Key Reminders About the Deliberate Triggering of Subsection 55(2)

Statements of the CRA's position on the deliberate triggering of new subsection 55(2) have appeared in a variety of places, so it may be useful to gather and summarize its position here. Three issues are discussed below: (1) one of the purpose tests must be met; (2) the part IV tax exception must not apply; and (3) the dividend must be in excess of safe income.

The Purpose Tests

Before the enactment of the new subsection 55(2) regime, taxpayers could choose to extract corporate funds through capital gains instead of taxable dividends. Now that the regime has been amended, taxpayers can pay intercorporate dividends while anticipating the dividends' recharacterization into capital gains by reason of the combined effects of subsections 55(2) and (2.1). Rather than pay a taxable dividend to the ultimate shareholder, taxpayers can file a CDA election and have that shareholder receive the non-taxable portion of the corpor­ation's capital gain realized on the recharacterization tax-free (see "Deliberate Triggering of Subsection 55(2)," Canadian Tax Focus, February 2016). The CRA confirmed that it would not invoke GAAR in these circumstances, but the strategy nonetheless raised some concerns for Finance (2015-0595641C6, October 9, 2015). In the 2017 federal budget, the government stated that it would address the issue (and others relating to the taxation of private corporations) in a paper "in the coming months."

Upon the payment of dividends to which subsection 84(2) or (3) does not apply, subsection 55(2.1) requires that the dividends meet one of three purpose tests: (1) a significant reduction of the capital gain that otherwise would have been realized on a disposition of a share, (2) a significant reduction in the FMV of any share, or (3) a significant increase in the cost of property of the dividend recipient. Thus, it should theoretically be easier to satisfy the purpose tests under the new regime (and, as a consequence, to trigger the application of subsection 55(2)).

However, it could be argued that if a taxpayer intentionally sought to meet one of the purpose tests, none of the tests would in fact be met because the purpose of the dividend payment would then not be to effect one of the purposes of paragraph 55(2.1)(b), but rather recharacterization as a capital gain. One could analogize to loss-consolidation strategies (see question 9 of the CRA Round Table in the 2015 Conference Report, where the CRA stated that no purpose test was met on dividend payments because they are in fact paid in order to use tax attributes within a corporate structure).

Part IV Tax Exception

Before the amendments to the subsection 55(2) regime, subsection 55(2) did not apply to dividends subject to part IV tax if the tax was refunded as a consequence of the payment of a dividend to a person other than a corporation as part of the same series. Under the new regime, this exception applies only to dividends that are subject to part IV tax when no dividend refund is received as a consequence of the payment of the dividend by a corporation and the payment is part of the same series.

In question 4 of the CRA Round Table at the 2016 annual conference, the CRA analyzed the possibility that a taxpayer might benefit from the subsection 55(2) dividend recharacterization if the RDTOH balance was positive and the dividend recipient was subject to part IV tax. The CRA, following the TCC's decision in Ottawa Air Cargo Centre Ltd. (2007 TCC 193, aff'd. 2008 FCA 54), stated that for the dividend to be recharacterized, a tax return must be filed and the part IV tax actually refunded; after the dividend refund, the dividend could be recharacterized. The increase in CDA could therefore apply only to future dividend payments.

Dividend in Excess of Safe Income

Finally, following the subsection 55(2) legislative changes, paragraph 55(5)(f) now applies automatically: any part of a taxable dividend paid in excess of the safe income on hand attributable to the share on which the dividend is paid will be considered a separate taxable dividend to the extent of the lesser of the taxable part and the safe income. Therefore, any tax planning involving the deliberate triggering of subsection 55(2) can occur only if the amount of the taxable dividend paid exceeds the safe income on hand attributable to the share. Otherwise, subsection 55(2) will not apply and the dividend will be fully deductible to the dividend recipient under subsection 112(1).

Félix Turcot
KPMG LLP, Montreal

Canadian Tax Focus
Volume 7, Number 2, May 2017
©2017, Canadian Tax Foundation