CRA’s (Re)interpretation of Paragraph 55(5)(f)

Subsection 55(2) is an anti-avoidance rule that deems an amount that would otherwise be a tax-free intercorporate dividend to be a capital gain, if certain conditions are met. The circumstances in which subsection 55(2) applies would be substantially altered by proposed modifications in the 2015 federal budget. However, a change that has received less attention is the CRA’s administrative reinterpretation of the “safe income” exception to subsection 55(2)—specifically, the mechanics of paragraph 55(5)(f)—in a manner that arguably contradicts both the wording of the Act and established case law.

Proposed subsection 55(2.1) sets out the conditions under which subsection 55(2) applies. Generally, where all the other conditions are met, if the amount of the dividend in question exceeds the safe income that could reasonably be considered to contribute to the pregnant capital gain on the share on which the dividend is received, the entire dividend is deemed to be a capital gain. Paragraph 55(5)(f) provides some relief by allowing the taxpayer to designate in its tax return for the year in which it receives the dividend a portion of the overall dividend equal to the safe income; that portion is then deemed to be a separate taxable dividend that will not be subject to subsection 55(2).

The FCA’s decision in Nassau Walnut Investments Inc. v. R ([1998] 1 CTC 33) is the leading case on paragraph 55(5)(f). In that case, the court confirmed the all-or-nothing nature of subsection 55(2) and the need for the taxpayer to actually make a designation in order to prevent the portion of a dividend that reflects the safe income on the shares from being recharacterized as a capital gain (paragraph 7). The court further held that a taxpayer is generally entitled to amend its returns to make such a designation following a reassessment.

Despite this decision, the CRA has issued administrative positions (2011-0412091C6, October 7, 2011, and 2012-0434501E5, February 6, 2012) stating that it would apply subsection 55(2) only to the portion of a dividend that exceeds the safe income on the shares, implicitly without the taxpayer making a designation. The rationale for this position may relate to the CRA’s concern about the intentional use of subsection 55(2) to effect surplus stripping. This plan generally involves the intentional payment of a dividend in excess of safe income in order to cause the entire amount of the dividend—including the portion attributable to safe income—to be deemed to be a capital gain. On a fully distributed basis, this may generally result in tax savings by allowing for corporate surplus to be extracted at capital gains tax rates rather than dividend tax rates. The CRA has indicated that it could seek to apply GAAR if a taxpayer either refuses to deduct the safe income from the taxable dividend subject to subsection 55(2) or if it self-assesses the full amount of the dividend as a capital gain (see the documents cited above, and see 2014-0522991C6, June 16, 2014). Such a GAAR challenge would likely be based on what the CRA perceives to be the general policy against surplus stripping in the Act (2012-0433261E5, June 18, 2013). The success of such a challenge is far from certain for two reasons: (1) to date the courts have refused to recognize such a general policy; (2) paragraph 55(5)(f) explicitly confers a discretion on the taxpayer to make a designation (or not to do so), and thus arguably to apply dividend or capital gains treatment (see Descarries v. The Queen, 2014 TCC 75; Gwartz v. The Queen, 2013 TCC 86; and Copthorne Holdings Ltd. v. Canada, 2011 SCC 63).

Adam Drori
Stikeman Elliott S.E.N.C.R.L., s.r.l./LLP, Montreal

Canadian Tax Focus
Volume 5, Number 3, August 2015
©2015, Canadian Tax Foundation