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Published: March 9, 2020

Last Updated: March 17, 2020

Taxation of inter-corporate dividends has been expanded by amendments to Subsection 55(2) of the Income Tax Act first proposed in the 2015 Federal Budget. This article provides an introduction to the “Purpose” test which determines the applicability of ss. 55(2) to a transaction.

What is Subsection 55(2)?

Canadian corporations are taxed on capital gains but can receive certain inter-corporate dividends tax-free. To take advantage of this, corporations will enter into transactions where capital gains are converted into tax-free inter-corporate dividends. These transactions, which vary in complexity and as to how they are conducted, are known as capital gains strips. A simple example of capital gains stripping is as follows:

  • HoldCo wishes to sell its ownership of its subsidiary SubCo to an arm’s length third party. This sale would create a taxable capital gain as the fair market value (“FMV”) of SubCo’s shares presently exceeds their adjusted cost base (“ACB”). Prior to the sale, HoldCo causes SubCo to pay it a tax-free inter-corporate dividend equal to the difference between the FMV and ACB. This decreases the FMV of SubCo allowing the shares to be sold without incurring a capital gain.


A dividend stripping anti-avoidance provision, ss. 55(2) is intended to remove the tax benefits of capital gains stripping. It applies where a corporation receives dividends from another Canadian corporation for one of the three purposes listed below. These inter-corporate dividends must be part of a transaction involving the disposal of shares to an arm’s length party. Subsection 55(2) recharacterizes these tax-free inter-corporate dividends as proceeds of disposition. Capitals gain tax is paid on proceeds of disposition, and thus there is no longer a tax benefit to capital gains stripping.

“Purpose” Test

Inter-corporate dividends will incur taxation under ss. 55(2) if the transaction is conducted for one of the purposes delineated in the subsection. Prior to the 2015 Federal Budget, the only purpose contemplated in ss. 55(2) was the reduction of capital gains. Two new purposes were added following the Budget. The current ss. 55(2) is applicable to transactions where one of the purposes of the transaction is:

  • A significant reduction in the capital gain on any share,
  • A significant reduction of the FMV of any share, or
  • A significant increase in the cost of property of the party receiving the dividend.


The Canada Revenue Agency (“CRA”) has stated the threshold of “significant” found in all three purposes could be measured as an absolute dollar or percentage amount. Whether an intended reduction or increase is significant will be determined on the facts in each case

This low threshold permits extends ss. 55(2) to transactions which may have other legitimate purposes. As a result, the taxpayer must prove, on a subjective basis, that none of the purposes of a transaction were those listed in ss. 55(2)

Expanded Scope of SS. 55(2)

The 2015 Federal Budget’s addition of two new purposes along with reducing the scope of ss. 55(2) exceptions for Part IV assessable dividends and related party transactions has increased the variety of transactions taxable under ss. 55(2). Taxpayers must be wary of the expanded ambit of this section, as the taxpayer in 101139810 Saskatchewan Ltd. v Queen (2017 TCC 3) found out. In this case, the application of ss. 55(2) led to possible triple taxation. The taxpayer, endeavouring to use his lifetime capital gains exemption, conducted a series of transactions. He split a corporation he owned into two new corporations and sold ownership of those new corporations to purchasers. The taxpayer recognized a capital gain himself, and ss. 55(2) applied to recharacterize the tax-free inter-corporate deemed dividends to all three corporations as taxable proceeds of disposition. The CRA ultimately chose only to apply ss. 55(2) to the new corporations, avoiding the possible triple taxation.

Safe Income on Hand Exception

Subsection 55(2) is intended to capture tax-avoidant taxpayers, accordingly amounts which have already been taxed are exempted from ss. 55(2). This exemption, found in paragraph 55(2.1)(c) of the Income Tax Act, is called the safe income on hand exception. Safe income on hand is the amount of after-tax income retained by a corporation which reasonably contributes to the capital gain. The 2015 amendments reduced the scope of the other exceptions to ss. 55(2) but the safe income on hand exception remained largely unchanged. These amendments have made the safe income on hand exception the primary tool for avoiding the application of ss. 55(2) where a transaction has one of the listed purposes.

The 2015 amendments did include two important changes to the language and operation of ss. 55(2). The wording of paragraph 55(2.1)(c) was changed from income reasonably “attributable” to the capital gain to income which reasonably “contributes” to the capital gain. This change was meant to reflect the expanded purpose test. The second change was made to paragraph 55(5)(f) of the Income Tax Act, which operates in conjunction with ss. 55(2).

Prior to the 2015 amendments, when a dividend was issued without sufficient safe income on hand to exempt the entirety of the dividend from ss. 55(2), the whole dividend would be taxed under ss. 55(2). In order to avoid this outcome, corporations would file a designation to split the dividend into smaller dividends. The smaller dividends isolated the amount which qualified for the safe income on hand exception from the excess amount of the dividend, preventing taxation of the entire dividend. Now, ss. 55(5)(f) applies automatically to divide a divided into the amount exempt as safe income on hand and the remaining amount which is taxed under ss. 55(2). The amendment to paragraph 55(5)(f) has made the safe income on hand simpler for taxpayers seeking to avoid recharacterization under ss. 55(2).

Tax Tips – The Importance of the Exceptions to Subsection 55(2)

The ss. 55(2) amended by the 2015 Federal Budget is a more complex provision with greater uncertainty for taxpayers of its applicability. The Government’s continued efforts to curb tax avoidance have created more opportunities for the CRA to collect tax. If one of the purposes of a taxpayer’s transaction is listed in ss. 55(2), the taxpayer should look to the exceptions to ss. 55(2) for safe income, related party transactions and Part IV assessable dividends. Contact our expert Toronto tax lawyers to learn how to protect your transactions from ss. 55(2) taxation.


"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."

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