Anonymised, illustrative composite. An operating company carried nine years of retained earnings in a marketable-securities portfolio that had nothing to do with the business the individual owner was selling. Moving it out before closing was the right instinct. The size of the dividend that moved it was not tested against the one number that limits it.
At a glance
OpCo ran a real operating business worth about $5,000,000 and also held roughly $9,000,000 in marketable securities, accumulated over nine years from retained after-tax profits the owner had never pulled out. None of that portfolio was used in the business. Before taking the company to market, the owner's advisers recommended the standard fix: purify the company by moving the passive portfolio up to Holdco, so that OpCo's shares would pass the all-or-substantially-all active-business-asset test a purchaser's own tax advisers, and a future small business deduction or share-sale structuring, would ask about.
The purification was executed as a single $9,000,000 dividend-in-kind of the portfolio, paid by OpCo to Holdco. Nobody checked the dividend against the shares' safe income before declaring it. Safe income and the fair market value of the passive assets are not the same number — the portfolio's value includes years of investment growth that was never itself OpCo's own earned income, and none of that growth is available to shelter a dividend under the anti-stripping rule.
Dividend paid: $9,000,000, the full fair market value of the portfolio being moved. Safe income on hand attributable to the OpCo shares, computed after the fact: $6,400,000. The shortfall — $2,600,000 — is not a rounding difference; it is the exact amount by which the purification exceeded what the anti-stripping rule allows to pass as a dividend rather than a gain.
A dividend between connected corporations is ordinarily deductible in full under ITA s.112(1). Section 55(2) overrides that where the conditions in s.55(2.1) are met, and all three are conjunctive. Paragraph (a) is satisfied automatically here — Holdco was “entitled to a deduction in respect of the dividend under subsection 112(1)”. Paragraph (b)(ii) is satisfied by the purification's own purpose: it applies where the dividend “is received on a share that is held as capital property by the dividend recipient and one of the purposes of the payment or receipt of the dividend is to effect (A) a significant reduction in the fair market value of any share, or (B) a significant increase in the cost of property”. Moving $9,000,000 of assets out of OpCo does both — it reduces OpCo's own share value and increases Holdco's cost in the securities it now holds directly. This is the ordinary-dividend branch of the test, and it is a materially different trigger from the redemption branch at s.55(2.1)(b)(i), which the statute expressly carves this kind of dividend out of.
Paragraph (c) is the one that decided the dollar outcome. It applies where “the amount of the dividend exceeds the amount of the income earned or realized by any corporation… that could reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value… of the share on which the dividend is received” — the safe-income test. Read on its own, paragraph (c) is a single yes/no gate on the whole $9,000,000 dividend, which exceeded the $6,400,000 safe income — and on a bare reading that would put the entire dividend, not just the excess, to s.55(2). What actually confines the result to $2,600,000 is s.55(5)(f), which applies “unless subsection (2.3) applies” — the stock-dividend-specific rule, which does not apply to a dividend-in-kind of a securities portfolio. Paragraph (5)(f) deems the single dividend to be two separate taxable dividends: “a portion of the dividend is deemed to be a separate taxable dividend equal to the lesser of (A) the taxable part, and (B) the amount of the income earned or realized by any corporation” contributing to the shares’ capital gain — the $6,400,000 sheltered portion — and “the amount, if any, by which the taxable part exceeds the portion referred to in subparagraph (i) is deemed to be a separate taxable dividend” — the $2,600,000 excess. Tested separately against paragraph (c), the first of those two deemed dividends does not exceed safe income and stays a dividend; the second does, and only the second is what s.55(2) reaches. Below the safe-income line, s.112(1) applies exactly as intended. Above it, s.55(2) deems that second, excess dividend “to be a gain of the dividend recipient, for the year in which the dividend was received, from the disposition of a capital property”. The $2,600,000 above safe income was not a deductible dividend at all; it was a capital gain to Holdco, computed and taxed as one.
This is a different question from whether a redemption dividend can bridge an asset-versus-share structuring disagreement — there was no redemption here, no buyer negotiating structure, and no deadlock to solve. The only question this file answers is whether a clean-up dividend paid before marketing the company was sized correctly against one number, and it was not.
The purification still achieved its purpose — OpCo's shares were purified going into the sale process, and the eventual share sale proceeded on that basis. But $2,600,000 of value that the owner's advisers had modelled as moving tax-free between connected corporations was in fact a taxed capital gain to Holdco, assessed exactly as the statute describes rather than as the plan had assumed.
Had the safe-income number been computed before the dividend was declared, the same purification could have been staged — a $6,400,000 dividend now, sheltered in full, with the remaining $2,600,000 of passive assets moved later once additional safe income had accrued, or accepted upfront as a planned, smaller capital-gain cost rather than a surprise found on reassessment. The purification itself was not the mistake. Sizing it to the portfolio's fair market value instead of to the shares' safe income was.
The instruction to the accountant was to “move out everything that isn't the business”. That is a correct description of what purification is for. It is not a number, and safe income is a number — one that has to be computed, not estimated from the size of the portfolio being moved.
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