Capital Gains Stripping: Section 55(2)

Capital Gains Stripping: Section 55(2)

What is Capital Gains Stripping?

  • Capital gains stripping is a method of avoiding corporate taxes by converting capital gains into dividends
  • To stop corporations from stripping capital gains tax free, section 55(2) came into effect

How do corporations strip capital gains tax free?

Few things to note before explaining capital gains stripping:

  • Corporations do not get the life time capital gains deduction; therefore, dividends are better tax-wise for corporations
  • Canadian dividends are tax free in the hands of Canadian corporations
  • In theory the FMV of a corporation’s share is equal to the present value of future cash flows; the payment of dividends will reduce the fair value
Consider the following examples:

Suppose the parent corporation wants to sell its subsidiary. The subsidiary’s shares have the following attributes: ACB = 10,000; PUC= 10,000; FMV=200,000

Example #1

  • The subsidiary will borrow money and pay dividends equal to the accrued capital gains of $190,000 (200,000-10,000) to the parent
  • Because inter-corporation Canadian dividends are tax-free, the parent will pay no Part I Tax
  • The dividend will cause the FMV of the subsidiary’s shares to go down by $190,000 to $10,000
  • The parent will now sell the shares of the subsidiary for the fair value of $10,000; since the ACB=Proceeds, no capital gains would result

Example #2

  • The parent will do a section 85(1) rollover, and transfer the shares of the subsidiary to the purchasing corporation at the adjusted cost base (ACB) = $10,000
  • The parent will take back boot of $10,000 preferred shares of the purchasing corporation valued at $190,000
  • The parent will redeem their preferred shares, this will trigger a deemed dividend of $190,000
  • Canadian dividends are tax free, the parent will pay no Part I tax on the $190,000

Section 55(2)

Section 55(2) applies when all the following are met:

  1. A corporation received dividends from a Canadian corporation as part of a transaction that involved the disposal of shares
  2. The purpose of the dividends is to reduce capital gains
  3. The shares are sold to an arm’s length party

Implications of Section 55(2)

The dividends will be added to be the original proceeds of disposition.

Example #1 and #2:

  • Section 55(2) will apply to these two examples because the purpose of the dividends is to reduce capital gains and shares sold to an arm’s length purchasing company
  • CRA will convert the deemed dividends into proceeds of disposition
Original Proceeds of Disposition$10,000
add: Dividends 190,000
Adjusted Proceeds of disposition200,000
Less: Adjusted Cost Base (ACB)-10,000
Capital Gains$190,000

Safe Income

  • Safe Income is the income earned or realized by any corporation after 1971 
  • It is basically the after-tax retained earnings computed based on taxable income rather than accounting income
  • Income earned = division B income
  • Section 55(2) does not apply to dividends paid out of the safe income balance
  • To find out to what extent the dividends are paid out of the safe income balance:
    • You use your past tax returns and financial statements to determine retained earnings from post-1971 division B income
    • Safe Income = post-1971 earnings in retained earnings less dividends paid in the past
  • In our example above,
    • if we assume that the subsidiary has $100,000 in its post 1971 retained earnings
    • safe income = 100,000
    • section 55(2) will only apply to $190,000-100,000 = 90,000 of the dividends
Original Proceeds of Disposition$10,000
add: Dividends 190,000
Less: safe income (100,000)
Adjusted Proceeds of disposition100,000
Less: Adjusted Cost Base (ACB)-10,000
Capital Gains$90,000

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