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:
- A corporation received dividends from a Canadian corporation as part of a transaction that involved the disposal of shares
- The purpose of the dividends is to reduce capital gains
- 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 disposition | 200,000 |
| 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 disposition | 100,000 |
| Less: Adjusted Cost Base (ACB) | -10,000 |
| Capital Gains | $90,000 |