Safe Income and You

Safe Income and You: Why inter-corporate dividend structures for related parties are at risk

Recent changes to the Income Tax Act have resulted in additional restrictions for inter-corporate dividends, and it is clear that accurately calculating “safe income” is now more important than ever, especially for corporations that historically relied on exceptions for related parties. 

Generally, “safe income” can be paid out in a dividend from an operating corporation (Opco) to a connected holding corporation (Holdco) on a tax free basis. This was broadly permitted because the safe income has already been earned, taxed and retained by Opco, and will eventually be taxed in the hands of the individual shareholder when the dividend is ultimately paid out by Holdco.

While referenced in the Income Tax Act, “safe income” is not defined. It applies as a limit to the anti-avoidance rule at section 55(2) of the Income Tax Act, which deems certain dividends to be capital gains in specific circumstances:

1. The dividend recipient is entitled to a deduction;
2. One of the purposes is
   1. to avoid capital gains that would have been realized on a disposition immediately before the dividend; or,
   2. to effect significant reduction in the fair market value of any share or to effect a significant increase in the cost of property; and,
3. The amount of the dividend exceeds the amount of the income earned or realized by the corporation that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value of the share on which the dividend is received.

One of the changes to the Income Tax Act was to add to the “purposes” for which a dividend can be deemed to be a capital gain. Prior to the change, it was only if one of the purposes was to reduce the portion of the capital gain that would otherwise have been realized. Now, as can be seen, the anti-avoidance rule applies if one of the purposes is to effect a significant reduction in the fair market value of the share, or to effect an increase in the cost of property. These “purposes” may be interpreted subjectively, and it is therefore at substantial risk of reassessment that a corporation would pay dividends that could be captured by this rule. 

This means that if Opco pays a dividend that is greater than the safe income on-hand associated with that share, the dividend may be deemed to be a capital gain if the dividend was paid for one of the “purposes” set out in section 55(2), and Holdco will lose the tax deferral benefit.

However, if the dividend is less than the safe income on-hand, the corporation does not need to worry about whether the payment of the dividend could be seen as having one of these “purposes”.

Safe income on-hand is different for each share: it can be stated as that share’s portion of retained earnings accumulated since the share was issued as a percentage of the total, less the required adjustments – in reality, the calculation of safe income on-hand is fairly complex.   

Historically, certain corporations would have been much less concerned with accurate calculations of safe income on-hand due to the exception to the anti-avoidance rule for “related parties”. 

The related party exception meant that section 55(2) did not apply to a transaction or series of transactions as a part of which the dividend was received by the corporation if there was no disposition of property to a person or partnership that was an unrelated person. So, if the dividend is paid by Opco to Holdco and is ultimately paid to a related person, the dividends received by Holdco would have fallen into the related party exception, even if the amount of the dividend exceeded the safe income on-hand associated with Holdco’s shares in Opco. The dividend paid to Holdco would be exempted from the deeming rule in section 55(2) that might otherwise have deemed the dividend to be a capital gain.

Before the changes, all types of dividends were protected by the related party exception – cash dividends, stock dividends, dividends-in-kind or dividends arising on an increase in the paid-up capital of the share.

Now, the related party exception is only available for deemed dividends in the course of a distribution of funds or property on a winding-up, discontinuance or re-organization; or, deemed dividends through the redemption, acquisition or cancellation of shares by the corporation.

This means that where Opco intends to pay a dividend to Holdco that is outside the scope of the new, limited, related party exception, special care should be taken to ensure that the dividend does not exceed the safe income on-hand associated with the shares. Otherwise, Holdco may be liable for capital gains tax to the extent the dividend is greater than the safe income on-hand.

 If these changes affect you, or if you want to learn more about inter-corporate dividends and corporate structures, contact our legal team here!

 The content of this article is intended to provide a general guide to the subject matter and is not legal advice. Specialist advice should be sought regarding your specific circumstance.