Income Earned or Realized – The Kruco Case
Subsection 55(2) of the Income Tax Act (the “Act”) is an anti-avoidance provision directed against arrangements designed to use the inter-corporate dividend exemption to reduce a capital gain on the sale of a share. Subsection 55(2) will generally apply where the purpose of the dividend (or the result in the case of a deemed dividend under subsection 84(3)) is to significantly reduce the amount of the capital gain that would otherwise have been realized on a fair market value sale of the share. However, subsection 55(2) does not apply to the extent that the gain that has been reduced can reasonably be attributed to the share’s portion of the income earned or realized by any corporation after 1971.
The expression “income earned or realized by any corporation after 1971” (generally referred to as “safe income”) means a corporation’s net income for income tax purposes, as adjusted by paragraphs 55(5)(b), (c) or (d), as the case may be. Consequently, the starting point is the corporation’s net income for tax purposes as determined under section 3 of the Act. (See 454538 Ontario Ltd. v. MNR, 93 DTC 427, [1993] TCJ No. 107.) To this amount are added the specific adjustments set out in paragraph 55(5)(b), (c) or (d) of the Act.
It has been the long-standing position of the Canada Revenue Agency (“CRA”) that safe income can only contribute to a gain on shares if it is on hand and available for distribution to shareholders as a dividend (i.e. what is commonly referred to as “safe income on hand”). Consequently, in computing the amount of safe income on hand that was attributable to a particular share during the relevant holding period, it had been the CRA’s 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 relevant holding period that had not otherwise been deducted in the calculation of the corporation’s net income 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). These guidelines for determining the amount of a corporation’s safe income on hand are described in various papers Footnote 1 presented by senior CRA officials at conferences of the Canadian Tax Foundation and have been supplemented by numerous technical interpretations that have been issued since subsection 55(2) was enacted.
The decision of the Federal Court of Appeal in the case of The Queen v. Kruco Inc., 2003 DTC 5506, [2003] 4 CTC 185, has overturned a number of the CRA’s published guidelines for determining the safe income on hand attributable to a share of a corporation. In this regard, Noël J. made the following comments at the end of paragraph 42 of this decision with respect to a phantom income adjustment that had been made in the computation of safe income on hand as described in the CRA guidelines:
“In short, it is not open to the Minister to modify the amount which Parliament has deemed to be a “corporation’s income earned or realized” for purposes of subsection 55(2).”
Noël, J. did, however, acknowledge at paragraph 41 of the decision that cash outflows which occur after the determination of a corporation’s income earned or realized, but before the dividend is paid (such as taxes and dividends) and that reduce the income to which the capital gain may be attributable can also be deducted in computing safe income on hand.
Although the decision in the Kruco case involved the computation of income earned or realized of a private corporation under paragraph 55(5)(c), the CRA acknowledges 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 under paragraph 55(5)(b).
The Federal Court of Appeal has indicated in the Kruco case that an amount will generally 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 mandated by the Federal Court of Appeal in the Kruco case.
Where the corporation owns shares of a foreign affiliate, the CRA believes that the decision of the Federal Court of Appeal in the case of Canada v. Brelco Drilling Ltd, [1999] 4 F.C. 35, 99 DTC 5253, [1999] 3 CTC 95, should still be followed.
While the Kruco case was decided in favour of the taxpayer, we recognize that some taxpayers may be adversely affected by the CRA’s change in interpretation resulting from this case; consequently for taxable dividends received prior to January 1, 2007 the CRA will allow the dividend recipient to choose either:
(a) to determine the safe income on hand attributable to the particular share in accordance with the CRA’s historical positions as described in the publications and technical interpretations referred to above; or
(b) to determine the safe income attributable to the particular share in accordance with the approach mandated by the Federal Court of Appeal in the Kruco case also as outlined above.
The determination of safe income on hand in accordance with the CRA’s historical positions as set out in option (a) above will only be available where the taxpayer is willing to accept the CRA’s guidelines as a package, in other words, both those adjustments set out in the CRA’s published guidelines which are advantageous to it along with any adjustments that will reduce its safe income on hand. For example, an amount that the CRA has previously accepted as an addition to safe income on hand and which is not specifically included in safe income pursuant to either of paragraphs 55(5)(b) or (c) of the Act (such as the amount deducted by the corporation as a resource allowance) can no longer be included in safe income unless the taxpayer is also willing to reduce safe income on hand by any downward adjustments stipulated in the CRA guidelines (including non-deductible expenses, such as crown royalties).
For any taxable dividend received after 2006, the safe income attributable to the particular share will need to be determined in accordance with the approach mandated by the Federal Court of Appeal in the Kruco case.
Link to source: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/itnews-33/archived-income-tax-technical-news-no-33.html