A Bigger Butterfly Net: Proposed Changes to Section 55(2) Could Catch Most Intercorporate Dividends

Of the more unexpected elements of the 2015 Federal Budget were the proposed changes to the capital gain stripping rules in subsection 55(2) and related provisions of the Income Tax Act (Canada), commonly referred to as the "butterfly rules".  55(2) is an anti-avoidance provision that attempts to prevent a shareholder from converting what would otherwise be a taxable capital gain from the disposition of shares into a tax-free inter-corporate dividend.  There are limited exceptions for dividends paid out of "safe income", to certain related parties or as part of a "butterfly" transaction.

Currently, subsection 55(2) could apply where one of the purposes of paying a dividend is to reduce the capital gain that would have been realized on a disposition of shares immediately before the dividend was paid.  For deemed dividends (such as on a redemption of shares), subsection 55(2) could apply if one of the results of the deemed dividend was to effect such a reduction in this hypothetical capital gain.  If subsection 55(2) applies, the dividend (or deemed dividend) will be recharacterized as a gain from the disposition of capital property.

Budget 2015 proposes to expand the "purpose test" under subsection 55(2) to include circumstances where one of the purposes of the dividend is to effect either (i) a significant reduction in the fair market value of any share or (ii) a significant increase in the total cost of properties of the dividend recipient.  This new purpose test is extremely broad and will capture dividends that are currently beyond the scope of 55(2).

However, by expanding the purpose test to include any significant reduction in fair market value of a share, rather than a reduction in a hypothetical capital gain, there is a risk that the new 55(2) will capture dividends that are not necessarily abusive under the existing purpose test.  For example, a creditor-proofing dividend arguably does not have as its purpose the reduction of a gain on its shares, particularly if no sale is contemplated at the time of the dividend.  However, it would be much harder to claim that such a dividend is not intended to reduce the value of the company's shares, regardless of whether a sale is on the horizon.

Budget 2015 also proposes to limit the related-party exception under paragraph 55(3)(a), which currently applies to all types of dividends. The proposed rule would exempt only deemed dividends under subsection 84(3), which arise on a corporation's redemption of its shares.  Furthermore, high-low stock dividends would now be fully caught by the expanded rule. Currently, only the PUC amount of a stock dividend is relevant in applying 55(2).  Budget 2015 would deem the amount of a stock dividend to be the greater of the PUC and FMV of the stock dividend shares.

This could make it more difficult to carry out certain transactions that are not otherwise offensive under the butterfly rules.  Take the example of a corporation that holds active business assets and investment assets.  It may be desirable to move the investment assets to a new corporation.   Often this is accomplished by way of either a "related party butterfly" or a "single wing butterfly" under paragraphs 55(3)(a) or (b).  Such structures commonly involve issuing a high-low stock dividend with FMV equal to the value of the investment assets.

Under the proposed rules, the stock dividend would be recharacterized as a capital gain unless the dividend payer has sufficient safe income.  The same result could still be achieved without a stock dividend; however, an alternative structure would likely necessitate obtaining a valuation of all of the corporation's assets rather than simply of the investment assets being transferred, potentially adding significant cost and time.

One other notable change involves the exemption for dividends paid out of "safe income" (essentially, the income tax equivalent of retained earnings).  Under the proposals, 55(2) would apply to dividends that exceed the safe income attributable to "the share on which the dividend is received".  The current version of 55(2) does not include this language.  One possible purpose of adding this language is to capture dividends paid on "dividend sprinkling" shares – i.e., discretionary dividend shares with a nominal redemption amount.  In recent technical interpretations, CRA has suggested that dividends paid on such shares may not trigger 55(2) provided the dividends do not exceed the safe income attributable to the common shares.  The proposed rules would appear to prevent this "shifting" of safe income from the common shares to such dividend sprinkling shares.

The proposed rules would apply to dividends received after April 20, 2015.  While the proposed amendments are still subject to consultation and changes are possible, it is important that these proposals be kept in mind when paying dividends.