Subsection 55(2) of the Income Tax Act (Canada) is an anti-avoidance rule targeted at strategies that convert accrued capital gains into tax-deferred intercorporate dividends. Where this subsection applies, the dividend is deemed not to be a dividend, but to be proceeds of disposition, likely resulting in the corporation realizing a taxable capital gain.
Proposed changes to subsection 55(2)
- Expanding the purpose test: The proposed legislation broadens the purpose test to include the following two scenarios: (1) where one of the purposes of the dividend is to effect a significant reduction in the fair market value of any share; or 2) where one of the purposes of the dividend is to effect a significant increase in the cost of property.
- Tightening the related party exception: The 55(3)(a) exception will be limited to deemed dividends arising on the redemption, acquisition or cancellation of shares. Thus, ordinary dividends within a related group could be caught by subsection 55(2).
- Streaming of safe income: Under proposed paragraph 55(2.1)(c), the safe income exception will only apply to the extent the safe income can reasonably be considered to have contributed to the capital gain that would otherwise have been realized on the share to which the dividend relates.
- Revised Part IV Tax exemption: The proposed rules exempt a dividend from subsection 55(2), where the recipient is subject to Part IV tax. However, to qualify for this exemption, the Part IV tax must not be refunded (in the series of transactions) by payment of a dividend by a corporation. The current wording refers to payment of a dividend “to” a corporation, which allows Part IV tax to be refunded by payment of a dividend to an individual or trust, without the exemption being lost. The proposed rules close this "loophole".
- New definition of “amount” of stock dividend: For the purposes of subsection 55(2), the proposed rules deem the “amount” of a stock dividend to be the fair market value of the new shares rather than their paid-up capital. Therefore, stock dividends with a high redemption price could now be subject to the application of subsection 55(2).
As a result of the proposed changes, entities paying intercorporate dividends should:
- Prioritize the calculation of safe income on hand and keep it up to date;
- Consider the possible application of subsection 55(2) to any intercorporate dividend; and
- Consider engaging tax counsel to assist in the planning of any significant dividend payment, transaction or reorganization.