Are Your Tax-Free Inter-Corporate Dividends in Jeopardy?

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1 Are Your Tax-Free Inter-Corporate Dividends in Jeopardy? May 27, 2015 No Canadian corporations that receive dividends from other Canadian corporations may be adversely affected by a recently expanded anti-avoidance rule that recharacterizes certain tax-free inter-corporate dividends as capital gains subject to tax. The changes significantly broaden the circumstances in which the rule can apply. Many standard corporate transactions that give rise to dividends may now be caught. If your corporation is contemplating a reorganization or a significant inter-corporate dividend, you should review the new rule in detail to determine whether it may apply. If so, it may be necessary to consider alternative transactions to achieve your business objectives. The new rule introduced in the 2015 federal budget expands the potential application of the existing anti-avoidance rule in subsection 55(2) of the Income Tax Act. This new rule, which will have implications for many corporations receiving inter-corporate dividends, applies to dividends received after April 20, This TaxNewsFlash-Canada highlights key changes to the subsection 55(2) anti-avoidance rule and their potential impact on Canadian corporations. What types of transactions may be caught? Several of the new measures could have a significant impact on standard transactions, including reorganizations of corporate structures and the movement of cash or other assets through a corporate chain. You will need to consider whether the expanded anti-avoidance rule in subsection 55(2) will apply if your corporation is paying a dividend in the following circumstances, among others: Distribution of cash from Opco Paying a cash dividend to a related or unrelated corporation Asset protection Paying a dividend from Opco to Holdco to potentially protect Opco s assets from its creditors Asset value extraction Paying a dividend using borrowed funds to extract the appreciated value of Opco s underlying assets Page 1 of 9

2 Purification for capital gains exemption Paying a dividend to remove non-active business assets from Opco to make Opco s shares eligible for the capital gains exemption Change of asset ownership Paying a dividend to move an asset within a related group of companies In-house loss utilization Paying a dividend to restructure the ownership of corporate assets to enable the corporate group to utilize tax losses Share ownership change Paying a dividend as part of the division of a corporation between related shareholders. These examples do not cover every situation; the new rules may apply in other situations as well. All types of dividends should be considered, including cash dividends, stock dividends (including high-low stock dividends), dividends-in-kind, deemed dividends on stated capital increases, deemed dividends on share redemptions and deemed dividends on taxable wind-ups. Related-party transactions Previously, transactions involving only related parties were often exempt from the subsection 55(2) anti-avoidance rule. Also, dividends paid out of safe income (i.e., income that has been realized and taxed in the corporation) are generally not subject to the antiavoidance rule. Corporations will no longer be able to rely on the related-party exception, unless the dividend is deemed to arise on a redemption, acquisition or cancellation of a share of the corporation under subsection 84(3) of the Income Tax Act. As such, it may be necessary to maintain safe income calculations when paying inter-corporate dividends, even when the transactions only involve related parties. Legislative status of the new rule The new changes to the subsection 55(2) anti-avoidance rule are not included in Bill C-59 that is currently before Parliament to enact certain 2015 federal budget measures. As a result, it is highly unlikely that these changes will become law before the federal election in the fall. This delay creates additional uncertainty for taxpayers because the new rule will affect dividends paid after April 20, Unfortunately, we are not likely to see the final wording of the new rule (including any modifications the government may make), and how the CRA will interpret and administer the new regime, until later this year at the earliest. Page 2 of 9

3 Inside this Issue Background How does the basic anti-avoidance rule work? When does the old anti-avoidance rule apply? New regime adds two new purpose tests Related-party exception narrowed Stock dividends New application of anti-avoidance rule Safe income exception Not available if no capital gain on shares Part IV tax exception narrowed Background How does the basic anti-avoidance rule work? The anti-avoidance rule in subsection 55(2) is complicated, like many of the transactions to which it applies. To illustrate the way the rule works, consider the following hypothetical example. A holding corporation (Holdco) intends to sell shares of a corporation (Opco) that operates an active business to a third party (Buyer). Before Holdco sells the Opco shares, Buyer lends funds to Opco. Opco then pays the funds as a dividend to Holdco. This inter-corporate dividend is tax-deductible for Holdco. The dividend has the effect of reducing the fair market value (FMV) of Opco s shares, which reduces Holdco s unrealized capital gain on the shares. When Holdco sells the Opco shares to Buyer, the capital gain Holdco realizes will be smaller than it would have been if Opco had not paid the dividend. This technique to reduce a capital gain by the payment of a dividend is sometimes known as capital gains stripping. To prevent such capital gains stripping, the subsection 55(2) anti-avoidance rule generally recharacterizes the dividend that Opco paid to Holdco as a capital gain. Page 3 of 9

4 When does the old anti-avoidance rule apply? The old rule under subsection 55(2) (before the 2015 federal budget changes) could apply when one of the purposes of a dividend was to significantly reduce a capital gain that would be realized on a disposition at FMV of any share immediately before the dividend was paid (known as the purpose test ). For deemed dividends arising on share redemptions, acquisitions or cancellations, the old rule could apply if one of the results of the deemed dividend was to significantly reduce a capital gain. The old rule did not apply if any of the following exceptions were met. These exceptions apply to a dividend that: 1. Could reasonably be attributed to after-tax retained earnings (i.e., safe-income-onhand ) 2. Was received in related-party transactions that involved no unrelated persons 3. Was subject to the refundable Part IV tax on dividends, provided that the Part IV tax was not refunded as a consequence of the dividend recipient paying a dividend to another corporation (i.e., if the Part IV tax was refunded by paying dividends to individuals, this Part IV tax exception was available), or 4. Was received in a butterfly reorganization using paragraph 55(3)(b) of the Income Tax Act. New regime adds two new purpose tests In the following sections, we take a closer look at the changes to the subsection 55(2) antiavoidance rule introduced in the 2015 federal budget. These measures add two new purpose tests to the existing subsection 55(2) anti-avoidance rule, apparently in response to the Tax Court of Canada s decision in favour of the taxpayer in D&D Livestock Ltd. v. The Queen (2013 DTC 1251 (TCC)). Under the old rule, subsection 55(2) did not apply to a dividend that reduced the FMV of a share that had an adjusted cost base equal to or greater than its FMV. In such a case, a dividend might reduce the FMV of the share, creating an accrued loss that could shelter an accrued capital gain on another property from tax. The new rule strives to catch this type of transaction by adding two new purpose tests. The new rule could apply to treat a tax-free dividend (other than a deemed dividend on a redemption, acquisition or cancellation of shares under subsection 84(3)) as a capital gain when one of the purposes of the dividend is to effect: a significant reduction in the FMV of any share, or a significant increase in the total cost of properties of the recipient of the dividend. Page 4 of 9

5 New purpose tests Example The following example illustrates the way the new purpose tests work. A corporation (Holdco) owns a property (Gain Property) with a fair market value (FMV) of $1 million and nominal adjusted cost base (ACB) (i.e., an accrued capital gain of $1 million), which it intends to sell to an arm s length buyer. Holdco also owns all of the shares of a subsidiary corporation (Subco). The Subco shares have an FMV and ACB of $1 million. Subco has $1 million of cash and has no safe-incomeon-hand. Holdco undertakes the following steps designed to shelter its capital gain that otherwise would be realized on its sale of the Gain Property to the buyer: 1. Subco pays a $1 million cash dividend to Holdco, causing the FMV of the Subco shares to fall to $nil, while their ACB remains at $1 million (i.e., creating a $1 million accrued loss on the Subco shares). The dividend is deductible to Holdco for income tax purposes. 2. Holdco transfers the Gain Property to Subco on a rollover basis for additional Subco shares such that the FMV of the Subco shares increases to $1 million and their ACB remains at $1 million. 3. Holdco sells the Subco shares to the buyer resulting in no gain or loss. Old rule Under the old rule, subsection 55(2) should not have applied to the $1 million cash dividend received by Holdco because the purpose of the dividend was not to reduce the capital gain on the shares of Subco, as there was no gain on the Subco shares before the dividend. By following the steps in this example, Holdco eliminated its capital gain on the disposition of the Gain Property without being subject to the old subsection 55(2) anti-avoidance rule. Page 5 of 9

6 New rule The new rule s purpose tests could apply because one of the purposes of the dividend is to effect a significant reduction in the FMV of the Subco shares. As a result, new subsection 55(2) could recharacterize the $1 million cash dividend as a capital gain to Holdco. Related-party exception narrowed The old rule provided an important exception for related-party transactions that applied to all types of dividends. The new rule provides that the related-party exception applies only to deemed dividends (computed as the redemption price less the paid-up capital (PUC) of the shares) arising on a corporation s redemption, acquisition or cancellation of its shares under subsection 84(3). KPMG observations Subsection 55(2) can now apply to deem an otherwise tax-free inter-corporate dividend to be a capital gain even if there are no transactions with unrelated persons. This is a fundamental change that will require a significant shift in the design and implementation of certain tax planning transactions, including, in some cases, the payment of an intercorporate cash dividend. Under the old rule, reliance on the related-party exception was key to the implementation of many reorganizations involving only related parties and avoided having to consider the subsection 55(2) purpose test and safe income availability. The limited scope of the new related-party exception will now require careful consideration as to how dividends can be used to accomplish tax-efficient related-party reorganizations. The narrowing of the related-party exception, combined with the introduction of the two new purpose tests, introduces significant uncertainty as to whether subsection 55(2) will apply to certain dividends. The purpose tests are broadly worded and may catch many dividends that are not protected by safe income or the new related-party exception, which now applies only to deemed dividends under subsection 84(3). These changes may require corporations to calculate safe income before paying large dividends, even where the transactions only involve related parties. Any Canadian corporation contemplating a reorganization or a large inter-corporate dividend should review the new rules in detail and update its safe income calculations. Page 6 of 9

7 Related-party cash dividend Example The following example illustrates the potential effects of the new rules as currently worded. As part of an asset protection plan or a corporate reorganization involving only related parties, an operating company (Opco) pays a cash dividend to a holding company (Holdco), which in turns lends the funds back to Opco. Since the dividend is not a subsection 84(3) deemed dividend (because no shares are redeemed, acquired or cancelled), the relatedparty exception will not apply under the new rules. Even though no unrelated persons are involved, new subsection 55(2) could apply if one of the three purpose tests is met. The current wording of the new purposes tests, combined with the narrowing of the relatedparty exception, creates uncertainty as to whether subsection 55(2) will apply in situations such as the example above. However, subsection 55(2) will not apply if the dividend is paid from safe income on a share that has an accrued gain. Stock dividends New application of anti-avoidance rule An important change to the subsection 55(2) rule now affects high-low stock dividends (i.e., issuance of shares with high value and low PUC) that shift value onto the shares issued as a stock dividend. Previously, only the PUC amount of a high-low stock dividend was subject to scrutiny under subsection 55(2). Under the new rules, the amount of a stock dividend for purposes of subsection 55(2) will no longer equal the PUC of the stock dividend shares but will now equal the greater of their PUC and their FMV. Thus, all types of stock dividends will be subject to the potential application of subsection 55(2). Page 7 of 9

8 Complex amendments to the stock dividend cost basis rules were also introduced in conjunction with the new subsection 55(2) changes. KPMG observation The new rule will limit the ability to use stock dividends but other types of share capital reorganizations may be available, such as a reorganization under section 86 of the Income Tax Act. Safe income exception Not available if no capital gain on shares Subsection 55(2) does not apply to a dividend paid out of income earned and retained by a corporation (i.e., safe-income-on-hand) when the dividend reduces a gain on a share that would otherwise arise on a disposition by a shareholder. From a tax policy perspective, income that has been realized and taxed in the corporation may be distributed to another Canadian corporation without an additional layer of shareholder-level corporate tax. Under the new purpose tests, subsection 55(2) can apply when there is an accrued loss on a share or the FMV of a share is equal to the adjusted cost base. In such situations, the safe income exception would not be available because it only applies when there is an accrued gain on the share. KPMG observation The new rules may limit the ability to access safe income in certain situations where there is no accrued gain on the share, but the desired planning may potentially be achieved using alternative transactions that would not trigger the application of the new subsection 55(2) anti-avoidance rule, such as a return of capital. Part IV tax exception narrowed A further change removes the Part IV tax exception from subsection 55(2) when the dividend recipient is subject to Part IV tax on the dividend but receives a dividend refund by paying a dividend to an individual. As a result, the exception is now only available if there is no dividend refund to the dividend recipient. Next steps for corporations Check with your tax adviser if you are undertaking transactions or reorganizations involving inter-corporate dividends Consider alternative transactions if it appears that the new subsection 55(2) rule may apply Keep safe income calculations up-to-date. Page 8 of 9

9 Download KPMG s Tax Hub Canada app KPMG s Tax Hub Canada app provides timely and convenient tax news to your iphone, ipad, BlackBerry and Android. Download now. We can help Many situations might be caught by the new rules; the examples above illustrate only some of the implications. Your KPMG adviser can help you assess the effect of the new subsection 55(2) anti-avoidance rule on your business, and point out ways to help mitigate its impact. For more details on this new rule and its potential impact, contact your KPMG adviser. Information is current to May 26, The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG s National Tax Centre at KPMG LLP, an Audit, Tax and Advisory firm (kpmg.ca) and a Canadian limited liability partnership established under the laws of Ontario, is the Canadian member firm of KPMG International Cooperative ( KPMG International ). KPMG member firms around the world have 162,000 professionals, in 155 countries. The independent member firms of the KPMG network are affiliated with KPMG International, a Swiss entity. Each KPMG firm is a legally distinct and separate entity, and describes itself as such. KPMG's Canadian web site is located at KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. Page 9 of 9