A Canadian corporation can generally pay dividends to another Canadian corporation tax-free under subsection 112(1) of the Income Tax Act (Act). Subject to certain conditions and exceptions, the Act limits tax-free inter-corporate dividends to the payor corporation’s ‘safe income on hand’ that contributes to the capital gain that could be realized on a disposition of the share on which the dividend is received.

In 626468 New Brunswick v. Canada, 2019 FCA 306, the Federal Court of Appeal (FCA) confirmed long-standing safe income computation principles that the taxpayer’s safe income calculation should be made after tax. One of the reasons given was that the fair market value (FMV) of a share is valued on an after-tax basis as no purchaser would buy a corporation’s shares without considering the taxes payable on that corporation's income.

Safe income primer

Subsection 55(2) of the Act is an anti-avoidance provision that prevents taxpayers from converting otherwise taxable capital gains into tax-free inter-corporate dividends. For example, deemed dividends resulting from increasing the paid-up capital (PUC) of shares will increase the cost base of those shares. This results in a corresponding reduction in capital gains on the disposition of the shares. Similarly, an actual dividend reduces the FMV of the payor’s shares so that any capital gain realized on the disposition of those shares is accordingly reduced.

While subsection 55(2) attempts to police such capital gains stripping techniques, the rule nevertheless contemplates certain carve outs, including very generally, for dividends that do not exceed the payor’s safe income on hand that contributes to the capital gain that could be realized on a disposition of the share on which the dividend is received.

Broadly stated, safe income is the equivalent to the tax retained earnings of the dividend paying corporation. Safe income ‘on hand’ is the cumulative income net of any actual or potential disbursements or outlays, e.g., amounts paid as dividends, income taxes or non-deductible expenses such as meals, entertainment, interest and penalties on income taxes. If income has already been distributed as dividends or used to pay taxes or non-deductible expenses, then it is not on hand and thus cannot contribute towards the gain on a disposition of a dividend payor’s share.

Safe income on hand is computed immediately prior to the ‘safe income determination time’, which is triggered when a dividend is first paid as part of a ‘series of transactions or events’. Thus, the safe income on hand that could reasonably be considered to contribute to a capital gain, that would be realized on a sale of the shares on which a dividend is received, is the income earned prior to the safe income determination time.

Subject to certain exceptions, if a dividend received by a corporation exceeds the payor corporation’s safe income on hand that contributes to the capital gain that could be realized on a disposition of the share on which the dividend is received, the excess dividend could result in a taxable capital gain, rather than a tax-free intercorporate dividend.

626468 New Brunswick - Relevant facts

In 2006, Mr. Rodney Gillis (Gillis) wanted to sell an apartment building to an unrelated party. To minimize overall taxes on the proposed disposition, Gillis incorporated Tri-Holdings Ltd. (Tri-Holdings) with nominal PUC and cost base and transferred the building to Tri-Holdings, in consideration for shares, on a tax-deferred basis.

Next, Gillis transferred his Tri-Holdings shares to 626468 New Brunswick Inc. (468 NB, or the Appellant), in consideration for shares, also on a tax-deferred basis. Tri-Holdings then sold the building to an unrelated third party, thereby realizing a taxable capital gain. The taxes on the capital gain were payable at the end of Tri-Holdings’ tax year.

After the sale, Tri-Holdings increased the PUC of its common shares several times from December 13, 2006 to December 18, 2006. These increases triggered several deemed dividends to 468 NB and corresponding increases in the cost base of 468 NB’s shares of Tri-Holdings. Given that the dividends were deemed paid to a corporate shareholder (468 NB), no adverse tax consequences arose for 468 NB under subsection 112(1). On or before December 31, 2006, 468 NB sold all its Tri-Holdings shares to an arm’s length purchaser.

Prior to the PUC increases, the cost base of 468 NB’s shares of Tri-Holdings was nominal, meaning that but for the PUC increases and deemed dividends, 468 NB would have realized a capital gain equal to the FMV of its shares of Tri Holdings. However, each PUC increase resulted in a tax-free deemed dividend, an increase in the cost base of the shares and a corresponding decrease in the expected capital gain on 468 NB’s eventual disposition of Tri-Holdings’ shares.

The Canada Revenue Agency (CRA) reassessed 468 NB’s year ended December 31, 2006 on the basis that the deemed dividend arising from the final PUC increase on December 18, 2006 exceeded Tri-Holdings’ safe income on hand so that subsection 55(2) applied and the final dividend should be deemed to be capital gain to 468 NB.

The Appellant claimed that safe income is a pre-tax concept and that the final dividend did not exceed Tri-Holdings’ safe income on hand because the taxes from the disposition of the building were payable at the end of Tri-Holdings’ tax year. Therefore, the taxes should not have reduced Tri-Holdings’ safe income on hand.

Safe income and accrued tax obligations

Following a review of the case law, the FCA held that Tri-Holdings’ safe income would be reduced by taxes payable (but unpaid) related to the sale of the building because ‘it would only be logical that any arm’s length third party purchaser of shares would take into account any existing tax liability of the corporation, even though such liability may not be payable until a later date.’ Further, the FCA noted that the words ‘earned or realized’ in subsection 55(2) refer to income after taxes.

In this case, the first deemed dividend (as part of the series of transactions or events) was issued on December 13, 2006 and Tri-Holdings sold the building prior to that time. The FCA observed that safe income should be determined, as prescribed by the Act, at the safe income determination time, i.e., immediately before the first dividend was issued as part of the series of transactions or events on December 13, 2006. Although the taxes arising from the sale of the building were not payable at the safe income determination time, the taxes could be readily computed at that time. Therefore, Tri-Holdings’ safe income on hand should be net of any tax liabilities, even if unpaid, at the safe income determination time.

The FCA therefore concluded that the final deemed dividend significantly reduced the capital gain that would have been realized by 468 NB on a FMV sale of its shares of Tri-Holdings, that this reduction was not attributable to its safe income on hand, and thus that subsection 55(2) of the Act was applicable.

Safe income calculations are not clear-cut

The 2015 amendments to subsection 55(2) tightened the rules governing tax-free intercorporate dividends. In response, some taxpayers have shifted their focus to the safe income exception to prevent their application. However, the principles governing the computation of safe income on hand can be confusing. Important tax issues such as treatment of contingent liabilities, refundable taxes, accounting reserves, losses, expenses deductible in future years, etc., have not yet been exhaustively addressed by the courts and therefore can create ambiguity for middle market businesses paying dividends to their corporate shareholders.