In last month's article “When to consider having a Holdco” I discussed the ability of a Holdco to receive tax-free intercorporate dividends from their Opco. Business owners frequently distribute dividends from their Opco to their Holdco for a variety of reasons, including creditor protection. The expectation is that these dividends will flow to Holdco on a tax-deferred basis. Upon receipt of these dividends, Holdco may decide to reinvest these dividends in a variety of investments, if desired, including a diversified portfolio of marketable securities and/or permanent life insurance. To be able to pay tax-free dividends, Holdco and Opco must be “connected” and Opco must have enough “safe Income” to allow the funds to flow tax-free. Today we’ll explore the section of the Income Tax Act (subsection 55 (2)) that defines when an intercorporate tax-free dividend can be paid and specifically, what qualifies as “safe income”. It may surprise you to find out what doesn’t qualify.
Before we dive into the world of “safe income” let’s review how a Holdco and Opco are “connected,” since this is one of the main requirements to being able to pay a tax-free dividend. To be connected, the recipient corporation must own shares of the payor entitling it to more than 10% of the underlying votes and value, or one of the corporations is controlled by the other corporation or by persons not dealing at arm’s length with the other corporation. Control in this context means owning more than 50%.
Now that we got that piece out of the way, let’s discuss the issue of “safe income.” To understand “safe income and intercorporate tax-free dividends, we must first delve into the section of the act that covers this topic. Subsection 55(2) is an anti-avoidance rule intended to prevent the conversion of a taxable capital gain into a tax-free inter-corporate dividend. For example, it was intended to stop transactions where an Opco would pay a significant tax-free dividend to a Holdco, and then sell the shares of Opco for a much lesser amount. Due to its subjective “purpose” test and the availability of a number of exceptions that can get you out of the rules (for example, safe income dividends and butterfly reorganizations), subsection 55(2) has always been an extremely complicated provision to understand. For this reason, I will not discuss this section in detail and suggest advisors have their clients consult with a professional tax advisor to confirm if, in fact, a tax-free intercorporate dividend is available. This is even more imperative given the changes introduced in 2015 to this section which has only broadened the circumstances in which subsection 55(2) can apply. If subsection 55(2) applies, the portion of the inter-corporate dividend that is not sheltered by one of the exceptions is converted to proceeds of disposition, resulting in a taxable capital gain to the recipient (Holdco). Therefore 50% of the distribution will be taxable to the recipient corporation.
So, what is “SAFE INCOME”?
Safe income is the taxable income received by a corporation after tax has been paid and that balance has been retained by the corporation. So, it’s basically after-tax retained income. However, “safe income” is not quite the same thing as ‘retained earnings. For example, claim proceeds received by a corporation from critical illness insurance or disability insurance do not increase “safe income.” Here are some transactions that can be affected by the safe income rules:
Transferring a large amount of funds as dividends, perhaps to fund premiums on an insurance policy held by the Holdco.
Transferring CI or DI claim proceeds as dividends from Opco to Holdco. This problem can occur in various buy-sell arrangements whereby Opco is the owner of the DI and/or CI policies: (1) In a promissory-note purchase method: The buyer-survivor’s Holdco may not end up with sufficient funds due to capital gains tax exposure on proceeds above the safe income levels. (2) In a share redemption purchase method, tax exposure may occur but only to the ‘seller-deceased’ party’s Holdco. One way to avoid this is to arrange a “criss-cross” purchase method. The Holdco would own the policy on the other shareholder and would not be subject to taxation because “safe income” rules would not apply. Therefore, all proceeds received would be available to fund the purchase from the disabled (or critically ill) Principals’ Holdco.
Lastly, transferring ownership of a policy of insurance from an Opco to a Holdco as an in-kind dividend since the transfer value will be its fair market value (FMV) which could be considerably more than the cash value. This is a common occurrence if and when the shares are to be sold. I’ll be covering the topic of policy transfers and taxation in all its glory in the next article.
As you can see, this is a really big issue that many financial advisors are not aware of that will affect any of your clients who are business owners when some or all of the shares of an Opco are owned by a Holdco. It’s important to be aware of this and know what the limitations are and when to call in the client’s professional tax advisors.
Tony Gallippi, B.A.S (Hons.) CFP CLU
Director, Advanced Planning, Insurance
This communication reflects the views of Qualified Financial Services Inc. as of the date published. The information in this publication is for general information purposes only and is not to be construed as providing individual legal, tax, financial or other professional advice. Qualified Financial Services Inc. assumes no responsibility for any errors or omissions in the information contained herein nor for any reliance placed on such information. Please seek independent professional advice before making any decisions.