Canada: The Subsection 55(2) Purpose Test – An Overview

According to subsection 112(1) of Canada's Federal Income Tax Act, if a corporation receives a taxable dividend from a Canadian resident corporation or taxable Canadian corporation, the recipient can deduct the amount of the dividend from taxable income. Pursuant to subsection 112(2), a dividend from a non-resident Corporation carrying on business in Canada through a permanent establishment can be deducted from income by the recipient corporation.

The phrase "capital gains stripping" refers to the use of the intercorporate dividend deduction to convert capitals gains to deductible dividends to gain preferential tax treatment. Subsection 55(2) specifically targets the abuse of the tax-free intercorporate dividend. In part, for it to apply, the corporation must have received a taxable dividend deductible pursuant to subsections 112(1), 112(2) or 138(6) of the Income Tax Act. The latter permits the deduction of intercorporate dividends by insurance corporations.

There are three exceptions to the application of subsection 55(2). Safe income, or income already taxed, is excepted, and can be paid out as a tax-free dividend. Paragraph 55(3)(b) allows an exception for the receipt of dividends pursuant to select corporate reorganizations and paragraph 55(3)(a) provides an exception for some related-property transactions.

The Subsection 55(2) Purpose Test

The provision applies to a Canadian resident corporation in receipt of a taxable dividend "as part of a transaction or event or a series of transactions or events." Pursuant to subparagraph 55(2.1)(b)(i), one of the purposes must have been to achieve a "significant reduction" in the capital gain due to the dividend characterization. According to subparagraph 55(2.1)(b)(ii), if the dividend is received on a share owned by the dividend recipient and the purpose of the dividend is to achieve, per subparagraph 55(2.1)(b)(ii)(A), "a significant reduction in the fair market value of any share...", subsection 55(2) is breached.

Or, pursuant to subparagraph 55(2.1)(b)(ii)(B), the provision is breached if the purpose is "a significant increase in the cost of property, such that the amount that is the total of the cost amounts of all properties of the dividend recipient immediately after the dividend is significantly greater than the amount that is the total of the cost amounts of all properties of the dividend recipient immediately before the dividend...". Or, pursuant to paragraph 55(2.1)(c), "the amount of the dividend exceeds the amount of the income earned or realized by any corporation — after 1971 and before the safe-income determination time for the transaction, event or series — that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value, immediately before the dividend, of the share on which the dividend is received."

In a Supreme Court of British Columbia decision (F. Newton Ltd. and John F. Newton v. Thorne Riddell, Thorne Ernst & Whinney, William Ramsay and Michael Fox, 1990 CarswellBC 737, [1991] 2 C.T.C. 91), the Justice, referring to subsection 55(2) stated, "[i]t surpasses my imagination that anyone considers language such as this to be capable of an intelligent understanding, or that such language is thought to be capable of application to the events of real life, such as the sale of a business...".

The Application of the Purpose Test

The purpose test of subsection 55(2) was examined and clarified by the Federal Court of Appeal ("FCA") in Canada v. Placer Dome Inc., 1996 CanLII 4094 (FCA). In Placer Dome, the corporation sought to sell its shares in two corporations. One agreed to pay dividends to Placer Dome Inc., in addition to an approximately $450 million share purchase.

CRA disagreed on the deductibility. A central issue was whether the purpose of the dividend payments was to achieve a "significant reduction" in capital gains. The Tax Court of Canada ruled that the purpose test was not contravened.

Objective or Subjective?

In Placer Dome, CRA took the position that the test was objective in nature versus subjective. The FCA recognized that introducing subjectivity into the analysis would require determining the intention or motivation of the respective parties versus a judgement based solely on the results of the transaction. And according to the FCA, the taxpayer must bear the burden to prove that they did not set out to reduce a capital gain and the CRA could assume that was the purpose. The FCA also determined that credible testimony was sufficient evidence, and a plain denial did not meet the burden.

The FCA dismissed the appeal and rejected the objective test, determining that the dividends were not issued in an attempt to reduce capital gains tax. The court noted that the legislation referred to the terms "purpose" and "result" in the same provision. For a dividend issued pursuant to subsection 84(3) the text of the provision states "one of the results of which..." was to realize a capital gains deduction. While in the same sentence, the provision states "one of the purposes of which," in regard to dividends issued outside of subsection 84(3). The wording may have resulted in the court having difficulty establishing a definitive legislative intent. It decided that "result" was evidently objective and in contrast "purpose" was subjective. Otherwise, according to the FCA, the drafters would have used the term "result" in both instances.

Collective or Individual Consideration?

In the Tax Court of Canada decision in 101139810 Saskatchewan Ltd. v. The Queen, 2017 TCC 3 (CanLII), through a complex set of transactions, the CRA alleged that the appellant had converted capital gains into deemed intercorporate tax-free dividends. Dividends were issued to Canadian resident corporations stemming from a share redemption pursuant to subsection 84(3). The dividends were deductible to the recipient corporation per subsection 112(1). Subsection 84(3) is a dividend deeming provision upon redemption.

The appellants took the position that in order to measure a "significant reduction" all of the transactions must be considered collectively and not individually. Accordingly, "since [the individual taxpayer] personally reported capital gains arising from the sale...of his shares in the appellants, there was not a significant reduction and additionally, the ""unrealized appreciation"" was not avoided by the use of intercorporate dividends...."

The decision in 729658 Alberta Ltd. v. The Queen, 2004 TCC 474 (CanLII) was referred to by the appellants in support of its position that the cumulative capital gains should be considered. However, according to the Tax Court of Canada in 101139810, a plain reading of the provision indicates that it is only applicable to a corporation. Therefore, the share transactions in the series that involved an individual shareholder were not considered relevant in measuring the reduction.

The TCC proceeded to examine the plain and ordinary meaning of subsection 55(2), relying upon the textual, contextual, and purposive analysis from the Supreme Court of Canada decision in Stubart Investments Ltd. v R, 1984 CanLII 20 (SCC). The court's key holding in ruling for the CRA was that subsection 55(2) applies to corporations only and not individual taxpayers. Therefore, transactions related to the latter were not included in the analysis. Further, the phrase "significant reduction" is targeted to a notional capital gain, not capital gains realized by the individual taxpayer on a share sale. The targeted capital gain is one that would have been realized but for the intercorporate dividend, a "notional capital gain." In the present case, the gain was reduced to nil by the dividend, a significant reduction according to the TCC.

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