Minden Gross LLP

Articles Newsletters Employment Newsletters		Eligible Dividends – the Good, the Bad and the Ugly by David Louis, B. Com., J.D., C.A., Tax Partner Minden Gross LLP, a member of MERITAS Law Firms Worldwide. (This release is based on an article published in Tax Notes #523, August 2006, CCH Canadian Limited)* ___________ I wouldn’t call the eligible dividend proposals[i] a model of simplicity. But my guess is that the Department of Finance was sensitive to those who warned about the possibility of undue complexity[ii]. But as we have seen over the years with other provisions[iii], the price of simplicity can be uncertainty, and this goes hand in hand with growing numbers of administrative edicts. While only time will tell how this will play out with these particular proposals, I will play a few hunches a bit later. A good overview of the proposals is contained in the introduction to the explanatory notes to the proposals, on the Finance website www.fin.gc.ca.[iv] In a nutshell, though, CCPCs[v] have something called a GRIP (General Rate Income Pool[vi]) which keeps track of income taxed at the high business rate (investment income and income eligible for the small business deduction are excluded). Eligible dividends can be paid to the extent of GRIP - so it’s a good tax account[vii]. Finance was kind enough to give CCPCs a throw-back rule, where GRIP is calculated for taxation years of a particular corporation ending after 2000[viii]. Public companies and other non-CCPCs have something called a LRIP (Low Rate Income Pool[ix]), which keeps track of income taxed at low rates, e.g., ineligible dividends received. LRIP is a bad tax account – because it blocks out eligible dividends until ineligible dividends paid clear out the account. Other than this blockage, non-CCPCs can pay out eligible dividends until the cows came home; so the rules allow a would-be CCPC to change its status[x] in return for giving up the small business deduction[xi]. The foregoing rules apply to deemed and actual dividends[xii]. Simple enough? We, the critics, warned about the complexities of such things as having a lower Part IV tax rate for eligible dividends, interaction with refundable tax, and the effect of the enhanced gross up on OAS claw-back. So guess what? The proposals don’t even deal with these. How simple can you get? Trouble is, you get a quirky system. For example if a company pays Part IV tax on an otherwise eligible dividend, this should be higher than the tax ultimately paid by the individual recipient. And since dividend refunds stem from taxable dividends - eligible or not - I don’t see anything stopping a corporation from paying an eligible dividend, while at the same time getting a dividend refund – truly a win-win situation. Quirky, but workable – so far. Sudden Impact Here’s where things get just a bit trickier. When the status of a company changes to/from a CCPC, you get an opening GRIP/LRIP account. In keeping with the KISS concept, the accounts are measured on a tax balance sheet approach[xiii]. Take a CCPC public, for example, and the net tax values (with a downward adjustment reflecting GRIP) become a LRIP account. In order to facilitate the changeover and keep things nice and simple, proposed subsection 249(4.1) calls for a deemed year end on a change of status. As this proposal is applicable to taxation years ending after 2005, there are a lot of companies that had a deemed year-end earlier this year and didn’t even know it - until now. Besides a company that went public, this could also include where the controlling shareholder ceased to be resident, or a corporation was taken over by a public company. Various deadlines could be missed. And you’d better hurry up and file tax returns. (Kids, can you say “retroactive legislation”?)) In fact, there could be several deemed taxation years. For example, if there is a binding agreement of purchase and sale entered into with a non-resident or public company, this could trigger a year end (because of paragraph 251(5)(b)), and there would be another deemed year end on a change of control itself. More quirky, but still workable. Here’s where things start to get interesting. Rather than get into what could be scores of pages of complicated legislation dealing with corporate groups, the GRIP (that’s the good account) and LRIP (that’s the bad account) are calculated on a per-company basis. There is no consolidation or related group concept - none of that stuff. An eligible dividend received enlarges a corporation’s GRIP[xiv] and an ineligible dividend received enlarges a corporation’s LRIP – that’s about it. So take an active CCPC public and it may have a LRIP (depending on its tax balance sheet) which blocks out the payment of eligible dividends. But instead, a public company vehicle could be used to acquire the company, say, in a reverse takeover. The public company may be free to take advantage of the eligible dividend regime – as long as it doesn’t get ineligible dividends from the bottom company. Or is it? Embedded in the fine print of the legislation is an anti-avoidance provision which could be applicable to this sort of structuring. It’s buried in paragraph (c) of the proposed definition of something called an “excessive eligible dividend designation”[xv] (hereinafter referred to as “(c)”). It says that the excessive dividend will be the entire amount of the eligible dividend[xvi] if – and I quote - “it is reasonable to consider that the eligible dividend was paid in a transaction, or as part of a series of transactions, one of the main purposes of which was to artificially maintain or increase the corporation’s general rate income pool [that’s the good account], or to artificially maintain or decrease the corporation’s low rate income pool [that’s the bad account].” It is interesting to note that this marks the re-emergence of the term “artificially” into the text of the Income Tax Act. On the strength of this term, the CRA has won a number of notable cases dealing with the now-repealed subsections 55(1) and 245(1).[xvii] Magnum Force For the sake of a few dollars more in a shareholder’s pocket, the consequence of tripping over this rule is rather severe – in the form of a 30%-of-dividend penalty tax on the company[xviii] which, by the way, specifically draws joint and several liability on the part of non-arm’s length recipients of dividends from CCPCs[xix]. The effect of (c) could even make Dirty Harry blush; so its scope is rather important. Simply taking an operating company public may result in a LRIP. Not being able to pay eligible dividends is obviously a competitive disadvantage vis-à-vis public companies which are not restricted in this manner. (This is somewhat ironic, because the proposals were supposed to encourage public company offerings.) However, if a company tries to “compensate” by creative tax planning, will it run straight into this anti-avoidance rule? For example, could a soon-to-be-listed corporation dividend out earnings[xx] to holdcos of pre-listing shareholders to reduce its tax balance sheet[xxi]? What if, prior to an outright sale to a public company, the selling shareholders did a safe income strip? Is that OK? If a public corporation takes over a CCPC and receives ineligible dividends from it, this blocks out eligible dividend status. What if, instead, the bottom company made a loan? Could this be considered to be artificially maintaining or decreasing the top company’s LRIP? (Are you sure? Well, are ya – punk?[xxii]). If this could be problematic, given the intricacies of intercorporate transactions, will a public company paying a dividend ever know when it is in jeopardy of a 30% tax[xxiii]? Will strategies develop to “jettison” LRIP, notably to non-resident and/or exempt entities[xxiv]? In the CCPC area, the obverse strategy (i.e., not streaming GRIP to these entities) will be preferable[xxv]. How will all this play out with the dreaded (c)? A 30% tax on a company’s dividends can be ugly. And uncertainty about this is the sort of thing that can be particularly ugly in the public company realm. Think audited financial statements, big financings, covenants, debt ratios. The more I think about it, the uglier it seems. Because the eligible dividend proposals necessitate a system of tax accounts, the price of certainty in this realm is complexity. Conversely, as I said earlier, a simpler system leads to uncertainty and administrative decrees. We have opted for the latter, and my guess is that we will eventually see something of a replay of the subsection 55(2) saga (hopefully at least, the decrees will come sooner rather than later). But it’s a no-win situation either way. In fact, this article may just scratch the surface of the issues raised by these proposals. The way I figure it, there’s some hot shot out there right now, fixing to write a long-winded tome on change-of-status elections, discontinuities of the LRIP and GRIP accounts[xxvi], or (c). Go ahead. Make my day. Thanks to Joan Jung and Michael Goldberg of Minden Gross LLP. Thanks also to Guy Dubé, BCF (Montreal) and Peter Wong, Boughton (Vancouver), both members of MERITAS. [i] Legislative Proposals and Explanatory Notes Relating to Income Tax - Dividend Taxation, released on June 29th. [ii] Myself included. For additional comments by the author on these proposals, see “Dividend Proposals — A New Ballgame for Private Companies?”, Tax Notes # 515 December 2005, and “What’s New”, Tax Notes #516, January 2006. [iii] E.g., subsection 55(2), to name one. [iv] For convenience, I have reproduced this note: The legislative measures described in these notes implement a new system for the taxation of "eligible dividends" paid after 2005 by corporations resident in Canada to individual shareholders resident in Canada. This new system builds upon, but does not replace, the existing "gross-up" and dividend tax credit provisions, and these notes assume that the reader is generally familiar with those provisions. From the standpoint of the individual taxpayer, an eligible dividend benefits from a 45% gross-up (as opposed to 25% for other taxable dividends from taxable Canadian corporations) and a federal tax credit equal to 11/18 of the gross-up. A dividend is an eligible dividend if the dividend-paying corporation has given the dividend recipient written notice to that effect. The recipient can rely on that notice, and need not know anything about the tax status of the corporation. For the dividend-paying corporation too, an eligible dividend is any dividend the corporation designates to be one. However, some corporations will have a limited capacity to pay eligible dividends. If their designations exceed that capacity, they are liable to a special tax. That tax applies to the excess amount or, if the corporation can reasonably be considered to have attempted artificially to increase its capacity to pay eligible dividends, to the full amount of the eligible dividend Corporations’ capacity to pay eligible dividends depends mostly on their status. If a corporation is a Canadian-controlled private corporation (CCPC) or a deposit insurance corporation, it can pay eligible dividends only to the extent of its "general rate income pool" (GRIP) – a balance generally reflecting taxable income that has not benefited from the section 125 small business deduction or any of certain other special tax rates. (A corporation resident in Canada that is neither a CCPC nor a deposit insurance corporation (a "non-CCPC") can pay eligible dividends in any amount, unless it has a "low rate income pool" (LRIP).) Some CCPCs are, because of their size or the nature of their income, ineligible for the small business deduction. Others may be willing to forego the small business deduction in exchange for being able to pay eligible dividends subject only to the LRIP limitation. A new election allows a CCPC to do this without also giving up other benefits of CCPC status. To simplify these and other cases where an existing corporation ceases to be (or becomes) a CCPC, a taxation year-end is imposed immediately before any such change in status, whether it results from the election or otherwise. Special rules apply to the computation of a corporation’s GRIP or LRIP, as the case may be, when it becomes or ceases to be a CCPC and when it has been party to an amalgamation or a winding-up. Other rules deal with the introduction of the new system, in certain cases giving existing CCPCs a starting GRIP. [v] And “deposit insurance corporations”, as defined in proposed subsection 89(15), hereinafter ignored for simplicity. [vi] Proposed subsection 89(1). GRIP can go negative, e.g., as a result of loss carrybacks and other “specified future tax consequences”. [vii] Excess dividends are calculated in accordance with the proposed “excessive eligible dividend designation” definition in subsection 89(1). Basically this will apply to the extent of the excess over GRIP for CCPCs and to the extent of LRIP for other corporations. Unless paragraph (c) of that definition applies (discussed below), a 20% tax applies, with the ability to designate separate non-eligible dividends in a manner reminiscent of Part III of the Act – see proposed Part III.1. I note in passing that there is actually nothing to “designate” in the “excessive eligible dividend designation” definition. The designating stuff is in Part III.1. Per proposed subsection 185.2(1), every Canadian-resident corporation that pays a taxable dividend (other than a capital gains dividend) must file a part III.1 return containing an estimate of Part III.1 tax payable. The explanatory notes do not specify what information is required in the return. [viii] See proposed subsection 89(7). The throwback rule in proposed s.89(7) is based on a notional 37% rate whereas GRIP for years ending after 2005 is based on an assumed 32% rate. [ix] See proposed subsection 89(1). LRIP is determined at any time in a taxation year; GRIP is calculated at year end. [x] See proposed subsections 89(11)-(13). [xi] See proposed paragraph 125(7)(d). [xii] A capital dividend cannot be an eligible dividend. [xiii] See proposed subsections 89(4) and (8). [xiv] It is worth noting that dividends received from foreign affiliates deductible under section 113 also increase GRIP. [xv] See proposed subsection 89(1). [xvi] With no possibility of designating a separate ineligible dividend under Part III.1. [xvii] Examples include Novopharm Limited v. The Queen, 2003 DTC 5195, FCA; The Queen v. Central Supply Company (1972) Limited, and Carousel Travel 1982 Inc., 97 DTC 5295, FCA; and The Queen v. Fording Coal Limited, 95 DTC 5672, FCA. The term artificial has generally been interpreted to apply when a transaction/deduction is contrary to the object and spirit of the Act, not in accordance with business practices, and does not have a bona fide business purpose. [xviii] See proposed section 185.1. [xix]See proposed subsections 185.2(3)-(5). While section 160 of the Act might also be applicable, the proposals include specific rules as to the extent of the joint and several liability and the effect of payments by the shareholder and/or corporation. For example, while section 160 would extend joint and several liability to the extent of the property transferred, subsection 185.2(3) imposes Part III.1 liability based on proportionate dividends received. [xx] E.g., its safe income. [xxi] Interestingly, this might also transfer a pre-existing GRIP account to the holdcos. Could this strengthen the argument for the application of (c) in respect of subsequent dividends (from both the private holdcos and the Pubco) – i.e., the transaction artificially increased both GRIP (to the holdcos) and LRIP (to Pubco)? [xxii] Would it make any different if there were memos or other evidence that this course of action was taken because of LRIP considerations? What if more complicated structures were put in place because of creditor issues resulting from the bottom company having a receivable as a result of a simple loan to the top company? [xxiii] Suppose for example that, rather than advance the funds to the public company, the public company borrowed from a third party lender, with the assets of the sub as security for the loan? [xxiv] One possibility that occurred to me is a special class of shares which would pay ineligible dividends. However, since a LRIP account should be cleared out prior to the payment of eligible dividends, query whether such a structure can be used on a systematic basis. One-off arrangements to “dump” a LRIP balance may, of course, be more problematic with respect to (c). What about reorganizations which may have the effect of transferring LRIP to another company? I.e., if a deemed dividend is involved, this would normally appear to reduce the LRIP balance of the payor corporation. I anticipate that practitioners will generally feel that rulings on the foregoing – i.e., that (c) will not apply - will be advisable, notwithstanding the limited comfort they often provide (e.g., in view of required representations, caveats, etc.). [xxv] The explanatory notes state: “subject to any constraints in the existing law and the need to avoid artificial manipulations of the pools, a corporation may choose which of its shareholders will receive eligible or other dividends.” While the CRA has not had difficulty with CDA streaming, to my mind, (c) is a more specific roadblock than the issues inherent in respect to CDA. [xxvi] Particularly subsection 89(4) and (8).