Intercorporate dividends are traditionally a very common tool for tax planning.

A common corporate structure involves an individual owning all of the shares of a corporation (the "Holding Corporation") that owns all of the shares of a corporation that carries on an operating business (the "Operating Corporation"). After each taxation year, profits earned by the Operating Corporation may be paid as dividends on the shares owned by the Holding Corporation.

Several advantages arise under the Holdco-Opco annual dividend payment strategy. First, to the extent actual cash is paid by the Operating Corporation to the Holding Corporation, a form of 'creditor protection' arises; the cash received by the Holding Corporation is 'shielded' from the liabilities arising in the business carried on by the Operating Corporation. The 'corporate veil' in the Holdco-Opco structure acts as a deterrent for a creditor, or claimant; as the cash is 'owned' by the Holding Corporation, the creditor cannot gain access to that property, as it is not owned by the Operating Corporation. Second, for various income tax reasons, it is advantageous to keep the assets of the Operating Corporation principally in an active business and to separate out funds which will be invested outside of the active business. Third, the dividends received by the Holding Corporation do not have to be paid out immediately to individuals, who are required to pay income tax on these dividends. This results in a 'deferral' of income tax, as intercorporate dividends are often not taxed when received by the Holding Corporation. This is because, pursuant to subsection 112(1) of the Income Tax Act (the "Act"), the Holding Corporation is usually eligible for a deduction equal to the amount of the dividend.

However, as part of the federal government's 2015 budget, the Minister of Finance proposed certain amendments to section 55 of the Act, effective April 20, 2015. While the Canada Revenue Agency (the "CRA") has not yet provided any significant comment on the application of the proposed amendments, initial analysis suggests these amendments mean strategies that relied on the tax-free intercorporate dividend deduction to defer taxable income, may now have the devastating tax consequence of being a taxable capital gain.

Section 55: The basic rules and some of the issues with the amendments

The proposed amendments to subsections 55(2) and (2.1) of the Act are designed to address the issue of 'surplus stripping' by potentially converting a tax-free intercorporate dividend into a capital gain if:

i. one of the purposes of the payment or receipt of the intercorporate dividend is to effect a significant reduction in the portion of the capital gain, that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend, or

ii. the dividend is received on a share that is held as capital property by the dividend recipient and one of the purposes of the payment or receipt of the dividend is to effect a significant reduction in the fair market value of any share, or a significant increase in the cost of the property of the dividend recipient immediately before the dividend.

The most obvious issue with the new legislation is that it appears to be broader than the previous subsection 55(2). Without going into details about the old legislation, given that it will be difficult to argue that one of the purposes of any dividend is not to effect a significant reduction in the fair market value of the dividend-paying corporation's shares, the new wording suggests that any intercorporate dividend which would be tax-free except for section 55 will be turned into a taxable capital gain unless another provision exempts the application of subsection 55(2).

Further, the new section 55(2) is harsher. Pursuant to subsection 84(3) of the Act, the amount paid above the paid up capital when redeeming shares is deemed a dividend. The old legislation allowed the cost base of redeemed shares to be taken into account in determining the deemed capital gain.  The new legislation turns the entire dividend amount into a capital gain. As a result, if a corporation acquired the shares at a cost above the paid up capital of the shares, the difference will be included in the taxable capital gain, and the after tax income used to buy those shares will be taxed a second time.

Given the above, in the absence of a comprehensive judgment of the Tax Court of Canada interpreting the proposed amendments, or a precise statement by the CRA regarding their administrative policy that otherwise limits our perceived application of 55(2), we would recommend that intercorporate dividends only be paid when a provision applies to exempt such intercorporate dividends from the application of subsection 55(2).

Please note, beyond the amendments discussed above, there were also several amendments which impact stock dividends. We will not be addressing those amendments for the purposes of this article. However, any corporation paying intercorporate stock dividends should review the plan with a tax advisor.

Exceptions to subsection 55(2)

There are two main exceptions to the application of subsection 55(2). The first is subsection 55(2.1)(c), which provides that 55(2) does not apply to dividends which are paid out of what is referred to as "safe income".

Safe income is income earned by the Operating Corporation which was subject to income tax in the Operating Corporation. It starts with the Operating Corporation's net income for tax purposes and is then subject to various additions and deductions to take into account transactions which would affect the Operating Corporation's cash levels. While it may appear to be similar to retained earnings for accounting purposes, there are significant differences between accounting financial statements and tax legislation: as such, the two numbers can end up being substantially different. Calculating safe income is complicated enough that it should be done by a tax professional.

The second exception traditionally relied upon is paragraph 55(3)(a) which exempted dividends paid to related corporations. However, paragraph 55(2)(a) now only applies to dividends under subsection 84(3), meaning deemed dividends as a result of a share redemption.

The purpose of this proposed amendment is not entirely clear, as it is difficult to determine the precise nature of the perceived abuse that is being addressed; it appears to be relatively straightforward to simply add extra steps to ensure all related party dividends result from share redemptions. However, this change does mean normal intercorporate dividends to move excess cash up from an Operating Corporation to a Holding Corporation are more risky. At this point we would recommend that no intercorporate dividends be paid unless the parties are confident that the Operating Corporation has enough safe income to cover the dividend or the transactions are structured in such a way that the dividends are as a result of a share redemption.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.