Inter-corp dividends paid on a disability buy out and subsection 55(2) implications
Question 5 of the 2018 APFF Canada Revenue Agency (CRA) Round Table involved an insurance-funded disability buy-sell situation. These are the facts of the situation:
Mr. A owns 100% of ACo, which owns 50% of the Class B shares of Opco which have a fair market value (FMV) of $500,000.
Mr. B owns 100% of BCo, which owns 50% of the Class B shares of Opco which have a FMV of
Mr. A owns 50% of the Class A shares of Opco with a FMV of $1 million.
Mr. B owns 50% of the Class A shares of Opco with a FMV of $1 million.
Opco owns $1.5 million of buy-sell disability insurance on each of Mr. A and Mr. B.
If Mr. A becomes disabled, Opco would pay a dividend to BCo of $1 million so that it can purchase Mr. A’s Class A shares of Opco. Afterwards, Opco would redeem the Class B shares held by ACo. BCo would now own 100% of the Class B shares of Opco and 50% of the Class A shares of Opco. Mr. B would continue to own 100% of BCo and the other 50% of the Class A shares of Opco.
The question explores whether or not each type of dividend – the inter-corporate dividend paid to BCo to purchase shares from Mr. A and the redemption dividend paid to ACo – would be affected by subsection 55(2) of the Income Tax Act.
One clarification that the CRA made is that to do a special dividend to one shareholder of the same class and not the other, they’d need to understand the attributes of the shares. Since the CRA didn’t have that information, they did not comment on the efficacy of paying the dividend to BCo as described. Let’s just assume that ACo and BCo had separate classes of shares, Class B1 and B2, which would allow for the payment of different dividends.
Here’s some background: “Safe income” and life insurance
If subsection 55(2) applies, it would have the effect of re-characterizing a tax-free, inter-corporate dividend as a capital gain. 55(2) would generally apply if one of the purposes of the dividend is to cause:
? a significant reduction in the capital gain that would have been realized prior to the dividend payment, on the disposition of any Opco share at FMV
? a significant reduction in the FMV of any Opco share, or
? a significant increase in the cost of property held by ACo or BCo.
With respect to a redemption of shares, according to paragraph 55(3)(a), subsection 55(2) may not apply if:
? as part of the series of transactions, no unrelated party obtains an ownership interest in the dividend payor (Opco) or dividend recipient (ACo),
? nor is there a disposition of property to an unrelated party for proceeds less than FMV.
Since BCo’s ownership interest in Opco increased due to the series of transactions, this exemption may not apply.
An inter-corporate dividend (or deemed dividend on a redemption of shares) can be protected from recharacterization if there is enough “safe income” attributable to the shares on which the dividend is received.
Put simply, safe income is a corporation’s accumulated, retained earnings calculated under tax rules.
The safe income must be accumulated during the period of ownership and before the “safe income determination time”. The safe income determination time is generally immediately before the inter- corporate dividend is paid.
Disability insurance premiums for buy-sell coverage are non-deductible for tax purposes. The disability insurance proceeds are non-taxable. For the purposes of calculating safe income, these amounts would not contribute to safe income.
In our example the CRA stated that 55(2) could apply to the dividend to BCo and the redemption dividend to ACo. The CRA left open the possibility that in any given situation it’s a question of fact and the taxpayer could submit a Ruling request. The Department of Finance confirmed that the CRA’s position aligns with tax policy and confirmed that amounts Opco received that are not included in its income, such as disability insurance proceeds, are not included in safe income.
This all means that to pay an inter-corporate dividend on a disability buy-out on a tax-free basis, Opco would have had to have accumulated sufficient safe income. The safe income must be attributable to the shares on which the dividend is paid. Having the tax-free cash available from disability insurance proceeds does not help in this determination.
For the example provided, if there isn’t sufficient safe income and subsection 55(2) applies to both the cash dividend and the deemed dividend on the redemption of shares, these would be the results.
If BCo has a nil adjusted cost base (ACB) in its Class B shares, BCo would realize a capital gain of
$1 million. That would result in a capital dividend account (CDA) credit of $500,000 for the non- taxable portion of the capital gain, and tax payable of $250,000 (assuming a 50% tax rate).
The refundable dividend tax on hand (RDTOH)would be $153,350 resulting in net, after-tax proceeds to BCo of $750,000 to buy Mr. A’s Class A shares, which is less than the full $1 million required to do the buy out.
Assuming Opco is a qualified, small-business corporation, if Mr. A has an available lifetime capital gains exemption (currently $848,252) on the sale of his personally held Class A shares, he would only have a capital gain on the difference ($151,748). Assuming a 50% tax rate, his net, after-tax proceeds would be $962,063.
Assuming ACo had a nil ACB on its Class B shares, ACo would realize a capital gain of $500,000 on the redemption. The resulting CDA credit would be $250,000 and the tax payable would be
$125,000 with the RDTOH of $76,675, resulting in net after tax to ACo of $375,000.
When Mr. A receives the redemption proceeds taxed in ACo as a capital gain, he would receive
$358,171 net of tax (assuming a 45% tax rate on ineligible dividends).
o The result is actually better for Mr. A than if the redemption were not recharacterized as a capital gain under 55(2). A $500,000 dividend to Mr. A would net him $275,000 after tax.