Even routine intercorporate dividends can unexpectedly be recharacterized as capital gains under subsection 55(2) of the Income Tax Act (Canada) (“ITA”), creating significant and avoidable tax exposure for clients. Although tax advisors routinely rely on dividends to move funds between corporations on a non-taxable basis, subsection 55(2) can apply whenever one of the purposes of the dividend is to reduce the capital gain that would otherwise be realized on a sale of the shares of the dividend payer. Before recommending or paying a dividend, advisors should pause to consider whether the transaction might fall within the reach of subsection 55(2).
Below are some common situations where extra caution is warranted:
- There is no established dividend policy.
- Safe-income balances are unclear or unavailable.
- The dividend could be considered as part of the same series of steps as a concurrent reorganization.
- A potential sale is being contemplated by the client.
Each of these scenarios is discussed in more detail below, along with practical considerations for managing risk.
Scope and Impact of Subsection 55(2)
It should be of concern to tax advisors that subsection 55(2) of the ITA can apply to many seemingly ordinary intercorporate dividends, since dividends inherently reduce the value of the payor’s shares. The CRA has acknowledged the potentially broad application of the provision, advising that dividends, “paid pursuant to a well-established policy of paying regular dividends”, based on a “reasonable dividend income return on equity on a comparable listed share”, will not offend the rule (2016-0627571E5). In practice, this leaves advisors with limited certainty, since the CRA’s position relies on subjective notions of what is “regular” and “reasonable”. This guidance is also CRA’s administrative position only and is therefore non-binding.
Paragraph 55(3)(a) provides relief for intercorporate dividends within certain related-person reorganizations, and section 55(2) will not apply to the extent that Part IV tax applies and is ultimately not refunded. Outside of those circumstances, advisors must always consider the potential impact of subsection 55(2) on each intercorporate dividend, even beyond the context of a larger reorganization.
Safe Income: Protected from Subsection 55(2)
When issuing an intercorporate dividend, it is extremely helpful to know if there is any “safe income” available. Safe income paid as an intercorporate dividend will not be recharacterized as a capital gain under subsection 55(2), and therefore corporations with a large safe income balance can pay intercorporate dividends with greater certainty. For accountants, confirming the availability of safe income is a practical step that can prevent unexpected 55(2) issues in routine dividend planning. As professionals, knowing that a corporation has a safe income balance can be very helpful for future planning, especially when considering a potential sale.
Broader Context: Series-of-Transactions
Intercorporate dividends should not be issued in isolation; there must be consideration of the broader context surrounding the dividend and the future plans of the dividend payor. In determining whether subsection 55(2) may apply, advisors must consider the broader transaction or “series of transactions” of which a dividend forms part. The phrase “series of transactions” is defined broadly in subsection 248(10) of the ITA and has been interpreted expansively by the courts (as in Copthorne Holdings Ltd.), meaning that even transactions that are reasonably contemplated can form part of the same series.
For example, if a client casually mentions that a sale “might be coming up soon,” even if no formal steps have been taken, advisors should consider whether a dividend issued in the meantime could later be viewed as part of the same series of transactions for purposes of subsection 55(2). Advisors should view this as a practical signal to pause and review the client’s broader plans before proceeding with dividends. It is crucial to consider the whole picture before advising on issuing an intercorporate dividend.
Final Thoughts
Intercorporate dividends may seem like a simple way to move funds between corporations on a non-taxable basis, but the broad application of subsection 55(2) means it is not so straightforward. There is much to consider when determining whether subsection 55(2) may apply to an intercorporate dividend, and seemingly innocuous transactions can sometimes result in unintended tax consequences. For strategic guidance on the application of subsection 55(2), feel free to reach out anytime to discuss in more detail. If you have a particular scenario, transaction, or set of circumstances you’d like to review, or would like help confirming whether 55(2) may apply, I’m always happy to connect and explore how I can support.
