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
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.
To print this article, all you need is to be registered on Mondaq.com.
Click to Login as an existing user or Register so you can print this article.
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).