2017-0726381C6 2017 CTF - Q5 - 55(5)(f) and 55(2.3) with 55(2.1)

Principal Issues: Is the non-safe income portion of a dividend subject to a separate test under 55(2.1)?

Position: No.

Reasons: See response.

Author: Ton-That, Marc
Section: 55(5)(f), 55(2.3), 55(2.1)

2017 CTF Annual Conference
CRA Roundtable

Question 5: Interaction between 55(5)(f) and 55(2.3) with 55(2.1)

Opco pays a dividend of $1,000 on the shares held by Holdco in Opco.  The shares have a fair market value of $1,500 prior to the dividend and the safe income that can reasonably be viewed as contributing to the gain on the shares of Opco held by Holdco is $900.  Paragraph 55(5)(f) deems the portion of safe income of $900 to be a separate dividend and the portion of $100 that exceeds the safe income to be another separate dividend.

A.    Are both dividends subject to a separate test under subsection 55(2.1) such that the portion of $900 of the dividend is exempt because it does not exceed safe income and the portion of $100 of dividend may be exempt if its purpose is not to significantly reduce the gain or the value of the shares on which it is paid?

B.    Similarly, when a dividend is a stock dividend subject to the rule in subsection 55(2.4), does the application of the rule in subsection 55(2.3) to segregate the dividend into 2 dividends result in the application of the test under subsection 55(2.1) separately to each such dividends?  Consider for example a stock dividend with a PUC of nil and a FMV of $1,000 and the safe income that contributes to the gain on the shares on which the stock dividend is paid is $900.

CRA Response

A.    Paragraph 55(5)(f) read as follows prior to its amendment introduced in Bill C-15:

where a corporation has received a dividend any portion of which is a taxable dividend,

(i) the corporation may designate in its return of income under this Part for the taxation year during which the dividend was received any portion of the taxable dividend to be a separate taxable dividend, and

(ii) the amount, if any, by which the portion of the dividend that is a taxable dividend exceeds the portion designated under subparagraph (i) shall be deemed to be a separate taxable dividend.

Subsection 55(2) read as follows prior to the amendment introduced in Bill C-15:

(2) Where a corporation resident in Canada has received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) or (2) or 138(6) as part of a transaction or event or a series of transactions or events, one of the purposes of which … was 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 of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the safe-income determination time for the transaction, event or series, notwithstanding any other section of this Act, the amount of the dividend …

(a) shall be deemed not to be a dividend received by the corporation;

(b) …

(c) where a corporation has not disposed of the share, shall be deemed to be a gain of the corporation for the year in which the dividend was received from the disposition of a capital property.

It was well understood then that paragraph 55(5)(f) was a relieving provision and a designation under paragraph 55(5)(f) allowed the taxpayer to only report the portion of the dividend that exceeds safe income as a gain under subsection 55(2).

The “Robertson paper” (footnote 1) gave the following explanation:

“A taxpayer is obligated by the law to report that portion of the gain attributable to something other than income earned or realized after 1971. Therefore, he must calculate his safe income and safe dividend as carefully as possible. Having done that, he must make the designation in accordance with the provisions of paragraph 55(5)(f). At this point, there should be no problem determining which separate taxable dividend is caught by subsection 55(2). The taxpayer will report the one supported by his calculation of safe income and of a safe dividend as a tax-free dividend and the other as additional proceeds or a gain, as the case may be.”

Interestingly, the question was never raised as to whether only the $100 portion of the dividend should be subject to the purpose test under subsection 55(2) since it was well understood that the purpose test in subsection 55(2) applied to the whole dividend (of $1,000 in the above example), such that a designation under paragraph 55(5)(f) would require the taxpayer to include only the portion of the dividend that exceeds the safe income (the portion of $100 of dividend in the above example) in its income under paragraphs 55(2)(a) and 55(2)(c).

The new rules introduced by Bill C-15 to paragraph 55(5)(f) and subsections 55(2) and 55(2.1) have not changed anything with respect to the above discussion, except that paragraph 55(5)(f) now operates automatically to segregate the dividends between “safe” dividends and “non-safe” dividends instead of requiring the taxpayer to make a designation for that purpose.  Except for such automatic segregation, the scheme of the application of paragraph 55(5)(f) to subsection 55(2) remains the same.

Hence, there is no reason why the deemed separate dividend of $100 in the above example should be subject to a separate test under paragraph 55(2.1)(b) and the words of paragraph 55(5)(f) and its application to subsections 55(2) and 55(2.1) should not lend themselves to an interpretation that is contrary to its object and spirit.  Since paragraph 55(5)(f) does not contain an ordering rule for the dividends, one may be tempted to argue that both deemed separate dividends under paragraph 55(5)(f) could be protected by the safe income that existed immediately prior to the payment of the whole dividend, as each separate dividend is subject to 55(2) under paragraph 55(2.1)(c) only if it exceeds the safe income immediately before the dividend.

Such interpretation results in a duplication of the safe income protection and is simply absurd since the purpose of paragraph 55(5)(f) is to bring into income the amount of the dividend that exceeds safe income.

An appropriate reading of the relevant provisions, in conformity with the purpose of the legislation, would be as follows, using the same numbers as in the above example:

*     The “taxable dividend” referred to in the preamble of subsection 55(2.1) is the whole $1,000 of dividend;

*     The “dividend” referred to in paragraphs 55(2.1)(a) and (b) is the whole $1,000 of dividend;

*     The “amount of the dividend” referred to in paragraph 55(2.1)(c) is the portion of the dividend that exceeds safe income and that is deemed to be a separate dividend under paragraph 55(5)(f), which is $100;

*     The “taxable dividend” referred to in the preamble of subsection 55(2) is the whole $1,000 of dividend; and

*     The “amount of the dividend” referred to in the preamble of subsection 55(2) that is deemed not to be a dividend and to be a gain is the amount referred to in paragraph 55(2.1)(c) as described above, being $100.

B. By virtue of subsection 55(2.2), the amount of a stock dividend, for purposes of the application of subsections 55(2), (2.1), (2.3) and (2.4), is deemed to be the greater of the PUC increase and the FMV of the shares issued as stock dividend.

The application of subsection 55(2.1) to a stock dividend is the same as for a cash dividend.  Once the amount is determined under subsection 55(2.2), the whole dividend of $1,000 is first subject to the tests under paragraphs 55(2.1)(a) and 55(2.1)(b).  Once it is determined that paragraphs 55(2.1)(a) and 55(2.1)(b) apply, then, by virtue of subsection 55(2.4), the stock dividend is segregated into 2 dividends under subsection 55(2.3).  The amount of the stock dividend that is in excess of safe income, the $100 portion, is the amount referred to in paragraph 55(2.1)(c).  It is that amount that is subject to the application of subsection 55(2).

M. Ton-That
2017-072638
November 21, 2017

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  John R. Robertson, "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55," Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982), 81-109.

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