TCC upholds “capital gains stripping” transaction

In the Canadian domestic tax context, an accrued gain on shares held by one Canadian company in another Canadian company may be safely reduced by the payment of an inter-corporate dividend provided the gain so reduced is attributable to underlying previously-taxed income (“safe income”, s. 112 and s. 55(2)). The reduction of a gain on shares by an inter-corporate dividend is sometimes referred to as “capital gains stripping” (or a “safe-income strip”, where the dividend is limited to the underlying safe income). The basic tax policy is that underlying safe income has already been taxed once at the corporate level; such income should therefore pass tax free from one Canadian company to another without any further Canadian corporate tax. Interesting safe income results can arise in a chain of companies. For example, the accrued gain on shares that a particular corporate shareholder (Company A) owns in another company (Company B) may be attributable to both (i) the underlying safe income in Company B and (ii) the underlying safe income in a subsidiary of Company B (Company C) – provided that both of these (safe income) amounts can reasonably be considered to contribute to the gain on Company A’s shares of Company B. At the very same time, the accrued gain on shares that Company B owns in Company C may also be attributable to the underlying safe income in Company C.

In D&D Livestock Ltd. v. The Queen, 2013 TCC 318 the corporate group exploited this concept of safe income within a corporate chain. The equivalent of Company A above managed to co-ordinate a complex series of stock dividends and share rollover transactions (within the group) which allowed it to, in effect, take advantage of Company C’s safe income twice, and thereby reduce a capital gain on a subsequent sale of shares to an arm’s length buyer. The Tax Court recognized that the use of this safe income twice defeated the general purpose of the rule that permits the use safe income to reduce the gain on a share (s. 55(2), see paragraph 33). However, based on the precise steps undertaken by the group – which resulted in safe income dividends on shares of both Company B and Company C – no ambiguity arose when it came to applying the actual words of s. 55(2). In the absence of such ambiguity, the Tax Court said it had no authority “to simply re-write the subsection to give effect to its purpose”. The Tax Court further observed that if the government finds such transactions to be abusive, it can always attack them using the general anti-avoidance rule (s. 245) or recommend that Parliament amend the Act.