The income tax rules governing the taxation of inter-corporate dividends for Canadian resident corporations were tightened by the 2015 amendments to the Income Tax Act (“ITA”) pursuant to the changes to Section 55. The amendments received Royal Assent on June 22, 2016 and they apply to dividends received after April 20, 2015.
Simply put, up until April 20, 2015 if Section 55 applied, it converted a tax-free inter-corporate dividend into a taxable capital gain in the recipient corporation’s hands if the dividend payment was made to reduce the capital gain on the sale of the dividend payer corporation’s shares and the dividend was part of a series of transactions whereby shares were acquired by an arm’s length party. Section 55 applied when the tax-free inter-corporate dividend was paid in preparation for the sale of the dividend payer corporation’s shares with the purpose or result of reducing the capital gain on the sale of those shares.
The 2015 amendments to Section 55 of the ITA expanded the purpose and result tests to include the hypothetical reduction of the value of the dividend payer corporation’s shares, even though no sale of the shares occurs or is contemplated. Therefore, it is no longer necessary that the inter-corporate dividend payment is made as a preliminary step in the share sale process. Any inter-corporate dividend could be caught by Section 55, excepting dividends paid out of the “Safe Income” of the dividend payer corporation.
“Safe Income” is a calculated amount, generally being the tax retained earnings applicable to the particular shares held by the recipient corporation on which the dividend was paid. Once the “Safe Income” calculation is completed it should be updated annually. In certain situations the “Safe Income” calculation may be time consuming, for example in the case of corporations with a long history, or many changes in the shareholders at different times.
In order to avoid the application of Section 55 of the ITA and the inadvertent conversion of a tax-free inter-corporate dividend into a taxable capital gain, more planning may be needed in some cases prior to the declaration or payment of inter-corporate dividends (generally when the inter-corporate dividend payment is not between a wholly-owned subsidiary and its parent company) to ensure that all or a portion of the dividend is not converted into a capital gain under the new rules. In this connection one of the steps is the determination and annual updating of the “Safe Income” applicable to particular shares held by the dividend recipient corporation.
Section 55 does not apply to dividends received by shareholders who are individuals.
KMSS will be pleased to discuss the new rules with you and their potential application if your corporation pays or receives inter-corporate dividends, and to assist with the planning required to pay inter-corporate dividends and to avoid or reduce the adverse tax consequences arising from the application of the Section 55 provisions.