Subsection 55(2) applies when the following conditions are met:
a taxable dividend must have been received by a corporation resident in Canada
the dividend received must be deductible by the corporation under subsection 112(1) or 138(6)
the dividend must have been received as part of a transaction or event or a series of transactions or events of which one of the purposes [or, in the case of a dividend under subsection 84(3), one of the results] was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at FMV of a share immediately before the dividend
the capital gain could reasonably be considered to be attributable to anything other than income earned or realized by the corporation after 1971, commonly known as safe income If the preceding conditions are met
the taxable dividend is deemed not to be a dividend received by the corporation
where a corporation has disposed of a share, the amount of the dividend is deemed to be POD of the share
and
where the corporation has not disposed of a share, the amount of the dividend is deemed to be a capital gain of the corporation for the year in which the dividend was received from the disposition of a capital property
Subsection 55(2) provides that, where Part IV tax applies on a portion of the dividend, that portion of the dividend is not considered as POD or a capital gain, depending on the case, except if the Part IV tax is refunded as a consequence of the payment of a dividend to a corporation as part of the series of transactions or events.
This subsection does not apply to the corporation paying the dividend. Thus the dividend paid is not considered to be an acquisition cost and does not increase the ACB of the property acquired; it retains its dividend status for the payer corporation.
Under the terms of the subsection, the dividend must have been received as part of a transaction, or series of transactions. Under subsection 248(10), a series of transactions or events includes related transactions or events completed in contemplation of the series.
For subsection 55(2) to apply, one of the purposes of the series of transactions or events must be to reduce significantly the capital gain that would have been realized on the disposition of a share. In the case of a dividend under subsection 84(3), one of the results of the transaction, or series of transactions, must be to effect a significant reduction in the capital gain realized on the disposition of a share. CRA has stated that a significant reduction should be measured in dollars, not percentages.
The test of “purpose” and the test of “result” referred to in subsection 55(2) differ in their thrust. According to legal precedent, the test of “purpose” must be interpreted subjectively.
The actual intent of the parties must be analyzed. If the taxpayer shows that none of the purposes of the series of transactions or events was to reduce the capital gain,
subsection 55(2) does not apply, even if the series of transactions or events had the result of reducing the capital gain that would otherwise have been realized on the disposition of shares.
The test of “result” that applies where there is a deemed dividend under subsection 84(3), when shares are either purchased or cancelled by the corporation, is an objective test. The intent of the parties is not important, and only the result of the transaction must be considered.
In order for subsection 55(2) to apply, the capital gain that was reduced must be attributable to anything other than income earned or realized by the corporation after 1971. It is thus necessary to determine what portion of the capital gain reduced by the payment is attributable 1. to income earned or realized after 1971 (the computation of earned or realized
income attributable to a share will be studied further on), and
2. to something else, such as the accrued gain not realized on assets including goodwill.
If the difference between the capital gain otherwise determined and the capital gain actually realized on the payment of the dividend is greater than the income earned or realized after 1971 on the share disposed of, the entire dividend (other than the portion subject to Part IV tax as mentioned above) will be considered to be POD or a capital gain, depending on the case. Example 4-13 illustrates how subsection 55(2) applies.
EXAMPLE 4-13
Return to Example 4-12 and assume that income earned or realized after 1971 with respect to the shares of Enterprise Ltd. is equal to the undistributed earnings of $849,000.
Tax consequences
Subsection 55(2) would apply if the series of transactions suggested in order to avoid the income tax payable of $469,765 were carried out, since all the conditions set out in subsection 55(2) would be met.
Bergeron Holding Ltd., a corporation resident in Canada, receives a taxable dividend.
Under subsection 112(1), the dividend received by Bergeron Holding Ltd. is deductible from its income.
The dividend received as part of a series of transactions or events of which one of the purposes [the result test is not applicable here, since this is not a deemed dividend under subsection 84(3)] was to reduce that capital gain that would have been realized on the disposition of the shares of Enterprise Ltd.
The reduction in the capital gain as a result of paying the dividend ($1,999,000) is greater than the amount of income earned or realized after 1971 and attributable to the shares.
Since subsection 55(2) would apply, the entire amount of the dividend ($1,999,000) would, under subsection 55(2), be considered POD of shares, resulting in a capital gain of $1,999,000 for Bergeron Holding Ltd.
4 Reading 4-4 Advanced Personal & Corporate Taxation Computation of capital gain:
Real POD $ 1,000
POD [55(2)] 1,999,000
POD 2,000,000
ACB (1,000)
Capital gain $ 1,999,000
Taxable capital gain (1/2) $ 999,500
Subsection 55(2) does not apply to Enterprise Ltd. The dividend of $1,999,000 paid by Enterprise Ltd. is recognized as such.
The effect of subsection 55(2) is to return the vendor to the situation in which he would have been if no dividend had been paid prior to the sale of the shares.
CRA considers that the portion of the capital gain attributable to income earned or realized after 1971 may be reduced by an inter-corporate dividend that must not be greater than the income earned or realized after 1971. It is thus possible to structure transactions in order to reduce the impact of subsection 55(2) and receive the income earned or realized after 1971.
Example 4-14 illustrates this type of planning.
EXAMPLE 4-14
Returning to the data in Example 4-12, assume that the income earned or realized after 1971 attributable to the shares is equal to the undistributed earnings of $849,000.
Instead of paying a dividend of $1,999,000 to Bergeron Holding Ltd., Enterprise Ltd. would pay two dividends. The first, in the amount of $849,000, would correspond to the income earned or realized after 1971, and the second, in the amount of $1,150,000, would correspond to the accrued gain on the goodwill. The first dividend, because it does not exceed the income earned or realized after 1971, would not be subject to the provisions of subsection 55(2), whereas the second would be.
Computation of the capital gain:
Real POD $ 1,000
POD under 55(2) 1,150,000
Adjusted POD 1,151,000
ACB (1,000)
Capital gain $ 1,150,000
Taxable capital gain (1/2) $ 575,000
The dividend of $849,000 would be treated as a dividend exempt from Part I tax under the deduction provided for in subsection 112(1) and exempt from Part IV tax if Enterprise Ltd.
received no dividend refund, since the corporations are connected.
In order to facilitate planning to receive income earned or realized after 1971,
paragraph 55(5)(f) provides that a corporation that has received a dividend may designate any portion of the dividend received to be a separate taxable dividend; the amount that is in excess of this portion is also deemed to be a separate dividend. This designation allows the
corporation receiving the dividend to designate a separate dividend equal to the income earned or realized after 1971, so that this dividend will not be considered to be POD or a capital gain under subsection 55(2). There is no prescribed form for making this designation;
it is made in a letter to be attached to the corporation’s income tax return. Example 4-15 illustrates the effects of this election.
EXAMPLE 4-15
Assume that, in Example 4-12, the income earned or realized after 1971 on Enterprise Ltd.’s shares was equal to the retained earnings of $849,000. Bergeron Holding Ltd. may receive a dividend of $1,999,000 and elect under paragraph 55(5)(f) to designate the dividend as consisting of two separate dividends, one of $849,000 followed by a dividend of $1,150,000.
This election will enable Bergeron Holding Ltd. to receive an inter-corporate dividend of
$849,000. The POD of the shares will be equal to $1,151,000 ($1,000 + $1,150,000), resulting in a capital gain of $1,150,000. This amount is less than the capital gain, which would have been realized if no election had been made.
Since the income earned or realized after 1971 may be computed erroneously, more than one designation may be made, thereby resulting in more than one separate dividend. The first designation would generally be an amount that is clearly less than the income earned or realized after 1971. This would ensure that the designation is covered by the income earned or realized after 1971, even in the case of error. Subsequent designations would be in intervals up to the amount of income earned or realized after 1971. For example, a corporation receives a $100,000 dividend. Even though the corporate accountant is sure that the income earned or realized after 1971 is at least $70,000, he believes that, from his computations, it could be
$80,000. The corporation may therefore make a multiple designation under
paragraph 55(5)(f): a separate dividend of $70,000 followed by two separate dividends of
$5,000 each and a final dividend of $20,000.