On Statutory Complexity and Safe Income Allocations

A recent CRA technical interpretation on the allocation of safe income among several classes of shares got me musing about our sometimes schizophrenic approach to drafting income tax legislation. Most often the drafters attempt to anticipate every nuance that might affect the application of any new section. So, many rules have a definition subsection, a charging subsection, an ‘includes’ subsection, one or more ‘for the purposes of’ subsections, and sometimes, a ‘for greater certainty’ clause. The foreign surplus account provisions (reg. 5907) are a particularly fine example of this approach, with the proposed restrictive covenant rules (still-to-be-enacted section 56.4) a close second. However, there are other cases in which the statutory language is deceptively transparent.

Consider section 9. It is at the heart of the calculation of income from a business or property. Yet its operation is summed up in the phrase: “income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.” “Profit” is not defined. Notably, the reference to “profit” (without a definition) is a carryforward from section 4 of the 1948 Income Tax Act. As such, it reflects an older approach to drafting that seems far removed from how it’s done today. It’s tempting to say that the ‘old’ approach has disappeared forever, but it lives on in some of the ‘modern’ (i.e., post-1972 tax reform) provisions of the current Act. One of these is the concept of “safe income” in subsection 55(2).

The subsection does not refer to safe income as such, but speaks instead of “income earned or realized by any corporation after 1971.” Although the calculation of safe income is an essential element of subsection 55(2), it is not defined in the Act or the regulations. Like “profit” in section 9, we are presumed to know safe income when we (or the courts) see it. It’s a bit of a mystery to me why the drafters of subsection 55(2) chose not to define the provision. Perhaps they assumed the idea was clear enough on its face and needed no elaboration.

As we now know, the full extent of subsection 55(2) is far from clear. Tens of thousands of words have been written about it. (The treatment of the subject in the fourth edition of the Canadian Tax Foundation’s publication “Taxation of Private Corporations and Their Shareholders” alone runs to some 97 pages. And the tax literature generally is replete with articles and notes on the same subject.) On the times when I think we could make tax legislation more understandable by replacing the intractable sections of the Act with short statements of principle, a little voice pipes up: “remember subsection 55(2)!”

Which brings me to Technical Interpretation 2012-0448651E5 (F) dated July 3,2012. Init, the CRA deals with the allocation of safe income among three classes of common shares, each of which is entitled to discretionary dividends. Under the terms of a unanimous shareholders agreement, one of the classes is entitled to a preferential payment of $5,000, which will be satisfied with an increase in the PUC of the shares of that class. In the CRA’s view, the safe income on hand in this scenario is to be allocated taking account of this entitlement, as well as the manner in which the classes of shares participate on a liquidation of the company. The TI is interesting for the way the CRA identifies the factors that might be considered in making the allocation. A key point is the relative fair market value of the respective classes after giving effect to the $5,000 entitlement, and the possible effect that a deemed dividend might have on the safe income calculation if the entitlement is satisfied with a PUC increase.

In its closing comments, the CRA notes that in other circumstances involving discretionary dividend shares there may be concerns regarding transfers of value between shareholders with possible consequences under one or more of subsection 15(1), subsection 69(1) and subsection 245(2).