Canada: Selected Safe Income Issues: Relevant Period, Global Computation And Allocation

A. INTRODUCTION

This is one of two papers covering subsection 55(2) presented at the 2017 Canadian Tax Foundation (CTF) Prairies conference. The other paper, written by Anthony Strawson, discusses planning techniques practitioners could consider in order to manage s.55(2).¹

One of the most alarming legislative changes impacting tax practitioners in recent years was the substantial overhaul of subsection 55(2), which applies to inter-corporate dividends received after April 20, 2015. The amendments greatly broadened the reach of subsection 55(2) primarily due to the addition of two new purpose tests and the restriction of the paragraph 55(3)(a) related party exception to only subsection 84(2) or (3) deemed dividends. Rather than attempt a comprehensive discussion of subsection 55(2),² this paper will focus on certain aspects of the safe income exception in paragraph 55(2.1)(c) which is the only objective safe harbour in dealing with revised subsection 55(2).

1. The Safe Income On Hand Exception

The underlying concept of safe income is that once corporate income has been taxed, corporations should be able to pass that income amongst themselves on a tax-deferred basis (subject to Part IV tax). Accordingly, paragraph 55(2.1)(c) provides that a dividend is not subject to subsection 55(2) if the amount of the dividend does not exceed an amount that is:

• the income earned or realized by any corporation, after 1971 and before the safe-income determination time (SIDT) for the series, and
• that could reasonably be considered to contribute to the shareholder's hypothetical capital gain on the share from which the dividend is received, at the moment immediately before the dividend.

The first part, the "income earned or realized by any corporation ..." is often referred to as "safe income", and this amount represents corporate income that has been subject to tax, modified by adjustments in paragraphs 55(5)(b), (c) and (d). This paper uses the terms "income earned or realized" and "safe income" interchangeably.

The second part, the amount of safe income that must reasonably be considered to contribute to a hypothetical capital gain, is often referred to as the "safe income on hand" or "SIOH" – being the safe income that needs to remain "on hand" in order to contribute to a gain. The original purpose for this is best understood by referring to subsection 55(2) as it read before April 21, 2015. The application of old subsection 55(2) was based on there being a reduction of capital gain of a share. However, old subsection 55(2) would only apply if the capital gain being reduced could reasonably be considered to be "attributable" to anything other than "income earned or realized". Therefore, for this exception to apply under the old rules, it was necessary that such "income earned or realized", i.e. safe income, must remain "on hand" for it to be attributable to the value, and thus the capital gain, of a share. This concept is retained under the current legislation through paragraph 55(2.1)(c), which provides that subsection 55(2) only applies if the inter-corporate dividend exceeds the income earned or realized that could reasonably be considered to "contribute" to a hypothetical capital gain. Income earned or realized that is no longer on hand to reasonably contribute to a hypothetical capital gain cannot protect a dividend against subsection 55(2).

Whether a capital gain could reasonably be considered to be "attributable" to safe income is arguably substantially the same as whether an amount of safe income can reasonably "contribute" to a capital gain. Indeed, according to the Department of Finance's technical notes, the change in wording was merely intended to accommodate the new purpose tests added to paragraph 55(2.1)(b). However, a subtle difference may exist between the two versions which may be relevant in some circumstances as discussed later in the paper.

Also, paragraph 55(2.1)(c) must now be read in conjunction with paragraph 55(5)(f). Prior to the amendments, paragraph 55(5)(f) allowed the filing of a designation to carve a single dividend into a series of smaller dividends, in order to protect against subsection 55(2) re-characterizing an entire dividend if SIOH happens to be less than the total amount of the dividend. Effective April 21, 2015, paragraph 55(5)(f) applies automatically to split a dividend that exceeds SIOH into two separate dividends: a dividend equal to the amount of the SIOH, and another dividend equal to the remainder. The former is protected by the safe income exception; the latter is subject to re-characterization under subsection 55(2) if one of the purpose tests in paragraph 55(2.1)(b) is met.

On the one hand, the automatic application of paragraph 55(5)(f) simplifies tax filings as a designation is no longer required. On the other hand, SIOH computation has become more important as the automatic application of paragraph 55(5)(f) suggests that a dividend must always first be applied against SIOH.³ Of course, the limitation of the paragraph 55(3)(a) exception and the subjective nature of the new purpose tests also made the SIOH exception, which is relatively objective, a lot more applicable than before.

A full review of the computation and allocation of SIOH is beyond the scope of this paper. Instead, this paper reviews two key areas often faced by practitioners when dealing with the safe income exception:

• The relevant period for calculating SIOH;
• Computation of "global" SIOH, and allocation of SIOH to different shares and shareholders.

A common theme prevalent in these discussions is that most of the guidance around SIOH is derived from the CRA's administrative practices, the core of which comes from the so-called "Robertson Rules" which are the framework and guidance set out by John R. Robertson (then the head of the Rulings Directorate) at the CTF 1981 annual conference,⁴ and later updated by other CRA officials. While these CRA's administrative practices are not law, and in some cases, may even appear inconsistent with judicial decisions, tax practitioners generally follow these administrative practices when dealing with safe income to avoid disputes with the CRA. Even then, these CRA administrative practices are sometimes not 'crystal clear' when they need to be applied in practice.

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Originally published by Canadian Tax Foundation.

Footnotes

1. [ADD REFERENCE TO ANTHONY'S PAPER]

2. The following are a few of the Canadian Tax Foundation papers discussing subsection 55(2): Rick McLean, "Subsection 55(2): What Is the New Reality?," Report of the Proceedings of the Sixty-Seventh Tax Conference, 2015 Conference Report (Toronto: Canadian Tax Foundation, 2016), 22:1-71; Ron Dueck, Janette Pantry and Rosanna Lau, "Subsection 55(2): Practical Applications" 2016 British Columbia Tax Conference (Toronto: Canadian Tax Foundation, 2016), 10: 1-38; Kim G.C. Moody and Kenneth Keung, "Subsection 55(2) - The Road Ahead" 2016 Prairie Provinces Tax Conference (Toronto: Canadian Tax Foundation, 2016), 10: 1-43;Rick McLean, "Subsection 55(2) Amendments: What's the Purpose?," 2016 St. John's Tax Seminar (Toronto: Canadian Tax Foundation, 2016), 2:1-48; Marissa Halil, Alex Ghani, and Manu Kakkar, "Is Safe Income Really Safe?" 2016 Ontario Tax Conference (Toronto: Canadian Tax Foundation, 2016), 10: 1-27.

3. Automatic application of paragraph 55(5)(f) also prevents historical planning that relies on intentionally not filing paragraph 55(5)(f) to trigger capital gains as a result of the application of subsection 55(2) on the otherwise safe income portion of a dividend.

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

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