This article by Rick McLean, CA, KPMG LLP, author of Understanding Section 55 and Butterfly Reorganizations and presenter in the October 13th webinar of the same title, discusses recent revisions to proposed amendments impacting safe income capitalization through paid-up capital increases and stock dividends.

The draft income tax technical amendments released by the Department of Finance on July 16, 2010 contain some welcome revisions to previously proposed amendments related to paid-up capital increases and stock dividends. The amendments restore two common safe income planning techniques involving the use of paid-up capital increases and stock dividends.

Background
In the past, both paid-up capital increases and stock dividends were used to achieve an increase in the cost of the shares of a target corporation that was about to be sold. The use of a paid-up capital increase or stock dividend created an inter-corporate dividend (deductible under subsection 112(1)), effectively capitalizing the target company’s safe income into the cost of its shares owned by a holding company, without having to move cash. However, this type of planning was curtailed by proposals included in the November 9, 2006 technical amendments (tabled as Bill C-33 and later as Bill C-10, which died on the order paper when Parliament was dissolved for the October 14, 2008 federal election).

Generally, an increase in stated capital results in a deemed dividend under subsection 84(1) and an increase in the adjusted cost base (ACB) of the share under paragraph 53(1)(b).

A stock dividend is a dividend paid by a corporation by the issuance of shares of its capital stock. The “amount” of a stock dividend under subsection 248(1) is generally equal to the increase in the paid-up capital of the corporation by virtue of the payment of the dividend. Under current law, shares received as a result of a stock dividend are deemed to have been acquired at a cost equal to the “amount” of the stock dividend under paragraph 52(3)(a).

For example, a preferred share with a redemption amount and paid-up capital equal to safe income could be issued as a dividend payment on common shares. The stock dividend share would have a cost (under paragraph 52(3)(a)) equal to the dividend amount. Due to the definition of “amount” in subsection 248(1), the amount of the dividend was equal to the paid-up capital increase.

2006 proposed amendments
However, the November 2006 amendments disrupted safe income capitalizations using stated capital increases or stock dividends. Under a proposed amendment to paragraph 53(1)(b), the increase in ACB for a subsection 84(1) deemed dividend is not available on dividends that are deductible under section 112(1) unless it can be shown that the dividend did not arise directly or indirectly as a result of a conversion of contributed surplus into paid-up capital. This created uncertainty in capitalizing safe income using paid-up capital increases. Under a proposed amendment to paragraph 52(3)(a), if the amount of a stock dividend is deducted under subsection 112(1) in computing taxable income, the dividend amount is not added to the cost of the share. As a result, stock dividends also could no longer be used to capitalize safe income.

2010 revised proposed amendments

The July 2010 technical amendments proposed revised draft amendments to paragraphs 52(3)(a) and 53(1)(b). Due to these changes, the denial of the cost base addition for paid-up capital increases and stock dividends are not to apply to safe income dividends. As a result, safe income capitalizations by way of stated capital increases and stock dividends should be available again under the proposed legislation. The revised draft amendments generally apply in respect of a dividend received by a taxpayer on or after November 9, 2006.

It is interesting to consider the implications of a dividend arising from a paid-up capital increase or stock dividend that is not a safe income dividend. For example, where a corporation increases the paid-up capital of its shares and no safe income is available, amended paragraph 53(1)(b) would deny any cost base increase for the amount of the dividend. It could be argued that subsection 55(2) should not apply to the dividend because the purpose (and result) of the dividend was not to reduce a capital gain because it was known that the ACB increase was not available. However, on a subsequent sale or redemption of the share, a capital gain would arise. In the case of a redemption, because the paid-up capital had been previously increased, no deemed dividend would arise under subsection 84(3) (at least to the extent of proceeds not in excess of paid-up capital) such that the amount paid on the redemption would be treated as proceeds of disposition for capital gain purposes due to the interaction of subsection 84(3) and the definition of "proceeds of disposition" in section 54.

It is not yet clear when the 2010 proposed amendments will be formally introduced into Parliament and passed into law.

Rick McLean along with a panel of experts from KPMG will present the webinar Understanding Section 55 and Butterfly Reorganizations on October 13, 2010. In this one-hour session, participants will learn how to achieve a tax-free divisive reorganization under the rules of Section 55 of the Income Tax Act and interact with the presenters in a live question period following the webinar. Register today at www.cch.ca/butterfly-reorganizations or call 1 800 268 4522.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP.

Information is current to September 1, 2010. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2010 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.