Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Determination of purpose under proposed paragraph 55(2.1)(b) in various hypothetical scenarios.
Position: General comments provided.
Reasons: See below.
Author: Mailhot-Gamelin, Annie
Section: 55(2), 55(2.1), 55(3)(a)
June 23, 2016
Re: Application of proposed amendments to section 55 of the Income Tax Act (Canada) (“Act”)
This is in response to your letter of January 19, 2016 in which you requested our views on the application of the proposed amendments to section 55 of the Act in various hypothetical scenarios. You have asked us whether the purpose of the dividends in the following scenarios would be described in proposed paragraph 55(2.1)(b) announced by the Minister of Finance on July 31, 2015. Since then, those changes were tabled and this letter will refer to the version that was tabled in the Notice of Ways and Means Motion tabled on April 18, 2016.
Unless otherwise stated, all statutory references herein are to the Act.
A dividend paying corporation (“Divco”) is a corporation resident in Canada for purposes of the Act. One or more shareholders of Divco are corporations resident in Canada and all shares of Divco held by such shareholders are held as capital property for purposes of the Act.
Scenario 1 considers the payment of dividends by Divco from its excess cash-flow to its shareholders where:
a) Divco has no written dividend policy;
b) the amount and timing for the declaration and payment of dividends are determined by the board of directors of Divco in its sole discretion; or
c) the amount of the dividend exceeds the reasonable dividend return that would be paid on a comparable listed share issued by a comparable corporation in the same industry because Divco is well-managed and outperforms its competitors.
Scenario 2 deals with the payment of dividends by subsidiaries of Divco to fund the payment of dividends by Divco to its shareholders pursuant to a “well-established dividend policy” or to fund the payment of general corporate expenses of Divco.
Scenario 3 describes the payment of year-end dividends by Divco to offset advances made by another corporation of the group under a cash pooling arrangement.
Scenario 4 assumes that Divco has a class of preferred shares entitling holders to a non-cumulative dividend calculated on the redemption value of the preferred shares, as and when declared by the board of directors. You have indicated that the dividend entitlement reflects a reasonable rate based on the market rates applicable at the time that the preferred shares are issued. You have asked us to confirm whether the purpose tests would be met in respect of the dividends paid by Divco on the preferred shares if:
a) Divco pays a dividend at every entitlement period;
b) Divco pays dividends occasionally, where operational circumstances permit; or
c) Divco pays dividends infrequently, depending on the liquidity needs of the preferred shareholders.
In addition, you have asked us to comment on the application of the exception under amended paragraph 55(3)(a) if instead Divco redeems some or all of the preferred shares in order to meet the liquidity needs of the preferred shareholders, and pays the holders their redemption value in cash, giving rise to deemed dividends under subsection 84(3). It is assumed that the preferred shares are not redeemed as part of the same series of transactions in which they are issued, and that none of the triggering events described in paragraph 55(3)(a) applies in respect of the redemption. Specifically, you have asked us (i) whether this would be considered a “bona fide corporate reorganization”, as described by the Minister of Finance in the Technical Notes to the proposed amendments to section 55, and (ii) to consider the impact of a capital reorganization prior to the redemption pursuant to which all the common shares of Divco are exchanged for preferred shares and new common shares such that the adjusted cost base of the common shares is allocated among the new shares either based on their fair market value or first to the preferred shares up to their fair market value and then to the new common shares.
In your letter, you indicate that in the scenarios described above:
a) none of the parties intend at the time of the payment of any dividend that the dividend recipient will either (i) reinvest the dividend proceeds in the dividend paying corporation, or (ii) transfer a property to the dividend paying corporation on a tax-deferred basis, in either case within the same series of transactions or events that includes the dividend;
b) each dividend will be paid in cash and will significantly reduce the fair market value of shares of the corporation paying the dividend; and
c) the safe income exception in proposed paragraph 55(2.1)(c) and the exception for Part IV tax will not apply in respect of any portion of the dividends.
This technical interpretation provides general comments about the provisions of the Act. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer 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 70-6R7, Advance Income Tax Rulings and Technical Interpretations, dated April 22, 2016.
Purpose test under proposed paragraph 55(2.1)(b)
Under proposed paragraph 55(2.1)(b), subsection 55(2) may apply to a dividend if one of the purposes of the payment or receipt of the dividend is to effect:
a) 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 of any share of capital stock immediately before the dividend;
b) a significant reduction in the fair market value of any share; or
c) a significant increase in the cost of property, such that the amount that is the total of the cost amounts of all properties of the dividend recipient immediately after the dividend is significantly greater than the amount that is the total of the cost amounts of all properties of the dividend recipient immediately before the dividend.
Factors relevant in determining “purpose”
The determination of purpose is based on facts that are particular to each situation including, but not limited to, the actions taken by the parties to the dividend and their motivation. As established by the Supreme Court of Canada in Ludco Entreprises Ltd. et al. v. The Queen, 2001 DTC 5505 (SCC), purpose has to be objectively determined, guided by both subjective and objective manifestations of purposes.
As we have indicated in the answer to the question on section 55 at the Tax Executive Institute Liaison Meeting on November 17, 2015 (“TEI Meeting”):
“Although a dividend on a share would normally result in a reduction of value of the share, or an increase in cost of property of a dividend recipient, it’s not the result that determines the application of proposed subsection 55(2.1). It’s the purpose and the motivation behind the purpose that could be established by finding the answer to questions such as: (i) What does the taxpayer intend to accomplish with a reduction in value or increase in cost?; (ii) How would such reduction in value or increase in cost be beneficial to the taxpayer?; (iii) What actions did the taxpayer take in connection with the reduction in value or increase in cost?”
“One of the purposes”
The test in proposed paragraph 55(2.1)(b) is whether “one of the purposes” of a dividend is described in that provision. This requires an analysis of all the purposes of the dividend in order to determine whether one of them is the reduction of capital gain or fair market value of a share or the increase of cost of property.
Application of the purpose test to the hypothetical scenarios
Your letter refers to the following statement that was made by the CRA at the 2015 Canadian Tax Foundation Round Table (“2015 CTF Round Table”) and that was published in the answer to the question on section 55 at the TEI Meeting:
“Where a dividend is paid pursuant to a well-established policy of paying regular dividends and the amount of the dividend does not exceed the amount that one would normally expect to receive as a reasonable dividend income return on equity on a comparable listed share issued by a comparable payer corporation in the same industry, we would consider that the purpose of the payment of such dividend is not described in proposed paragraph 55(2.1)(b).”
The terms “reasonable dividend income return on a […] listed share” refer to dividends paid regularly by widely-held corporations to their shareholders on publicly listed shares. A corporation that has a policy of paying on its listed shares quarterly dividends that are set at a fraction of yearly earnings would fit that description. The example extends to a comparable corporation that is not listed but is in a comparable industry and follows a similar well-established policy of paying dividends regularly. Where the amount and the timing for the declaration and payment of dividends are to be determined by the board of directors of the corporation in its sole discretion, this would generally not constitute a well-established policy of paying dividends regularly.
The situation described in the statement is only one example where we would consider that the purpose of the payment of a dividend is not described in proposed paragraph 55(2.1)(b). We understand that, in such situation, a dividend paid by a corporation would generally not result in a significant reduction of the fair market value of a share. However, in certain circumstances, it could result in a significant increase of the cost of property for the dividend recipient.
Scenario 1 is not the situation that was described in the example that was presented at the 2015 CTF Round Table and the TEI Meeting. None of the factors listed in Scenario 1 would, in and of themselves, be determinative of whether one of the purposes of the payment or receipt of a dividend is described in proposed paragraph 55(2.1)(b). We understand that, in your hypothetical situation, the safe income of the corporation paying the dividends would be less than its retained earnings. As you noted in your letter, this may be because the corporation was entitled to tax benefits such as accelerated capital cost allowances that significantly reduced its income under the Act. In such case, the tax benefits are provided at the corporate level. The application of subsection 55(2) to a distribution of the retained earnings of a corporation to another corporation in the form of a dividend where one of the purposes of such dividend is described in proposed paragraph 55(2.1)(b) does not impact such tax benefits. The tax policy that applies to the earnings of a corporation does not normally extend to the shareholders. Moreover, the scheme of the Act is that income that has already been taxed at the corporate level should be distributed tax-free to corporate shareholders. If corporate income has not previously been taxed, whether because the corporation was entitled to certain tax benefits under the Act or for any other reason, then a dividend paid by the corporation from such income should be subject to subsection 55(2) unless none of the purposes of the dividend is described in proposed paragraph 55(2.1)(b). The same comments would also apply in a situation where a corporation borrows money to pay a dividend or to redeem shares of its capital stock. The fact that the interest on the borrowing would be deductible under paragraph 20(1)(c) under the “fill-the-hole” principle is not in itself conclusive of the absence of purpose under proposed paragraph 55(2.1)(b).
With respect to Scenario 2, a dividend that is paid by a subsidiary of Divco to fund the payment by Divco of dividends described in the example provided at the 2015 CTF Round Table and the TEI Meeting or general corporate expenses might not be considered to have a purpose described in proposed paragraph 55(2.1)(b), however that can only be determined after a review of all relevant facts and circumstances. The use of the funds by Divco is an indication of purpose but it is not determinative by itself. Moreover, proposed paragraph 55(2.1)(b) requires that we look at the purpose of the payment and receipt of each particular dividend. The purpose of a dividend has to be analyzed at each level of payment through a corporate chain. There is no consolidated approach in determining whether the purpose tests are met.
Similar comments would also apply to Scenario 3 in respect of dividends paid in the context of cash pooling arrangements. Although year-end dividends that are only designed to offset intercorporate advances made under conventional cash pooling arrangements might not be considered to have a purpose described in proposed paragraph 55(2.1)(b), that can only be determined after a review of all relevant facts and circumstances.
With respect to Scenario 4, we assume that the redemption value of the preferred shares of Divco is equal to the fair market value of the consideration received by Divco upon the issuance of the shares. In addition, we assume that the dividend rate on the preferred shares reflects a reasonable dividend income return on equity on a comparable listed share issued by a comparable payer corporation in the same industry as Divco. In this context, it is our view that the terms and conditions of the preferred shares of Divco would generally be considered as an objective manifestation of the absence of purpose in proposed paragraph 55(2.1)(b). However, the determination of purpose or absence of purpose also requires looking at subjective manifestations of purpose and the circumstances surrounding the payment and receipt of a dividend, which would generally include, among others, the reason why the preferred shares were issued in the first place, the transactions related to their issuance, and the manner in which the preferred shares structure will be unwound. If a review of all the relevant facts and circumstances demonstrate that none of the purposes of the dividends paid by Divco on the preferred shares is described in proposed paragraph 55(2.1)(b), then we are generally of the view that the frequency of payment of dividends would not, in and of itself, be conclusive on such determination.
The scenarios described in your letter do not provide enough information to determine whether one of the purposes of the dividends is described in proposed paragraph 55(2.1)(b). Although you indicate that the dividends would generally not be paid or received for any avoidance tax purpose, your letter does not provide enough information to ascertain how that assumption informs the application of proposed paragraph 55(2.1)(b). The fact that none of the parties intend at the time of the payment of any dividend that the dividend recipient will reinvest the dividend proceeds in the dividend paying corporation or transfer a property to the dividend paying corporation on a tax-deferred basis is not sufficient to conclude that none of the purposes of the dividend is described in proposed paragraph 55(2.1)(b).
Exception under amended paragraph 55(3)(a)
In the Technical Notes to the proposed amendments to paragraph 55(3)(a), the Minister of Finance indicates that:
“The amended exception in paragraph (a) for related-person dividends is intended to facilitate bona fide corporate reorganizations by related persons. It is not intended to be used to accommodate the payment or receipt of dividends or transactions or events that seek to increase, manipulate, manufacture or stream cost base.”
The determination of whether a redemption of shares that would be exempt under paragraph 55(3)(a) frustrates the object, spirit and purpose of proposed subsection 55(2) and therefore could be subject to the general anti-avoidance rule requires a review of all relevant facts and circumstances. A mere redemption of shares for cash or note might frustrate the object, spirit and purpose of proposed subsection 55(2) if it is exempt under paragraph 55(3)(a) while having a purpose described in proposed paragraph 55(2.1)(b). However, we would normally not consider such redemption of shares that have no accrued gain to have such a purpose. Where there is an accrued gain on shares redeemed by a corporation, the absence of a reinvestment of the redemption proceeds in the corporation or of transfer of property to the corporation is not, by itself, conclusive in determining whether none of the purposes described in proposed paragraph 55(2.1)(b) exists.
As previously indicated, the purpose or absence of purpose described in proposed paragraph 55(2.1)(b) in respect of the payment or receipt of a dividend can only be determined by a review of all the particular facts. While we are willing to provide examples of circumstances where proposed subsection 55(2) does not apply, this will be done through the issuance of advance income tax rulings.
Although paragraph 19(h) of IC70-6R7 indicates that the CRA will not issue an advance income tax ruling in situations involving primarily a factual determination, the CRA will consider issuing a favourable opinion under proposed subsection 55(2) where all manifestations of purpose and corroborating circumstances support the absence of one of the purposes described in proposed paragraph 55(2.1)(b). The opinion would be conditional on the representation made by the taxpayer that the purposes for which the dividend was paid do not include one of the purposes described in proposed paragraph 55(2.1)(b) and on the completeness of the description of all the manifestations of such purpose and corroborating circumstances.
We trust that our comments will be of assistance.
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without the prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5.
© Her Majesty the Queen in Right of Canada, 2016
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2016