For many years, the CRA has maintained that the partial realization of a gain on shares in the capital of a corporation would reduce the “safe income” attributable to those shares pro rata. As a result, a vendor of shares was often required to choose between claiming the $500,000 capital exemption and using safe income to reduce taxes on the sale of shares. 729658 Alberta Ltd. v. The Queen, 2004 TCC 474, suggests that the CRA position might be wrong and that a vendor might be able to have his exemption cake and eat it too.
Safe income, according to Justice Woods in 729658 Alberta Ltd. v. The Queen, 2004 TCC 474, is “the term commonly used to describe the amount of corporate income that can be extracted by way of tax-free intercorporate dividends without being re-characterized as capital gains under subsection 55(2).†“Safe income†is an important concept for a tax professional who is advising a vendor of shares of a corporation. It is quite common for such a vendor to attempt to extract or “strip†safe income from the corporation before the shares are sold to the purchaser. The strip reduces the purchase price (and the tax) that would otherwise be paid on the sale, removes assets that the purchaser probably does not want and allows the vendor to continue to enjoy the economic benefits of the assets financed by the safe income.
Safe income is “income earned or realized … after 1971â€, and “income†for these purposes generally means income as computed for the purposes of the Act. If a dividend is paid from safe income, then the dividend will not be re-characterized as a capital gain, and in general the corporate recipient of the dividend can receive it tax free. Looked at another way, a gain inherent in shares can be attributed to safe income and something other than safe income. If a dividend reduces the gain attributable to safe income, the dividend will not be subject to subsection 55(2). If the dividend reduces the gain attributable to something else, then subsection 55(2) will apply.
But what part of a gain is attributable to safe income? The CRA took the position that the safe income of shares is reduced, pro rata, by a gain realized on the shares. If X owned shares of Opco with a $1,000 accrued gain and $200 of safe income, and X realized a gain of $500 on the shares by transferring them to a Holdco under section 85, then the CRA took the position that only $100 of safe income remained in respect of the Opco shares held by Holdco, apparently even if X paid tax in respect of the gain. That is, on these facts, Holdco could extract only $100 of safe income from Opco as a dividend prior to a sale. Any dividend in excess of $100 would be re-characterized as a capital gain under subsection 55(2).
729658 Alberta Ltd. calls this position into question, however. Following this decision, it appears that Holdco should be entitled to receive $200 of safe income in respect of its Opco shares. Why?
The Department of Justice lawyers, on behalf of the CRA, tried to argue that the safe income should be reduced pro rata because a portion of it was inherent in the gain that had been triggered on the transfer to Holdco and was reflected in the cost of the Opco shares to Holdco. Justice claimed that taking the contrary position would “double count†the safe income. Justice Woods pointed out that this argument begged the question before her. The Justice argument was valid only if one assumed that safe income should be allocated to the gain inherent in the Opco shares pro rata for the purposes of the subsection 55(2) analysis. The wording of the statute does not support this assumption, and in fact the CRA itself does not always abide by it: it accepts that intercorporate dividends should be treated as if they had been paid first from safe income. Indeed, if it did not accept that position, the scheme of the Act would be undermined (see ¶19 of 729658 Alberta Ltd.).
Justice also tried to argue that the CRA position was in accordance with the scheme of the Act, but Justice Woods rejected that proposition. She noted that subsection 55(2) was enacted as an anti-avoidance provision and as a kind of compromise. At ¶5 of her judgement, she quoted Noel J.A.’s summary of the legislative scheme in The Queen v. Kruco, 2003 FCA 284 (at ¶32 and ¶35):
The goal was to ensure that the capital gain inherent in the shares of a corporation that is attributable to an unrealized appreciation since 1971 in the value of the underlying assets of the corporation was not avoided by the use of intercorporate tax-free dividends (subsection 112(1)). At the same time, Parliament did not want to impede the tax-free flow of dividends that were attributable to income which had already been taxed. […]
Conceptually, this approach captures the tax applicable to the portion of the notional gain attributable to an increase in value of the underlying assets while maintaining the tax-free treatment of that part of this gain attributable to ‘income earned or realized’ since 1971.
The CRA position did not appear congruent with the foregoing scheme because in the example above, between X and Holdco, tax would be paid in respect of $900 of the $1,000 gain, even though only $800 of that gain was attributable to something other than safe income. Justice Woods accepted the taxpayer’s argument, which in effect required tax to be paid in respect of only $800 of the gain on the sale to the arm’s-length party. The taxpayer’s position, she wrote, did not result in the avoidance of tax; it appeared to result in exactly the right amount being paid.
It will be interesting to explore the implications of 729658 Alberta Ltd. in our planning for clients. For example, will it be possible to employ this decision to allow a vendor to claim the $500,000 capital gain exemption and the full benefit of the safe income of the shares being sold? In the past, the CRA position rejected by 729658 Alberta Ltd. made this difficult. Perhaps the case has created new opportunities for taxpayers and their advisers.
[A version of this article by John Loukidelis and Joseph Monaco originally appeared in the March, 2005 issue of The Bottom Line.]
