Tax II Chapter 16
Spring 2013
Notes
Chapter Sixteen Lecture Notes
Section 55 Inter-Corporate Dividends Deemed to be Gains
David Christian
Spring Term 2013
Thorsteinssons LLP
UBC Faculty of Law
______________________________________________________________________________
Notes
It surpasses my imagination that anyone considers language such as this to be
capable of an intelligent understanding, or that such language is thought to be
capable of application to the events of real life, such as the sale of a business.
Finch, J. (1990)
On s.55(2)
1.
This Chapter looks at the conceptual flip-side of s.84.1. The “capital gain
strip”. Recall s.84.1 can turn a gain on the sale of shares by an individual
into a deemed dividend. Here we look at a rule that can turn a dividend
received by a corporation into a capital gain.
2.
Consider one example to which the rule in s.55(2) was aimed.
Client
FMV
ACB
$2m
$100k
Holdco
FMV
ACB
$2m
$100k
Opco
FMV
Tax Cost
$2m
$100k
Apartment
Buildings
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3.
4.
Client wants to sell and not pay any tax immediately. If Opco sells, there
would be capital gain and possibly some recapture of CCA. If Holdco
sells, it has a capital gain. If the client sells, still a capital gain. What
about QSBC Shares? Employees? Assume no RDTOH in Opco.
Instead, can Opco pay Holdco a $1.9m dividend equal to the accrued gain
on the assets? Consider:

purchaser lends $1.9m cash to Opco;

Opco pays the cash dividend of $1.9m to Holdco;
Client
Holdco
Purchaser
1.9m cash
dividend
Loan
$1.9m
Opco
L&B
$2m FMV
$100k ACB
At this point the gain on the shares of Opco has been reduced by
$1.9m. They now have a value of only $100k. Hence the term
“capital gain strip”. Their ACB is still $100k. Look at
s.53(2)(a)(i). A taxable dividend, the $1.9m cash dividend, does
not reduce the ACB.

Holdco then sells the shares of Opco to the Purchaser for their
value of $100k.
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Client
Purchaser
Holdco
sale
FMV $100k
ACB $100k
Loan
$1.9m
Opco
$2.0m
Cash
L&B
FMV
$2m
Tax Cost $100k
5.
What has happened? Client’s Holdco could have sold Opco shares for
$2m, had a capital gain in Holdco of $1.9m, and a taxable capital gain of
$950k. What would be the tax system, or rate, on that capital gain to
Holdco? Recall Chapter 4. Instead, Holdco first receives a dividend of
$1.9m, and no capital gain? The dividend to Holdco is tax deductible to
Holdco (s.112, with no Part IV tax). Holdco then sold the shares for
$100k, and they still had a cost of $100k. Thus, there is no capital gain on
the sale by Holdco, right? Enter s.55(2).
6.
Read s.55(2). Put names to the words (“the corporation”, “a corporation”,
etc.).
7.
Does Holdco have a capital gain of $1.9m?
8.
Notice some interesting things about s.55(2).

It does not apply if Part IV tax applies to the dividend, and is not
part of a “series” that results in a refund of the Part IV tax on
payment of a further dividend to a corporation.

It does not apply unless a s.112(1) deduction is available.

If it is an actual dividend, the test is “one of the purposes”. If it is
a deemed dividend under s.84, the test is “one of the results”.
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
9.
If the shares are “disposed of”, the dividend is considered to be
“proceeds of disposition” instead. If shares are not disposed of, the
dividend is considered to be a “pure” capital gain. The former can
happen if shares are bought back or redeemed. The latter can
happen if actual dividends are paid.
Can you think of other ways to avoid a capital gain on a share?

What about a simple share buy-back in this situation:
Y (arm’s length)
X
FMV
ACB
PUC
Holdco
50%
FMV
ACB
PUC
$1m
$50k
$50k
$1m
$50k
$50k
50%
Opco
Business
FMV
$2m
Tax Cost $100k
Opco buys-back Holdco’s shares for $1m. Holdco has a deemed dividend
of $950k under s.84(3). Has the gain on a share been reduced? Was the
dividend deductible under s.112? Did Part IV tax apply to that dividend?
10.
Notice, these transactions amount to an economic sale of an interest in a
company to another person. The Purchaser in the first example, Y in the
second example.
11.
Read s.55(3)(a). “Subsection (2) does not apply … if …”. Read the
classic cases described in s.55(3)(a)(iii) and s.55(3)(a)(ii). These are
precisely the examples discussed above. Notice the conditions. There has
to be an “unrelated person” (s.55(3.01)(a)). Brothers and sisters are
deemed to be unrelated (s.55(5)(e)(i)) for this section only. “Unrelated” is
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tested with reference to the company that receives the dividend in the
transaction.
12.
Thus, you can have a transaction that seems to fit the words of s.55(2), i.e.,
an inter-corporate deductible dividend, and yet be saved by this exception
in s.55(3)(a) because there is no “unrelated person” involved in the
transaction (part of the series of transactions). Can you think of a situation
where this would be helpful? Family restructuring (not brother and sister,
though). Internal corporate group restructuring.

Family:
Dad
Daughter
50%
Holdco
FMV
ACB
PUC
50%
$1m
$50k
$50k
Opco
FMV
ACB
PUC
$1m
$50k
$50k
Opco uses cash to buy-back Holdco shares. Daughter takes over all of
Opco. No “unrelated person” is involved in relation to Holdco as the
deemed dividend recipient.
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
Internal Corporate Group:
Parentco
B Co
A Co
FMV
ACB
PUC
$1m
$50k
$50k
50%
Business A
50%
Opco
FMV
ACB
PUC
$1m
$50k
$50k
Business B
Opco distributes (active) Business A to ACo on a buy-back of ACo’s
shares of Opco. Opco pays any tax on dividend in kind (s.69(4)) (or has
losses). ACo has a deemed dividend of $950k. Section 55(2) does not
apply to the dividend in ACo because BCo and Parentco are not “unrelated
persons” in relation to ACo.
13.
A second exception to s.55(2) is the “safe income” exception. Read the
phrase in s.55(2). The best description in the case law is as follows:
The Income Tax Act provides that … dividends received by one corporation
from another are exempt from income tax [s.112]. The purpose of this
exemption is to preclude double taxation at the corporate level, i.e., once by the
corporation earning the income giving rise to the dividend and again by the
corporation receiving the dividend income.
In circumstances where the Income Tax Act provides that dividends paid from
one corporation to another are exempt from taxation, there is an incentive for the
shareholding corporation to receive [taxable] capital gains in the form of [tax
deductible] dividends. Section 55 is an anti-avoidance provision that is intended
to limit the use of tax exempt [actually, tax deductible] inter-corporate dividends
where they would otherwise be taxable. Where the limitation applies, the intercorporate dividend will be deemed not to be a dividend, but rather, proceeds of
disposition of property, or a gain, of the recipient corporation, subject to tax at
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the rate applicable to capital gains. However, where the inter-corporate
dividend is attributable to “income earned or realized by any corporation”, the
anti-avoidance provision does not apply and the inter-corporate dividend will
continue to be treated as a dividend. This is sometimes referred to as “safe
income”.1
The purpose of the safe income exception was succinctly described by Noël, J.A. in
Kruco Inc. v. R., 2003 DTC 5506 (F.C.A.) as follows:
The goal [of subsection 55(2)] was to ensure that the capital gain inherent in the shares of
a corporation that is attributable to an unrealized appreciation since 1971 in the value of
the underlying assets of the corporation was not avoided by the use of intercorporate taxfree dividends (subsection 112(1)). At the same time, Parliament did not want to impede
the tax-free flow of dividends that were attributable to income which had already been
taxed.
…
Conceptually, this approach captures the tax applicable to the portion of the notional gain
attributable to an increase in value of the underlying assets while maintaining the tax-free
treatment of that part of this gain attributable to ‘income earned or realized’ since 1971.
14.
Note the following on “safe income”.

“safe income” must “contribute to the existing gain” on the shares
to be protected under this exception to s.55(2) [Read the language
again.] Thus, if the income is somehow “gone” from the company,
it is not safe income “on hand” that can be protected under the
exception (i.e., taxes and dividends paid). Read the decision in
729658 attached to this Chapter;

“income” means income for tax purposes as computed in the Act
(s.3). Read the decision in VIH Logging attached to this Chapter;

safe income of “any corporation” may contribute to the gain on the
shares in question (i.e., income in lower tier companies can
contribute to the gain on the share of a high tier company).
15.
Consider the first example again, and assume some “safe income on hand”
in Opco:
1
Lamont Management Ltd. v. The Queen.
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Client
Holdco
Accrued
Gain $1.9m
FMV $2m
ACB $100k
Opco
$200k
“after-tax income”
(available as cash)
L&B
FMV
Cost
$1.8m
$100k
$200k of the
total $1.9m gain
is “attributable
to” the after- tax
income retained
in Opco as cash
(“safe income”)
Assume active business income. Therefore, Opco can pay a $200k
dividend to Holdco, reducing the gain on those shares by that amount, and
then Holdco sells the shares of Opco to the purchaser for $1.8m.
Subsection 55(2) would not apply to convert the $200k dividend into
proceeds of disposition, because the $200k actual dividend is paid out of
“safe income” of Opco. No Part IV tax.
16.
What if the client is $100 short in computing “safe income”? Is the whole
$200k dividend caught by s.55(2)? The section says that if $200k
dividend is attributable to anything other than safe income, the whole
dividend is recharacterized. Now read s.55(5)(f). You can designate
separate dividends, artificially. This allows a “carve-up” of one actual, or
one deemed, dividend. So, if you are offside, you are not way offside.
This can hedge the uncertain portion of a dividend, i.e., if you are not sure
it is safe income.
17.
In practice, the CRA has a number of administrative positions on
computing safe income. Be wary of these, which are beyond the scope of
this course.
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18.
There is a third exception to s.55(2), which we examine in Chapters 17
and 18 – the “Butterfly Reorganization”.
19.
Consider one “stop-loss” rule.

If the taxpayer is a corporation, you must reduce the capital loss on
a share by dividends received and deducted under s.112, as well as
dividends paid out of the capital dividend account. Why?

There is an exception in s.112(3.01) if:


the taxpayer did not own more than 5% of shares of any
class, and

the taxpayer owned the share for more than one year prior
to the sale (giving rise to the loss).
Common example?
Parentco
ACo
FMV
ACB
PUC
$500
$300
$100
Opco
$500
cash
Opco buys-back ACo’s shares for $500. ACo has a deductible dividend of
$400, and s.55(2) does not apply. Does ACo have a capital loss of $200,
being proceeds of $100 less ACB of $300? No – the loss is stopped by
s.112(3)(b).
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