Safe Income Calculation – the Kruco Case
Subsection 55(2) does not apply to a dividend to the extent that the gain on the share that has been reduced by the payment of the dividend can reasonably be attributed to the share’s portion of the income earned or realized (generally referred to as “safe income”) by any corporation after 1971. It has been the long-standing position of the CRA that safe income can only contribute to a gain on shares if it is on hand and is available for distribution to shareholders as a dividend (i.e. what is commonly referred to as “safe income on hand”). The CRA’s guidelines for determining the amount of a corporation’s safe income on hand are described in various papers [Footnote 10] presented by senior CRA officials at conferences of the CTF and have been supplemented by numerous technical interpretations that have been issued since subsection 55(2) was enacted. However, the decision of the Federal Court of Appeal in the case of The Queen v. Kruco Inc[Footnote 11] has raised questions concerning the continued validity of many of these positions.
Question 1
Can the CRA explain the difference between its historical approach to the computation of safe income and that adopted by the courts in the Kruco decision?
Response 1
Historically, the CRA has taken the position that the safe income of a corporation should be reduced by the amount of any actual or potential disbursement or outlay arising in the holding period that had not otherwise been deducted in the calculation of the corporation’s net income for tax purposes and which would reduce the gain inherent in the particular shares of the corporation. In addition, it was the CRA’s position that safe income on hand should be reduced by the amount of any phantom income (i.e. income not represented by any actual receipt of funds). It is our understanding that these positions were consistent with the tax policy underlying subsection 55(2).
The CRA and Finance believed that Parliament did not feel the need to make any downward adjustments to the amount deemed to be a corporation’s income earned or realized as subsection 55(2) itself stipulated that the gain on the share had to be attributable to the safe income. If the income was not on hand, then it was logical that it could not contribute to any gain on the share. However, in the Kruco case, the courts did not agree with this interpretation. Instead, the Federal Court of Appeal found that, for the purposes of applying subsection 55(2), the amount of the gain that is attributable to safe income will, subject to certain exceptions, be equal to the amount deemed to be a corporation’s “income earned or realized under paragraph 55(5)(b) or (c)”.
Question 2
Has the CRA considered revising any of its published guidelines as a result of the Kruco decision?
Response 2
Yes we have. On our reading of the Kruco decision, the Federal Court of Appeal has found that an amount will only be included in a corporation’s safe income to the extent that it has been included in the determination of its net income for tax purposes or is an adjustment specifically set out in paragraph 55(5)(b) or (c). Similarly, an amount that has been deducted in computing a corporation’s net income for tax purposes will reduce the corporation’s safe income. Otherwise, safe income will generally only be reduced by those cash outflows that occur after the determination of net income, but before the dividend is paid (such as taxes and dividends) to the extent that such disbursements reduce the income to which the capital gain may be attributable. The CRA will follow the approach to the calculation of safe income mandated by the Federal Court of Appeal in the Kruco case.
Also, although the decision in the Kruco case involved the computation of income earned or realized of a private corporation, the CRA accepts that this reasoning is also applicable to the computation of income earned or realized of a corporation resident in Canada that is not a private corporation.
Question 3
Although the Kruco case was decided in favour of the taxpayer, some taxpayers may be adversely affected by this change to the CRA’s interpretation. For example, for corporations in the resource sector, the CRA’s historical position permitted the taxpayer to add back to income any amount deducted as a resource allowance as this deduction was based on the amount of the company’s resource profits and does not involve an outflow of funds. While the taxpayer will no longer be required to reduce its safe income for amounts included in its net income because of paragraph 12(1)(o) or the non-deductibility of Crown charges, for many taxpayers the amount of the resource allowance generally exceeded these amounts. Will the CRA provide any transitional relief for any taxpayers who may be adversely affected by its revised position?
Response 3
Yes, we are aware of this problem and, as announced in the recently published Income Tax Technical News No 33, transitional relief will be provided for taxable dividends received prior to January 1, 2007. For such dividends, the CRA will allow the dividend recipient to choose either:
(a) to determine the safe income on hand in accordance with the CRA’s historical positions; or
(b) to determine the safe income in accordance with the approach mandated by the Federal Court of Appeal in the Krucocase.
For greater certainty, the option of calculating safe income on hand following the CRA’s historical positions will only be available where the taxpayer is willing to accept the CRA’s guidelines as a package. In other words, we will not permit taxpayers to cherry pick by following those historical positions which are favourable to them while relying on the Krucodecision to avoid those adjustments that will reduce its safe income on hand. For example, a corporation in the resource sector will not be permitted to add back an amount that it had deducted as a resource allowance unless it is also willing to reduce its safe income on hand by any non-deductible Crown charges or phantom 12(1)(o) income inclusions.
For any taxable dividend received after 2006, safe income will need to be determined in accordance with the approach mandated by the Federal Court of Appeal in Kruco.