Does a large pre-sale dividend affect my safe income?

This question arises when a holding company, not an individual, owns the shares of the operating company being sold. Section 55(2) of the Income Tax Act targets a specific pattern: a dividend paid to a corporate shareholder that reduces the gain the shareholder would otherwise have realized on selling the shares. Safe income is the measuring stick that decides how large a dividend can be before the rule bites.

What safe income measures

The Act uses the phrase safe income in its headings and builds the test around income earned or realized by any corporation that could reasonably be considered to contribute to the capital gain on the share. A dividend that stays within that amount is outside the rule. One that exceeds it can be caught. The Act computes income earned or realized under its own rules, so a balance-sheet figure is only a starting point.

How a large dividend draws it down

Safe income is a limited amount. For stock dividends the Act says so outright: the separate dividend amount is deemed to reduce the income that counts toward the gain. For other dividends, the Act measures that income as at the safe-income determination time, which it defines by reference to the series of transactions and the earliest dividend paid as part of it. The size and order of pre-sale dividends can therefore matter, and an advisor should model them.

What happens when the dividend is too large

If the conditions in subsection 55(2.1) are met, the dividend is deemed not to be a dividend at all. The Act instead treats the amount as proceeds of disposition when it arrives on a redemption, and otherwise as a gain from the disposition of capital property. The rule also turns on purpose: broadly, one of the purposes of the dividend must be a significant reduction in the gain or in the value of the shares.

Why the calculation needs an advisor

The safe-income figure is measured at a time the Act defines, depends on the value of the shares, and changes with the corporate structure. An individual who owns the operating company directly faces different rules, including the capital gains deduction the CRA describes for qualified small business corporation shares. How a business sale is taxed in Canada shows where this fits.