The premise behind safe income is that income that has been earned, taxed and retained within the company increases the value of the company's shares. To the extent that this safe income contributes to the inherent gain on the shares, it could be subject to tax twice – first when earned, and then again through capital gains tax on a disposition of the shares. To prevent such double taxation, it should be possible to extract – or strip – the safe income amount from a company in a tax-efficient manner, reducing the gain inherent in the shares and thus reducing capital gains tax on a sale. As it happens, Canadian tax law permits this very thing.
Pre-sale transactions involving the payment of intercorporate dividends to a connected holding company may be used to extract safe income from the target company. This safe income dividend may be used to remove excess cash from the target company, to create a note payable or to increase the adjusted cost base of shares being sold. Each of these options will result in a reduction in the value or gain on the target shares and in the capital gains tax payable on their sale.
To the extent that this dividend is paid out of safe income, it may flow to the holding company on a tax-deferred basis. The tax deferral may be preserved for as long as this value is retained in the holding company and not distributed to shareholders. If safe income is exceeded on the dividend, it may be recharacterized and taxed as a capital gain, negating the desired tax benefit. Accordingly, a reliable estimate of safe income is required before undertaking such planning.
Simply put, safe income could be described as the accounting retained earnings of a company restated on a taxable income basis. In practice, however, the calculation of safe income can be much more complex than this simplified description might suggest. A safe income calculation commonly begins with a review of the company's corporate tax returns. Various adjustments, as required by law or policy, are made to the company's taxable income to arrive at the safe income.
As safe income is cumulative, past years' returns and financial statements must be reviewed. For older companies, it may be necessary to gather information from as far back as 1971, when capital gains taxation was introduced and safe income became relevant. Consequently, it is helpful if business owners have retained such records, often for longer than the six years normally required by tax law for record retention. Safe income also may be calculated on a consolidated basis, so the safe income of any subsidiaries of the target company should be considered.
Safe income accumulates to particular shareholders on a per-share basis, with consideration given to the holding period of the share. This can result in differing amounts of safe income for different shareholders, particularly where reorganizations have occurred in the past or where shares have changed hands. As a result, an understanding of the share ownership history is required.
Once safe income is calculated and allocated to particular shares and shareholders, the pre-sale transactions required to extract the safe income are implemented. A reorganization of the company's share capital may be required, particularly when safe income planning is to be combined with capital gains exemption planning. Value may be isolated in one class of shares to trigger a gain sufficient to use a capital gains exemption on the sale of those shares. To the extent that safe income may be allocated to other classes, it may be extracted to reduce the gain on those shares. The individual shareholder commonly transfers the safe income shares to a connected holding company, after which the safe income is extracted by way of a tax-free intercorporate dividend. The holding company may then sell its target company shares to the purchaser at a reduced gain, achieving a deferral of personal tax for as long as value is retained in the holding company.
A safe income strip can be a valuable but complex tool to achieve a tax-efficient sale of a business. Due to the intricacies involved, professional advice is critical.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
