Subsection 55(2): The Reasonable Regular Dividends Exemption

At the 2015 Tax Executives Institute Liaison meeting (see CRA document no. 2015-0613821C6, November 17, 2015), the CRA stated that the new subsection 55(2) will not apply (in respect of the purpose test in paragraph 55(2.1)(b)) “[w]here 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.” This interpretation, although not obvious from the wording of the legislation and not based on existing jurisprudence, may be helpful to taxpayers seeking to pay out dividends for normal commercial reasons without being concerned about whether the dividend will be recharacterized as a capital gain. (Note that dividends paid to remove value from an Opco for creditor-proofing purposes already meet the purpose test: CRA document 2015-0623551C6, November 24, 2015.) Dividend rates that satisfy the CRA criteria may be ascertained by using a database such as Capital IQ or Compustat.

For example, suppose that Opco is a private corporation based in Alberta that engages in oil and natural gas exploration and drilling. Its SIC (standard industrial classification) codes are 1381 (drilling oil and gas wells); 1382 (oil and gas exploration services); and 1389 (oil and gas services). An independent valuator has determined that the fair market value of Opco is $100 million.

To identify comparable companies, I searched Capital IQ for TSX-listed Canadian companies with a market cap below $300 million and a SIC code of 1381, 1382, or 1389. I used comparable company analysis, which follows the educational curriculum of the Canadian Institute of Chartered Business Valuators. This methodology first selects companies in an industry similar to that of the subject company, on the assumption that all firms within a given industry segment are subject to common risks. The list is then further refined to include companies that are similar in size (measured in terms of market capitalization, which can also be interpreted as the value of equity). Size is important because larger companies tend to enjoy a greater degree of market presence, financial stability, and economies of scale. Other filters could be applied, such as geographic coverage, profitability, degree of vertical integration, level of tangible assets, and historical and future growth rates.

I further restricted the search to companies with a positive dividend yield on their common shares. Although many companies that otherwise fit the parameters would pay no dividends, the CRA’s use of the phrase “comparable listed share” seems to imply that only companies that pay dividends are comparable.

The search identified five companies that had an unweighted average dividend yield of 4.67 percent (using the latest data): the range was from 2.38 percent for North American Energy Partners Inc. to 6.51 percent for Black Diamond Group Limited.

The result derived from the comparable set forms a lower bound for the reasonable dividend yield. A prudent investor will require a higher rate of return on private company shares than publicly traded shares: private company shares are relatively illiquid, and there may not be a market for them. As a result, a modest 20-25 percent premium could be added. Therefore, a reasonable dividend yield for Opco would be in the range of 4.67 percent to 5.8 percent. Using the midpoint of 5.25 percent, Opco can pay a quarterly dividend in the amount of $1,312,500 ($100 million × 5.25%/4).

To create the “well-established” practice of paying regular dividends required by the CRA policy, the company could make a decision at its annual general meeting that from that time on it will pay a regular quarterly dividend of $1,312,500. (The quarterly payment seems appropriate, since public corporations usually pay dividends on a quarterly basis.) Whether this policy would have to be continued for some period of time to meet the CRA’s requirements is unclear.

The payment of these regular dividends should not affect the company’s ability to pay out a dividend equal to the safe income on hand. However, the amount of the regular dividends paid will reduce the safe income on hand.

Vincent Didkovsky
S+C Partners LLP, Mississauga

Canadian Tax Focus
Volume 6, Number 4, November 2016
©2016, Canadian Tax Foundation