2016-0669651C6 2016 CTF–Computation of safe income

Principal Issues: a) and b) how to apportion safe income on discretionary-dividend shares? c) are detailed safe income calculations essential?

Position: a) and b) no response until study is completed c) duty of taxpayer is to use due care in making claim that a dividend is protected by safe income. Incorrect claim could be subject to 152(4), 163(2) or 239(1) depending on circumstances

Reasons: see above

Author: Ton-That, Marc
Section: 55(2), 55(2.1)(c), 15(1), 56(2), 69(1), 245(2), 154(2), 163(2), 239(1)

2016 CTF Annual Conference
CRA Roundtable

Question 2: Computation of safe income on discretionary-dividend shares

In order to clarify the CRA’s position on the allocation of safe income on hand on circumstances commonly encountered by taxpayers, we would like the CRA to illustrate the application of the safe income exception in paragraph 55(2.1)(c) to the following hypothetical situation.

In Year 1, Holdco A and Trust B incorporated Opco as follows: Holdco A subscribed for 50 Class A common shares and Trust B subscribed for 50 Class B common shares, and the subscription price was nominal for both. Trust B is a discretionary personal trust and one of the beneficiaries is Holdco B. Holdco A is not related to and deals at arm’s length with both Trust B and Holdco B. The share articles of Opco provides that all classes of its common shares are voting, participating, entitled to discretionary dividends independent of other classes, and entitled to pro-rata sharing of net assets with other common share classes upon liquidation.

At the end of Year 2, the shares of Opco have an aggregate fair market value of $2 million and Opco’s aggregate safe income on hand was also $2 million. At that time, the following transactions occurred:

*     Holdco C, a corporation related to Holdco A, subscribed for 50 Class C common shares in Opco for a subscription price of $1 million.
*     Holdco D, a corporation not related to any of the above entities, borrowed $500,000 from Opco and used the funds to purchase 25 Class B common shares from Trust B.

During year 3, Opco earned additional safe income on hand in the amount of $3.6 million. At the end of Year 3, Opco declares the following dividend in order to effect a significant reduction in the fair market value of Opco:

*     $3 million dividend on Class C
*     $2.6 million dividend on Class B (i.e. $1.3 million to Trust B and $1.3 million to Holdco D)

Trust B allocates and pays the entire $1.3 million it receives to Holdco B, whereas Holdco D repays the $500,000 it owes Opco using part of the dividend proceeds it receives.  All corporations are taxable Canadian corporations.

a)    Can the CRA comment on whether each of the dividends paid in Year 3 would fall outside of the safe income exception in paragraph 55(2.1)(c), and if so, how much would be re-characterized as a gain to the respective dividend recipients pursuant to subsection 55(2)?

b)    Would the response be different if, at the same time as the subscription by Holdco C, Holdco A exchanged all of its Class A Opco shares on a fully tax-deferred basis under subsection 86(1) for 50 preferred shares of Opco redeemable and retractable for $1 million in aggregate, with a cumulative dividend entitlement of 1% [of the redemption amount] per annum?

c)    Given the expanded scope of section 55 what are the information requirements with respect to safe income computations?  For example, are detailed safe income computations essential in relatively simple case where there is a holdco / opco structure and no or limited differences in accounting versus taxable income? 

CRA Response:

a) and b) We do not believe that this type of example is, as suggested in the question we have received, representative of situations commonly encountered by taxpayers.  Holdco A and its related corporation, Holdco C, have given up a portion of their collective value in Opco in favour of two unrelated persons: Trust B and Holdco D.  How this is justifiable from a common business sense is not readily understandable and relevant facts are certainly missing in the example.  A detailed analysis would have to be made to determine whether any of the provisions such as subsection 15(1), 56(2), 69(1), 246(1) or 245(2) could apply in these circumstances.  Furthermore, we would like to point out that this type of share structure would become problematic if and when a butterfly distribution of Opco is envisaged under paragraph 55(3)(b) since it could be impossible to determine whether the butterfly distribution would qualify as a distribution under subsection 55(1) because of the uncertainty in establishing the fair market value of the shares of Opco.

As previously indicated, recent CRA comments on the allocation of safe income to discretionary dividend shares were not intended to suggest that the CRA has no concerns about the use of those shares.  The CRA will study the subject and will not provide additional views until the study is completed.

c) The calculation of safe income has a purpose of substantiating the claim that a dividend is not subject to the application of subsection 55(2). It is the duty of taxpayers and their representatives to use due care in making such claim, which is one of the foundations of a self-assessing system.  We should note that an incorrect claim could be subject to the application of subsections 152(4), 163(2) or 239(1), depending on the circumstances.

Marc Ton-That
2016-066965
November 29, 2016

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