Subsection 55(2.1)

When asked to provide any update on the application of s. 55(2) to ordinary course intra-group dividends, CRA indicated:

• Consistent with 2015-0613821C6, 2016-0627571E5 and 2018-0761561C6, CRA was open to consider a ruling request involving the determination of the purpose where all manifestations of purpose in the circumstances supported the absence of the purposes described in s. 55(2.1)(b) and the taxpayer represents that there is no such purpose.
• Where a taxpayer request relates to safe income (so that reliance is not being placed on the s. 55(2.1)(b) purpose tests), taxpayers have needed to manage the safe income determination time notion (of a series with respect to the safe income exception in 55(2.1)(c).)

A corporation resident in Canada ("Parent") owning 100% of "Target" accepts an offer from an unrelated third party ("Purchaser") to purchase all of the Target shares for $3 million, with the sale agreement specifying that assets which Purchaser does not wish to acquire ("Excluded Assets") are assigned a value of zero. The ACB of the Target shares is $3 million and the safe income attributable to them is nil.

Immediately prior to its sale to Purchaser, Target pays a dividend in kind of $250,000 (the "Dividend") to Parent by transferring an Excluded Asset to Parent.

CRA rejected a suggestion that since, whether or not the Dividend was paid, the value of the Target shares would be $3 million, and the capital gain would be nil, s. 55 could not apply. It stated:

Considering that the FMV of shares in the capital stock of Target would be reduced as a result of the payment of the Dividend, it is necessary to determine whether one of the purposes for which the Dividend was paid was to significantly decrease the FMV of a share in the capital stock of Target, in light of, among other things, the answers that would be given to the following questions:

• What does Parent intend to accomplish by decreasing the value of shares in the capital stock of Target?
• How does the reduction in the value of the shares of the capital stock of Target benefit Parent?
• What actions has Parent taken in connection with the reduction in value of the shares of the capital stock of Target?

In addition, the CRA generally considers that the Purpose Tests [in ss. 55(2.1)(b)(i) and (ii)] could apply to a dividend paid by an operating company to its corporate shareholder in order to dispose of surplus assets for the purpose of the purification and subsequent sale of [its] shares … 2017-0724021C6 … .

… [T]he payment of the Dividend and the Sale are part of the same series … . In light of the parameters established by the CRA and the applicable approach for purposes of applying the Purpose Tests, it seems difficult to argue that none of the purposes of the payment or receipt of the Dividend is to significantly decrease the FMV of the shares of the capital stock of Target.

Consequently, subsection 55(2) should likely apply … .

A purchaser incorporated a Buyco to acquire the assets of the vendor corporation and then, a few weeks later, the net asset proceeds on the closing of the sale were dividended by the vendor to its corporate shareholders. Did Buyco’s incorporation trigger a "safe-income determination time" such that the taxable income from the sale was not included in computing safe income, thereby resulting in a capital gain on the associated dividend of that taxable income? CRA responded:

Assuming that the incorporation of the corporation is part of the same series of transactions that may create an increase in the total direct interest in a corporation of an unrelated person, we agree that the "safe income determination time" defined in subsection 55(1) could be the time after that first increase in interest.

However, practical solutions to these types of technical issues exist and therefore the CRA does not consider that a flexible approach is necessary in the[se] circumstances … .

As to whether safe income from the sale would be permanently lost, CRA stated:

If the safe income from the sale of the assets is not included in safe income for the purposes of the dividend paid following the sale, this safe income is generally not lost and may be used in the subsequent payment of dividends to the extent that such subsequent dividends are not part of the same series of transactions as the sale of the assets.

CRA further indicated:

[I]n situations of a total sale of assets of a corporation followed by a winding-up dividend pursuant to subsection 88(2), the CRA would be prepared to consider, after a detailed analysis of a file, that the subject matter of the dividend would not fall within paragraph 55(2.1)(b).

Background

After the death of Father, his estate (whose equal beneficiaries are his surviving children, A, B and C) holds Class E and J preferred shares of Opco (which had recently sold all its marketable securities and holds only cash), whereas Opco’s voting participating Class A, B and C shares are held respectively by Holdcos A, B and C, which are respective Holdcos for A, B and C and their respective family trusts and (in the case of Holdco A) A's children.

Proposed transactions

1. The estate will distribute its Class E and J shares equally to A, B and C.
2. A, B and C will exchange their Class E shares under s. 51(1) for Class J shares.
3. Opco will redeem all the Class J shares for $1.00 per share. No deemed dividend will arise since the PUC will also be $1.00 per share.
4. Holdcos A, B and C will pass a special resolution for the winding-up of Opco. On the winding-up, Holdcos A, B and C will be deemed to have received dividends pursuant to ss. 88(2)(b) and 84(2) equaling the excess of the amount distributed on their Class A, B or C shares over those shares’ PUC, which dividends will be designated by Opco under s. 89(14) as eligible dividends.
5. Any dividend refund generated by Opco will be distributed equally.
6. Thereafter, Articles of Dissolution will be filed.

Additional information

Each s. 84(2) dividend described above will not significantly reduce the capital gain that, but for that taxable dividend, would have been realized on a disposition of a share of Opco at FMV immediately before such dividend.

Rulings

Regarding computation of deemed dividend under ss. 88(2)(b) and 84(2), and non-application of ss. 55(2) and 245(2).

Parentco holds shares of a wholly-owned subsidiary (Subco1) with a fair market value (“FMV”) and adjusted cost base (“ACB”) of $200,000 and $2,000, respectively. Subco1 held a subsidiary (Subco1) whose shares had an FMV and ACB of $20,000 and $2,000, respectively. Subco2 is spun-off to a newly-incorporated subsidiary of Parentco (i.e., Parentco transfers 10% of its shares of Subco1on an s. 85 rollover basis to Newco for Newco shares, Subco1 transfers its Subco2 shares on an s. 85 rollover basis to Newco for Newco shares, and the cross-shareholdings are cross-redeemed) as a result of which Parentco’s shareholding in Newco now had an FMV and ACB of $20,000 and $200, respectively. On an s. 88(1) winding-up of Newco, Parentco acquired the shares of Subco2 at a cost (under s. 88(1)(c)) of $2,000 (i.e., an $1,800 increase over the $200 ACB that it had for its shares of Newco).

Is CRA concerned by this $1,800 increase in the ACB of the assets of Parentco?

CRA indicated that the transfer of the Subco1 shares by Parentco causes a misalignment between outside and inside basis, so that the reorganization, followed by the winding up of Newco, results in what CRA considers as an inappropriate tax benefit.

In situations like the one described, CRA would not rule favourably and would consider applying the GAAR, because there is an undue increase in the hands of Parentco that is contrary to the scheme of the Act, and, more specifically, of s. 55(2).

CRA then referred to an alternative reorganization where, there was an arrangement of the transactions such that, upon the winding-up of Newco into Parentco under s. 88(1), the outside basis in Newco ($2,000) matches the inside basis (a $2,000 ACB of the shares of Subco2 to Newco). In that situation, there could be a favourable ruling because Parentco thus had transferred enough ACB in the shares of Subco 1 to Newco to cover the ACB of the assets that were then transferred by Subco 2 to Newco. This would result in an alignment of the outside and inside basis.

What guidance can be provided on the purpose test? Is there a CRA audit manual that could be made available? CRA responded:

A favourable ruling could be provided where all manifestations of purpose and corroborating circumstances support the absence of one of the purposes described in paragraph 55(2.1)(b). The ruling 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 paragraph 55(2.1)(b) and on the completeness of the description of all the manifestations of such purpose and corroborating circumstances. However, other than rulings on loss-consolidation, the CRA has not been deluged by requests for rulings on this topic.

Respecting the second question, CRA stated that the “Manual used … [in] audits of small and medium-sized businesses does not contain any information on the application of subsection 55(2) and the purpose test, in particular.”

Messrs. A and B wholly-own Holdco A and B, respectively, each of which, in turn, holds half of the Class B shares of Opco having an FMV of $500,000. Messrs. A and B also each hold half of Opco’s Class A shares having in each case an FMV of $1,000,000. Opco holds an insurance policy that pays out in part in the event of disability. In the case of disability of either individual, Opco will receive the proceeds of the policy covering such event in order to then pay a special dividend of $1,000,000 to the Holdco of the active shareholder to fund the purchase by the latter of the shares held directly by the disabled individual – with Opco then redeeming shares held by the purchased Holdco of the disabled individual for $500,000.

After indicating that there was insufficient information to provide more than a general discussion of the purpose tests in ss. 55(2.1)(b)(i) and (ii), CRA noted that, in 2015-0613821C6, it indicated that it could issue a favourable advance ruling on a determination of purpose “where all manifestations of purpose and corroborating circumstances support the absence of one of the purposes described in subparagraph 55(2.1)(b)(ii) and (ii)” with such determination “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)(i) and (ii) … .”

CRA then stated:

Although in certain circumstances the dividend paid by Opco to the holding corporation of the active shareholder may not be considered to have any of the purposes described in paragraph 55(2.1)(b), that determination can only be made after a review of all the facts of a particular situation.

Respecting a triangular loss-shifting arrangement for the shift of non-capital losses by Parentco to its wholly-owned Profitco (with Profitco using the proceeds of an interest-bearing loan from Parentco to subscribed for preferred shares of a Newco subsidiary of Parentco, with dividends on such shares being funded with contributions of capital from Parentco), CRA ruled that s. 55(2) would not apply to the dividends paid by Newco to Profitco to fund the interest on the loan by Parentco to Profitco, based on a representation that:

The only purpose of both the payment and the receipt of the dividends on Newco’s Preferred Shares … is to provide a reasonable return on the Newco Preferred Shares issued by Newco to Profitco. More specifically, none of the purposes of the dividends is to reduce the fair market value or capital gain of any share, nor to increase the total cost amounts of properties of Profitco.

Opco pays a dividend of $1,000 to Holdco. Its shares had a pre-dividend fair market value of $1,500. As the safe income that can reasonably be viewed as contributing to gain on Opco shares was $900, does s. 55(5)(f) deem two separate dividends of $900 and $100? Are both dividends separately tested under s. 55(2.1), so that the $900 is exempt as not exceeding safe income, and the $100 is exempt if its purpose is not to significantly reduce the gain or the value of the shares on which it is paid?

CRA indicated that under the old s. 55(2) regime, it was well understood that the purpose test applied to the whole dividend, so that the s. 55(5)(f) only required the inclusion under s. 55(2) of the portion of the dividend exceeding safe income. The new rules did not change this. The contrary interpretation would results in duplication of the safe income protection, and contrary to the s. 55(5)(f) purpose of bringing into income the amount by which the dividend exceeds safe income.

Under an appropriate purposive reading, the dividend referred to in:

• the s. 55(2.1) preamble and in ss. 55(2.1)(a) and (b) is the whole $1000;
• s. 55(2.1)(c) is the portion exceeding safe income ($100);
• the s. 55(2) preamble is the whole $1000; and
• the s. 55(2) preamble that is deemed not to be a dividend but to be a gain, is the s. 55(2.1)(c) amount ($100).

2016-0658841E5 indicates that paying a dividend of surplus assets with the goal of purifying the corporation for “qualified small business corporation share” (QSBCS) purposes would be a relevant factor that should be taken into account, but that it should be ensured that the dividend has no other purpose described in paragraph 55(2.1)(b) so that, for example, if the dividend paid to the corporation exceeds the amount that would be required to transfer the surplus assets, this could be a sign that the dividend has another purpose.

Q.(a)

If the dividend’s only purpose is to maintain QSBCS status, the dividend should not have a purpose (but might have the result) of reducing the FMV or the gain on the shares. In this situation, would CRA agree that the purpose tests are not met?

CRA indicated that whether the payment of a dividend can be viewed as having only the purpose of maintaining QSBCS status, but has no purpose of reducing the value of the gain on the share or increasing the cost of property to the dividend-recipient, is a factual determination. It went on to indicate that where the dividend is paid with non-surplus assets, that may signify that it has a purpose referenced in s. 55(2.1)(b), and that another such sign could be where the removal of a surplus asset is made in contemplation of the disposition of the shares of a corporation.

CRA went on to question why on the facts there was no safe income corresponding to the surplus assets.

Q.(b)

Is the test under Ludco the right test to use to determine “purpose” as contrasted to that in Placer Dome?

After quoting the statement in Ludco that “courts should objectively determine the nature of the purpose, guided by both subjective and objective manifestations of purpose,” CRA indicated that Ludco followed the purpose test in Symes, and the Symes/ Ludco test (consistently with many other decisions) constitutes the benchmark of purpose. In both Placer Dome, and McAllister Drilling referenced therein, the Court determined the purpose of the taxpayers by not only listening to their testimony, but also by examining all the facts, so that neither contradicts Ludco and Symes.

The participating and non-voting Class AA shares of Opco, which were held equally by two unrelated individuals (A and B), were worth $500,000 and had a safe income of $300,000 on January 1, 2016, and had a nominal paid-up capital and adjusted cost base. Nominal-value voting shares of Opco were held by Holdco, which was owned equally by A and B. On January 1, 2016, Holdco also subscribed $100 for 100 Class X shares of Opco, which were entitled to participate annually in Opco’s profits proportionately with the number of issued and outstanding AA and X shares and with the shares' redemption value reflecting the undistributed amount of such profits plus their initial subscription price.

On December 31, 2016, Opco had accumulated $100,000 in after-tax profits and safe income, and on January 1, 2017, Opco paid a dividend of $50,000 to Holdco pursuant to a strategy of eliminating excess liquidity in Opco in order to qualify the Class AA at all times for the capital gains deduction and also for asset protection purposes, thereby causing the Class X shares’ redemption value to decrease to $100.

Q.1:

Would the purpose of the transactions be to reduce a capital gain or reduce the market value of a share as described in s. 55(2.1)(b)? CRA responded:

[P]aying a dividend with the goal of [so] purifying the corporation…would certainly be a relevant factor that should be taken into account. However, it also should be ensured that the dividend has no other purpose described in paragraph 55(2.1)(b). For example, if the dividend paid to the corporation exceeds the amount that would be required to transfer the surplus assets, this could be a sign that the dividend has another purpose, which was one of those referred to in paragraph 55(2.1)(b).

In 2015-0604521E5, a promissory note issued to Holdco on a share redemption was subsequently transferred to Newco as a capital contribution. Since the amount of the promissory note was higher than the ACB of the redeemed shares and increased Holdco’s ACB of the shares of Newco, CRA indicated that it would seek to apply GAAR to Holdco’s reliance on s. 55(3)(a).

Is a subsequent transaction to use the note (or other property, including cash, received as consideration for a share redemption), such as the above transfer of the note to Newco, a necessary trigger for GAAR to be so applied, i.e., could the receipt of a note with a high ACB in itself cause GAAR to apply?

CRA indicated that where a purpose is to increase the cost amount of property of the dividend recipient, GAAR would be triggered, and it is irrelevant whether the cost amount has been used in a series of transactions that includes the dividend.

On death, an estate receives shares of an investment holding company (H1), and then immediately structures a pipeline under which the H1 shares are transferred to H2 for a note - with the H1 shares of H2 then being redeemed. Could s. 55(2) apply? Would the starting safe income to the estate be nil?

CRA indicated that because there would be no capital gain if those shares were disposed of for fair market value proceeds immediately before the redemption, the redemption of shares of H1 would not result in a reduction of any gain. Also, the purpose test in s. 55(2.1)(b)(ii) does not apply to a dividend that is deemed to be received under s. 84(3). Here, the cost amount of the property is the same before and after the redemption, and the reduction of the fair market value of the shares being redeemed does not result in any deductible loss to H2. The CRA would not seek to apply GAAR in this situation.

Accordingly, the deemed dividend on the redemption would not be subject to s. 55(2) or the application of GAAR - and there is also no carry over of safe income, since the safe income has already been crystallized in the ACB of the shares.

Is cash considered to be property for purposes of the application of s. 55(2.1)(b)(ii)(B)?

CRA indicated that it is contrary to the scheme of the Act to allow for a tax-free increase in costs, and that there is a lack of tax integration where a corporate shareholder receives, as a non-taxable dividend, property whose cost exceeds the amount on which tax has been paid. After also noting that (consistent with the s. 248(1) definition of property) cash, i.e., money, is property , CRA also noted that cash received on a dividend can be used to purchase any other property or even additional shares of the dividend payor, and this results in an increase in the cost amount of the shares of the dividend payor.

Accordingly, cash is property for this purpose.

Respecting the payment of a non-participating dividend to a holding company on preferred shares whose paid-up capital and ACB equals their redemption amount, CRA indicated that “the hypothetical capital gain that would have been realized on a FMV disposition of [the] preferred shares immediately before the dividend…would be nil,” so that the dividend would not be considered to come out of safe income on hand. Since the safe income harbour was not available, whether s. 55(2.1)(b) applied was a question of fact.

Divco, a Canadian-resident corporation with Canadian corporate shareholders, pays cash dividends from its excess cash-flow to its shareholders whose amount is determined in the Board’s discretion or which exceeds the reasonable dividend return that would be paid on a comparable listed share issued by a comparable corporation in the same industry and which, in either case, will significantly reduce Divco’s fair market value and are not paid out of safe income. Would the dividends’ purpose be as described in s. 55(2.1)(b)? CRA responded:

None of the factors listed [above] 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). …[T]he safe income of [Divco] would be less than its retained earnings… because [it] was entitled to tax benefits such as accelerated capital cost allowances that significantly reduced its income under the Act. … 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. ...

After also stating respecting dividends paid by Divco subsidiaries that “there is no consolidated approach in determining whether the purpose tests are met,” and that “year-end dividends that are only designed to offset intercorporate advances made under conventional cash pooling arrangements might not be considered to have [such] a purpose,” CRA was then asked about a scenario where Divco regularly or infrequently pays dividends on its non-cumulative preferred shares. CRA responded (before adding cautions):

[W]e 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).

Respecting a redemption of the preferred shares, CRA stated:

[W]e 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.

In connection with the butterfly split-up of DC equally between the family holding companies (Shareholder1 and Shareholder2) for two unrelated families, the shares of Subco2, which might be a significant subsidiary of DC, are split 50-50 between the two transferee corporations (TC1 and TC2) on the butterfly, then TC1 sells its shares of Subco2 to TC1 for FMV consideration.

Holdco holds all the shares of Opco, which have a fair market value (“FMV”) of $1M and an adjusted cost base (“ACB”) of $100. Opco (which carries on a construction business) has retained earnings of $1M and no safe income is attributable to Holdco’s shares of Opco.

“With the sole purpose of protecting its assets from the risks inherent in the construction sector,” Opco paid a $1M dividend to Holdco, which was not subject to Part IV tax and for which Holdco took a $1M s. 112(1) deduction, with Holdco lending the sum back to Opco. Holdco had no intention of selling the Opco shares, and the Opco shares were not redeemed etc. on the dividend payment.

Would s. 55(2) and draft s. 55(2.1)(b)(ii) apply to deem the dividend to be a gain from the disposition of capital property? CRA responded (TaxInterpretations translation):

It appears to us that one of the purposes of the payment of the dividend was to effect a significant reduction in the FMV of a share in the capital of the operating company when the purpose of the transaction was to shelter from creditors the assets of a corporation carrying on a business or to secure those assets by diminishing the total value of the operating corporation and augmenting the value of its shareholder (the holding company)… .

In the facts indicated by you, there was no safe income attributable to the shares in the capital of Opco, held by the holding company, even though the shares in the capital of Opco held by Holdco had an ACB of $100, an FMV of $1M and the retained earnings were $1M. We would have thought that on these assumptions, there would be an amount of safe income on hand which it was reasonable to consider as contributing to a capital gain which would have been realized on a disposition at FMV, made immediately before the dividend, of the shares held by Holdco on which the dividend was received.

However, on the assumption indicated by you respecting safe income, subsection 55(2) would apply to the amount of the dividend. This amount would be deemed not to be a dividend…[and] would be deemed to be a capital gain from the disposition of capital property by virtue of paragraph 55(2)(c).

CRA declined to express a view as to whether an $8,000 reduction in an accrued capital gain of $120,000 was significant. A $50,000 dividend received by two Holdcos from Opco (with no indication of the total FMV of all the shares) would be considered to be significant.

TEI members remain concerned that, because all dividends result in a reduction of the fair-market value of shares held by the dividend payor and increase the cost of properties held by the dividend recipient, the CRA may try to reassess ordinary course dividends on the basis that a purpose of every dividend is a tainted purpose. Comments? CRA responded:

The "significant" aspect could be measured in terms of an absolute dollar amount or on a percentage basis.

…[A] dividend that is directly or indirectly instrumental in the creation of an accrued loss on any share that may be used, or has the potential to be used, to shelter a gain on some other property provides an indication that the FMV reduction purpose exists (for example, one might consider transferring a property with an accrued income or capital gain to the corporation that issued shares that have an accrued loss). Also, the use or possibility of using an increased cost amount of properties to shelter a gain is an indication that the purpose of the dividend is to increase cost.

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, the CRA would consider that the purpose of the payment of such dividend is not described in proposed paragraph 55(2.1)(b).

Profitco is wholly-owned by Lossco, which is wholly owned by Parent. Profitco borrows from Profitco (at an interest rate reflecting the loan’s subordinated status) and subscribes for non-voting cumulative redeemable retractable preferred shares of Lossco. Parent will agree, in a support agreement with Lossco, to make capital contributions to fund Lossco’s payment of the dividends, which will occur on the unwinding of the transactions.

CRA provided an opinion that, after giving effect the July 31, 2015 draft amendments, s. 55(2) will not apply to this dividend.

Holdco holds shares of Opco with a nominal ACB and no safe income. In a corporate reorganization "aimed at protecting the assets of Opco, whose purpose is to reduce the fair market value (FMV) of Holdco’s shares in Opco," Holdco lends money to Opco equal to the accrued gain on the shares (of $1M), and receives that money back as an actual $1M dividend (targeted to be tax-free). It does not matter if this transaction has no capital gains avoidance purpose. CRA accepted that since the purpose of the creditor-proofing is to reduce the fair market value of the Opco shares, the full amount of the dividend is deemed to be a capital gain.

Under a variation of the first alternative, the shares of Opco have full ACB (of $1M) and also safe income on hand of $1M. CRA indicated that this assumption that the safe income attributable to the shares of Opco held by Holdco was equal to the amouont of the dividend received was "surprising," stating "by way of example, the cost could reflect the accumulated safe income before an acquisition of shares by Holdco and, if Opco had not increased in value since that time, the safe income would be nil after such acquisition of shares by Holdco." However, accepting these assumptions, the dividend here as well of $1M would also be a capital gain, so that the ACB could only be utilized on a future disposition of the Opco shares.

Aco held all the shares (having a minimal adjusted cost base) of Holdco (a small business corporation), which held all the shares (being common shares) of Opco. For creditor-proofing reasons, Holdco transferred inventory and other business assets to Opco on a. 85(1) rollover basis and Opco over the next few days paid dividends to Holdco approximating the value of the Opco common shares, with such proceeds then being lent back to Opco under a secured loan. Aco sold 35% of its Holdco shares to an unrelated third party as part of the same series of transactions, thereby realizing a significant capital gain.

In commenting on the purpose test, CRA stated:

[T]he capital gain realized by Aco on the sale of a portion of its interest in Holdco remained the same as if the dividend had not been paid.

… In addition, even though we are dealing with a situation described in subparagraph 55(3)(a)(iv), it should be noted that the main purpose of that subparagraph was to prevent a form of purchase butterfly. … [I]t would seem that we are not in such a circumstance.

Consequently … Holdco would have arguments in favour of concluding that the purpose test in subsection 55(2) would not be satisfied.

The CRA "Update on Subsection 55(2) ..." (Full paper released on 22 December 2023) stated that, where a shareholder acquires preferred shares as consideration for the transfer of property on a tax deferred basis, the accrued gain on the property, when subsequently realized by the corporation, would be viewed as contributing to the gain on the preferred shares, and accordingly would be included in the preferred shares’ safe income. Does this position also apply where the preferred shares are acquired in exchange for common shares, so that the accrued gains on the underlying property held by the corporation and any of its subsidiaries at the time of the share exchange get allocated to the safe income of the preferred shares once realized? For example, if Holdco owns all the common shares of Midco with an FMV and ACB of $1,000 and $1, and MIdco owns all the common shares of Subco with an FMV and ACB of $1,000 and $1, and Holdco exchanges its Midco common shares for Midco preferred shares with a FMV of $1,000 on a tax-deferred basis, will the gain on the property held by Subco when eventually realized be included in the safe income of the Midco preferred shares?

CRA indicated that such extension of its position would not occur, and that the allocation of the safe income to the preferred shares would follow its longstanding position that a portion of the safe income to which the exchanged shares would have been entitled immediately before the exchange simply flows through to the preferred shares. Regarding the safe income realized after the exchange, the preferred shares would generally participate in the safe income of the corporation in accordance with the shares’ dividend entitlement only.

Example 12 of the "CRA Update on Subsection 55(2) and Safe Income: Where are we Now?” was essentially as follows:

In Year 1: Holdco1 transferred goodwill with an FMV of $500 and nominal cost amount on a rollover basis to Opco in consideration for preferred shares with a $500 redemption amount and nominal dividend entitlement; and Holdco2 subscribed a nominal amount for Opco common shares. While Holdco2 held its common shares, Opco earned a safe income of $500 that is represented by cash on hand. The preferred shares are redeemed with this cash at a time that the FMV of the common shares is $500.

In this situation, although the cash that has been generated by Opco with its safe income no longer supports the value of the common shares held by Holdco2, the safe income of $500 that is considered to contribute to the gain on the common shares of Opco held by Holdco2 is considered to remain unchanged.

After commenting on the application of s. 55(3)(a) in the context of Example 12 (viewed as “a share redemption that results in a deemed dividend that is supported by little safe income, but where the dividend is technically exempted by paragraph 55(3)(a)”) CRA then returned to Example 12, and stated:

Ultimately, whether or not the exemption in paragraph 55(3)(a) applies will have no impact on the safe income of the common shares in Example 12. In addition, as stated in the Update, the gain realized on the sale of goodwill for $500 or less could not constitute safe income on the common shares because such gain does not contribute to the gain on the common shares, even when the goodwill was sold after the redemption of the preferred shares. If, on the other hand, the goodwill were sold for more than $500, the gain on the excess over $500 would constitute safe income on the common shares.

The starting structure in Example 30 of “CRA Update on Subsection 55(2) and Safe Income” is that Holdco owned the shares of Opco with an FMV, ACB and safe income of $500, 0 and 0; and Opco owned Subco1 (whose shares also had an FMV, ACB and safe income of $500, 0 and 0) and Subco2 (whose shares had no value, ACB or safe income). Then:

1. Subco1 transfers its assets with an FMV and ACB of $500 and 0 on an s. 85(1) rollover basis to Subco2 for Subco2 shares.
2. A third-party purchaser subscribes $500 for Opco shares.
3. Subco2 redeems the shares of Subco1, generating a $500 deemed dividend.
4. Subco1 repurchases the shares of Opco, then Opco repurchases the shares of Holdco, in each case generating a $500 deemed dividend.

In Example 30, CRA indicated that although the deemed dividend from Subco2 to Subco1 would be exempted under s. 55(3)(a) by virtue of s. 55(3.01)(g), the deemed dividend from Subco1 to Opco, and from Opco to Holdco, would be subject to s. 55(2). In particular, the dividend from Subco2 is not subject to tax in the hands of Subco1 and none of the accrued gain on the assets has been realized, so that such dividend does not result in safe income to Subco1.

In response to a follow-up question, CRA indicated that the purpose of this example was merely “to illustrate the concept that a dividend income that has not been subject to tax should not constitute safe income for the benefit of a shareholder.” CRA went on to indicate that:

The order of transactions described in the example would unlikely be implemented as such in the real world (for example, Subco1 does not need to redeem its shares held by Opco to achieve the results sought by Holdco) and a discussion on possible double-taxation in the scenario described is fruitless.

That issue as to double taxation was that, although “the capital gain realized by Opco on the redemption of shares of Subco1 would be included in the safe income of Opco and would not result in any double-taxation” (presumably because it would be there for potential future use), “[u]nfortunately, the deemed capital gain under subsection 55(2) would not be part of the safe income computed before the safe income determination time if all the transactions described are part of the same series of transactions” so that both Opco and Holdco would realize a capital gain. CRA went on to state:

[W]e understand that transactions can be successfully implemented in a way to attract only one level of taxation if the ordering of transactions is carefully thought out and taxpayers do not attempt to systematically avoid taxes on a disposition.

There is to be a division of the assets of a family group of corporations among the respective holding companies for the four children of Mr. X, most notably, the holding company (HoldcoF) for Mr. A, who manages a group of companies beneath Dco, and the holding company (HoldcoB) for Mr. B, who manages a group of companies which, as a preliminary matter, are transferred on a rollover basis into a new subsidiary company (PBco1), which issues special voting shares to Mr. X so that he can maintain control (and Mr. X also has held special voting shares in Dco all along.)

Transactions are implemented in reliance on s. 55(3)(a) (and on the absence of the application of s. 55(4) having regard to the continued control by Mr. X of the spun-off companies and of the transferee corporations whose equity ended up being mostly held by HoldcoB or HoldcoF) to effectively spin-off PBco1 to HoldcoB and Dco to HoldcoF (along with further transactions for the benefit of the holding companies of the other two children).

Here, the application of the formula in 2020-0861031C6 for the allocation of direct safe income (DSI) would lead to a disadvantageous result for the taxpayers involved since it would result in an undue loss of ACB/DSI. More specifically, the ACB, to HoldcoB or HoldcoF, of the shares the property (shares of NewAco) transferred to PB1co or Dco will be nominal and the ACB, to the transferor corporation (NewCco) of the shares of PB1co or Dco will be eliminated. To avoid this result, the DSI would be calculated as follows:

A. The DSI of the transferor corporation (“Transferor”) that has accrued on the shares of its capital stock held by shareholders other than the transferee corporation (“Transferee”), determined immediately after the reorganization, will be calculated in accordance with the following formula:

DSI on shares of capital stock of Transferor held by all shareholders immediately after the reorganization = DSI immediately before the reorganization X total net cost amount of property retained by Transferor / total net cost amount of all property of Transferor immediately before the reorganization.

B. The DSI of the shares of capital stock of Transferee held by shareholders immediately prior to the Reorganization shall be increased in accordance with the following formula:

DSI of the shares of the capital stock of Transferor held by all of its shareholders immediately prior to the Reorganization - DSI of the shares of the capital stock of Transferor held by the remaining shareholders immediately after the Reorganization as calculated under item A above.

A corporation, with a December 31 year-end, sold all of its assets on November 30 (thereby resulting in a capital gain and refundable dividend tax on hand ("RDTOH")), and then immediately (on December 1) made a dividend payment of its net asset value. 9429465 suggests that the refund of RDTOH could not be included in safe income until the end of the year (December 31), so that the dividend would result in a partial capital gain on December 1, equaling the unrealized safe income related to the dividend refund ("DR"). Is this correct? CRA responded:

In the context of a situation as described in the question and to the extent that it is reasonable to consider that the DR contributes to the hypothetical capital gain in respect of the shares on which the dividend was received (assuming a disposition at FMV of the shares immediately prior to the dividend), the CRA would be willing to take the position that the DR receivable is to be considered in computing income earned or realized as of December 1.

Consequently, in such a situation, the taxes payable and not refundable in respect of the income arising from the sale of the assets will have to be subtracted from the safe income calculated for the period, as it is reasonable to assume that they do not contribute to the capital gain that would be realized on a share of the capital stock of the corporation.

2016-0672321C6 indicated that that safe income on hand should be reduced by accounting contingencies, reserves and allowances because of their effect on the value of a share. Suppose that the FMV of Holdco’s shares of Opco (having a nil PUC and ACB) is $1,000,000, consisting of shareholder’s equity (i.e., share capital and retained earnings) of $800,000, unrealized gains of $500,000 and contingent liabilities and accounting provisions valued at $300,000, and suppose further that such retained earnings correspond to the safe income earned attributable to the Opco shares of Holdco.

In determining safe income on hand, should safe income be reduced by accounting contingencies and reserves? It was suggested that it was more appropriate that such amounts should instead be applied first to the unrealized gains. CRA stated:

The CRA is maintaining its longstanding position that to the extent that contingencies and accounting reserves have the effect of reducing the inherent gain on a corporation's share, such amounts should reduce the corporation's safe income on hand.

Consequently, safe income on hand of a corporation must generally be reduced by actual or potential cash outflows, such as non-deductible expenses, contingencies and accounting reserves, in determining the amount of safe income that can be considered to contribute to the gain on a share.

The CRA would, however, be prepared to consider more specific situations in the context of a request for advance rulings so as to make a safe income determination based on all the facts of a case.

9711005 indicated, before the bifurcation of RDTOH into the eligible refundable dividend tax on hand (“ERDTOH”) and non-eligible refundable dividend tax on hand (“NERDTOH”) accounts, that it was not possible to use both the Part IV tax exception to s. 55(2) and the safe income exclusion.

Holdco holds all the shares of Opco having attributable safe income of $1,000,000 and a fair market value of $5,000,000. Opco has a general rate income pool of $1,000,000 and a NERDTOH balance of $70,000. Before Holdco’s sale of the Opco shares, Opco first pays a $1,000,000 dividend (designated as an eligible dividend) - and then pays a non-eligible dividend of $182,608, which generates a refund of the $70,000 of NERDTOH.

CRA seemed to indicate that Holdco can take advantage of both the $1,000,000 safe income exclusion and of the Part IV tax exclusion.

In particular, it noted that the $1,000,000 dividend is not subject to s. 55(2) as it does not exceed the $1,000,000 of safe income. Furthermore, since Opco is entitled to a dividend refund of its $70,000 in NERDTOH, Holdco is liable for $70,000 of Part IV tax on that dividend, so that such dividend is not subject to s. 55(2) under the Part IV tax exclusion in the s. 55(2) preamble, to the extent that such Part IV tax is not refunded as part of the same series.

Assume that Parentco owns 100% of the shares of Holdco 1 which owns 100% of Holdco 2 which owns 100% of Opco. The group intends to transfer one of Opco’s existing business assets (“Property 1”) to Holdco 1. Holdco 1 and 2 own assets in addition to the above shareholdings.

Tax attributes include:

The correspondent presented two scenarios which CRA appeared to consider to have a similar effect. Under “Alternative B”:

1. Opco transfers Property 1 to Newco (newly formed by Holdco 1) on a s. 85(1) rollover basis in exchange for Newco preferred shares.
2. Holdco 2 exchanges all of its Opco shares under s. 85(1) for Opco preferred shares with a redemption value equaling the fair market value (“FMV”) of Property 1 (and, per s. 85(1)(g), having a cost of $65), and for new common shares.
3. The Newco preferred shares held by Opco, and the Opco preferred shares held by Holdco 2 are redeemed through the issuance by Newco, and the assignment by Opco, of Newco A Promissory Note.
4. Holdco 1 exchanges all of its Holdco 2 shares under s. 85(1) for Holdco 2 preferred shares with a redemption value equaling the FMV of Property 1 (and, per s. 85(1)(g), having a cost of $75), and for new common shares.
5. The Holdco 2 preferred shares held by Holdco 1 are redeemed in consideration for Holdco 2 assigning Newco A Promissory Note.
6. Newco is wound up under s. 88(1) and, by virtue of a s. 80.01(4) election, Newco A Promissory Note (held by Holdco 1) is deemed to have been settled at its cost amount.

The questioner noted that Newco A Promissory Note, whose amount represented a streaming of cost base under s. 85(1)(g) is cancelled, thereby eliminating the cost based that was steamed under s. 85(1)(g) and that, under the transactions, there should be no concern about misalignment of outside and inside basis as described at 2020-0860991C6. In this context, does CRA require representations regarding direct safe income (“DSI”) and indirect safe income (“ISI”) of each corporation, both prior to and following the reorganization, before ruling?

CRA indicated:

• Prior to the reorganization, the $65 cost of the Opco shares to Holdco 2 and Opco’s $170 safe income had contributed to the acquisition of property of Opco with a total cost of $235 ($100 + $135).
• Applying the position in 2020-0861031C6 and 2021-0876441E5, when Opco has transferred Property 1 out on a tax-free basis, its DSI should be reduced and, in particular, Opco is considered to have transferred a portion of its DSI on the tax-free transfer of Property 1to Holdco 2 and, in turn, by Holdco 2 to Holdco 1.
• The DSI and ISI of each corporation and the required ACB transfer to avoid misalignment of outside and inside cost would be calculated as follows:

1. DSI on the shares of Opco after reorg: DSI of Opco prior to reorg ($170 x net cost amount of assets retained by Opco ($135) / total cost amount of assets of Opco prior to reorg ($235) = $98.

2. DSI of Opco considered to be transferred to Holdco 2: $170 - $98= $72.

3. The ACB of shares of Opco held by Holdco 2 that is required to be eliminated on the reorg is $28 (i.e., the fraction represented by the $100 cost amount of the transferred property to the pre-transfer cost amount of all the Opco property of $235 applied to the $65 beginning ACB of the Opco shares, is $28), resulting in a remaining ACB in the shares of Opco held by Holdco 2 after the reorg of (65-28) $37. In the current situation, this ACB of $37, combined with the remaining safe income of Opco of $98 would be the correct amount required to support the cost of the remaining assets of Opco of $135.

4. DSI of Holdco 2 after reorg: (DSI of Holdco 2 prior to reorg ($10) + $72 DSI considered to have been received from Opco per 2 above) x net cost amount of assets considered retained by Holdco 2 ($37 per 3 above, plus the $20 cost of other assets, totaling $57) / (net cost amount of assets of Holdco 2 “prior to” [sic] reorg ($57) + net cost amount of assets considered to have been received from Opco ($100 cost of Property 1)) = 82 x 57/157 = $30.

5. DSI of Holdco 2 considered to be transferred to Holdco 1: $82 – $30 = $52.

6. ISI of Holdco 2 after reorg: equal to DSI of Opco after reorg = $98.

7. The ACB of shares of Holdco 2 held by Holdco 1 that is required to be eliminated on the reorg is $48, resulting in a remaining ACB in the shares of Holdco 2 held by Holdco 1 after the reorg of (75-48) $27. In the current situation, this ACB of $27, combined with the remaining safe income of Holdco 2 of $30 would be the correct amount required to support the cost of the remaining assets of Opco of $57 ($37 in the cost of the shares of Opco and $20 in the cost of other assets).

8. DSI of Holdco 1 after reorg: DSI of Holdco 1 prior to reorg ($1,000) + amount considered to have been received from Holdco 1 ($52) = $1,052. The DSI of Holdco 1 of $1,052, combined with the cost on the shares of Holdco 1 held by Parentco of nil, would be the correct amount required to support the cost of the assets held by Holdco 1 after the reorg of $1,052 (being the aggregate of $100 of cost on Property 1, remaining ACB in the shares of Holdco 2 of $27 and cost of other assets of $925).

9. The ISI of Holdco 1 after reorg would be $98 + $30= $128.

• CRA indicated that, as the safe income at each level below Holdco 1 is reduced, the ACB of the shares held by a direct parent in each corporation does not need to be totally eliminated in order to avoid a misalignment of inside and outside ACB. Conversely, the full elimination of ACB of the shares of a corporation in a reorganization does not necessarily address the issue of misalignment of ACB “especially when the corporations involved have a significant amount of safe income that was not capitalized.’ However, in the above situation, where there was the full elimination of ACB on the shares at each level, there did not seem to be a misalignment of ACB that would be of concern.

Background

Holdco, a wholly-owned subsidiary of Parent (also resident) holds a controlling position (the “Historical Portion”) in Subsidiary. Parent acquired all the other Common Shares of Subsidiary (the “Recently Acquired Portion”) with an s. 85(1) election to be filed respecting such acquisition.

Proposed Transactions

1. Parent will wind-up Holdco as described in s. 88(1). As a result of the application of the cost base averaging rules in s. 47, there will be an unrealized gain on each Common Share following the winding-up.
2. Parent will exchange all its Common Shares of Subsidiary on a s. 85(1) rollover basis for non-voting redeemable retractable non-cumulative preferred shares of Subsidiary (the “New Pref”) and Class A Common Shares with attributes identical to those of the Common Shares other than a different period of notice for shareholders’ meetings and being convertible into Common Shares on a one-for-one basis. The PUC of the Common Shares is allocated to the new shares on a relative FMV basis. The New Prefs will have a cost equaling their redemption amount.
3. Parent will convert all of the issued Class A Common Shares of Subsidiary into Common Shares.
4. Subsidiary will declare a cash dividend on the Common Shares.
5. Subsidiary will effect an additional cash distribution by redeeming all or a portion of the then outstanding New Pref, which will not affect the FMV of the Common Shares.

Purposes

The Class A Common Shares will be created to ensure that there will be a disposition of the Common Shares on the exchange in 2, and the conversion of the Class A Common Shares back to Common Shares in 3 will occur to restore the characteristics of the Common Shares.

The purpose of such exchange is to isolate a portion of the Common Shares’ ACB in the New Pref and to enable the additional cash distribution through the redemption of the New Pref for an amount equal to their ACB.

Rulings

As a result of the acquisition of the Historical Portion by Parent on the wind-up of Holdco, the safe income on hand attributable to the Historical Portion will be averaged across all of the Common Shares held by Parent immediately following the winding-up of Holdco.

The safe income on hand attributable to the Common Shares will not be reduced as a result of a redemption of the New Pref.

Income Tax Technical News No. 37 (2008) indicates that non-deductible expenses must be deducted in computing safe income on hand. What are non-deductible expenses for the purposes of s. 55?

CRA indicated that non-deductible expenses can be generally described as cash outflows which are not deducted in the computation of a corporation’s net income for tax purposes, other than an expense or disbursement made for the acquisition of property or for the repayment of the principal amount of a loan - and safe income should be reduced by such non-deductible expenses in order to determine the safe income on hand.

Some examples of non-deductible expenses include:

• dividend paid or payable;
• taxes, including refundable taxes;
• non-deductible interest and penalties;
• charitable donations, gifts and political donations that are not already deducted in net income for tax purposes; and
• the non-deductible portion of expenses or expenditures such as the non-deductible portion of meal and entertainment expenses.

In addition to the above items, 2016-0672321C6 states that contingent liabilities and accounting reserves also need to be taken into account.

In connection with confirming the position in the Robertson paper that:

A deduction for any expense incurred or disbursement made in the period that was not allowed or not claimed as a deduction in computing income will reduce safe income. However, there will be no deduction for an expense incurred or disbursement made in respect of the acquisition of property, an eligible capital property, or a repayment on account of the principal amount of a loan.

CCRA went on to indicate that:

• No adjustment (from the income computed for ITA purposes) should be made to computing safe income on hand in respect of an expense that constitutes an eligible capital expenditure such as incorporation expenses or costs incurred in a share capital restructuring.
• No such adjustment should be made where there has been continued claiming of CCA respecting a depreciable property that was scrapped, but it is still included in the UCC of the class because there are other properties remaining in the same class.
• On the disposition of a Class 10.1 passenger vehicle, the corporation's safe income on hand should be adjusted by reducing it by an amount equal to the excess of the acquisition cost of the vehicle in question over its deemed capital cost, since an amount of earned income equal to that loss is no longer on hand and therefore cannot contribute to the gain on the disposition of a share of the corporation.
• Furthermore, an amount determined under s. 13(2) in respect of a corporation, which is not required to be included in computing the corporation's income, has no impact on computing that corporation's safe income on hand.
• Borrowing costs in excess of the amounts thereof deducted under s. 20(1)(e) reduce the corporation's safe income on hand.
• Where a $10,000 capital loss is incurred in a taxation year preceding that for the realization of a $10,000 capital gain, if the period for determining the safe income on hand includes only the first year, the SIOH will be reduced by the capital loss.

In 2015, Opco, which had safe income of nil, paid a dividend on its 100 common shares to its sole shareholder (Mr. X) equaling the fair market value ("FMV") of Opco, being the $100,000 value of an intangible asset. The dividend was funded with a $100,000 loan.

A Holdco ("Holdco Y") for an arm’s length individual (Mr. Y) then subscribed $100 for 100 common shares of Opco.

In 2018, Mr. X transferred his 100 common shares to a newly-formed wholly-owned corporation ("Holdco X") on a rollover basis at the shares’ ACB of $100.

Subsequent to the payment of the dividend in 2015, the aggregate safe income generated by Opco was $200,000. At the end of its 2018 taxation year, Opco had $100,000 in cash and the value of the intangible was still $100,000. The $100,000 loan was repaid out of the $200,000 of income earned. The FMV of all the shares in the capital stock of Opco at the end of 2018 was $200,000.

(a) If a dividend of $200,000 were paid on the Opco common shares, what would be the safe income of the 100 Opco common shares held by Holdco X?

(b) Would the answer be the same if instead of there being a dividend in 2015, Opco repurchased Mr. X's shares and issued 100 new common shares of its capital stock to Mr. X and Holdco Y, respectively?

Q.(a)

CRA indicated that at the time of the s. 85(1) transfer by Mr. X of his 100 Opco shares to Holdco X, their safe income was retained and that, since the loan was “was repaid out of the corporation's earned or realized income … that income cannot be viewed as contributing to the unrealized gain on the common shares of the capital stock of Opco” – so that the relevant safe income of the 100 Opco common shares of Holdco X (and also of Holdco Y) was $50,000.

Q.(b)

Assuming that Opco received a loan to redeem its shares held by Mr. X in 2015 so as to generate a deemed taxable dividend to him and that such loan also was repaid at the end of 2018, the answer would be the same.

Could CRA reiterate its views on the consolidation of safe income in a corporate group?

After noting that its longstanding position had been that “a corporation can consolidate safe income of other corporations in which it has significant influence,” CRA reaffirmed that, in addition:

One can consolidate safe income of a corporation over which there is no significant influence if it can be clearly demonstrated that the safe income of such corporation contributes to the gain on the shares, bearing in mind that, in the case of portfolio investments in public corporations, what would be considered to contribute to the value of the shares held by the shareholder is not the income of the public corporations but rather the trading value of its shares on the stock exchange.

CRA went on to state:

The above discussion would also apply to consolidation of income from foreign corporations that are not foreign affiliates of the shareholder, as confirmed in Lamont.

… [T]he negative safe income of corporations would reduce the safe income of a holding corporation only to the extent that it can be considered to result in a reduction of the value of the shares of the holding corporation, for example, either because of a guarantee made by the holding corporation, or because of an actual payment for the losses by the holding corporation [citing Brelco].

CRA provided various examples to illustrate the impact of reorganizations on safe income. CRA indicated that this determination essentially turned on the application of the words “reasonably” and “contribute” in s. 55(2.1)(c).

Fxample 1 (allocation of direct safe income)

Opco is wholly owned by Holdco and has realized after-tax income of $1,000. This income is reflected in the ACB of Asset 2 held by it, which it acquired with the income realized. Now Opco proceeds with a s. 55(3)(a) spin-out of Asset 2 to Newco. Consequently, Asset 2, having an ACB of $1,000, is transferred to Newco on a rollover basis.

CRA indicated that, as the direct safe income of Opco was used to acquire Asset 2, it would be inappropriate to split that safe income so that a portion remains with the Opco shares. Instead, it should all go to the Newco shares.

This result accords with the observation that the direct safe income of $1,000 transferred to the Newco shares contributes to the gain on the Newco shares, and it should not be considered as contributing to the gain on the Opco shares that are left behind (the only asset of Opco is one with no ACB, so that all the unrealized gain remains in the assets retained by Opco.)

Example 2 (allocation of indirect safe income following an internal reorganization)

The structure is similar to Example 1, but now Opco has two subsidiaries, Subco 1 and Subco 2. Here Opco did not realize any income, so that there is no direct safe income in Opco - but there is indirect safe income in Opco, because Subco 2 realized income that constitutes direct safe income, and indirect income, of $1,000 on the shares of Subco 2, and Opco, respectively.

Opco transfers Subco 2 in a s. 55(3)(a) reorganization, and again the question is how to allocate the indirect safe income afterwards. Once again, because the shares of Subco 2 are transferred to Newco on a rollover basis, the direct safe income in the shares of Subco 2 is transferred over to Newco. On a consolidated basis, the shares of Newco held by Opco have indirect safe income of $1,000. Again, the indirect safe income is pushed over to Newco.

This accords with the observation that there no longer should be any indirect safe income in the Opco shares, as there is only unrealized gain on the assets owned by Opco (the shares of Subco 1), and there is no underlying safe income in Subco 1. By contrast, there is unrealized gain on the Newco shares, which is fully supported by the direct safe income in the Subco 2 shares.

Example 3 (misalignment of outside and inside basis)

Holdco owns Opco, and Opco has two subsidiaries (Subco 1 and 2). Holdco had acquired Opco for $300 a few years previously, and at that time, Subco 2 had direct safe income of $200, and since then Subco 2 generated an additional $150 of safe income. Thus, even though Subco 2 has $350 of direct safe income, Opco only has an indirect safe income of $150, as the $200 of preacquisition safe income generated by Subco 2 is reflected in the ACB to Holdco of the Opco shares.

The safe income is then capitalized before the reorganization, so that Holdco would have an ACB for its Opco shares of $450, being $300 plus the indirect safe income of $150. If Opco were wound up, Holdco would have shares of Subco 1 and Subco 2 with an aggregate ACB of $350. The maximum ACB that Holdco could have in the subs should be $450.

Suppose that there is a s. 55(3)(a) spin-off of Subco 2 to Newco, and that to effect that spin-off, Holdco transfers shares of Opco having an ACB of $150, and an FMV of $500. The transaction occurred on a rollover basis, so the direct safe income of $350 in the Subco 2 shares is transferred over to Newco on a consolidated (and rollover basis), and the indirect safe income of $150 on the Opco shares is transferred over to the Newco shares, as in the previous two examples.

However, this results in a duplication of ACB - because if the safe income is capitalized after the reorganization and Newco is wound-up, there is a resulting aggregate ACB of $500 in the shares of Opco and Subco 2, which exceeds the $450 maximum stated above. In CRA’s view, this $50 ACB increase is unacceptable, and the solution would be to proceed with a reorganization that results in an alignment of the basis.

Instead of transferring Opco shares to Newco with an ACB of $150, Opco shares having an ACB of at least $200 could be transferred. This would achieve alignment of the basis.

The above structure is similar to the one in Example 3. The only change made here is that Subco 1 has realized its safe income of $500 after the acquisition of control. If the safe income is capitalized before the transaction, there will be an ACB of $950 of the Opco shares. If Opco is wound up, Holdco will have an aggregate ACB of $950. In Example 3, our magic number was $450, and now it is $950, the maximum ACB that these entities can hold.

CRA went on to provide examples illustrating a misalignment going the other way (resulting in the loss of basis), and stated that it was “ready to find solutions to avoid what would be perceived as a loss of safe income or tax basis.”

A holding corporation (Holdco) and an individual are the beneficiaries of a discretionary trust (the Trust) that holds shares of Opco having safe income on hand of $1,000. An Opco dividend of $2,500 to the Trust is distributed by it as to $1,000 to Holdco and $1,500 to the individual, respectively, and designated under s. 104(19). Could the trustees’ discretion be exercised by determining that the portion of the dividend received by the corporate beneficiary will benefit from all of the safe income on hand? CRA responded:

A corporate beneficiary of a trust in respect of which a [s. 104(19)] designation is made is … deemed to have received the dividend for the purposes of section 55 and can benefit from the safe income exception in paragraph 55(2.1)(c). However, the deeming rule in subsection 104(19) does not provide an ability to the trustees of a trust to adjust the safe income associated with a portion of the dividend that has been allocated to a particular beneficiary. As such, the safe income on hand associated with the dividend would be allocated on a pro rata basis amongst the portions of the dividend received by the corporate and individual beneficiaries.

When Holdco was incorporated and capitalized with $500,000 of share capital, it incorporated Opco 1 and 2 and subscribed $100 and $499,900 for shares of Opco 1 and 2, respectively. Opco 1 realized $900,000 in safe income and its shares now have a fair market value (FMV) of $1,000,000. Opco 2 realized operating losses of $2,000,000 in building up an intangible asset. As it financed the losses in part with third-party debt of $1,500,100, the shares of Opco have an FMV of $499,900.

Should the safe income attributable to the shares of Holdco be reduced by negative safe income given that the latter does not reduce the accrued capital gain in the shares – or is such amount $900,000?

After noting that (based on Brelco) “the losses of an affiliate can reduce a parent corporation's safe income on hand even if the parent corporation has not directly or indirectly guaranteed the affiliate's losses.” CRA stated:

[T]he fact that Opco 2's trading losses ultimately did not have the net effect of reducing the fair market value of the Holdco shares, and assuming that no entity in the Holdco Group had guaranteed or financed the debt of Opco 2, the CRA is of the view that Opco 2's trading losses should not reduce the consolidated safe income attributable to the shares of the capital stock of Holdco. Indeed, it is our understanding that Opco 2's operating losses were funded by debt from an entity unrelated to Holdco and by the investment of Holdco in Opco 2. Furthermore, those losses are now reflected in the value of the intangible asset created and held by Opco 2. Consequently, the losses of Opco 2 ultimately had no effect on the fair market value of the Holdco Shares. It would therefore be reasonable to consider that the safe income attributable to the shares of the capital stock of Holdco should be $900,000, which is the safe income attributable to the shares of the capital stock of Opco 1 held by Holdco.

At the 2016 CTF Annual Conference, the CRA indicated that it was conducting a study in connection with the proper allocation of safe income in circumstances involving a corporation that has issued shares that are entitled to discretionary dividends. What did CRA conclude? CRA indicated that:

• It stands by all positions on this matter that it has expressed since the 2015 CTF Annual Conference.
• On a going-forward basis the CRA is willing to provide assurance on the tax treatment of the discretionary dividend shares, but only in the context of a ruling request – and thus will no longer express its views on this matter in Technical Interpretations or Roundtable responses.

In 2017 STEP Roundtable Q.7, 2017-0693421C6, CRA stated that safe income of a corporation owned by the deceased did not flow through to his estate. Would this apply if the shares transferred on a rollover basis under s. 70(6) to the estate?

CRA indicated that the basis for the referenced position was that the safe income was crystalized in the ACB of the shares that were now held by the estate. However, where the shares were disposed of at their adjusted cost base because of the s. 70(6) rollover, the safe income that could reasonably be considered to contribute to the accrued gain on those shares would flow through to the estate.

In connection with the implementation of an earnout transaction for the purchase of Holdco common shares by a key employee, the equal unrelated (corporate) shareholders of Holdco (a Canadian-controlled private corporation holding Opco) first transfer a portion of their Holdco common shares to Opco in consideration for tracking preferred shares of Opco, with Opco immediately selling those shares on a five-year earnout basis to the key employee.

Before the implementation of the above transactions, Holdco and Opco adopted a policy of dividending out all of their operating earnings – but deferred paying any of these dividends until the rulings were granted. CRA ruled that the dividend determination time for the “Second Annual Dividends” (i.e., dividends payable based on the annual income for the Opco taxation year ending after the sale of the Holdco common shares by Opco to the key employee) is the time immediately before their payment rather than the time immediately before the payment of the previous dividends, so that the safe-income exception in s. 55(2.1)(c) could access the more recent earnings. The safe-income determination time for the dividends on the tracking preferred shares was the same time as the payment of the previous dividends.

CRA provided an example illustrating the operation of s. 55(2.3), which streams safe income to stock dividend shares and away from the shares upon which the stock dividend is paid, where the dividend recipient is a corporation..

Opco’s two shareholders (Holdco and Ms. X) each own a bloc of 50 common shares with an ACB, FMV and safe income on hand of $5,000, $500,000 and $450,000, respectively. Opco pays a $700,000 stock dividend consisting of preferred shares with an aggregate redemption amount and PUC of $700,000 and $1, respectively.

Because the amount of the stock dividend is deemed to be $350,000 for s. 55(2) purposes, Opco’s safe income that contributes to gain on the 50 Opco common shares of Holdco is deemed to be reduced by $350,000. Holdco now owns half the preferred shares with an ACB pursuant to s. 52(3)(a) of $350,000, and 50 common shares with a FMV of $150,000 and an ACB of $5,000, resulting in an inherent capital gain of $145,000. Thus, Opco has $100,000 of safe income that contributes to the inherent capital gain on Holdco’s original 50 common shares and the other $350,000 of safe income is now reflected in the ACB of Holdco’s preferred shares of Opco.

As for Ms. X, Opco’s safe income of $450,000 that contributes to the gain on her 50 common shares is not reduced by the stock dividend paid, and this safe income of $450,000 will be apportioned between her preferred shares received as a stock dividend, and her original 50 common shares, based on their respective accrued gains, as determined after the payment of the stock dividend.

The participating and non-voting Class AA shares of Opco, which were held equally by two unrelated individuals (A and B), were worth $500,000 and had a safe income of $300,000 on January 1, 2016, and had a nominal paid-up capital and adjusted cost base. The voting shares of Opco, having an aggregate redemption value of $100, were held by Holdco, which was owned equally by A and B. On January 1, 2016, Holdco also subscribed $100 for 100 Class X shares of Opco, which were entitled to participate annually in Opco’s profits proportionately with the number of issued and outstanding AA and X shares, so that their holders were entitled (and only entitled) to dividends equal to the cumulative earnings from the time of their issuance and the redemption value of the shares (which otherwise would equal such proportionate accumulated profits plus the issue price) was reduced by the dividends paid.

On December 31, 2016, Opco had accumulated $100,000 in after-tax profits and safe income, As there were 200 outstanding AA and X shares, the X class shares had a redemption value on January 1, 2017 of $50,100 (($100,000 x 100/200) + $100 of PUC) On January 1, 2017, Opco paid a dividend of $50,000 to Holdco.

Q.2:

Would the dividend be excluded under s. 55(2.1)(c)? After noting the Robertson rule that “income will be attributable to a particular class of shares in the same ratio in which each class would be entitled if all earnings of the corporation, but not share capital, were to be distributed,” CRA stated:

[G]iven that…the Class X and AA shares were entitled to an equal share of Opco’s profits following the issuance of the Class X shares and that the value of the shares of each class would increase due to this share of profits, … the safe income earned or realized annually following the issuance of the Class X Shares could be proportionately allocated based on the number of shares of each class. Accordingly, based on…the share of Opco’s safe income contributing to the hypothetical capital gain on the Class X shares would be $50,000…and no part of the $50,000 dividend would be subject to subsection 55(2).

Q.3:

Alternatively, although the after-tax net profits remained at $100,000, the cumulative safe income in the year was only $90,000, with safe income attributable to the Class X shares of $45,000, and the $50,000 dividend was paid in two tranches of $45,000 and $5,000. CRA indicated that “it would be reasonable to consider that half of the safe income earned during the year would contribute to the hypothetical capital gain on the Class X Shares and half of the safe income would contribute to the hypothetical capital gain on the Class AA Shares if a dividend was paid on those shares,” so that the first dividend, but not the second, would enjoy the safe income exclusion.

Q.4:

As a further alternative, the 2016 profits instead were $200,000, the cumulative safe income in that year was $190,000, and the total market value of all the shares of Opco was $800,000 as a result of such profits and an increase in the value of intangibles. Class X shares had a redemption value of $100,100 (50% of the profits plus the paid-up capital). On January 1, 2017, OPCO paid a dividend of $95,000, followed by a second of $5,000, to Holdco.

CRA stated:

it would still be reasonable to conclude that half of the safe income would contribute to the hypothetical capital gain on the Class X shares. The increase in the value of the Class AA Shares would result from an unrealized capital gain for tax purposes and therefore would not be included in the safe income for the year. Consequently, the dividend of $95,000 would not be greater than the amount of safe income on hand and, therefore. would not come within subsection 55(2).

Q.5:

Under a further variation, an amount representing 50% of OPCO’s safe income would be allocated to the Class X shares and the balance of the accounting profits would be allocated to the Class AA shares. Assuming an aggregate safe income since the Class X share issuance and accounting profits of $100,000, if there were a distribution of all the accounting profits, the Class X and AA shares would receive $45,000 and $55,000, respectively. CRA stated:

[T]he increase in the corporation's safe income (during the holding of the Class X shares) for that year should be allocated based on the amounts to which each Class would be entitled. For example, 45/100 of $90,000 (i.e., the total safe income during the holding of the Class X shares) would be allocated to the Class X shares, or $40,500.

Therefore, it is not be possible to isolate the safe income of the corporation or a portion thereof in a particular class of shares if the corporation's safe income was less than the accounting profits

a. Given the historical records required to prepare safe income calculations, what type of practical approaches and assumptions are accepted by CRA?

b. Could CRA provide copies of previous tax returns and (re)assessments dating back to the incorporation of the entities required to compute safe income?

c. What type of audit practices can taxpayers expect in respect of supporting documentation used to calculate safe income that contributes to the capital gain on a share?

d. Given that the safe-income determination time is no later than the time immediately before the earliest dividend paid as part of a series, how is this applied where a company pays a regular (e.g., quarterly or annual) dividend?

e. Do contingent liabilities and reserves, such as for pensions obligations reduce the safe income that can reasonably be considered to contribute to the capital gain on a share given that Kruco held that safe income should be reduced by cash outflows?

CRA responded:

a. … The onus is on the taxpayer to provide support for the calculation of safe income that can reasonably be viewed as contributing to the capital gain on a share. The CRA expects the supporting documentation to be organized as an accumulation of year-by-year computations. …

…[W]here…the taxpayer offers an alternative proxy such as the accounting retained earnings or adjusted retained earnings balance…the CRA auditor might conclude that retained earnings is a fair proxy for safe income on hand but only after a very stringent validation process.

…[A]n incorrect claim could be subject to the application of subsections 152(4), 163(2) or 239(1), depending on the circumstances.

b. …[W]hen a taxpayer makes a request to the CRA to obtain a copy of income tax returns and/or notices of assessment, the CRA will attempt, in regards to available resources, to provide the requested documentation. However…it is not in a position to provide assurances that these requests will be actioned in all cases.

c. The audit practices…include…a verification of the portion of the safe income that can reasonably be considered to contribute to the capital gain on each share of the corporation in any given year. This typically involves a validation that a detailed analysis was done using share registers and minute books provided by the taxpayer. The analysis should be carried out for each year and the adjustments should take into consideration any changes in the shareholdings.

d. In a recent ruling, the CRA took the view that regular, recurring annual dividends would not, in the circumstances of the ruling request, be part of a series of transactions. Accordingly, a ruling confirmed that the safe income determination time in respect of the first and second annual dividends will be immediately before each such dividend.

CRA went on to discuss 2016-0633961E5 (respecting recapture of depreciation realized on sale before safe-income determination time being included in safe income.)

e. As discussed in ITTN-37…Kruco requires a second stage inquiry in respect of the calculation of a corporation's safe income to determine whether the income earned or realized was kept on hand (i.e., whether such income can reasonably be viewed as contributing to the capital gain on a share). The decision supports the notion that the safe income should be reduced by actual or potential cash outflows such as non-deductible expenses, contingent liabilities and accounting reserves in the determination of the amount of safe income that can be viewed as contributing to the capital gain on a share.

On the incorporation of Opco in Year 1, two unrelated Holdcos (HC and HB) each subscribed $100 for 100 Class C or Class B voting common shares. In Year 8, HA (also unrelated) subscribed $50,000 for 100 Class A voting common shares of Opco at a time that Opco's aggregate safe income was $70,000 and the FMV of its shares was $100,000 (or $150,000 after the subscription). In Year 10, at a time that the aggregate safe income of Opco was $90,000 and the FMV of its shares was $170,300, a $35,000 dividend was paid on the Class A shares of HA. How should the global safe income be allocated among the different classes given their different holding periods?

CRA indicated that if the $20,000 of safe income generated in the two years up to the dividend payment was business income (rather than, for instance, being from the realization of gains that had already accrued at the time of HA’s share subscription), and making some surmises on the contribution of this safe income to the accrued capital gain on the shares of HA, “the amount of $20,000 would represent a separate taxable dividend pursuant to paragraph 55(5)(f) and would not be subject to subsection 55(2),” whereas if the purpose test in s. 55(2.1)(b) was satisfied, the balance of the dividend could be subject to s. 55(2).

Before referring to various conferral-of-benefit provisions, GAAR and the difficulties posed by discretionary dividend shares in a butterfly, CRA stated that it was “not intended to give our general approval for the use of discretionary dividend shares.”

Holdco holds 100 common shares of Opco and 100 non-participating preferred shares which are redeemable for, and have a PUC and ACB of, $100. Opco has some safe income. Would the payment of a dividend on the pref shares trigger the application of s. 55(2)?

After noting that “the hypothetical capital gain that would have been realized on a FMV disposition of class "B" preferred shares immediately before the dividend…would be nil,” so that the dividend would not be considered to come out of safe income on hand, CRA stated that if s. 55(2.1)(c) thus applied then (subject to the Part IV tax exclusion) “subsection 55(2) would apply in the present situation if all the conditions of paragraphs 55 (2.1)(a) to (c) were established.” If it so applied, “the amount of the dividend would not reduce the SIOH of the corporation.”

X (an individual) holds 799,000 Class A common shares of Opco having a safe income on hand (“SIOH”) of $1M and a FMV of $1.8M. Opco pays a stock dividend of Class B shares which are voting, participating, bear discretionary dividends and are redeemable by Opco for $1, which is their PUC. X incorporates Holdco and transfers the Class B shares to Holdco under s. 85(1). Opco then pays a $1M dividend to Holdco. Does s. 55(2) apply? What if instead there is a $1M s. 84(1) dividend?

After noting that there was no transfer of safe income to the Class B share in light of its nominal value and taking into account CRA’s “long-standing position on the transfer of safe income on a stock dividend – “and no SIOH would contribute to the hypothetical capital gain on the class "B" share in the capital stock of Opco held by Holdco,” CRA noted that accordingly:

If all other conditions were satisfied, subsection 55(2) would apply in respect of the dividend of $1 million. …

If Opco proceeded with an increase in PUC rather than a cash dividend…the CRA would have the same answer… .

Holdco A holds 100 voting common shares of Opco with a paid-up capital and adjusted cost base of $100, as well as 100 estate freeze non-participating, non-voting preferred shares bearing a pre-determined dividend of 8% on their redemption amount of $1,000,000, having an ACB of $100 and having safe income of $700,000 traceable to the shares for which they had been exchanged. The shares of Opco have an aggregate fair market value of $2,500,000 and its global safe income is $1,700,000. (a) If Opco generates safe income in the year of $150,000 and declares a dividend of $80,000 on its preferred shares, what portion of the dividend will be covered by the global safe income and, following the dividend’s payment, what will be the preferred shares’ safe income? (b) What if Opco did not generate any safe income in the year before that dividend was declared?

CRA responded:

If the dividend of $80,000 was not greater than the SIOH of the corporation which contributed to the hypothetical capital gain on frozen preferred shares (the amount of $700,000 transferred at the time of the freeze could have been reduced due to previous dividends as well as SIOH that accumulated since the freeze if it contributed to the hypothetical capital gain on preferred shares), paragraph 55(2.1)(c) and subsection 55(2) would not apply. The dividend of $80,000 would firstly reduce the SIOH of the corporation from the time of the freeze if it contributed to the hypothetical capital gain on the freeze preferred shares and up to the lesser of safe income that contributed to the hypothetical capital gain on the freeze preferred shares and the dividend amount. Any difference between the amount of the dividend and this reduction in the post-freeze SIOH of the corporation would reduce the SIOH of $700,000 that is specifically attached to the freeze preferred shares freeze (less any prior reduction).

Depending on circumstances, it may be that the only SIOH contributing to the hypothetical capital gain on the frozen preferred shares was the amount of $700,000 less any previous reduction of such safe income. If the dividend amount of $80,000 was not greater than such SIOH, paragraph 55(2.1)(c) and subsection 55(2) would not apply. In such case, the SIOH of $700,000 (less any previous reduction) would be reduced by the amount of the dividend.

Following the sale of depreciable properties and eligible capital properties and before the end of its taxation year, a corporation pays a dividend or redeems shares in its capital. Would the income arising from such sales be considered to be earned or realized before the safe-income determination time? CRA responded (TI translation):

It is only at the end of the taxation year of the corporation that income determined in accordance with subsection 13(1) (resulting from the sale of depreciable property of the corporation) or subsection 14(1) (resulting from the sale of eligible capital) is included in the income of the corporation.

...Thus, based only on the wording of the legislation, the income computed under subsections 13(1) and 14(1) would not technically be part of the safe income in this situation.

However…we will accept that income determined under subsections 13(1) and 14(1) will be included in computing the income earned or realized before the safe-income determination time so long as the sale of assets that gave rise to such income had occurred before the safe-income determination time and to the extent that this income contributes to the hypothetical capital gain on the shares on which the dividend was received (under the assumption that there is a disposition at fair market value of the shares immediately before the dividend). Moreover, in such a case, we also will take the position that the taxes payable on these earnings must be deducted from that safe-income… .

[T]he equivalent position will apply in respect of a terminal loss… .

Opco has a fair market value of $2M and its safe income is $1M. Its issued share capital consists of 1,000 Class A common shares and 1,000 Class B common shares held by two unrelated holdcos (Holdco1 and Holdco 2), who had subscribed for their shares on incorporation for nominal consideration. Opco repurchases all the Class B shares for $1M (Alternative 1) or Opco pays a discretionary dividend of $1M to Holdco 2 and the repurchases the Class B shares for nominal consideration, with the FMV of the Class A shares remaining at $1M, and the FMV of the Class B shares reduced by the dividend amount (Alternative 2). How is the safe income of Opco attributed to the Class A and B shares?

Respecting Alternative 1, CRA stated (TI translation):

[I]t is reasonable to conclude that the income earned or realized that contributes to the capital gain for each class is equal for each class ($500,000 per class under the above assumptions) given their value and nominal adjusted cost base.

Accordingly, s. 55(2) would apply to the excess of the deemed dividend over $500,000.

Respecting Alternative 2, CRA stated:

Under this alternative, it may be that we could conclude that the Class B shares had a value equal to the total of the discretionary dividend and the redemption value of $1 and that the Class A shares retained their value of $1M. …

If this were the case…it would be reasonable to consider in this hypothetical alternative that the income earned or realized that contributed to the hypothetical capital gain on the class B shares was equal to half of the Opco safe income [thereby producing the same result as in Alternative 1]. …

The dividend of $1M would normally reduce the subsequent safe income on hand. However, we accept that the separate taxable dividend that was subject to subsection 55(2) did not reduce the safe income on hand of Opco.

In light of this policy, the safe income attributable to the Class A shares would be $500,000.

Were ss 55(2) and 55(2.1) as set out in the July 31, 2015 Legislative Proposals intended to exempt, from capital gains treatment, a s. 84(3) dividend resulting from a redemption of shares whose amount does not exceed the safe income and which would be deductible under s. 112(1) or 112(2) by a Canadian recipient corporation?

After paraphrasing s. 55(2.1)(c), and before referring to the Part IV tax and s. 55(3)(a) exception, CRA stated (TI translation):

Therefore, if this [s. 55(2.1)(c)] condition is not satisfied, subsection 55(2) will not apply. We would consider that a deemed dividend arising on the redemption of shares that is equal to or lower than the safe income on hand respecting the redeemed shares does not have a purpose of effecting a significant reduction of the capital gain. In this regard, paragraphs 55(5)(b) to (d) are the rules for calculating the income earned or realized by a corporation.

1^st situation. Three unrelated Holdcos (A, B and C) each hold all the 100 voting participating shares of a separate class of discretionary dividend shares of Opco, which has safe income on hand of $90,000, whose shares collectively are worth $120,000, and with the three share classes sharing equally on liquidation and having a nominal adjusted cost base (“ACB”). The directors declare a $35,000 dividend on the Class OA shares held by Holdco A only.

2^nd situation. The same as the 1^st except that the shares are non-voting and non-participating [i.e., are non-cumulative preferred shares] and that other voting and participating shares were issued by Opco to the three Holdcos.

3^rd situation. Two unrelated individuals (A and B) each held 39 Class A shares of Opco and their respective Holdcos (Holdco A and B) each held 11 Class B or 11 C shares, respectively. All three classes are voting, participating and discretionary-dividend shares and their collective safe income on hand is $100,000, their collective fair market value (“FMV”) is $120,100 and their ACB is $1 per share. Holdco A and B each receive a $50,000 dividend.

4^th situation. Two brothers (A and B) each held 49 Class A shares of Opco and their respective Holdcos (Holdco A and B) each held 1 Class B or 1 C shares, respectively. The Class A shares are voting, participating and discretionary-dividend shares, the Class B and C shares are voting, non-participating and discretionary-dividend shares and the collective safe income on hand is $100,000. Holdco A and B each receive a $50,000 dividend.

5^th situation. Mr and Ms A hold 99 Class A and 1 Class B voting, participating and discretionary-dividend shares of Opco which they had acquired at the same time, having an aggregate FMV now of $120,100, and an ACB of $1 per share and CRA also assumed safe income on hand for Opco of $100,000. A separation agreement provides that Ms A will transfer her Class B share to a newly-incorporated holdco (HoldcoMsA) under s. 85(1), Opco will pay a dividend equal to 90% of its NAV on the Class B share and then repurchase that share for $1.

Question. What is the treatment of the dividends (and, in the first two situations, the impact on safe income on hand) in these transactions?

1^st situation. CRA stated (TaxInterpretations translation):

The question is whether… it is reasonable to consider that an amount of safe income on hand equal to the dividend contributed to the capital gain which would be realized on a disposition at FMV, immediately before the dividend, of a share on which the dividend was received (the “hypothetical capital gain”). The amount of the hypothetical capital gain would be a function of the FMV which could be attributed to the share on which the dividend was declared, such FMV being measured immediately before the dividend payment but keeping in mind that such share would have a right to an additional amount equal to the dividend declared thereon.

…Taking into account [such] an additional value of $35,000 for the Class OA shares…the $35,000 dividend would not be greater than the safe income on hand which it would be reasonable to consider as contributing to the hypothetical capital gain.

Following the dividend…the safe income on hand of Opco would be reduced to $55,000.

If no other dividend was declared, and Opco was liquidated and the residue of its property paid in equal parts to each class of participating shares, the capital gain which would be realized on the shares of each class, if there was a disposition at FMV immediately before the dividend…would be $28,333. In such a case,…the safe income on hand which it would be reasonable to consider as contributing to the capital gain on the shares of each class would be $18,333 ($55,000/3).

2^nd situation. After again referencing that the shares would have a right to an additional amount immediately before the payment time equal to the declared dividend, CRA stated:

It could be…that there would be no hypothetical capital gain if the FMV of the non-participating and non-voting shares was equal to their ACB. For example, this could occur if the unpaid dividends represented distinct rights from the shares to which they related.

In such a case, the condition in paragraph 55(2.1)(c)…would be satisfied. If no capital gain arises on a disposition at FMV of shares on which the dividend is paid, there indeed is no safe income on hand which contributes to the hypothetical capital gain.

…[Respecting] paragraphs 55(2.1)(a) and (b)…the dividend…would reduce the… capital gain which could be realized on a disposition at FMV of the common shares. … With a dividend in the order of magnitude of $35,000…we could conclude that the reduction is significant or the increase in cost is significant.

…If one of the purposes of the payment or receipt of a dividend is as stated in subparagraphs 55(2.1)(b)(i) and (ii), subsection 55(2) could apply to the $35,000 dividend if the other conditions were satisfied. In such a case, the CRA would accept that the amount of the dividend does not reduce the safe income on hand of the corporation. If instead, subsection 55(2) did not apply to the dividend on the preferred shares, the amount of the dividend would reduce the safe income on hand of the corporation.

…[I]f the amount of the hypothetical capital gain for the non-voting and non-participating shares was equal to $35,000, it might be that we would consider that the $35,000 dividend was not greater than the safe income on hand which it was reasonable to consider as contributing the hypothetical capital gain. If so, subsection 55(2) would not apply. In that case, the safe income on hand of the corporation would be reduced by the amount of the dividend.

3^rd situation. CRA noted that this was similar to Situation 1, repeated essentially the same analysis, and concluded:

…Taking into account [such] an additional value of $50,000 equal to the amount the dividend which would be paid on the shares…of Class B and C…each dividend of $50,000 would not be greater than the safe income on hand which it would be reasonable to consider as contributing to the hypothetical capital gain on each of Classes B and C. Consequently, subsection 55(2) would not apply… ..

The dividends which were not subject to subsection 55(2) would reduce the safe income on hand for the shares of Opco.

4^th situation. CRA noted that this was similar to Situation 2, and provided the same analysis but adding that subsection 55(2) would not apply if Part IV tax applied to the dividends and was not refund by reason of a payment of a dividend by the Holdco.

5^th situation. After noting that the analysis was similar to the 1^st situation, CRA stated:

[]I]t is necessary to compare the dividend paid by HoldcoMsA, being 90% of $120,000 ($108,000) to the safe income on hand of Opco ($100,000).

...[T]he dividend is greater than the safe income on hand of such share by $8,000. The question is whether the dividend of $108,000 would significantly reduce the FMV of the "A" shares in the capital stock of Opco. If this were the case and one of the purposes was such reduction, the conditions for the application of subsection 55(2.1) would be satisfied. Subsection 55(2) would apply respecting the dividend (subject to the application of paragraph 55(5)(f)) received by HoldcoMsA, unless Part IV tax applied and the tax was not refunded by the payment of a dividend by HoldcoMsA.

A discretionary trust (the "Trust"), whose beneficiaries were A, A's spouse, their children and a corporation ("Holdco") all of whose participating and voting shares were held by A, received a dividend on its shareholding (being all the non-voting common shares) in Opco, and distributed that dividend to Holdco, making a s. 104(19) designation, and with Holdco claiming a s. 112(1) deduction for its income inclusion under s. 104(13). The Opco dividend amount equalled the safe income on hand respecting the Trust's shares, and no Part IV tax was payable (by virtue inter alia of A being the sole voting shareholder of Opco).

Should the dividend be recognized in the calculation of Holdco's safe income? After noting the availability and making of the s. 104(19) designation in respect of the dividend which was included in Holdco's income under s. 104(13), CRA stated (TaxInterpretations translation):

[I]t would be reasonable to consider that the amount of the dividend allocated to Holdco by virtue of subsection 104(19) which was included in the computation of its income, would increase its safe income by an equivalent amount.

A corporation has insufficient safe income in respect of its shares and, rather than making a s. 55(5)(f) designation, self-assesses itself for a capital gain to the extent of the insufficient safe income on hand? Is it permissible for it to self-assess the dividend received by it as proceeds of disposition?

CRA referred to Nassau Walnut, which found that a s. 55(5)(f) designation is not an election (and "is, in some respects, no different than the deduction provided under subsection 112(1)") and, more generally, referred to Brelco, Lamont and Kruco for the principle "that the safe income of a corporation should not be subject to double taxation when distributed as a dividend to another corporation." CRA then stated:

CRA's long standing practice is to apply subsection 55(2) only to the excess of the taxable dividend paid on a share over the safe income on hand attributable to that share, when issuing an assessment based on subsection 55(2).

Prior to a sale by Holdco of all the shares of Opco to an arm's length purchaser for $1,000,000, Opco will transfer its interest in the Policy on the life of Mr. X (the sole shareholder of Holdco) to Holdco as a dividend-in-kind. The Policy has a nil ACB, $200,000 FMV, $100,000 CSV and $1,000,000 death benefit. What will be the impact of the dividend-in-kind on the computation of safe income on hand?

Timing of addition to SIOH

After noting that Opco would be deemed by ss. 148(7) and (9) to receive proceeds of disposition equal to the Policy's CSV rather than FMV, CRA stated:

[T]he safe-income determination time for the Dividend-in-Kind… is the time that is immediately before the time that the Dividend-in-Kind is paid to Holdco. Because the income inclusion resulting from the disposition of Opco's interest in the Policy…will be added to Opco's safe income after the Dividend-in-Kind is paid to Holdco, it will not contribute to the capital gain that could be realized on a disposition at fair market value of an Opco share immediately before the time the Dividend-in-Kind is paid.

Effect of non-deductible policy premium on SIOH

After noting that "premiums payable by a taxpayer under a life insurance policy are generally considered to be on account of capital" and referencing "the payment of premiums on the Policy over the period throughout which Opco was a private corporation," CRA stated:

The portion of such premiums that contributes to the increase of the cash surrender value of the Policy would be considered to be on hand at the safe income determination time to the extent that it contributes to the accrued capital gain on a share of the capital stock of Opco at that time. … However, the portion of such premiums that does not contribute to the increase of the cash surrender value of the Policy at that time will not be on hand at the safe income determination time and would therefore reduce the amount of safe income that could reasonably be considered to contribute, immediately before the Dividend-in-Kind, to the accrued capital gain on the Opco shares on which that dividend is received.

Mr. X holds all 100 of Opco's Class A shares with a fair market value of $1,000,000 and nominal ACB and PUC. Opco pays a stock dividend comprising Class B shares which have a retraction right for $900,000; the 100 Class shares are exchanged for estate freeze Class C preferred shares; and the family trust subscribes for Class A shares for $10. What would be the safe income attributable to the Class B shares issued as the stock dividend? CRA responded (Tax Interpretations translation):

When there is a stock dividend of a class having a redemption amount higher than its nominal paid-up capital, it will be necessary to apportion the safe income and the safe income on hand which is attributable to the shares on which the dividend was paid, being the Class A shares, between such shares and the shares received as a stock dividend, being the Class B shares. The apportionment of this safe income and safe income on hand which will thereupon be attributable to the Class B shares will be effected in accordance with the proportion of the gain inherent in the Class B shares as compared to the gain inherent in the Class A shares prior to the stock dividend. The amount of safe income and safe income on hand which would be attributable to the Class B shares would reduce the safe income and safe income on hand which was attributable to the Class A shares prior to the payment of the stock dividend.

The only source of income of ABC, a CCPC, is its interest in a partnership (P) with a fiscal period end of XX. ABC has an income inclusion under s. 34.2(2) and claims a reserve under s. 34.2(11). May ABC choose not to claim the transitional reserve provided under s. 34.2(11) for a taxation year for the purposes of the computation of its safe income on hand? CRA first stated (TaxInterpretations translation):

[T]he CRA expects that, in general, a corporation's income will not be artificially inflated by failing to claim capital cost allowance or a usually claimed reserve.

In general, it is acceptable to allocate the income calculated for a taxation year of a corporation or partnership, on a pro rata basis, to determine the income attributable to a corporation’s stub period if such allocation is reasonable in the circumstances. ...

...[I]n the calculation of safe income on hand, a downward adjustment cannot be made to remove or modify the [adjusted stub perod accrual] included in computing a corporation's income for a particular taxation year under subsection 34.2(2) on the basis that the ASPA represents an approximate amount based on a partnership's past year's income.

Similarly, an upward adjustment cannot be made to ignore the Transitional Reserve deducted by virtue of subsection 34.2(11).

Such adjustments would have the effect of directly conflicting with the wording of paragraph 55(5)(c) and of subtracting or adding amounts that are part of taxable income determined as the basis for taxation for purposes of subsection 55(2).

In response to the specific question, CRA stated:

BC may not claim an amount in respect of the Transitional Reserve under subsection 34.2(11) to determine its SIOH immediately before the "safe income determination time" respecting a particular transaction, insofar as the corporation does not claim such reserve for the taxation year which includes the stub period, if any.

The principal reason for our position is the fact that the Transitional Reserve is temporary and that it could reasonably be considered that, in general, the "qualifying transitional income" on which the Transitional Reserve is based results in an increase in the value of the shares of the capital stock of the corporation.

Buyco acquired all the shares of Opco on 15 January 2010 from Sellco. A CRA audit resulted in a 2011 reassessment to increase Opco's income for its 2008 and 2009 years. CRA stated (TaxInterpretations translation):

[no price adjustment]

[W]here nothing in particular is provided in the agreement of purchase and sale for the shares of the capital stock of Opco respecting the amount of additional income tax payable by Opco, the amount of additional tax paid by Opco, in general, would reduce the safe income on hand attributable to the shares held by Sellco for the purposes of subsection 55(2). In such a situation, it appears to us that the payment of the additional tax by Opco would have the effect of reducing the safe income on hand that can reasonably be considered to contribute to the gain on the shares of the capital stock of Opco held by Buyco [per the summary, "the gain inherent in the Opco's shares"].

[price adjustment to Buyco]

In the situation where the agreement of purchase and sale contains an adjustment clause to the price for the shares payable by Buyco by reason of a reassessment sustained by Opco, the amount received by Buyco by reason of the price adjustment clause, in general, would reduce the acquisition cost of the shares of Opco.

Furthermore, the amount of the additional tax payable by Opco by reason of the reassessment for a taxation year ending prior to the acquisition of control would, in general, have the same effect on Opco’s safe income on hand as ... above.

[price adjustment to Opco]

In the situation where the agreement of purchase and sale for the shares of the capital stock of Opco provides that Sellco is responsible for the amount of any reassessment for a taxation year prior to the acquisition of the shares and to the extent that Opco received or is considered to have received from Sellco an amount equivalent to the amount of additional tax arising under the reassessment, the calculation of the safe income on hand attributable to the Opco shares held by Buyco would need to take into account the application of paragraph 12(1)(x) or subsection 12(2.2) to the compensation received from Sellco.

The three corporate shareholders of Opco each held 1/3 of the shares, being 100 Class A, B or C common shares but which, in the case of the Class A shares of Shareholder 1, was entitled by virtue of an agreement to this effect in the unanimous shareholder’s agreement (“USA”) to an exclusive preferred dividend of $5,000 per annum. The shares had a nominal adjusted cost base and paid-up capital and an aggregate fair market value of $21,000. Opco’s safe income on hand was $12,000. Opco increased the paid-up capital of the Class A common shares by $5,000, thereby resulting in a $5,000. This increase in paid-up capital resulted in a deemed dividend paid on the Class A common shares under subsection 84(1). This amount increased the shares’ ACB by $5,000. What is the safe income on hand attributable to each of the common share classes?

After noting that at the 1988 CTF Annual Conference, the Department stated that the safe “income was attributable to a particular class of shares of the capital stock of a corporation on the basis of the proportion of the profits of the corporation to which that class gave entitlement, if all the profits were distributed on a winding-up of the corporation,” CRA noted that, here, the USA established a preferential right of the Class A shares to a $5,000 dividend, thereby suggesting that the Class A shares would have an additional $5,000 profits entitlement on winding-up, and then stated:

[T]he Class A common shares of the capital stock of Opco would give the right to a value of $10,333 ($5,000 + (($21,000 - $5,000)/3)). The Class B common shares and the Class C common shares of the capital stock of Opco would be entitled respectively to $5,333 (($21,000 - 5,000)/3)). The $12,000 safe income on hand would then be allocated to each of the classes of common shares based on that value. Thus, the safe income on hand of the Class A common shares before the deemed dividend would be $5,905 ($12,000 × ($10,333/$21,000)) [and $905 after the $5,000 deemed dividend] and the safe income on hand attributable to the other two categories of shares would be $3,047 respectively ($12,000 × ($5,333/$21,000)).

Must a corporation add a s. 110.5 addition to its taxable income in computing its safe income? After stating that

...income "earned or realized," to which subsection 55(2) refers, is the net income, as computed in Division B of Part I.

whereas “section 110.5 provides for an addition to taxable income,” CRA stated:

Consequently, taking into account our interpretation of the word "income" as a starting point for paragraphs 55(5)(b) to (d), that amount would not be included. Paragraphs 55(5)(b) to (d) do not contain any adjustment that would add the amount of taxable income added under section 110.5 to the safe income calculation. Consequently, that amount would not be part of the safe income or "income earned or realized" under those provisions.

Respecting queries on how to calculate the safe income on hand ("SIOH") of a CCPC (Corporation A) that recognized income on a lumpy basis when it made progress billings, CRA noted that the SIOH attributable to a particular share may be based on a holding period that contains two stub periods (the period from the date of acquisition of the share to the first year-end; and the period from the last year-end to the safe income determination time) and that:

[T]he calculation of the SIOH in respect of the "stub" period should generally not be calculated as if an end of a taxation year has occurred at the SIDT but, rather, in proportion to the number of days of the "stub" period in relation to the total number of days in the particular taxation year of Corporation A.

In addition, we agree with your position that the calculation of the SIOH attributable to the shares of the capital stock of Corporation A in respect of a "stub" period must generally take into account the income taxes payable by the corporation and attributable to the "stub" period.

200 Class A shares of Opco held by a shareholder had a safe income on hand ("SIOH") and FMV of $200 and $1,000 per share, respectively, and 100 Class F shares with a SIOH per share equalling their FMV of $1,000. The 200 Class A share are converted under s. 51 into 200 Class F shares.

CRA noted:

[W]here there is a transfer of shares on a rollover basis, as provided for in sections 51, 85, 85.1, 86 and 87, the shares issued during the rollover participate proportionally in the SIOH attributable to the shares exchanged immediately before the transfer

CRA went on to indicate that all the Class F shares following the conversion including the newly issued ones will share proportionately is the SIOH formerly attributed to the exchanged shares, so that their average SIOH per share of the Class F shares is reduced from $1,000 to $600.

The safe income on hand of Holdco, which redeemed shares of Holdco held in a year by “Portco”, was based on the safe income on hand of Opco, which had a non-capital loss (NCL) in that year because it excluded work-in-progress (WIP) from its income for purposes of the Act in that year as that income would not be realized for purposes of the Act until it was billed. The taxpayer’s computation of the safe income on hand of Opco did not deduct the NCL, and instead treated it as a deduction from safe income on hand in the subsequent years to which the NCL was carried forward. In rejecting this approach, the Directorate stated:

[T]he tax loss sustained by Opco in XXXXXXXXXX is not fictitious. That loss instead results from the application of the Act and reflects expenses actually incurred by Opco. Indeed, the fact that an item of revenue recognized at the accounting level can be deducted when calculating the net taxable income of a corporation operating in the construction sector does not detract from the fact that the expenses that create that tax loss have actually been incurred by the corporation. The peculiarity here instead lies in the fact that part of the income invoiced by the corporation will be included in the computation of the net income of the corporation at a later date and cannot therefore be part of the "realized or earned" income of the corporation until that later time. …

The CRA's longstanding position is instead to reduce the safe income on hand by every dollar of expenses that contributed to the loss sustained by the corporation on the grounds that such income is no longer on hand to contribute to the unrealized capital gain on a share.

On January 1 of Year 1, Mr. A (the sole shareholder of Holdco) and Holdco subscribed, respectively, $100 and $900 for 100 Class A voting discretionary-dividend common shares and 900 Class B non-voting non-participating discretionary Preferred Shares on the incorporation of Opco. Only the Class A shares were entitled to participate on any winding-up. In its first five years of operation, Opco realized an annual after-tax profit of $200,000, all of which were annually paid to Holdco as dividends. At the beginning of Year 6, Mr. A sells his Opco shares to an arm’s length purchaser, when Opco’s fair market value is $500,000 (represented by the unrealized appreciation in Opco’s assets). Before this sale, Opco redeems the Class B preferred shares for their PUC of $900.

How should Opco’s safe income on hand be allocated between the two classes of shares? CRA responded:

[B]ased on … 2003-0006305 … and the rights, privileges, conditions and restrictions attaching to the Class B Opco shares (and taking into account in particular that the right to dividends of such Class B shares would be subject to the discretion of the board of directors and that such shares would not give rise to the right to share in the remainder of Opco's assets in the event of liquidation), it is possible that the safe income on hand realized by Opco from the time of the issuance of the Class B Opco shares may be fully allocated to the Class A shares of the capital stock of Opco. This is the position … in … 2002-0158885.

In the course of indicating that, in some instances, it would consider applying ss. 84(2) and 245(2) to tuck-under transactions, CRA stated:

T]he CRA maintains its long-standing position that subsections 84(2) and 245(2) should not apply to a "tuck under" transaction to extract the safe income on hand relating to the interest of a corporate taxpayer in a target corporation … .

The partnership interest (in “SENC,” which holds all the shares of Subco, to which safe income is attributable) of an individual (X) was transferred under s. 85(1) at its adjusted cost base rather than its higher FMV to an unrelated holding corporation ("Holdco") in consideration for Class B preferred shares of Holdco. At the same time, X subscribed for Class A shares and an unrelated family trust subscribed for Class C (participating) shares, of Holdco. Should the safe income attributable to the Subco shares at time of transfer be considered in computing the safe income attributable to the Class B preferred shares in Holdco of X? CRA responded:

[I]t is possible that a portion of the safe income on hand generated by Subco prior to the transfer of the interest held in the partnership may be allocated to the preferred shares of the capital stock of Holdco on a reasonable basis. Furthermore, it is possible that the amount of safe income on hand generated by Subco allocated to the preferred shares of the capital stock of Holdco may vary over time and be replaced by an amount of income earned or realized by Holdco.

For example, the amount of safe income on hand generated by Subco that is allocated to the preferred shares of the capital stock of Holdco at the time of the transfer by the individual could decrease after the transfer if the partnership receives a dividend from Subco in respect of that portion of the safe income on hand generated by Subco or if the partnership realizes a capital gain on the sale of the shares it holds in the capital stock of Subco. On the other hand, Holdco will add its share of the dividend or capital gain to its income by virtue of paragraph 96(1)(f). This income of Holdco will form part of its safe income on hand. We are of the view that any increase in Holdco's safe income on hand resulting from such dividend or capital gain that would arise from Subco's income previously allocated to the preferred shares of the capital stock of Holdco should be considered to form part of the safe income on hand of such preferred shares and should not be added to the safe income on hand in respect of the common shares of the capital stock of Holdco. As such, there would be no duplication of safe income in respect of the same income.

Similarly, if Holdco were to sell its interest in the partnership, Holdco may realize a capital gain and that capital gain would be part of its safe income on hand. It would then be necessary to take into account that a portion of the safe income on hand generated by Holdco would reflect the safe income on hand generated by Subco allocated to the preferred shares of the capital stock of Holdco and to ensure that there is no increase in that portion when computing the safe income on hand in respect of the common shares of the capital stock of Holdco so as to avoid duplication.

Opco has safe income of $2M, which equals the value of its net tangible assets. X does a s. 51 exchange of its Opco common shares (being the only issued and outstanding shares) in exchange for new preferred shares having a $2M value, and for new common shares, having a value of between $1M and $4M, given the uncertain value of Opco’s goodwill and intellectual property. Next:

• X transfers such preferred shares to Newco
• Opco transfers its tangible net assets to Newco in consideration for Newco common shares.
• The shareholdings between Opco and Newco are cross-redeemed.
• X sells its (new) common shares of Newco to a third party based on an earnout clause.

The correspondent submitted that “the safe income of $2M should be allocated to the preferred shares of the capital stock of Opco up to the value of the preferred shares on the basis that the new preferred shares represent the value of the tangible net assets, that they were created to represent the value of those tangible net assets and that the safe income is also represented by the value of the tangible net assets” and, conversely, the new common shares represent “the capital appreciation of the business, i.e., something other than safe income.”

In rejecting this submission, CRA stated:

Assuming that the adjusted cost base of the exchanged common shares was nominal … the value of each class of shares … received on the exchange … would generally represent both a share of income earned or realized by Opco and a share of income not earned or realized …. Accordingly … the new shares issued by Opco would generally share the safe income on hand attributable to the old common shares on the basis of the gain inherent in each of them at the time of the exchange.

The safe income on hand of Opco attributable to the former common shares would therefore … generally be allocated based on the proportion that the unrealized gain inherent in the Preferred Shares at the time of the exchange bears to the total unrealized gain, at the time of the exchange, inherent in the shares received on such exchange.

CRA indicated that 943963 Ontario had essentially confirmed its position in 9711005, which stated:

[W]hen a corporation receives a dividend, part of which is attributable to safe income on hand and part subject to tax under Part IV of the Act, it is not possible to treat the part attributable to safe income on hand as not subject to Part IV tax. Any dividend paid by the payer corporation is considered to be paid first out of the safe income on hand attributable to the recipient corporation's shares of the payer corporation. Where a particular corporation is subject to Part IV tax because a payer corporation is connected with the recipient corporation and the payer corporation receives a dividend refund as a result of the payment of the taxable dividend, by virtue of paragraph 186(1)(b), the Part IV tax will be attributable to the first part of the dividend which is equal to 4 times the dividend refund receivable by the payer corporation. Therefore, the portion of the dividend received by the recipient corporation that would be subject to tax under Part IV of the Act would also include any safe income attributable to the shares of the payer corporation held by the recipient corporation.

Opco, whose shares had always been held by Holdco, acquired an interest in a life insurance policy (the Policy) to insure the life of a shareholder of Holdco, was the owner of the Policy and paid the premiums on the Policy, of which a portion was the savings component that was reflected during this period in the cash surrender value of the Policy. The Policy was subsequently disposed of to Holdco and then, Holdco disposed of all the shares of Opco to an unrelated third party. The Directorate stated:

Opco must deduct in computing its safe income on hand attributable to the shares held by Holdco all amounts paid by it during the relevant calculation period as premiums under the Policy … . However, since the Policy has a cash surrender value … the portion of the premiums paid that did not reduce the gain inherent in the shares of the capital stock of Opco held by Holdco, that was not deducted in computing the net income of Opco pursuant to the Act, and that contributed to the increase in the cash surrender value of the Policy, should not be deducted in computing the safe income on hand of Opco attributable to the shares held by Holdco in the relevant period. Based on the information you have provided to us, this amount is equal to … the ACB of the Policy.

Mr. A, who held ½ of the common shares of Opco having a PUC and ACB of $100, a safe income on hand of $699,900 and a fair market value of $1,000,000, transferred his common shares to a new corporation (“Holdco”) in consideration for common shares of Holdco, with the s. 85(1) agreed amount being $300,000, thereby realizing a $299,900 capital gain for which he claimed the capital gains deduction. Opco then purchased for cancellation for a cash purchase price of $1 million, the 100 common shares held by Holdco, resulting in a deemed dividend of $999,900.

Regarding a submission based on 729658 Alberta that only $300,000 of the deemed dividend would be deemed to be a capital gain, CRA indicated that this situation was different from that considered in 729658 Alberta, and stated:

[T]he safe income on hand attributable to the 100 common shares of Opco held by Holdco (after the transfer by Mr. A) should be approximately $489,900, because a portion of the unrealized capital gain on the 100 common shares of the capital stock of Opco was realized on the transfer of the shares to Holdco.

The Directorate adopted a statement by the Appeals Branch that “the Federal Court of Appeal concluded in Kruco Inc. 2003 DTC 5506 that no adjustment should be made for phantom income, and that all objections and similar appeals pending the conclusion of the Kruco Inc. case should be resolved accordingly.”

A personal trust designated an amount in respect of its sole corporate beneficiary under s. 104(13.1), includes such amount in its income, and then distributes an equivalent amount to such beneficiary. In finding that such amount would not be included in determining the corporate beneficiary's safe income or safe income on hand, CCRA indicated “that ‘safe income’ in respect of a share of a corporation means the net income of the corporation, determined in accordance with the Act and adjusted by paragraph 55(5)(b), (c) or (d) … that is attributable to that particular share during the holding period” so that, as the amount distributed to the corporation would not be included in its income by virtue of the operation of s. 104(13.1), such amount could not be included in its safe income. Furthermore, the reference to safe income earned by “any corporation” could not justify the consolidation by the corporation of the income of the trust for safe income purposes as the latter was not a corporation.

Investco subscribed for a convertible debenture of a wholly-owned subsidiary (Opco) of Portfolioco and, two years’ later, converted the debenture in accordance with the agreed conversion ratio into common shares of Opco at a time that the common shares of Opco had appreciated. Could any portion of the safe income on hand realized by Opco during the two-year period be attributed to Investco as a result of its acquisition of common shares of Opco? CCRA responded:

[I]n [such] a situation … a person who acquired shares of a corporation upon the exercise of the person’s conversion right under the terms of a convertible debenture could generally participate in the safe income on hand earned by the corporation from the time of the issuance of the debenture as if the person had acquired the person’s shares of the corporation at the time of the issuance of the debenture.

Where a dividend equal to the total amount of safe income on hand of the corporation is paid on only one of its outstanding classes of discretionary common shares: (i) would the total amount of safe income on hand of the corporation be considered to be attributable to that class of shares; and (ii) could the total amount of safe income on hand of the corporation, if so attributed to that single class of common shares to the extent that the safe income was realized prior to the issuance of the shares of that class?

Regarding the first question CCRA indicated that the determination of the safe income attributable to a particular class was a question of fact, that the fact of a dividend being paid on the shares of one class of discretionary shares is not, in itself, determinative of the safe income attributable to the shares of that class, and noted that Nassau had considered CCRA’s pro rata allocation method to be reasonable.

Regarding the second question, CCRA indicated that generally a share participates in the safe income on hand of a corporation, based on its entitlement to participate in the income of the corporation earned during the "holding period" of the share, i.e., from the time it is acquired to the day of the safe- income determination time.

Two brothers each holding half of the shares (being common shares) of Opco, formed respective Holdcos, which subscribed for one newly-created Class F share of Opco. The Class F shares were non-voting, non-participating on a winding-up and entitled to any dividend as declared in the discretion of the Board.

In discussing what safe income on hand (SIOH) of Opco should be allocated to the Class F shares, CCRA indicated that, having regard to the discretionary nature of the dividends and the non-participation on a winding-up, it was possible that all of the SIOH for the period commencing with the issuance of the Class F shares and before the safe income determination time should be allocated to the common shares. However, it was also possible that the payment of dividends on the Class F shares would not result in a significant reduction described in s. 55(2) - but such dividends would reduce the capital gain that could be realized on the common shares and, thus, the SIOH attributable to them.

Opco paid a $50,000 dividend to wholly-owning Holdco on June 29, 2000 and then was disposed of on July 1, 2000 to a third party, thereby causing a stub taxation year to end on June 30, and s. 111(5.1) to apply to generate a loss of $15,000 on Opco depreciable property (also recorded in the financial statements). Opco’s cumulative safe income to December 31, 1999 was $45,000 and for the stub year was $5,000 ignoring s. 111(5.1). In finding that Opco’s safe income on hand at the safe income determination time (June 29) should be reduced by the s. 111(5.1) write-down, CCRA referred to the statement in the 1988 Robert Read paper that:

If it is reasonable to expect that any of the income earned or realized in a stub period will be offset by losses in the remainder of the year, then the calculation of the safe income on hand for the stub period should reflect the anticipated losses, since that income could not reasonably be considered to be reflected in the inherent gain in the shares.

CCRA then stated:

[T]he income earned on hand attributable to the Opco shares immediately before the "safe income determination time" could amount to $35,000, plus the notional amount of refundable taxes if there were a carryback of the $10,000 loss realized in the taxation year ending June 30, 2000 (a notional amount that it seems reasonable to consider as contributing to the capital gain on the shares).

… [T]he potential deduction resulting from the application of subsection 111(5.1) would affect not only the safe income on hand earned by the corporation during the period from January 1 to June 29, 2000 ($5,000 in your example), but all of the corporation's cumulative safe income on hand immediately before the "safe income determination time" (including the amount of $45,000 …).

The Directorate indicated that where a public corporation repurchased some of its shares on the open market such that there was no deemed divided by virtue of s. 84(6)(b), the safe income on hand of the shares that remained outstanding was not reduced by any premium it paid over the repurchased shares’ paid-up capital. It noted that the 1984 Hiltz paper had taken a similar position regarding private company redemptions.

A freeze transaction entailed all of the (1,000) Class A Opco common shares held by Holdco with a FMV of $10 million and a safe income on hand of $8 million being exchanged under s. 51 for 10,000 Class B non-cumulative redeemable preferred shares having the same nominal PUC and ACB. Immediately thereafter, Opco issued 1,000 new Class A shares to Holdco for a nominal amount: 900 shares to Holdco and 50 shares each to two Opco employees. CCRA indicated:

• Regarding a redemption of the 10,000 Class B shares during 2001 for $10 million, CCRA would generally consider “the redemption of the preferred shares is part of a series of transactions that includes the exchange of shares and the acquisition of new participating shares as part of the freeze” and that both the 1998 acquisition of the Class A participating shares under the freeze, and the 2001 redemption of the Class B preferred shares effected significant increases in holdings covered by s. 55(3)(a)(ii).
• “Where participating shares are exchanged for preferred shares having a FMV and a redemption value equal to the FMV of the participating shares, and because of the application of subsection 51(1) to the exchange, the ACB of the preferred shares is equal to the ACB of the exchanged participating shares, then the portion of the income earned on hand attributable to the participating shares immediately before the exchange is transferred to the preferred shares” – so that $8 million safe income of the Class A shares transferred to the 10,000 Class B shares.
• Since the dividends on the Class B preferred shares were non-cumulative, the capital gain that would be realized on a disposition of the participating Class A and, thus, the safe income attributable to the Class A shares, would only be reduced in respect of dividends on the Class B shares as and when such dividends were declared and paid.

An Opco whose shares, being common shares, are equally owned by two individuals (A and B) engages in a purification transaction (to qualify as a small business corporation) pursuant to which they transfer a portion of their common shares on a s. 85(1) rollover basis to their respective new Holdcos, whose Opco common shares are exchanged under s. 51 for redeemable preferred shares. To extract Opco excess cash, the stated capital of the preferred shares (producing s. 84(1) deemed dividends and ACB increases) and the resulting PUC is distributed in cash.

CCRA stated:

In general, where common shares are exchanged for preferred shares having a FMV and a redemption value equal to the FMV of the common shares, and an election is made pursuant to subsection 85(1) for which the agreed amount is the ACB of the common shares, the portion of the safe income on hand attributable to the common shares immediately before the exchange is transferred to the preferred shares.

Consequently, the s. 84(1) deemed dividends received by the Holdcos came out of safe income.

If rather than exchanging their Opco common shares for preferred shares, the Holdcos subscribed for Opco preferred shares, there would be no such safe income transfer to the preferred shares.

CCRA confirmed that a corporation’s safe income for the year of its acquisition of a depreciable property is unaffected by an investment tax credit deducted in computing its tax payable for the year, whether the regular ITC under s. 127(5), or the refundable ITC under s. 127.1, and noted that the ITC reduces the capital cost of the property in the subsequent year pursuant to s. 13(7.1)(e).

How is the safe income allocable to shares of a public company acquired on the exercise of options by a minority shareholder (Holdco) computed where an amount was included in the Holdco’s income pursuant to s. 15(1) when the options were granted (resulting in an increase in the cost of those options pursuant to s. 52(1))?

CCRA indicated that since the cost of the shares acquired by Holdco on exercise of the options was increased by the amount of the adjusted cost base of the options pursuant to s. 49(3)(b)(ii), only a portion of the safe income on hand that would otherwise be allocable (without the cost increase) to the acquired shares (as described in 1999-0011695) could reasonably be considered to be allocable to those shares since the effect of the cost increase was to reduce any unrealized capital gain on the acquired shares.

If Holdco purchases Opco at a time when Opco has unrealized appreciation in certain assets such as inventory or capital property, gain from a subsequent sale of such asset will not increase the safe income attributable to the shares of Opco held by Holdco. However "notwithstanding the above, and as a practical matter, normally we do not require a detailed analysis of all the elements making up the capital gain on a share as long as safe income on hand is computed pursuant to our published guidelines".

A public corporation (Pubco) granted options on its shares to a minority shareholder (Holdco). Between the time of such granting of the option and its exercise, Pubco paid a dividend on all its shares.

Regarding the allocation of safe income of Pubco to the “new shares” acquired on exercise of the option, the Agency confirmed its position in the 1988 Read paper that where a person acquires an option to purchase shares of a corporation, for purposes of computing the safe income attributable to the new shares, the person is considered to have acquired the new shares at the time of acquisition of the option, so that some portion of any income earned by the corporation after its issuance of the option will accrue to the unexercised options rather than to the existing shares, and so that a gain inherent in the new shares may be referable to income earned by the corporation before the option was exercised. The Agency then confirmed that there would be a pro rata reduction for any such safe income attributed to the new shares based on the dividend that was declared and paid in the interim period.

Discussion of allocation of safe income when shares of a corporation are exchanged on a rollover basis for more than one class of shares.

Where a corporate shareholder transferred public company shares to a new holding company pursuant to s. 85(1), the safe income on hand of the shares of the new holding company would ordinarily include the safe income on hand attributable to the public corporation's shares even if no significant influence is exercised over the public corporation. CCRA stated:

[I]n computing the safe income of a corporation, the shares of a corporation over which the shareholder corporation exercises significant influence should be consolidated and the shares that represent portfolio investments should not be consolidated. However, Mr. Michael A. Hiltz ... [in] "Section 55: An Update" in the 1984 Conference Report ... [stated]:

"...., the Department is prepared to make an exception in cases where a corporation does not exercise significant influence, if it can be clearly demonstrated (emphasis added) that the income of the other corporation contributed to the unrealized gain on the shares."

Discussion of proration formula for determining safe income where an individual realizes a capital gain of $100,000 in connection with bumping the ACB of her shares, then rolls her shares into a holding company in whose hands the shares are redeemed.

Safe income on hand will flow through on an s. 107(2) rollover in a similar manner to rollovers effected under ss.51, 85, 85.1, 86 and 87.