Subsection 55(2) of the Income Tax Act (Canada) is an anti-avoidance provision intended to prevent capital gains stripping by deeming an inter-corporate dividend to be proceeds of disposition or a capital gain if one of the purposes (or, if subsection 84(3) applies, one of the results) of the dividend is to effect a significant reduction of a capital gain attributable to anything other than safe income on hand. There are exceptions to the application of subsection 55(2), such as those relating to Part IV tax and paragraphs 55(3)(a) and 55(3)(b).

Budget 2015 announced amendments to section 55, referring specifically to the Tax Court of Canada’s decision in D & D Livestock Ltd., 2013 TCC 318. The case involved a complex series of transactions that resulted in the double-counting of a subsidiary’s safe income. The Court held that subsection 55(2) was not applicable because the safe income attributable to shares of a subsidiary is not reduced by a dividend paid on the shares of its parent company. The Crown did not rely on GAAR, but the CRA says it will apply GAAR to such planning in the future.

On July 31, 2015, the Department of Finance released updated draft amendments for consultation. The consultation period ended on September 30, 2015.  The proposed amendments, once enacted, will be effective as of April 21, 2015. Here are the five key changes proposed to section 55 and advice to help deal with the consequences of the changes.

5 Key Changes To Section 55. The proposed amendments entail these five key changes to section 55:

1. Paragraph 55(3)(a) Related Person Test Restricted. One of the main changes is to limit the application of the paragraph 55(3)(a) related party exception to deemed dividends under subsections 84(2) (winding-up) and 84(3) (redemption). An ordinary dividend will no longer have the benefit of the bright line exception in paragraph 55(3)(a).

2. Different Safe Income Exception. Currently, a dividend is protected if the capital gain on a share that is reduced by the dividend is reasonably attributable to safe income. The safe income does not have to be allocated to the share on which the dividend is paid. For example, a dividend on discretionary dividend shares which reduces a gain on common shares is permitted, if the gain is attributable to safe income allocated to the common shares.  However, under the proposed changes, a dividend will only be protected by safe income if the safe income contributes to a capital gain on the share on which the dividend is paid.  As a result, dividends paid on discretionary dividend shares will not have any safe income protection, since they have no safe income allocation or inherent gain.

3. New Purpose Test for Ordinary Dividends. Currently, subsection 55(2) applies if one of the purposes of a dividend is to effect a significant reduction in a capital gain not attributable to safe income. The proposed rules extend the application of subsection 55(2) so it will also apply if one of the purposes is to effect a significant reduction in the fair market value of any share or a significant increase in the cost of any property. Finance is concerned about dividends that create or increase losses. Subsection 55(2) is presently understood to not apply to dividends that create or increase a loss on a share. Where the value of a share is already nil, a new provision will ensure a dividend can still reduce its value, as the value of a share will be deemed to be increased immediately before the dividend is paid by the amount by which the amount of the dividend exceeds the fair market value of the share.

4. Inter-Corporate High-Low Stock Dividends. Currently, the “amount” of a stock dividend is the amount of the increase of the paid-up capital of the corporation’s shares. The amount of a dividend paid by the issuance of shares with a high redemption price but low paid-up capital would be the amount of the low paid-up capital. However, this will change for the purposes of section 55: the amount of the inter-corporate stock dividend will now be the greater of the paid-up capital increase and the fair market value of the stock dividend shares. These new rules address capital loss plans whereby value was shifted from one class of shares to another to create an unrealized loss on the first class of shares.

5. Changes to Part IV Tax Exception. Currently, the rules refer to tax under Part IV that is not refunded as a consequence of the payment of a dividend to a corporation. However, the new provision refers to the payment of a dividend by a corporation. As a result, the Part IV tax exception will not be available when the Part IV tax is refunded as part of the same series, even if the refund arises by paying a dividend to an individual. The policy reason for this extension of the existing rules is not clear.

Consequences of Section 55 Changes for Ordinary Dividends. Ordinary dividends will no longer have the benefit of the related party exception but must qualify for the safe income exception or “fail” the purpose test. This makes discretionary dividend shares now dangerous to use because the only protection is the purpose test. To address this increased risk:

• Corporate Beneficiary Structure. If a corporate beneficiary structure doesn’t exist, a taxpayer should consider implementing it now. Otherwise, the continued use of discretionary dividend shares is possible if the taxpayer is comfortable the purpose test is satisfied. In that context, it will be good practice to record the purpose of the dividend.

• Transfer & Redeem. Another approach is to transfer some shares to an investment holding company and redeem them in order to get access to the related party test. Taxpayers and their advisors must consider which is better: the related party test or the purpose test? The related party test seems more certain but also involves a higher risk of being more obviously wrong; the purpose test always leaves some scope for argument. When relying on paragraph 55(3)(a) related party test, it’s important to carefully analyze all the shareholders to ensure there are no unrelated parties. Any possible future steps involving an unrelated party must be identified to determine if those steps may form part of the same series of transactions.

The Purpose Test. The leading case on the purpose test is The Queen v. Placer Dome 1996 DTC 6562 (FCA). The key aspects of the test are:

• it is a subjective test;
• the taxpayer has the onus of proof;
• mere denial by taxpayer is not sufficient, although additional or corroborative evidence is not required; and
• if the transaction significantly reduces a gain, the Minister can infer the purpose and the taxpayer must rebut that presumption.

The test is met if only one of the purposes of the dividend is an enumerated improper purpose.  Although every dividend reduces the fair market value of a share, section 55 is an anti-avoidance provision that the CRA (and courts) will not, hopefully, apply too widely.

Family Trusts. If the regular distribution of earnings will be structured as redemptions more often, then reliance on paragraph 55(3)(a) must be carefully considered. Paragraph 55(5)(e) provides that a person is only related to a trust if the person is a corporation controlled by the trust or a person related to each beneficiary of the trust. It will be even more important under the new rules to consider and ensure, when the trust is established, that trust beneficiaries are related (or related to the person who controls the corporation, as applicable) for purposes of section 55.

Advice. The proposed changes to section 55 mean transactions involving inter-corporate dividends will be even more complex. As a result, practitioners must:

• carefully consider upon which exceptions to rely;
• consider all purposes of a dividend and how to establish that none are bad;
• analyze all parties to ensure application of the related party test, including careful scrutiny of trust beneficiaries; and
• be prepared to conduct complex safe income calculations.

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Please contact your McInnes Cooper lawyer or any member of our McInnes Cooper Tax Solutions Team to discuss this topic or any other legal issue.

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