Blog: What has Changed with Inter-corporate Dividends

June 15th, 2017 inter-corporate dividends

The amendments to the anti-avoidance provisions in subsection 55(2) of the Income Tax Act (Canada) that were enacted a few years ago have created some uncertainly and even confusion to private companies and their tax advisors.  Dividends paid by one corporation to another corporation now require extra scrutiny to ensure that the adverse tax consequences of subsection 55(2) are avoided.

This article will focus on practical applications of the subsection 55(2) anti-avoidance rules and provide a brief overview of recent developments in the area. Click here for a detailed discussion of the changes that were made to the rules (i.e. the “new rules”), in our article “Inter-corporate Dividends: Are They Still Tax-Free?”.

The new rules: A brief overview

The purpose of the anti-avoidance provisions in subsection 55(2) is to negate taxpayers from stripping corporate surplus by taking advantage of the general rule that allows inter-corporate dividends to be received tax-free in many cases. Generally,, where the subsection 55(2) provisions apply, the portion of the inter-corporate dividend that fails to meet specific criteria outlined in the provisions, is re-characterized as a capital gain that is taxable to the dividend recipient corporation, rather than an otherwise tax-free dividend.

Amendments to subsection 55(2) were proposed in the 2015 federal budget and they have now been enacted (i.e. the “new rules”), subject to minor modifications. The new rules apply to any dividends received by connected corporations from another corporation after April 20, 2015.

The new rules substantially broaden the application of subsection 55(2) by adding two additional “purpose” tests. Subsection 55(2) can therefore now apply if one of the purposes of paying a dividend (whether as part of a series or not) is to effect:

  1. A significant reduction in the capital gain that would be realized on the disposition of any shares at fair market value (“FMV”) immediately prior to the dividend payment;
  2. A significant reduction in the FMV of any share; or
  3. A significant increase in the cost of the dividend recipient’s property.

The anti-avoidance rules are only applicable if one of the “purpose” tests above is met. Therefore, where it could be shown that the payment of a dividend does not offend one of the purpose tests, or where the effect is not significant, subsection 55(2) should not apply. However, such a determination would be a question of fact and, hence may be difficult to prove in most cases.

With respect to the first test above, where the inter-corporate dividend arises from a redemption of shares, the “purpose” test becomes a “results” test. This means that where a dividend arising from a redemption of shares “results” in a significant reduction in the capital gain that would be realized on the disposition of any shares at FMV immediately prior to the dividend payment, subsection 55(2) could apply, even if it was not one of the purposes of the dividend payment.

Also, the second and third purpose tests do not apply where the inter-corporate dividend results from a share redemption or wind-up of a corporation. In other words, these purpose tests can only be met where cash dividends, stock dividends and other dividends alike are paid.

Where one of the purpose tests above applies, the application of subsection 55(2) can be avoided if one of the following exceptions is met:

  1. The dividend recipient corporation is subject to Part IV tax on the dividend received, and the Part IV tax is not refunded to the dividend recipient corporation as a consequence of a subsequent dividend payment (that is within the same series) by a corporation;
  2. Dividends are paid out of “safe income” (i.e. there is sufficient safe income on hand that is attributable to the shares of the corporation on which the dividend was paid). “safe income” is generally the retained earnings of the corporation as computed for tax purposes; or
  3. Dividends triggered on share redemptions arising from “bona fide” reorganizations between related parties (i.e. where there are no dispositions of the shares (nor increases in the interests) of the dividend payer or dividend recipient by unrelated parties).

One significant change under the new rules is that the related party exception can no longer be relied upon where cash and in-kind dividends are paid from one corporation to another. The related party exception is available in respect of dividends arising from share redemptions triggered by corporate reorganizations between related parties.

The new rules: Is there a need to keep track of safe income?

 It is now prudent to calculate safe income on hand prior to the payment of an inter-corporate dividend. In this section, we highlight the Canada Revenue Agency’s (the “CRA”) most recent views on inter-corporate dividends in different scenarios, and whether there is a need to rely on safe income calculations.

Well-established Dividend Policies

An argument can be made that one of the purpose tests is not offended where a corporation has a history of paying inter-corporate dividends on a regular basis, and these dividend payments are continued post April 20, 2015. In a technical interpretation, the CRA stated that “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 payer 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) (i.e. the “purpose” tests).”*

It must be noted, however, that the CRA later stated that this was just a mere example and that they would not provide any sort of “blanket exception” for inter-corporate dividends. Therefore, whether each inter-corporate dividend meets one of the purpose tests is a question of fact and an automatic assumption that subsection 55(2) does not apply should not be made..

As a result, safe income calculations may be required even where dividends are paid pursuant to a well-established dividend policy.

Creditor Proofing Dividends

A common ownership structure in the private company context often involves a holding company owning all the shares of an operating company. Where there is excess cash in the operations, the operating company pays cash dividends to the holding company to creditor proof its assets/retained earnings.

In a technical interpretation, the CRA was asked whether one of the purpose tests would be met where the following transactions are undertaken:

  1. A dividend (equal to the value of the operating company) was paid by the operating company to the holding company; and
  2. A loan is made by the holding company to the operating company (equal to the value of the dividend payment).

The CRA was of the view that this would meet one of the purpose tests (i.e. that it would result in a significant reduction in the FMV of the shares of the operating company) and therefore subsection 55(2) could apply.** The only way to safely avoid the application of subsection 55(2) is to ensure that there is sufficient safe income on hand attributable to the shares on which the dividend is paid.

In the same interpretation, the CRA appears to have taken the view that the amount of the reduction in the FMV of the shares of the operating company was significant, since the amount of the dividend was equivalent to the entire value of the operating company.

What amount of dividend is considered to be “significant” is a subjective determination, and therefore there is a constant risk that subsection 55(2) applies to all cash dividends that are not paid out of safe income. Paying dividends in increments would not be a solution, as the CRA would likely take the view that each dividend payment would be part of the same series resulting in a significant reduction in the FMV of the shares of the operating company.

Dividends Paid in Loss Utilization Strategies

Where there are loss companies within a related entity group, the CRA generally allows for loss utilization planning whereby a profitable company within the group is able utilize the losses of the loss companies. Many of these loss utilization strategies may involve a dividend payment by one corporation to another.

The CRA has generally stated that these strategies, where they would have accepted them in the past, would not meet any of the “purpose” tests under the new rules, as long as any additional cost basis that is created as a result of the loss consolidation structure is eliminated on the unwinding of the structure.***

Purification Dividends

In an owner-manager context, it is important that an operating company continue to meet the stringent tests of a small business corporation such that if there is ever a sale of the operating company, the individual owner-managers can utilize their lifetime capital gains exemptions to minimize capital gains tax on the sale. Where there is excess cash in the operating company, however, the company may be at risk of not meeting these tests. Thus it is a common strategy for the operating company to pay cash dividends to its holding company to purify the operating company.

Where there is insufficient safe income from which to pay  the purification dividends, there is significant risk that the new rules would apply as the payment of the dividend(s) may significantly reduce the FMV of the operating company.

Planning around the new rules

Because of the uncertainty caused by the new rules, thoughtful planning should be considered prior to the payment of dividends. The following are common planning strategies to avoid or minimize the risk of of the new rules being triggered on the payment of dividends:

  1. Keep track of safe income – As discussed above, it may be prudent to keep track of safe income on hand and paying inter-corporate dividends only to the extent of safe income available. Moreover, it is not sufficient to rely on the retained earnings of the company as reflected on the financial statements. The taxpayer must make a reasonable attempt at computing safe income.
  2. Use of redemptions and repurchases of shares instead of cash dividends (i.e. to meet the related party exception) – Note that there is significant risk in relying on the related party exception where a disposition of the shares (or increases in the interest), to unrelated parties, of the dividend payer or dividend recipient is expected. Moreover, the related party exception that may be relied upon in respect of deemed dividends triggered on share redemptions applies only to the extent there is a “bona fide” corporate reorganization. Thus, one cannot simply structure a dividend as a redemption of shares to circumvent the application of the new rules.  The CRA has commented that these types of transactions could invoke the application of the General Anti-Avoidance Rule (“GAAR”).
  3. Return of inter-corporate paid-up capital – Paid-up capital (i.e. prior contributions of capital by shareholders) can generally be returned by a corporation to its shareholders on a tax-free basis. Where a parent company is in need of cash, or where the subsidiary wants to move cash out of the operations, the subsidiary company can return, via cash payment, the parent’s paid-up capital. A return of capital is not considered to be a dividend.
  4. Simplify the corporate structure – Where there are only negligible benefits of having a tiered corporate structure, it may be worthwhile to tear down and simplify the corporate structure such that payments of inter-corporate dividends would no longer be required.
  5. Obtain a CRA Ruling – Where there is a significant reorganization involving inter-corporate dividends, or the amount of inter-corporate dividends is significant, it may be worthwhile to obtain an advanced income tax ruling from the CRA requesting their views on the application of subsection 55(2). The CRA considers themselves to be bound by these rulings, thus allowing taxpayers to comfortably proceed with the pre-arranged set of transactions as set out in the ruling request. However, the costs of preparing and obtaining the ruling and the timeliness of the CRA’s response must be considered. The CRA’s goal is to issue rulings within 90 business days of receipt of all information required for them to issue the ruling.

The amendments to subsection 55(2) have caused taxpayers significant uncertainty  when it comes to the payment of inter-corporate dividends. This article focuses on practical applications of the new rules and provides a few common planning strategies in light thereof. We encourage you to contact your Crowe Soberman advisor to assist you in thoroughly assessing the implications of subsection 55(2) to your business.

Connect with the Authors

This article was prepared by Silvia Jacinto, Partner and Ananth Balaingam from Crowe Soberman’s Tax Group. If you have any questions relating to this article, we encourage you to contact them.

Silvia Jacinto, MTax, Partner

Ananth Balasingam, Tax Specialist

This article has been prepared for the general information of our clients. Specific professional advice should be obtained prior to the implementation of any suggestion contained in this article. Please note that this publication should not be considered a substitute for personalized tax advice related to your particular situation.

*CRA Document 2015-0613821C6
**CRA Document 2015-0617731E5
***CRA Document 2015-0610671C6


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