2016-0639251I7 Capital Dividend Account and 149(1)(n)

Principal Issues: Whether 149(1)(n) entity can have and use a capital dividend account.

Position: Yes, provided conditions are met.

Reasons: See below.

Author: Meers, Rob
Section: 149(1)(n), 83(2), 89(1), 89(1.2)

                                                                                                                                   August 17, 2016

Toronto Centre Tax Services Office                                                                           Headquarters
Aggressive Tax Planning                                                                                           Income Tax Rulings Directorate
1 Front Street West                                                                                                   Rob Meers
Toronto, ON M5J 2X6                                                                                                613-670-9037

Attention:  Nadeem Hemani                 2016-063925

Capital Dividend Account and 149(1)(n)

This is in response to the e-mail we received from you enquiring as to whether an entity exempt from tax pursuant to paragraph 149(1)(n) of the Income Tax Act (the “Act”) could have and use a capital dividend account (“CDA”) as described in subsection 89(1) of the Act. In this letter all statutory references are to the provisions of the Act unless otherwise expressly stated.

The exemption from Part I tax provided under paragraph 149(1)(n) has two conditions. First, the company must be a “limited dividend housing company”. The term “limited dividend housing company” is defined in section 2 of the National Housing Act to mean a company incorporated to construct, hold and manage a low-rental housing project; the dividends payable by such a company must be limited by the terms of its charter or instrument of incorporation to five percent per annum or less. Second, all or substantially all of the company’s business must be the construction, holding or management of low-rental housing projects. Therefore, a corporation ceases to be exempt from tax pursuant to 149(1)(n) at such time that it fails to satisfy either of these conditions. It remains a question of fact as to when a particular corporation ceases to be exempt from tax pursuant to 149(1)(n).

A private corporation may elect, in prescribed manner and form, to pay its shareholders a dividend out of its CDA under subsection 83(2). Very generally, no part of a capital dividend is included in computing the Part I income of a shareholder resident in Canada and no amount is deducted in computing the adjusted cost base of a shareholder’s shares for such a dividend, provided that the election is made for the full amount of the dividend.

Therefore, a 149(1)(n) entity may qualify to have a CDA if it is a private corporation. Under subsection 89(1), a CDA consists of, among other things, the excess of the corporation’s capital gain over the corporation’s “taxable capital gain”. A taxpayer’s “taxable capital gain” from the disposition of any property is defined in paragraph 38(a) to be one half of the taxpayer’s capital gain from the disposition of that property. Therefore, whether the entity is exempt from tax or not, the taxable capital gain is one half of the capital gain and the amount eligible to be added to the CDA will never be greater than one half of the capital gain. This means that the tax-free amount available to the shareholders of a corporation (including a corporate 149(1)(n) entity), through the CDA, will generally be limited to one half of the capital gain.

However, subsection 89(1.2) provides that where a corporation exempt from tax under Part I loses its exempt status its CDA is eliminated. This is achieved by requiring the amount of its CDA immediately after the time of the change in status to be deducted in computing the corporation’s CDA at and after the change in status. As such, the corporation would have no CDA and consequently would be unable to make a valid election under subsection 83(2).

You have also expressed concern about a potential timing issue with respect to the interaction of subsection 89(1.2) and paragraph 149(10)(b). In particular, you are concerned whether there could be a point in time immediately before the corporation ceases to be exempt where it would have access to the capital dividend account balance generated by the deemed disposition under subsection 149(10).

Subsection 149(10) sets out the tax treatment of a corporation that either becomes or ceases to be exempt from tax under Part I. It is a deeming provision the purpose of which is to ensure that any gain or loss subsequently realized after the change in status does not include any gain or loss which accrued prior to the change in status. This is often referred to as the “fresh start” principle. Paragraph 149(10)(a) deems the taxation year of the corporation to have ended immediately before that point in time when it becomes or ceases to be exempt. Paragraph 149(10)(b) deems the corporation to have disposed of all of its assets immediately before the time that is immediately before the corporation becomes or ceases to be exempt and reacquired them at fair market value at that time. In this particular situation, where a corporation ceases to be exempt, the deemed disposition will be exempt from tax since it is deemed to take place while the entity still meets the conditions of paragraph 149(1)(n). Paragraph 149(10) only applies at the time that the corporation becomes or ceases to be exempt from tax.

Subsections 89(1.2) and 149(10) apply, simultaneously and independent of each other, at the time that a corporate entity ceases to be exempt from tax. At this time, subsection 89(1.2) applies to reduce the corporation’s capital dividend account to nil and the deemed disposition under paragraph 149(10)(b) is also triggered. Therefore, any amounts that would have been added to the capital dividend account as a result of the deemed disposition under subsection 149(10) will not be available to the corporation should it wish to elect to pay out a capital dividend to its members.

We trust that these comments will be of assistance.

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.

Roger Filion, CPA, CA
Manager
Non-Profit Organizations and Aboriginal Issues
Business and Employment Division
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 redistribuer de l'information, sous quelque forme ou par quelque moyen que ce soit, de façon électronique, mécanique, 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