Sub nom "Aside from that Mrs. Lincoln, how did you enjoy the play?"
There has been much discussion lately about the proposed changes to Section 55 of the Income Tax Act (the "Act").
The proposed changes were introduced in 2015 and in the 2016 Budget the Government indicated its plan to move ahead with the changes. The changes will apply to any dividends paid after April 21st, 2015.
Section 55 is an anti-avoidance provision that is intended to prevent "capital gains stripping" through the payment of intercorporate dividends. Where the provision applies, subsection 55(2) operates to convert an otherwise tax-free intercorporate dividend into a (taxable) capital gain.
There has been a longstanding exception to the application of section 55 in the case of dividends paid between related corporations. Under the existing rule, it is possible to pay cash dividends or to spin-out assets to related corporations without having to consider whether subsection 55(2) would apply to convert dividends into capital gains. Further, in order to run afoul of Section 55, the dividend had to be part of a series of transactions ending in an arm’s length sale – if there was no sale transaction contemplated, the dividend would be safe (this is a bit overly simplistic, but the gist of it is correct). The Draft Legislation proposes to limit this exception only to deemed dividends between related corporations arising by virtue of the redemption, acquisition or cancellation of shares of the dividend-paying corporation. Ordinary cash dividends paid to a related corporation will not qualify for the related-party exception under the Draft Legislation. Accordingly, the payment of cash dividends within a related corporate group will now have to take into account the potential application of section 55 to the intercorporate dividends.
Under the proposed rules, a cash dividend received by Holdco could be recharacterized as a capital gain if the amount of the dividend exceeds the "safe income" of the payor corporation. "Safe income" is the post-1971 after-tax retained earnings determined on a tax basis (and subject to certain adjustments in the Act).
Accordingly, it will now be necessary to perform safe income calculations in most cases where cash dividends are paid between related corporations. If the amount of a dividend might (or would) exceed safe income, then it will be necessary to redeem or purchase for cancellation the Opco shares held by Holdco so as to result in a deemed dividend to fit within the more narrow related party exception in paragraph 55(3)(a) of the Act.
In many related party corporate groups, a corporation may hold a nominal value share (a so-called "skinny" share) to enable dividends to be paid within a corporate group in a flexible manner. Under the new rules, inter-corporate dividends on these shares will be subject to the rules in Section 55. Accordingly, it will be necessary to review all of our clients’ structures where we have used skinny shares between the corporations. If we are fully satisfied that a dividend paid in respect of the skinny shares will satisfy the purpose tests, discussed below, then dividends can continue to be paid in respect of those shares. However, until the Courts have commented on the CRA view of the purpose tests, this is a risky proposition.
For those clients with professional corporations, where we have been issuing skinny shares to a side company and then redeeming those shares to strip the excess cash out of the professional corporation, we will need to re-structure these transactions. Unfortunately, this will mean additional accounting and legal costs for our clients. But, especially for our dentist clients, the game will be worth the candle. If the professional corporation ceases to qualify for the capital gains exemption as a result of having too much accumulated cash, each shareholder who might otherwise claim an $800,000 (indexed) tax free capital gain will now pay approximately $215,000 of tax.
New Purpose Tests
There are other significant changes to section 55 under the Draft Legislation, including the expansion of the "purpose" tests. Under the Draft Legislation subsection 55(2) will now apply if one of the purposes of a dividend is to effect: (1) a significant reduction of the fair market value of any share; or (2) a significant increase in the cost of property owned by the dividend recipient.
In its commentaries, CRA has expressed its view that in a basic creditor proofing situation, the rules in Section 55 may apply.
It is difficult to know how the purpose tests will ultimately be interpreted by the Courts. It is likely that the CRA view will not be upheld in its entirety.
At the CRA Roundtable in November, 2015, the CRA made the following statements:
The CRA said that where a dividend is paid pursuant to a well-established dividend policy and the amount of the dividend does not exceed a reasonable dividend return on equity on a listed share issued by a comparable corporation in the same or similar industry, the purpose of the dividend would not be described in proposed paragraph 55(2.1)(b)
In response to a panel question as to whether the CRA would consider the payment of an annual dividend to distribute cash flow to fall under a well-established dividend policy, the CRA said that from a tax policy perspective a normal course dividend should not be subject to subsection 55(2)
However, the CRA acknowledged that there is no definition of what constitutes a "normal course" dividend.
CRA Round Table - November 2015 - Creditor Proofing
CRA Response
We [the CRA] understand that a creditor-proofing transaction could be achieved by having Holdco lend money to Opco either before or after the payment of the dividend. When Opco pays a "lumpy" dividend such as in this creditor-proofing transaction in order to significantly reduce the value on the Opco shares, the apparent purpose of the payment of the dividend for the application of subsection 55(2) is to reduce the value on the Opco shares. When such purpose is present, subsection 55(2) applies to the dividend.
From the two excerpts above there are a couple of observations. The CRA is prepared to accept a dividend paid pursuant to a well established dividend policy. This makes good sense. However their caveat that the dividend not exceed a reasonable return on a listed share in a similar industry is ludicrous. One would hope that the Courts will see it as improper, but it will take time for this matter to get before the Courts.
The CRA also said that an annual dividend to distribute cash flow would not be subject to subsection 55(2). But then they go on to say that a "lumpy" dividend such as one that might be paid in a creditor proofing transaction would be subject to subsection 55(2). I believe that these two statements are inconsistent.
Although not definitive, I believe that it will be important to fully set out the "purpose" of a large dividend that is paid, particularly as part of a creditor proofing transaction.
Recommendations
Based upon the discussion above I would make the following recommendations:
It is crucial that our clients’ minute books be brought up to date, and kept up to date, to reflect all share redemptions and accurate shareholdings and, especially, to reflect all dividends declared prior to April 21st, 2015;
An accurate history should be prepared outlining the dividends paid annually by Opco to Holdco and the level of cash reserves retained in Opco. I would suggest a resolution of the Directors reflecting this history and stating their intention to continue with their policy of paying out any excess cash flow;
A Safe Income calculation be completed for Opco. Although retained earnings are not fully determinative of the safe income amount, they certainly gives a good indication as to whether there is safe income. Once completed to date, the cost and effort of keeping the safe income calculations up to date will not be onerous – but for most clients these records have not been kept and there will be a significant accounting cost involved initially;
Any further dividends should not be paid in respect of skinny shares until we see the Court’s opinions on the purpose tests;
When large dividends are to be paid, it will be necessary for the common shareholders to roll over a portion of their common shares of Opco into Holdco and then those shares should be repurchased for cancellation to trigger deemed dividends up to the amount of safe income on hand. To continue this it may require either stock dividends or stock splits to conveniently increase the numbers of shares owned by the common shareholders. Again, once we see the Court’s opinions on the purpose tests we can re-visit this.
I look forward to working with you to determine the best policies for our mutual clients.