Revisions to Section 55 of the Income Tax Act (“ITA”) may prevent the tax-free payment of inter-corporate dividends within a related corporate group.

With the exception of Part IV tax where applicable, the related party exemption per S55(3)(a) will no longer be available to allow cash dividends say paid from Opco to Holdco unless there is safe income in the payor corporation at the time of the dividend payment.

A broader “purpose test” in section 55 will convert the cash dividend to a capital gain if there is insufficient post-71 tax retained earnings or what is generally called ‘safe income”. Many practitioners are concerned in that old files of tax returns and statements are not available to determine what the safe income is at the particular time. For the most part, retained earnings may be representative of safe income however in certain situations, it will not be such as fast write off of depreciable assets for tax purposes as opposed to a slower rate for accounting, safe income will be lower that retained earnings.

One may make the S55(5)(f) “designation” with the T2 to minimize the risk of the conversion to a capital gain.

Another option would be to freeze the OPCO shares and redeem over time the new special shares. In this regard, an inter-corporate share redemption is exempt under the S55(3)(a) related party exemption, so the safe income at the time of the freeze which is moved as part of the share exchange from the existing common shares to the new special shares, even though it may not be accurately determinable, does not cause a problem. The new common shares issued after the freeze would attract post-freeze safe income to which one may track going forward.

Purification techniques utilized in the past to retain the QSBC status for the capital gains exemption may no longer work under the new S55 rules. For example,sprinkling special shares were generally issued to a sister holding company to move discretionary cash dividends. Such dividends were generally exempt under Part IV due to the S186(2) connected corporation rules but also exempt under S55 due to the related party exemption. As these shares never had any safe income attributable to them and payment of dividends would reduce the value of the common shares or what is defined in the legislation as a reduction in the fair market value “of any share”, the dividend payment would likely result in a capital gain to the sister Holdco. As their redemption value was always a nominal amount (generally their nominal issue price), their redemption would not move any dollars to the sister Holdco.