Author: Peter Weissman, FCPA, FCA, TEP
Editors: Peter Weissman FCPA, FCA, TEP and Matthew Cho CPA, CA, TEP
The Income tax act contains a number of anti-avoidance provisions. Subsection 55(2) applies to convert some intercorporate actual or deemed dividends into capital gains or proceeds of disposition, respectively.
This provision was created when capital gains tax rates were higher than dividends. The intent of the section is to allow companies to move their tax paid retained earnings (“Safe Income”) out of, say, an operating company to a holding company, tax free. There is no further tax paid until the amounts are paid out as dividends to a shareholder who is a “natural person” where the amounts are taxed as eligible or “ineligible” dividends.
To the extent intercorporate dividends exceed Safe Income they are considered to be reducing the untaxed appreciated value and are converted into capital gains which would be taxable.
Given that capital gains tax rates are actually lower than dividend tax rates, it is sometimes beneficial to pay dividends in excess of Safe Income. This strategy, effectively, allows shareholders access to capital gains tax rates on funds they might otherwise have to pay higher dividend tax rates on. This type of capital gains stripping is not liked by the Department of Finance but a solution has been elusive to date.
Whether you want the tax deferral Safe Income can provide or want to create a capital gain above Safe Income, it is critical to calculate Safe Income properly. The calculation is inherently imprecise to start with, given that there is no definition in the Act, and the calculation is based on administrative positions that go back to the early 1980’s, when the rules were first introduced.
It is generally accepted that the Safe Income calculation is performed on a “consolidated” basis for investee companies, no matter what percentage is owned, where it can be clearly demonstrated that the Safe Income of the investee companies contribute to the inherent gain in the holding company’s shares. However, relying on consolidated Safe Income in planning is dangerous.
A holding company with $1 million of consolidated Safe Income may derive that total from Subsidiary A, with $250,000 of Safe Income and Subsidiary B, with $750,000 of Safe Income. If the $1 million is moved up to the holding company with dividends of $300,000 from Subsidiary A and $700,000 from Subsidiary B a $50,000 capital gain will be triggered. Although the total dividends equal the consolidated Safe Income, the holding company will pay tax on a $50,000 capital gain due to the dividend in excess of Safe Income ($300,000 – $50,000) from Subsidiary A.
Understanding how to use Safe Income properly can avoid unexpected tax or create an intentional conversion of a dividend into a capital gain. If you have situations where Safe Income is an issue, a Cadesky Tax representative would be happy to assist you.