How do subsection 55(2) and Part IV of the Income Tax Act (Canada) work together? The Tax Court considered this question recently in Ottawa Air Cargo Centre Ltd. v. The Queen, 2007 TCC 193 (“Air Cargo”).
The taxpayer held special shares in the capital of another corporation. The two corporations were not connected for the purposes of Part IV. Another corporation owned all of the taxpayer’s issued shares. All of the corporations were taxable Canadian corporations. The special shares did not have any safe income. The issuer of the special shares redeemed them.
The taxpayer took the position that subsection 55(2) applied to re-characterize as a capital gain the deemed dividend resulting from the redemption of the shares. The taxpayer used losses to offset the taxable portion of the gain. The non-taxable portion it added to its capital dividend account and then paid a capital dividend to its corporate shareholder. The taxpayer took the position that 55(2) applied because, while Part IV applied to the dividend received from the issuer of the special shares, the tax payable would have been refunded as part of the series of transactions that included the redemption of the shares, and so the exception to the application of 55(2) did not apply. Subsection 55(2) reads in part as follows:
Where a corporation resident in Canada has received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) or (2) or 138(6) as part of a transaction or event or a series of transactions or events, one of the purposes of which (or, in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the safe-income determination time for the transaction, event or series, notwithstanding any other section of this Act, the amount of the dividend (other than the portion of it, if any, subject to tax under Part IV that is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of the series) [Emphasis added.]
The taxpayer believed that the emphasized exception to the application of 55(2) did not apply because the Part IV tax would have been refunded as a consequence of the payment of a dividend to its shareholder (per subsection 129(1)).
The Minister reassessed on the basis that Part IV, not 55(2), applied to the deemed dividend arising on the redemption of the special shares. Among other things, the Minister applied Part III tax to the capital dividend paid by the taxpayer. The Minister took the position that because the taxpayer never actually paid a dividend, the exception to the application of 55(2) applied and Part IV tax was payable. The Minister argued that the taxpayer, if it wanted 55(2) to apply, should have observed the following procedure:
It may be observed that the Appellant might have reported the deemed dividends as assessable dividends under Part IV and paid the appropriate tax, claimed a dividend refund with respect to the dividends paid to it [sic] shareholder, 1101332 Ontario Inc, which would have had a Part IV tax liability as a consequence, and thereby ensured that the deemed dividends would be converted back to Proceeds of disposition by the operation of subsection 55(2). (¶33 of the Respondent’s written argument at ¶7 of Air Cargo)
The Tax Court agreed with the Minister. As a result, in these circumstances, 55(2) will apply only if the taxpayer is required to include a taxable capital gain in its income and its shareholder receives a dividend that is subject to Part IV tax. In other words, 55(2) will apply and so will Part IV so that tax is paid twice in respect of the same dividend!
The taxpayer has appealed the decision to the Federal Court of Appeal.
