Canada: Anti-Avoidance And Intercorporate Dividends: Changes To Section 55 Of The Income Tax Act

The Income Tax Act (ITA) contains many anti-avoidance rules forbidding taxpayers from misusing the provisions of the ITA to achieve tax benefits contrary to Canadian tax policy. The 2015 Federal Budget has proposed changes1 to one of these anti-avoidance rules, which may significantly impact the ability of business owners to move cash and assets between companies.

The changes affect section 55 of the ITA. Section 55 contains provisions that convert tax-free intercorporate dividends (dividends paid by a corporation to another corporation that owns shares of the payor) into capital gains. The effect of this conversion is to take something that would otherwise be non-taxable (an intercorporate dividend) and to make it taxable (a capital gain). The proposed legislation will expand the application of these rules and make such ordinary practices as moving money from an operating company to a holding company considerably more complicated.

The rules apply for dividends paid after the budget day, April 20, 2015. There are several major changes that will impact ordinary transactions.

Cash dividends between related companies

Under the current legislation, there is an exemption from the application of section 55 when the series of transactions surrounding the dividend does not involve unrelated parties. The proposed legislation seeks to limit this exemption to dividends resulting from redemptions of shares – cash dividends will no longer be eligible for the exemption. Business owners who pay cash dividends within a related party corporate structure must, for the first time, take account of the application of section 55 to their intercorporate dividends.

Intercorporate discretionary dividend shares

The related party exemption allowed related party corporate groups to use nominal value intercorporate preferred shares (often called "discretionary dividend" shares) to move dividends around a corporate group simply and cost-effectively. The removal of the related party exemption, however, forces such cash dividends to be paid out of after-tax retained earnings (often called "safe income"). However, the proposed legislation adds that the safe income in question must be considered to contribute to a capital gain, which would be realized on the share on which the dividend was paid. Because such shares have a nominal fixed value, it would be difficult to suggest that the company's after-tax retained earnings could contribute to a gain on those particular shares. As a result of these first two changes, intercorporate dividends on discretionary dividend shares can only escape conversion into capital gains where none of the purpose tests (discussed below) are met.

Payment of intercorporate dividends on separate classes of common shares

The changes described above (the elimination of the related party exemption for cash dividends, and specifying that the safe income in question must be considered to contribute to a capital gain, which would be realized on the share on which the dividend was paid) have made it difficult to pay differential intercorporate cash dividends on separate classes of common shares. This change is evident in the context of related party structures, where shareholders could previously pay different dividends on each class of common shares without worrying about whether the amounts paid were out of safe income.

Expansion of the purpose tests

For section 55 to apply, the current legislation requires that one of the purposes of a cash dividend be: to effect a significant reduction in the portion of the capital gain that would be realized on a disposition at fair market value of any capital stock. The proposed legislation expands this purpose test by adding two additional scenarios in which section 55 will apply: if one of the purposes of the dividend is to effect a) a significant reduction of the fair market value of any share, or b) a significant increase in the cost of property owned by the dividend recipient. For cash dividends paid on discretionary dividends and separate classes of common shares, it will be necessary to argue that the dividend did not have any of these three effects as even one of its purposes.

Additional impacts

The changes to section 55 will also impact the ability of business owners to use intercorporate stock dividends and shareholder adjusted cost base in corporate tax planning.

The proposed changes to section 55 will profoundly impact the complexity and cost of paying intercorporate dividends for small business owners, particularly those who previously could largely ignore the section. If you are considering paying an intercorporate dividend in the coming months, contact your Collins Barrow advisor for more information and guidance.


1. The draft legislation has been released by the Department of Finance but, as of the date of this Tax Alert, has not yet been passed by Parliament. The implications of the legislation as discussed in this Tax Alert may be altered if the legislation is amended before being passed.

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.

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