Introduction – Tax Free Inter-Corporate Dividends
Under Canadian tax law, corporations are able to issue dividends to certain other Canadian corporations on a tax free basis. This can be accomplished through the use of s.112(1) of the Canadian Income Tax Act ("ITA") where the Canadian corporation that received a taxable dividend from another Canadian corporation is able to deduct an amount equal to that dividend from its income for that year, resulting in what is essentially a tax free transfer. However, a refundable Part IV tax may still apply on that dividend unless the two Canadian corporations are connected which requires that one of the corporations owns at least 10% of the shares of the other corporation and those shares are worth more than 10% of the fair market value of all issued shares of that other corporation, usually referred to as at least 10% of vote and value.
The general idea is that business is often conducted through various connected corporations and that the movement of funds between these corporations is often ultimately tax neutral to for the Canada Revenue Agency ("CRA"). The corporation that is paying the dividend typically earned it and has already paid corporate taxes on that dividend and when that money is eventually paid out to shareholders or employees, tax will be paid on that regardless of whether the it is the first corporation paying it out or a different corporation. As such, inter-corporate dividends are allows to flow tax free between connected corporations. To learn more about inter-corporate dividends call our top Toronto tax firm.
Capital Gains Stripping
However, these tax free inter-corporate dividends are also relevant when considering the sale of a corporation. A large part of the value of a profitable corporation will often be in its business assets, intangible property such as intellectual property or tangible property such as real estate or equipment. But, that same corporation may also have a substantial amount of retained earnings or cash reserves. When the shares of the corporation are sold, the seller is typically subject to a capital gain based on the increase in value of the shares which includes both the business assets as well as any cash it may have. In order to reduce that gain as much as possible, it is a common tax planning practice to utilize tax free inter-corporate dividends to remove as much of the cash as possible.
For example, consider a corporation with $1,000,000 in business assets and $300,000 in cash and the adjusted cost base of the shares was $1. Upon selling the shares, a capital gain of $1,299,999 would be realized and the taxable portion of that would be $649,999.50 which would be included in the seller's income for that year. However, if the cash is removed from the equation, the gain would accordingly drop to $999,999 and the taxable gain would be reduced to $499,999.50, saving something in the range of $75,000 in tax assuming a tax rate of 50% (approximate top marginal tax rate).
For income that has already been subject to corporate tax, this practice is not a problem. However, it is possible for a corporation to have cash that has not been subject to corporate tax. For example, that same business with $1,000,000 in business assets might get a $500,000 loan and then immediately transfer that by way of inter-corporate dividend. This would reduce the fair market value of the corporation accordingly and reduce the capital gain on sale to $499,999.5 and the taxable capital gain down to $249,999.75. Since that $500,000 came from a loan, it would not have been subject to corporate tax. In that case, anti-capital gains stripping provisions can apply to deem the amount that the offending inter-corporate dividend reduced the capital gains on the sale of the corporation to be proceeds of disposition and thus subject to a capital gain. As such, the after tax retained earnings of a corporation needs to be tracked and is referred to as safe income in this context.
Safe Income on Hand
However, just having enough safe income is not enough to safely issue the dividend. The safe income must also be on hand. The safe income on hand is the safe income earned during the relevant holding period that could reasonably be considered to contribute to the capital gain that would be realized on a disposition at fair market value of the share at that time. What that means is that if income has already been distributed previously as a dividend or used to pay taxes or a non-deductible expense, then it can no longer contribute to the fair market value of the share and thus is not considered to be on hand.
Tax Tip – Don't Wait until a Share Sale to calculate Safe Income on Hand
Not only is the concept of safe income on hand rather complicated, a sometimes unrecognized issue is that it cannot always be calculated when one is contemplating a share sale if it was not properly being tracked. This is because the safe income on hand is a running calculation from as far back as 1971 to present that needs to track all safe income earned and all relevant reductions of it to obtain the safe income on hand amounts. However, corporations will often not retain financial records for that back, so if one has not been keeping track of safe income, one's ability to minimize capital gains on the eventual sale of the shares may be reduced to only that amount that can be calculated from what records exist at that time. Corporations need to make sure that they are keeping proper track of these important tax attributes in order to take maximum advantage of available tax planning and tax mitigation strategies. Speak to one of our experienced Toronto tax lawyers and make sure you are doing everything you can to reduce your taxes.
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.