To create an effective corporate structure plan, business owners in Canada should understand the tax concept of safe income, as this obscure detail of the Canadian Income Tax Act (“ITA”) could cause you unnecessary grief if not considered in your planning. This article will provide information on what safe income means, how it is calculated, what challenges might be present, and what influence it has on corporate structure planning.
Corporate taxpayers resident in Canada are generally required to include inter-corporate dividends received in income, and if certain criteria are met, may deduct the same amount, in practice turning that inter-corporate dividend income into tax-free income. However, to prevent taxpayers from abusing these inter-corporate dividend distributions, Section 55 of the ITA is an anti-avoidance rule that aims to prevent taxpayers from converting capital gains on shares into tax-free intercorporate dividends.
Were it not for subsection 55(2), taxpayers would be able to pay a dividend to reduce the fair market value (“FMV”) of a share or increase the cost of property received by the recipient of a dividend on a share, thereby reducing the tax payable on subsequent disposition. In other words, these rules prevent a company from depleting its value through tax-free inter-company dividends; as such, if you are contemplating a sale of a business, safe income is a key factor that must be understood and planned for to ensure a tax-efficient result for your sale transaction.
Subsection 55(2) is a specific anti-avoidance rule intended to prevent capital gains stripping. It provides that, in certain circumstances, the amount of a taxable dividend received by a corporate shareholder may be deemed to be a capital gain and not a tax-free inter-corporate dividend for the year in which the dividend was received.
The conditions of application for subsection 55(2) are found in subsection 55(2.1):
- The dividend is a taxable dividend;
- The dividend recipient is a corporation resident in Canada;
- The dividend recipient may deduct the dividend from its income pursuant to subsection 112(1);
- One of the purposes of the payment of the dividend is to significantly reduce the capital gain that otherwise have been realized on a disposition of any share in the capital of the dividend payor, significantly reduce the fair market value of any share of the dividend payor or significantly increase the cost amount of any property of the dividend recipient; and
- The amount of the dividend exceeds the safe income on hand allocable to the share on which the dividend was paid (the “Safe Income Exception”).
Safe Income and Safe income on hand (“SIOH”)
Safe income is not defined in the ITA, but is a generally accepted abbreviation for the amount referred to in paragraph 55(2.1)(c), as income earned or realized by any corporation after 1971 that can reasonably be considered to contribute to the capital gain on a disposition of the share on which the dividend is received. The reasoning is that the income earned and retained by the corporation should increase the value of its share and has already been taxed, permitting the corporation to distribute the “Safe income” to a corporate shareholder via dividends without incurring additional tax. Dividends that exceed safe income are recharacterized as capital gains with some exceptions. The detailed discussion of these exceptions are beyond this article. These include certain related party reorganizations and dividends paid out of the Capital Dividend Account (“CDA”), and the portion of a dividend that is subject to Part IV tax that is not refunded to the dividend recipient.
The calculation of safe income relies on guidance from the CRA administrative position referred to as “Robertson Rules”. The safe income is computed on the basis of net income for tax purposes. SIOH incorporate adjustments made to safe income for amounts that will or will not contribute to the gain inherent in the corporation’s shares. For example, meals and entertainment, charitable donations, or other amounts not deductible for tax purposes will not contribute to the gain inherent in the shares and will reduce the corporation’s SIOH. Any dividends payable or paid will also reduce the SIOH attributable to the respective classes of shares of the corporation.
The starting point of the SIOH attributable to that share starts on the date on which a shareholder acquires a share, provided the acquisition date of a share is after 1971. If a shareholder acquires a share on a tax-deferred share exchange, the SIOH of the old share should flow to a new share. Where there are multiple classes of shares received for consideration for the old share, the SIOH of the old share should be allocated to the new share on the proportionate capital gain that would be realized on the disposition of the new shares.
Business owners should keep in mind that safe income is calculated on a cumulative basis. It means that to calculate safe income, the corporation would need to have on-hand after-tax earnings and dividend payment information since the shares of the corporation was acquired.
For example, a corporation has SIOH of $150,000 in Year 1 and pays out $50,000 in dividends. In Year 2, the corporation has SIOH of $100,000 and pays out $20,000 in dividends. The corporation's safe income at the end of Year 2 would be $180,000 ($150,000 + $100,000 - $50,000 - $20,000).
It might be a challenging task to calculate safe income for corporations that have been operating for a few decades and does not have a well-organized system of the calculation of their net income for tax and dividend payouts. It is important to keep in mind that any errors in past tax filings and dividend payments could result in errors in safe income calculations for the following years as SIOH balance is a cumulative balance. Corporate reorganizations such as mergers, acquisitions, and restructurings, adds a layer of complexity to SIOH calculations, as the SIOH balance will be required to be allocated to the additional or new classes of shares. If no accurate records of earnings and dividend payouts are available, or the company had a corporate reorganization in the past, business owners should seek the help of a tax professional or accountant to calculate estimated SIOH.
Even though the calculation of safe income might be challenging and complicated for companies that have been in operation for many years, it might become a valuable tool in case of the sale of the business. Prior to a corporation being sold, the SIOH and capital dividends from any available capital dividend account (“CDA”) can be distributed to the corporate shareholder(s) in the form of tax-free dividends and capital dividends respectively. The CDA account balance is made up of generally the non-taxable portion of capital gains and capital dividends received. A dividend paid in excess of SIOH will have the risk of the dividend recharacterized as a capital gain absent any availability of exemption and exceptions. This may result in immediate additional taxes on the capital gain, whereas the dividend paid from SIOH would be tax free to the corporate shareholder and tax deferral until the ultimate dividend is paid out to the individual shareholder. Knowing a corporation’s SIOH balance can assist management in determining the amount of dividends able to be paid up to a corporate shareholder (i.e. a Holding company) on a tax-free basis. The holding company is able to defer the personal taxes paid until the ultimate payment of the dividend to the individual shareholder. Planning can also be done by intentionally using ss.55(2) to convert table dividends into capital gains. By trigger a capital gain on the dividend paid in excess of SIOH, the non-taxable portion of the capital gain amount (50%), is added to the CDA account, which can be paid tax free to the individual shareholder. The disadvantage would be paying the tax on the capital gain immediately as opposed to the deferral of tax paid by the corporate shareholder until the dividend is paid to the individual shareholder.
In conclusion, safe income is an important aspect to be considered by business owners as it can become a valuable tool for their corporate structure planning. By understanding the concept of safe income, how it is calculated, and what challenges and benefits it might possess, owner-managers can make informed decisions about their corporate structure and related distributions that would maximize their wealth creation, minimize tax obligations, and protect their assets.
As safe income calculations are cumulative, they might require consultation with a tax professional to ensure that the business takes advantage of all available tax planning opportunities, and the calculations are done correctly. Reach out to our expert team for more advice on how to improve your corporate structure and ensure your wealth is preserved through intelligent tax planning.