etc. Where such tax-free intercorporate dividends are used in a manner that reduces capital gains that could have been realized on a fair market value ("FMV") disposition of any share of capital stock immediately before the dividend, old section 55 could apply to re-characterize the otherwise tax-free intercorporate dividends into proceeds of disposition or gains that were immediately taxable to the recipient corporation.4 Because of this, the old section 55 rule was also known as the "capital gain stripping" rule. The new section 55 rules are born of the same spirit of the old rule, but its mandate and reach has been dramatically broadened.

Unless otherwise specified in the paper, the provisions of new section 55 apply to dividends received after April 20, 2015.

New subsections 55(2.1) and (2)

The charging provision of new section 55 remains in subsection 55(2). If it applies, new subsection 55(2) re-characterizes a taxable dividend received by a dividend recipient into either proceeds of disposition or a gain. The conditions that need to be met for subsection 55(2) are now in subsection 55(2.1), and these conditions are met if as part of a transaction or event or a series of transactions or events:

1. The dividend recipient is a corporation resident in Canada that has received a taxable dividend and is entitled to a subsection 112(1) or (2) or 138(6) deduction;
2. It is the case that
   
   
   1. One of the purposes of the payment or receipt of the dividend (or, in the case of a subsection 84(3) deemed dividend, one of the results of which) is to effect a significant reduction in the portion of the capital gain that, but for the dividend would have been realized on a disposition at fair market value ("FMV") of any share immediately before the dividend, or
   2. The dividend (other than a subsection 84(2) or (3) dividend) is received on a share that is held as capital property by the dividend recipient and one of the purposes of the payment or receipt of the dividend is to effect
   3. 1. a significant reduction in the FMV of any share, or
      2. a significant increase in the cost of property, such that the amount that is the total cost amount of properties of the dividend recipient immediately after the dividend is significantly greater than immediately before the dividend; and

3. The amount of the dividend exceeds safe income, 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 FMV immediately before the dividend, of the share on which the dividend is received.

The conditions in paragraph 55(2.1)(a) and subparagraph 55(2.1)(b)(i) are the same as the old subsection 55(2), and similar to before, the entire series of transactions or events must be considered. However, new subsection 55(2.1) now adds two new alternative purpose tests: to effect a significant reduction in the FMV, i.e. clause (b)(ii)(A), or a significant increase in the dividend recipient's cost base, i.e. clause (b)(ii)(B). As confirmed by the CRA in the 2015 Canadian Tax Foundation ("CTF") Roundtable5, subsection 55(2) can apply if one of the new alternative purpose tests are met even if there is no capital gain inherent in the share (i.e. the condition in subparagraph 55(2.1)(b)(i)). Hence, the rule that used to be known as the capital gain stripping rule has now been expanded to police value stripping and basis multiplication, even in situations where no capital gain is being avoided.

Although the purpose tests in new section 55 now extend to situations where there is no capital gain inherent in a share, the safe income dividend exception in new subsection 55(2.1)(c) still requires that the safe income be reasonably considered to contribute to the capital gain that could be realized on a FMV disposition. The previous subsection 55(2) used the wording "attributable to" the capital gain, which arguably carries similar meaning as "contribute to". According to Finance's explanatory notes, this change of wording is intended to accommodate the new purposes as described in subparagraph 55(2.1)(b)(ii). This is not a change in the rules, but the fact that the safe income exception is not keeping up with the expansion of the purpose tests (to include situations where no capital gain is being avoided) could cause unfortunate results to the unwary as will be explained later.

It should also be noted that the subparagraph 55(2.1)(b)(i) capital gain reduction test continues to apply to both actual and deemed dividends, while applying a 'result test' for subsection 84(3) deemed dividends similar to old subsection 55(2). On the other hand, the new subparagraph 55(2.1)(b)(ii) value reduction / basis multiplication tests do not apply to deemed dividends under subsections 84(2) or (3), and only contain purpose tests.

If conditions in subsection 55(2.1) are met, then new subsection 55(2) applies to re-characterize the dividend provided that the new Part IV tax exception does not apply. The idea behind the Part IV tax exception is that if Part IV tax applies to an inter-corporate dividend then there is no deferral, hence no mischief, to prevent. The new Part IV tax exception is worded as follows:

"the amount of the dividend (other than the portion of it, if any, subject to tax under Part IV that is not refunded as a consequence of the payment of a dividend by a corporation where the payment is part of the series referred to in subsection (2.1))".

Except for one word, the new Part IV tax exception is exactly the same as it was in the old rule. In old subsection 55(2), the exception was rescinded to the extent the Part IV tax was refunded as a consequence of the payment of a dividend "to" a corporation. Whereas, in new subsection 55(2), the exception is rescinded to the extent the Part IV tax is refunded as a consequence of the payment of a dividend "by" a corporation. What this means is that under the old rules, the Part IV tax exception protected an inter-corporate dividend from subsection 55(2) re-characterization even if the Part IV tax was refunded due to a later dividend to an individual or trust as part of the same series. Under new subsection 55(2), such a refund cancels the Part IV tax exception because a later dividend to an individual or trust is still a dividend "by" a corporation.

Aside from the Part IV tax exception, new subsection 55(2) contains another difference from the charging portion of old subsection 55(2). In old subsection 55(2), the dividend was deemed not to be a dividend to the recipient corporation. Instead it was re-characterized into proceeds of disposition if the share in question was disposed of, and only if there was no disposition, would the dividend be re-characterized into a gain. Under new subsection 55(2), the dividend is also deemed not to be a dividend to the recipient corporation. However, unless the dividend is a subsection 84(2) or (3) deemed dividend, the dividend is re-characterized to be a capital gain of the dividend recipient for the year in which the dividend was received.

While the difference between re-characterization into proceeds versus gains at first blush appears to be a matter of lexicon, this difference actually stems from the heart of new subsection 55(2). Under old subsection 55(2), there is a presumption that if subsection 55(2) applied it would partly be because of a disposition of the share in the year or sometime in the foreseeable future, so it was appropriate that the default application was to re-characterize the dividend into proceeds that would otherwise have arisen on the disposition. Under new subsection 55(2), although the old purpose test remains in subparagraph 55(2.1)(b)(i), whether there is a disposition of shares in the year or in the future is no longer relevant in most cases due to the new purpose tests in subparagraph 55(2.1)(b)(ii). In this light, it seems appropriate for new subsection 55(2) to just re-characterize dividends into capital gains.

However, the fallout of this change is that unlike deemed proceeds, the amount of adjusted cost base ("ACB") inherent in the dividend-paying share is irrelevant in the determination of a deemed capital gain because by deeming a dividend to be capital gain, the re-characterization bypasses the normal subdivision-c concept of proceeds minus ACB equals capital gains. To illustrate, assume a holding corporation (Holdco) owns shares in an operating corporation (Opco) with a FMV of $1 million and an ACB of $5 million and Opco pays a dividend of $1 million to Holdco and one of the purpose tests in paragraph 55(2.1)(b) is met. Also, there is no safe income reasonably considered to contribute to capital gain that could be realized on a FMV disposition of the Opco shares immediately before the dividend (because the share has an accrued loss), so the paragraph 55(2.1)(c) exception does not apply. As a result, the $1 million dividend is deemed to be a capital gain under subsection 55(2) even though the Opco shares on which the dividend is paid has an ACB of $5 million.

Theoretically there is no double taxation from this result because the $1 million dividend reduces the FMV of the Opco shares by $1 million (assuming there is no other shares outstanding), while the $5 million ACB of the shares is preserved. If the Opco shares are subsequently disposed of and there are no other changes to FMV, then the disposition should result in a $5 million capital loss to Holdco which theoretically offsets the $1 million capital gain. However, there are a couple of potential pitfalls here. Firstly, the future capital loss on disposition can only offset the deemed capital gain in respect of the dividend if the disposition occurs within the three-year capital loss carryback period.6 Secondly, the capital loss on the disposition could potentially not be available to the extent certain stop-loss or loss suspension rules apply to the capital loss. For instance, subsection 112(3) would reduce the $5 million capital loss by any taxable dividends and capital dividends Holdco has ever received on those shares (this would not include the $1 million dividend though because paragraph 55(2)(a) deems it not to be a dividend received by Holdco). Also, if the Opco shares are sold to an affiliated person, subsection 40(3.4) would suspend the loss in Holdco's hands. Under old subsection 55(2), the dividend would generally have been re-characterized into proceeds to be applied against ACB, prior to the application of these stop-loss or loss suspension rules.

Also, practitioners should consider the timing of the capital dividend account ("CDA") addition under the new rules. Where dividends were deemed to be proceeds of disposition under old subsection 55(2), it was clear that the CDA arose at the time of the disposition. Under new subsection 55(2), dividends other than subsection 84(2) or (3) deemed dividends are deemed to be capital gains 'for the year'. It is somewhat unclear whether this means that the addition to CDA occurs at the time of the dividend or at the end of the year. Until the CRA provides further guidance on this, it may be prudent to wait until immediately after the year to pay out the capital dividend from CDA.

The above discusses the re-characterization for dividends other than subsection 84(2) or (3) deemed dividends arising on a redemption, acquisition or cancellation of shares. For such deemed dividends, new paragraph 55(2)(b) deems the amount of the dividend to be proceeds of disposition. This is appropriate because the share is treated as being disposed of for the purpose of the Act, and the issues discussed above generally would not be an issue for such deemed dividends.7 It is of interest to note that in the original version of proposed subsection 55(2) that appeared in the Notice of Ways and Means Motion released by Finance on April 21, 2015, all dividends subject to subsection 55(2) were to be re-characterized into a gain. This was revised to its current form in the July 31, 2015 draft legislation, presumably because if a subsection 84(2) or (3) deemed dividend is re-characterized into a capital gain, double-taxation occurs if the share being disposed of has an ACB higher than PUC. This is because the re-characterized capital gain would be equal to the excess of redemption or wind-up proceeds over PUC with no regard to the higher ACB that would otherwise have resulted in a lower capital gain on a straight disposition.

New subsections 55(2.2), (2.3) and (2.4) and amended subsection 52(3)

Other than for purposes of applying Part VI.1 tax, the amount of a stock dividend is limited to the amount by which the payor's paid-up capital ("PUC") is increased by reason of the payment of the dividend.8 Because of this, it was relatively easy for both public and private corporations to issue shares as stock dividends that have high FMV but that carry nominal income inclusion to the recipient generally by limiting the legal stated capital increases to a dollar in their dividend resolution.9 Such stock dividends are often referred to as "high-low" stock dividends for this reason. Old section 55 was generally never a concern when dealing with high-low stock dividend because any section 55 re-characterization risk was limited to the often nominal "amount" of the stock dividend.

New section 55 has now added to its arsenal subsections 55(2.2), (2.3) and (2.4), targeting inter-corporate "high-low" stock dividends. New subsection 55(2.2) requires that for purposes of applying subsections 55(2), (2.1), (2.3) and (2.4), the amount of a stock dividend and the dividend recipient's entitlement to a deduction under section 112 is to be determined as if it is equal to the greater of (i) the increase in the payor's PUC by reason of the dividend, and (ii) the FMV of the shares issued as stock dividend at the time of payment.

New subsections 55(2.3) and (2.4) are technical rules necessary to provide for a partial safe income dividend when a portion of the FMV of a high-low stock dividend does not exceed safe income on hand. It is a relieving provision for high-low stock dividends analogous to paragraph 55(5)(f) for regular dividends, and similar to the new paragraph 55(5)(f), no designation is necessary. It also makes certain that a stock dividend paid out of safe income properly reduces safe income. Since these provisions are directed to high-low stock dividends, they only apply if conditions in subsection 55(2.4) are met, which are:

1. a dividend recipient holds a share upon which it receives the stock dividend;
2. the FMV of the share(s) issued as stock dividend exceeds the amount by which the payor's PUC is increased because of the dividend (in other words, a high-low stock dividend); and
3. subsection 55(2) would apply to the dividend if subsection 55(2.1) were read without reference to its paragraph (c).

The condition in paragraph (c) refers to all the conditions in subsection 55(2.1) being met if the safe income exception in paragraph 55(2.1)(c) were ignored. This is to cause subsection 55(2.3) to replace paragraph 55(2.1)(c) as the operative safe income exception for high-low stock dividend.

If the conditions in subsection 55(2.4) are met, subsection 55(2.3) applies to produce the following results:

1. the amount of the stock dividend that does not exceed safe income on hand reasonably considered to contribute to the capital gain that could be realized on a FMV disposition, immediately before the dividend, of the share on which the dividend is received is deemed for purpose of subsection 55(2) to be a separate taxable dividend; and
2. the amount in (a) above is deemed to reduce the safe income on hand of the share on which the dividend is received.

As an illustration, assume that Opco has safe income on hand of $100 and its Class A shares which are held wholly by Holdco have an aggregate accrued capital gain of $100 or more. Opco declares on its Class A shares a stock dividend of Class B shares with a legal stated capital of $1 but a FMV of $150. Assume Holdco and Opco are connected and Opco does not have a refundable dividend tax on hand ("RDTOH") balance, so that Part IV tax does not apply to Holdco on receipt of the stock dividend. Per subsection 55(2.2), for purposes of applying the new section 55 rules, the amount of the dividend and the subsection 112(1) dividend deduction entitlement would be considered to be $150, being the greater of the payor's PUC increase and the FMV of the shares issued. Assuming one of the purposes of the issuance of the Class B stock dividend were to significantly reduce the FMV of the Class A shares, all of the conditions in subsection 55(2.4) should be met so that subsection 55(2.3) would apply. As a result, subsection 55(2.3) would cause Holdco to have received two separate taxable dividends: (i) $100 paid out from Opco's safe income on hand that could reasonably be considered to contribute to the accrued gain on the shares on which the dividend is received and for which Holdco would receive as a taxable dividend that it can claim a subsection 112(1) deduction against, and (ii) $50 which would be re-characterized by subsection 55(2) as a capital gain to Holdco. Also, Opco's safe income on hand would be reduced by $100 to $0 immediately after the stock dividend by virtue of paragraph 55(2.3)(b). Note that subsection 55(2) would apply similarly if it were a 'same class' stock dividend, i.e. a stock dividend of Class A shares paid on Class A shares.

Where an individual shareholder receives a share by virtue of a stock dividend, the shareholder's cost in the share received equals the 'amount' of the stock dividend – here, 'amount' being the increase in the payor's corporation's PUC since the modified meaning of 'amount' in new subsection 55(2.2) does not apply beyond subsection 55(2) to (2.4). However, where the recipient of the stock dividend is a corporation, paragraph 52(3)(a) limits the cost of a share received to the amount of the stock dividend less any portion deductible under subsection 112(1) to the extent it exceeds safe income on hand. Amended subsection 52(3) provides that in the case of a corporate recipient of a stock dividend, the recipient's cost of the shares received shall be determined by subparagraph 52(3)(a)(ii) to be the total of:

1. the amount if any, by which
   
   
   1. the lesser of the amount of the stock dividend and its FMV, exceeds
   2. any portion of the amount of the dividend deductible under subsection 112(1) to the extent it exceeds safe income on hand reasonably considered to contribute to the capital gain that could be realized on a FMV disposition, immediately before the dividend, of the share on which the dividend is received; and

2. the total of A + B where

To illustrate this, we will use the numeric example from above whereby Opco with $100 safe income on hand declares a stock dividend with a legal stated capital of $1 but a FMV of $150 to Holdco. The amount determined under clause 52(3)(a)(ii)(A) would be $1, because the amount determined under subclause (A)(I) is $1 (being the lesser of the amount of the stock dividend and its FMV), and subclause (A)(II) is $0 because the whole $1 is from safe income. The amount determined under clause 52(3)(a)(ii)(B) would be $149. This is because variable A is $50, being the deemed capital gain under paragraph 55(2)(c), and variable B is $99, being the $100 safe income reduction under paragraph 55(2.3)(b) minus the $1 determined under clause 52(3)(a)(ii)(A). Holdco's cost of the shares received on the stock dividend is the total of clause (A) and (B), which is $150. This is a reasonable result because $100 of the value of the stock dividend is derived from safe income on hand, and Holdco incurred $50 of deemed capital gain under subsection 55(2).

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