Corporate Taxation of Dividend Income – We Scare Because We Care

Corporate Taxation of Dividend Income – We Scare Because We Care

The title of a recent presentation by the Welch LLP tax group to our accounting colleagues borrowed the tag line, We Scare Because We Care, from the movie Monsters Inc.Our goal was to highlight modified rules impacting inter-corporate dividends. We shared the concern that certain inter-company dividends, which were not subject to tax in the past, may now be taxable. The effect may have been to scare our colleagues, however we were doing so because we care about our clients. We also enjoy scaring our accounting colleagues, however this was not the main purpose of the presentation.

Overview

The changes relate to section 55 of the Income Tax Act (the “Act”) and apply to dividends paid after April 20th, 2015. There was some uncertainty with respect to the new rules when they were first proposed by virtue of a consultation process between the tax advisory community and the Minister of Finance. Tax advisors expressed concern with the broad scope and unintended consequences of the new rules and were optimistic that Finance would restrict the scope of the changes. However, the changes to section 55, when enacted, implemented the rules as originally proposed.

Our tax regime provides an opportunity for business income, which has been subject to corporate tax, to move up a corporate chain via dividends, without additional corporate tax. Personal tax is incurred when dividends are paid to individual shareholders. We arrive at this result because a corporation deducts Canadian dividend income in the computation of its taxable income. This deduction, when applicable, means that corporations do not pay regular corporate tax, referred to as Part I tax, on Canadian dividend income. Notwithstanding that a dividend is not part of a corporation’s taxable income, a corporation may be subject to refundable tax with respect to dividend income – this refundable tax is known as Part IV tax, which we discuss below.

Subsection 55(2) of the Act can convert a tax-free dividend to a capital gain for the dividend recipient. The policy objective is to eliminate inappropriate surplus stripping which we can highlight with the following example. If a buyer agrees to purchase shares of an operating company (“OpCo”), held by a holding company (“HoldCo”), for $2 MM, we could avoid tax on the capital gain via the following steps:

  • OpCo declares and pays a $2 MM dividend to HoldCo. If OpCo does not have $2 MM, then it would satisfy the dividend by issuing a promissory note payable to HoldCo for $2 MM.
  • HoldCo is not subject to tax on the dividend.
  • The $2 MM dividend reduces the value of the OpCo shares by $2 MM.
  • The buyer advances $2 MM to OpCo which is used to pay the $2 MM promissory note owing by OpCo to HoldCo.
  • The buyer pays a nominal amount to acquire the OpCo shares held by HoldCo.

The effect of the planning is the avoidance of a $2 MM capital gain by virtue of shifting value from OpCo to HoldCo via a tax-free dividend. This is a tax-deferral because personal tax will arise when the $2 MM is distributed by HoldCo to individual shareholders. Both the old and current version of subsection 55(2) would apply to the planning with the effect that some or all of the tax-free dividend would be converted to a capital gain.

The Old Rules

Under the old rules, subsection 55(2) applied where one of the purposes of a dividend was to effect a significant reduction in the capital gain that would be realized on the disposition at fair market value (“FMV”) of any shares of the dividend payor. A large dividend payment by a corporation, for example, significantly reduces the FMV of its shares, as cash has been extracted from, or a liability created on the declaration of the dividend by the corporation. If subsection 55(2) applies, the tax-free inter-corporate dividend is re-characterized as a capital gain and will be subject to tax in that year of receipt.

Under the old rules, subsection 55(2) would not apply to the dividend if one of following exceptions applied:

  • Dividend paid out of “safe income” – To the extent there is sufficient safe income attributable to the shares on which the dividend is paid, subsection 55(2) would not apply. In simplified terms, safe income is the accumulated retained earnings of the company as computed for tax purposes and that is attributable to the shares on which the dividend is paid. We discuss safe income in more detail below.
  • Related party exemption – As long as there has not been a significant increase in the total direct interest(s) in a corporation by an unrelated party, subsection 55(2) would not apply. For purposes of subsection 55(2), related parties include spouses, children, and parents, but do not include siblings, uncles, aunts, nieces or nephews. This exemption is often relied upon in implementing related party corporate reorganizations. The related party exception is in paragraph 55(3)(a) of the Act.
  • Arm’s-length split-up “Butterfly reorganizations” – These reorganizations allow arm’s-length shareholders to divide their interests in the underlying assets of a corporation on a pro rata basis. To effect such a reorganization, strict conditions must be met in accordance with paragraph 55(3)(b) of the Act.

The New Rules

The new rules retain the essential framework of subsection 55(2), however broaden the circumstances when the provision may apply. For example, the paragraph 55(3)(a) exception now only applies with respect to a dividend realized on a share redemption. This is problematic because most inter-corporate dividends are not by virtue of a share redemption and instead are a payment of dividends on issued common or preference shares.

The wording of the new purpose test, which is contained in proposed subparagraph 55(2.1)(b)(i) of the Act, has been amended to include both the payment and the receipt of the dividend. That is, the dividend must be examined from the perspective of both the dividend payor and the dividend recipient to determine if the dividend will be deemed to be a capital gain. It is also important to note that the purpose test which determines when subsection 55(2) applies is a reference to one of the purposes of the payment or receipt of a dividend. The scope of subsection 55(2) would be reduced if instead the reference was to the main purpose of the payment or receipt of a dividend – unfortunately this is not the case. We can have a valid non-tax reason for paying dividends, for example we are paying dividends from OpCo to HoldCo to engage in proactive creditor proofing, however one of the separate purposes of the dividend may be a reduction of the FMV of OpCo shares such that 55(2) is applicable.

The Canada Revenue Agency has provided some guidance with respect to the purpose test and has introduced the notion of normal course dividends, which is not a defined term. The CRA’s comments on the subject are as follows:

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 payor 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).

The CRA’s thought process was that:

Although a dividend on a share would normally result in a reduction of value of the share, or an increase in cost of property of a dividend recipient, it’s not the result that determines the application of proposed subsection 55(2.1). It’s the purpose and the motivation behind the purpose that could be established by finding the answer to questions such as:

  • What does the taxpayer intend to accomplish with a reduction in value or increase in cost?
  • How would such reduction in value or increase in cost be beneficial to the taxpayer?
  • What actions did the taxpayer take in connection with the reduction in value or increase in cost?

A challenge with CRA’s guidance is that we do not have a specific framework to determine whether or not dividends paid are normal course dividends. We need to be concerned with what are sometimes referred to as lumpy dividends, i.e. material dividends that are paid at irregular intervals, which are not in the nature of a rate of return on shares, and do not follow a fixed or discernible pattern. Such lumpy dividends are frequently paid by private company groups.

Safe Income

The implication of the new rules is that reliance on the safe income exception may be essential to the avoidance of subsection 55(2). Safe income is generally the cumulative after-tax income retained within a corporation that is responsible for all or part of a gain on a share. The retained earnings of a corporation reported on its financial statements may be a general proxy for safe income. A safe income dividend may be paid on a share without resulting in the application of subsection 55(2). If any part of an inter-corporate dividend is attributable to something other than safe income, then subsection 55(2) would apply subject to any other exceptions. The policy rationale is clear – income that has been subject to corporate level tax may pass between taxable Canadian corporations in the form of a dividend without tax.

The rules in section 55 provide a mechanism to bifurcate a dividend when part of the dividend is paid out of safe income and part is not. Returning to our OpCo $2 MM dividend example, if the OpCo shares held by the HoldCo had $1.2 MM of safe income, then such amount would not be subject to subsection 55(2). In other words $1.2 MM of the dividend would be a tax-free inter-corporate dividend, whereas $800,000 would be a capital gain pursuant to subsection 55(2). The bifurcation of the dividend is imposed by paragraph 55(5)(f) of the Act; the provision was previously elective, whereas paragraph 55(5)(f) is now automatic.

The Benefits of Subsection 55(2)

When subsection 55(2) applies, the recipient corporation is subject to tax on the dividend in the form of a capital gain with the result that ½ of the gain is subject to tax and the other ½ is not subject to tax and added to the recipient corporation’s Capital Dividend Account (“CDA”). The application of subsection 55(2) may lead to a beneficial result for corporate groups that intend to declare dividends to individual shareholders because subsection 55(2) leads to a lower cumulative tax burden. This is illustrated in the following table:

Top rate on non-eligible dividends 45.3%
Inter-corporate dividend taxed as a capital gain per 55(2) $100.00
HoldCo tax on capital gain [$100 x ½ x 50.2%] -25.10
Refundable tax to HoldCo [$100 x ½ x 30.7%]      15.35
Cash dividend to be paid by HoldCo $90.25
Tax-free CDA dividend to HoldCo shareholder 50.00
Non-eligible dividend to HoldCo shareholder 40.25
Personal tax on non-eligible dividend [$40.25 x 45.3%]      -18.23
Personal after-tax funds      $72.02
Effective tax rate by virtue of capital gains treatment 27.98%
Our illustration is based on the top personal tax rates for a resident of Ontario. The same logic would also apply to shareholders with lower effective tax rates, however the numerical results would be different. The key conclusion should still be that less cumulative tax is incurred because ½ of the 55(2) gain is not subject to corporate or personal tax. Whereas the entire dividend flowing to a HoldCo shareholder, if 55(2) does not apply, would attract personal tax.

As reported in the illustration, a shareholder that wants to extract the HoldCo funds incurs less tax if HoldCo is subject to subsection 55(2). This is because the taxation of the income is based on capital gains rates which are lower than the dividend tax rates. The key part of the tax reduction arises from the fact that ½ of the gain realized by HoldCo is tax-free, $50 in our illustration, and this tax-free amount can be paid to a HoldCo shareholder by virtue of the CDA mechanism.

It is important to note that subsection 55(2) may lower the cumulative tax burden on the distribution of corporate funds. However, subsection 55(2), when applicable, precludes the tax deferral opportunity on dividends paid from OpCo to HoldCo. This is because the dividend paid from OpCo to HoldCo would attract the tax on the capital gain, the $25.10 illustrated above, however the refundable tax of $15.35 is only recovered if taxable dividends are paid by HoldCo. If the plan is to retain the pool of funds in HoldCo, then the receipt of a tax-free dividend by HoldCo is preferred because corporate and personal tax is deferred.

The CRA was asked to comment on a plan whereby subsection 55(2) was intentionally triggered, to benefit from the lower tax burden, and whether or not the General Anti-Avoidance Rule (“GAAR”) would apply. GAAR, when applicable, can override specific provisions in the Act on the basis that the provisions are being used abusively. The CRA stated that the application of GAAR to a subsection 55(2) plan would be dependent on the fact pattern and related transactions, however for the specific transaction reviewed they concluded that GAAR would not apply.

A Word on Part IV Tax

The role of Part IV tax is to preclude the use of a corporation to postpone personal tax with respect to portfolio dividend income. In the absence of Part IV tax, an individual could transfer an investment in a public company to HoldCo and postpone tax because HoldCo would not pay tax on the public company dividend income. Part IV tax is imposed at a rate of 38.33% on dividends that are received from a non-connected corporation. A payor corporation will be connected to a recipient corporation in one of two ways:

  • the recipient corporation owns shares of the payor that represent more than 10% of the votes and value of all issued payor corporation shares; or
  • the payor corporation is controlled by the recipient corporation, or more than 50% of the payor corporation’s voting shares are held by persons who are related to the recipient corporation.

Further, a dividend that is received from a connected corporation will attract Part IV tax to the extent that the payor corporation recovers refundable tax. The Part IV tax for the recipient corporation is paid on a pro rata basis, i.e. it pays refundable tax based on its share of the payor corporation’s total dividends paid. For example, if HoldCo received 25% of the dividends paid by OpCo and OpCo recovered $200,000 of refundable tax, then HoldCo would be subject to $50,000 of refundable tax [$200,000 x 25%].

The refundable tax that accumulates in a corporation is recovered when the corporation pays taxable dividends to its shareholders. The refundable tax is recovered at a rate of $1 for every $2.61 of dividends paid. For example, if a corporation received $100,000 of portfolio dividends that are subject to Part IV tax, it would pay $38,333 of refundable tax [$100,000 x 38.33%]. The corporation would fully recover the refundable tax by paying $100,000 of taxable dividends [$100,000 / $2.61].

A dividend received by a corporation is not subject to subsection 55(2) if Part IV tax applies, and the Part IV tax is not refunded as a consequence of the payment of a dividend by a corporation.

The Road Forward

It is imperative for corporate groups to address the potential application of subsection 55(2) when inter-corporate dividends are paid. Some common corporate structures no longer accommodate the payment of tax-free inter-corporate dividends. For example, it has been popular to have a corporate structure where individuals or a family trust own the common shares of an OpCo, whereas a HoldCo owns OpCo shares that have nominal value and a dividend entitlement. The nominal value dividend shares are sometimes referred to as skinny shares. The structure was ideal because OpCo common shares appreciated in value, a gain could be realized on the sale of the common shares, and this gain could qualify for the lifetime capital gains exemption. The skinny shares were an avenue for funds to move from OpCo to HoldCo as tax-free dividends. The dividends from OpCo to HoldCo may not have been subject to subsection 55(2) by virtue of the paragraph 55(3)(a) related party exception. Unfortunately, the related party exception now only applies to dividends that are related to a redemption or retraction of shares which would not apply to dividends paid on skinny shares.

The new rules make safe income a more important tax attribute, thus creating the need to calculate and track safe income. This can be a complex exercise for corporate groups that have not previously calculated safe income. In particular, there could be a need to review financial statements and corporate tax returns for many years. The safe income analysis may also be affected by reorganizations that have been implemented in the past. Once a safe income computation is completed, it is advisable to update the analysis annually or whenever material dividends are paid.

Addressing alternative avenues to distribute corporate funds has also become more relevant. For example, a corporation with a material amount of stated capital may make a tax-free return of capital to preclude the payment of a dividend and the application of subsection 55(2). Further, where an OpCo can pay a HoldCo for services or for the use of property, then this may provide an effective avenue to move funds between the corporations. For example, if HoldCo owns real estate used by OpCo, then it will be important for OpCo to pay FMV rent for the use of the real estate. The rental fee will be deductible to OpCo and taxable to HoldCo and will have the effect of transferring value from OpCo to HoldCo.

Conclusion

The new inter-corporate dividend rules are an important issue for private company groups and should be addressed proactively. It is not safe to assume that inter-corporate dividends are tax-free. Further, corporate groups should be prepared for the CRA to scrutinize inter-corporate dividends more actively in light of the new rules. We will be pleased to help our clients understand the implications and to address related planning matters.

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