Accountants and the tax community are slowly gaining increased clarity from Canada Revenue Agency (“CRA”) regarding very significant, complex, unfavorable tax changes proposed during the 2015 year which have widespread impact to private corporations that move funds, as dividends, within a corporate group, among other things.
Historically, dividends have usually been received by Canadian corporations from other Canadian corporations within a corporate group on a tax-free basis. The proposed tax changes (which are expected to be enacted during the coming months) apply to dividends after April 20, 2015. They significantly broaden the situations in which a tax anti-avoidance rule could apply to deem an inter-corporate dividend, which would otherwise be tax-free to the receiving corporation, to be taxable as a capital gain.
These are among the most important tax changes to business owners in many years. They significantly impact funds distributed as dividends within corporate groups and could result in very large tax liabilities to unsuspecting corporations in the absence of careful tax planning prior to the dividend.
It is common, for example, for an operating corporation (“Opco”) to distribute funds it earns to a holding corporation (“Holdco”) as a dividend. In general terms, in order to avoid double taxation, the CRA continues to permit the portion of the gain inherent in the shares of Opco owned by Holdco that represents income earned by, and taxable to, Opco (“safe income”) to be distributed as a tax-free dividend from Opco to Holdco (“safe income exception”).
Likely the biggest impact of the tax changes is it is now strongly advisable (and necessary) to perform technical tax safe income calculations (and keep them updated each year) and rely on the safe income exception. The reason is that a different exception that was previously frequently relied on instead (“related party exception”) will now only apply to dividends for tax purposes arising from share redemptions.
Using safe income calculations should also avoid having to ever prove to CRA that none of three, very subjective “purpose tests” (which include two new purpose tests) are met which trigger recharacterization of a tax-free inter-corporate dividend into a capital gain.
The extent of the work required to calculate the available safe income in any client situation will depend on several factors including how long the corporate has existed, whether there has been any previous tax reorganizations / tax structuring and whether there are or have been numerous shareholders. Once an initial safe income calculation has been performed, the amount of work required to keep it updated each year should typically be fairly minimal.