The Kruco Case

The Kruco case is a pivotal case in the determination of safe income available for a tax-free intercorporate dividend from a subsidiary to its parent company.  The CRA’s inconsistent position on this has been interesting.  I posed a question to the CRA via CRA / STEP Round Table 2021 conference that asked for clarification on defining ‘non-deductible expenses’ for the purposes of section 55.  They noted “non-deductible expenses can generally be described as cash outflows which are not deducted in the computation of a corporation’s net income for tax purposes (other than an expense or disbursement made in respect of the acquisition of property or a repayment on account of the principal amount of a loan) and safe income should be reduced by such non-deductible expenses in order to determine the same income on hand.”  The CRA went on to provide five examples that included:

• “Dividends paid or payable;
• Taxes (including refundable taxes);
• Non-deductible interest and penalties;
• Charitable donations, gifts and political donations that are nota aready deducted in net income for tax purposes; and
• Non-deductible (portion of) expenses or expenditures, such as the non-deductible portion of meal and entertainment expenses.”

See question 9 for their detailed response.

CRA Position and Cases leading to Kruco

The computation of safe income on hand typically starts with the safe income calculation.  This includes the net income for income tax purposes of the dividend payor and their subsidiaries as a starting point.  The calculation is considered over the holding period and includes any relevant stub periods.  A series of subtractions and additions are then made to this amount to arrive at the safe income on hand.[1]  The legislation of the safe income calculation does not indicate a deduction for taxes and dividends paid, however a logical conclusion would be to deduct these amounts.  Not to do so would result in including the same safe income to be distributed in subsequent years, and that does not seem to be in line with the purpose of this legislation.[2]  The legislation aims to differentiate amounts that should be allocated to income earned verses amounts attributable to what would be capital gains, and this division requires a calculation that is open to interpretation.

One of the contentious subtractions mandated by the CRA is the non-deductible expenses.  While this subtraction does not include outlays to acquire capital property, eligible capital property or life insurance premiums contributing to cash surrender values, it is not clear why any non-deductible expenditures need to be subtracted from safe income to arrive at safe income on hand.[3]

Non-deductible expenses

Non-deductible expenses are not defined in the Act, however there are several sections that specifically note where a deduction is not permitted (such as subsection 20(8) stating no deduction cam be taken in respect of property in certain circumstances).  The result of expenses not being permitted within the Act is an increase in taxable income, which would therefore increase safe income available to distribute as dividends.  These funds have nevertheless been expended and would therefore result in less cash on hand that would be available to distribute when issuing a dividend.

55(2.1)(c) Safe Income on Hand

Paragraph 55(2.1)(c)[4] can be broken down in two parts.  The first is the “safe-income” as discussed in the previous chapter, and the second is the amount that is “reasonably considered to contribute to the capital gain that could be realized on a disposition at fair market value”[5], which can be referred to the safe income on hand.

The new rules in 55(2.1)(c) retain the old character that requires the safe income or “income earned or realized” to be “on hand” prior to an inter-corporate dividend issuance if this dividend is to be excluded from the 55(2) rule to recharacterize the amount as a taxable capital gain.[6]

Much of the guidance on calculating safe income on hand is derived from the CRA’s administrative practices that include Robertson’s Rules, named after head of the rulings department of the CRA at the time the rules were published at the Canada Tax Foundation 1981 annual conference.[7]  These rules are not law and as will be seen throughout this chapter, are at times conflicting with judicial rulings.  However, tax practitioners often follow these rules to avoid challenges with the CRA.

Paragraph 55(2.1)(c) subjects dividends that exceeds “income earned or realized by any corporation after 1971 and before the safe-income determination time for the transaction, event or series” to the 55(2) deemed capital gain.[8]  This serves as the starting point of the calculation, by determining the safe income amount.  The paragraph goes on to require the amount to “reasonably be considered to contribute to the capital gain that could be realized on a disposition at fair market value, immediately before the dividend”[9].  Kung explains this second segment of the paragraph is what the CRA underlines as the starting point in calculating safe income to be after the corporate shareholder has acquired the shares because the ACB of the shares should reflect corporate earnings on hand prior to the acquisition as the purchase price (and ACB) will include any prior safe income amounts.  This interpretation would disqualify a corporate purchaser, immediately after acquisition, from issuing inter-corporate dividends without resulting in a deemed capital gain under subsection 55(2).[10]  The legislation itself does not pronouncedly state this, however this has become accepted practice based on the CRA position.

However, Kung further explains exemptions include shares acquired on a fully tax-deferred share exchange (under suctions 51, 85, 85.1, 86, or 87), the safe income on hand of the old shares would flow to the new shares.  Share splits, mergers and other transactions would follow the same logic with safe income on hand amounts calculated and allocated to the resulting shares on a per share basis.[11]  Entities that have gone through corporate reorganizations would therefore be required to calculate pre-reorganizational safe income available for distribution and allocate these amounts to new share classes to gain comfort over any dividends retaining their intercorporate tax-free dividend status.

Robertson’s Rules (1988)

John Robertson preferences the CRA interpretation of 55(2) by indicating the purpose of this subsection is to prevent transactions that were in fact arm’s length sales rather than reorganizations within a corporate group from being reconstructed into a perpetual postponement of capital gains by using tax-free intercorporate dividends.  In that regard, he determines the intent of the calculation of “income earned or realized” or safe income is to allow income to pass tax free subject to Part IV tax within the corporate division only to the extent that it has been taxed at the corporate level.[12]  However, the proposed adjustments to calculate safe income go further than that and add levels of complexity to the calculation.

Several CRA policies as outlined in Robertson’s Rules have been set aside by the courts, including

• The whole amount of a dividend that is caught by subsection 55(2) is deemed a capital gain.[13]
• The computation of safe income with respect to a particular share is confined to the holding period, which commences after a share is acquired.
• There should be no artificial creation of income by not claiming things such as CCA.[14]
• Computing safe income on a consolidated bases will result in losses offset with taxable income amounts between parents and subsidiaries.[15]

Roberson further provides a series of 22 more complicated situations, logging CRA’s position that results in further adjustments to safe income.  These positions have also been contentious, including rules xviii through xx, which include deductions to the safe income amount for expenses incurred or disbursements made that were not allowed or claimed as deduction in computing taxable income and the introduction of ‘phantom income’.  These are the CRA policies that require a deduction of non-deductible expenses to arrive at safe income.[16]

It is logical that only the safe income on hand is distributable as a dividend per subsection 55(2).  However, the CRA position taken via Robertson’s Rules liberally augment the legislation with a bias to minimize safe income available to distribute.  The result no longer simply precludes the use of inter-corporate dividends to indefinitely defer capital gains on what should be arms length sales, but rather restricts what should be an allowable tax-free intercorporate dividend.  CRA’s obstinate position has been litigated repeatedly.  Some of these cases will be reviewed here.

454538 Ontario Ltd. (1993)

In 454538 Ontario Ltd.[17], the taxpayer argues the complexities and vagueness of subsection 55(2) should result in a resolution in favor of the taxpayer.  The courts addressed this argument by noting a statute would be vague where no meaning can be taken from it.  Admitting the problems with application due to the complexities with section 55(2), the court found the difficulties in interpretation were not sufficient to render the subsection void because a reasonably intelligent and well-informed taxpayer is able to ascertain meaning from the statute.[18]

The taxpayer also questioned the CRA interpretation of the words “income earned or realized by the corporation” and the calculation of “safe income”.  The court answered the taxpayer with a review of the Act and interpretations of the same, landing on defining “income earned or realized” as income determined by Division B of Part I of the Act.[19]  Adjustments to safe income would therefore use this as a starting point.

This interpretation by the courts was notably different from the convoluted adjustments proposed in Robertson’s Rules.

Placer Dome Inc. (1996)

In the case of Placer Dome Inc.[20] (Placer), Placer had a non-controlling interest in a connected company Falconbridge Inc. (Falconbridge).  Placer was going to sell its share in Falconbridge.  Falconbridge decided to bid on these shares to prevent a competitor from acquiring them.  The Falconbridge offer was accepted, which included a payment of dividends to all its shareholders.  The dividend was considered tax-free by Placer under subsection 112(1), however the CRA reassessed the total dividend as a taxable capital gain under subsection 55(2), underlining one of the purposes of the transaction was a significant reduction in capital gains that would have otherwise been realized on a sale at fair market value.[21]

Subsection 55(2) acknowledges “where a corporation resident in Canada… received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) or 138(6) as part of a transaction or series of transactions or events (… one of the purposes of which or in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value…”[22]  Placer received a dividend under subsection 112(1) and therefore should be subject to a purpose test; dividends received under subsection 84(3) would be subject to a results test.  While the result was a reduction in capital gain on this transaction, the question should be focused on if the purpose of the transaction were to achieve that result.[23]

Justice Bell (TCC) noted it was proper for the CRA to question the purpose of the transaction due to the result of a significantly reduced capital gain, and it was the taxpayer’s responsibility to rebut the assessment by offering an explanation that reveals none of the intentions of the transaction was to advantage a significant reduction in capital gain.  The FCA further explained the requirement to differentiate “purpose” from “result” where both terms are used and concluded the discussions between Placer and Falconbridge did not establish a purpose to reduce capital gain. As the purpose test was not met, subsection 55(2) was found not to be applicable.[24]

The case underlines the importance of knowing when the purpose test is applied verses a results test and the significant difference between the tests.  The judicial interpretation is again a move away from the CRA position in the Robertson’s Rules.

Nassau Walnut Investments Inc (1996)

While the Act required intercorporate dividends that are greater than safe income to be deemed as capital gains, paragraph 55(5)(f) allowed a designation for only the portion of the dividend more than the safe income amount to be considered as capital gains.  Without this designation, 55(2) would result in all the dividend being deemed a capital gain.

In Nassau Walnut Investments Inc.[25] (Nassau), the taxpayer’s accountant miscalculated the safe income amount, resulting in an intercorporate dividend more than the safe income available.  The CRA reassessed the entire amount of the dividend as a deemed capital gain and refused to accept a late filed 55(5)(f) designation.  Both the TCC and FCA considered substance over form and allowed the late filed designation, resulting in only the portion of the dividend more than the safe income amount being deemed a capital gain.  The FCA noted paragraph 55(5)(f) was intended to prevent the entire dividend being deemed as a capital gain when a portion of that dividend included safe income.[26]

While this was a clear divergent from Robertson’s Rules, it should also be noted that the new rules in 55(5)(f) effective April 21, 2015 now automatically split the dividend that exceeds safe income on hand into two separate dividends and as such a designation is no longer required.[27]

Gestion Jean-Paul Champagne (1996)

In Gestion Jean-Paul Champagne[28], two brothers who held their shares in a corporation via their own holding companies had a falling out, resulting in one brother being bought out.  The operating company repurchased the shares of one brother from that brothers holding company.  The CRA invoked subsection 55(2) and deemed the entire amount a capital gain without consideration to deemed dividends to a connected corporation under subsection 84(3).

The taxpayer argued 55(5)(e)[29] did not apply to related parties and should not apply here.  This was found not applicable and revised 55(5)(e)(ii) now specifies brothers are not considered related and are dealing at arms length for this section.

The taxpayer’s second argument was that only accumulated income (earned after 1971) should be included in computing income for the safe income calculation, without adjustments for dividends and taxes paid and certain expenses not included in computing income.  This contention also included a right to distribute the safe income amongst its shareholders disproportionately to their holdings.  The CRA calculation of income available for dividend distribution included taxable income earned after 1971, less dividends paid, less non-deductible interest on taxes, less federal and provincial income tax, and less non-deductible debt (emphasis added).  The adjustments were not limited to those noted in paragraph 55(5)(c), which limits adjustments to income earned or realized by a corporation income for the period otherwise determined assuming no deductions taken from paragraph 20(1)(gg) or section 37.1.  The taxpayer cited 454538 Ontario Inc in which it was accepted that income earned or realized is determined by Division B of Part I of the Act.[30]

Justice Proulx found no inconsistency with the decision in 454538 Ontario Inc and Robertson’s Rules, underlining safe income was logically required to be on hand before the distribution.  As such, undistributed earnings in which corporate tax had already been paid would be attributable to the value of the share repurchase on a dollar-for-dollar basis and any amount beyond this would be attributable to something other than income earned or realized.  However, to come to this conclusion, amounts that are not reasonably attributable to income would need to be considered as proceeds from the disposition of shares.  The adjustments made by the CRA were found to be in line to calculate safe income on hand and therefore allowed.[31]  This assessment by the courts of CRA’s calculation being correct is a significant platform for the current CRA policy that will be reviewed in chapter 4.

Justice Proulx also cited Justice Dickenson in McClurg in reference to the right to distribute dividends disproportionately to the shareholders.  It was noted there is an equality of rights amongst shareholders unless allotted for in the articles of incorporation.  As there was no such allotment, this taxpayer argument was dismissed.[32]

The court did find that the taxpayer was entitled to designate a portion of the distribution as a capital gain and a portion as a dividend in accordance with paragraph 55(5)(f).[33]

The significance of the adjustments to safe income on hand will be revisited in chapter 4, where The CRA cites this case specifically as reason for a revision to a revised position on the safe income calculation.  This case is the strongest support for adjustments made under Robertson’s Rules and in particular the deduction of non-deductible expenses from safe income.

Deuce Holdings (1997)

In the case of Deuce Holdings Ltd.[34] (Deuce), Deuce held 50% of the shares of GQ.  The other 50% was held by M Inc.  GQ held $2 million in business assets, $800,000 in notes receivable from F Inc. and shares in F Inc.  Each of M Inc and Deuce wanted to retain their investment in F Inc. while no longer operating GQ together.[35]

GQ issued a dividend of $988,498 to each of M Inc and Deuce, resulting in the only asset remaining in GQ being the receivable from and shares in F Inc.  GQ then exchanged the shares of F Inc. for redeemable shares in each of M Inc and Deuce (redemption values of $780,000 each).  This butterfly transaction resulted in GQ owning shares in M Inc and Deuce, while M Inc. and Deuce held shares in GQ.  GQ redeemed the shares in M Inc and Deuce, while M Inc and Deuce redeemed all but one shares each in GQ.  The remaining one share each was return of capital.  A retiring allowance and management fee totalling $215,500 were subsequently paid to the shareholder of Deuce.  The CRA deemed the full $1,768,095 as a capital gain under 55(2) by including all the dividend payments as one, and deducted the retirement allowance, management fees and income taxes from the safe income calculation.[36]

The court found the following:

• The dividends of $988,498 should be treated as two separate dividends and not one dividend as was assessed by the CRA
• The safe income calculation must be made after the deduction of federal and provincial income tax
• The retiring allowance and management fees occurred after the dividend payments and should therefore not be accounted for in the safe income calculation.[37]

It was significant to note the courts found the income earned or realized must be disposable in their interpretation of subsection 55(2).  This included the deduction from safe income of taxes or dividends paid.[38]

Brelco Drilling Ltd. (1999)

The FCA has underlined that where the meaning of the legislation is clear and unambiguous, the statutory provisions are to be applied regardless of object or purpose.  However, section 55 is ambiguous and does not have a clear and plain meaning and as such, it is left to the Court to provide a functional meaning.  And because of the complexities and ambiguity of this section, the judgement in Brelco Drillings Ltd.[39] (Brelco) found resolutions should be in favor of the taxpayer.

The FCA then went on to provide meaning to section 55 and underlined the section was enacted to prevent capital gain stripping by issuing inter-corporate dividends that would result in no tax payable and avoid what would otherwise result in a capital gains tax.  The court noted this section is also in place to avoid double taxation on dividends issued on amounts that are reasonably attributed to income earned by the issuing corporation to a connected corporation.[40]

The case includes Brelco, a Canadian corporation that owned 50% of the shares of Tricil Ltd. (Tricil Canada), a Canadian corporation.  Triclil Canada in turn owned 100% of Tricil Inc (Tricil USA), a U.S. resident corporation, which in turn had several U.S. subsidiaries, some of which had income and some of which had debts or deficits.  Tricil Canada issued a dividend from its safe income to Brelco and Brelco subsequently sold its shares of Tricil.  The CRA reassessed Brelco’s safe income calculation to include the debts or deficits from its foreign subsidiaries.  Both the TCC and FCA ruled in favor of Brelco, noting section 55 does not require the consolidation of the losses of one foreign subsidiary with the surplus of other foreign subsidiaries.  If this were intended, Parliament would have explicitly included provisions for these adjustments.[41]

The judicial ruling was another deviation from Robertson’s Rules that included a consolidation of income and losses for a group.

Case Summary of Kruco TCC and FCA

Kruco litigates the deemed capital gain resulting from the application of subsection 55(2) and paragraph 55(5)(c) of the Act.  In that case, Kruco was issued a tax-free intercorporate dividend from its subsidiary Krugar in a series of transactions that resulted in a decrease in the taxable capital gain that would have otherwise been deemed.  CRA reassessed Kruco based their calculation of safe income.  Kruco argued that CRA’s administrative policy on calculating safe income resulted in an unauthorized alteration of the definition of income earned or realized as provided by Parliament as the starting point of safe income.[42]

Facts

Bernard Krugar owned a holding company named Kruco.  Kruco owned 32.493% of Krugar.  Bernard’s brother, Jean Krugar owned Hicliff.  Hicliff owned 61%of Krugar.  Krugar was one of North America’s largest private pulp and paper companies.  The Krugar brothers had a disagreement that had lasted several years during which time dividends have not been issued from Krugar.  In 1989, an agreement was reached in which Krugar would repurchase its shares from Kruco for $99 million of which Krugar guaranteed $70 million was safe income for purposes of subsection 55(2) of the Act.[43]

As Kruco was a connected corporation to Krugar pursuant to subsection 186(4) and therefor not subject to Part IV tax on dividends deemed issued from Krugar to Kruco.  As such, the dividend that would be deemed to Kruco on the shares repurchase by Krugar would be tax-free to the extent there was safe income to support the amount as set out in section 55.[44]

Krugar had engaged professionals to calculate the amount of safe income.  The calculation was based on the taxable net income on schedule 1 of the corporate tax returns from 1972 onwards, with adjustments made according to subsection 55(5)(c) and other adjustments to reflect non-deductible expenses or deemed income referred to in section 17 of the Act.   The CRA reassessed based on three adjustments of their own.[45]

The first CRA adjustments was based on a $2,000,000 debt that cost Krugar $4,000,000.  Krugar had received a $2,000,000 scientific research and experimental development tax credit for this debt, however the remaining $2,000,000 was not deductible for tax purposes.  As such, CRA decreased Krugar’s safe income by $2,000,000.  Kruco’s share of the decrease was $649,860.[46]

The second CRA adjustment was from a lower depreciation taken on assets.  The capital cost or underpredicted capital cost of assets held by Krugar and its subsidiaries was reduced under paragraphs 13(7.1)(e) and 13(21)(f)(vii).  The reduction resulted in a lower depreciation that could be claimed.  CRA took the position that the lower depreciation resulted in ‘phantom income’ from investment tax credits, as there would be no cash-flow from the lost deduction.  A revised depreciation based on the total assets was assessed.  CRA decreased safe income to Krugar by $66,024,068.  Kruco’s share of the decrease was $21,453,200.[47]

The third CRA adjustment was like the second.  An adjust to undepreciated capital cost of assets held by Krugar was reduced under paragraph 12(1)(t), which in turn resulted in a lower depreciation that could be taken.  Using the ‘phantom income’ justification, CRA decreased safe income to Krugar by $6,355,999.  Kruco’s share of the decrease was $2,065,255.[48]

Justice Dussault (TCC) found the second and third adjustments made were based on the administrative policy of CRA and not on the legislation as set out in subsection 55(2) or the calculation in subsection 55(5).  The first adjustment was presented by the CRA as a non-deductible expense requiring an adjustment in computing safe income.  This adjustment was allowed by the courts. [49]

Issues

The CRA position was based on the calculation of safe income requiring adjustments to the safe income available in Krugar to be distributed to Kruco.  CRA argued its administrative policy on adjusting for phantom income was readily available from its presentation at the Canadian Tax Foundation in 1988 dubbed Robertson’s Rules.[50]

Kruco disputed the principle of the adjustments made by the CRA, noting a change in policy on how safe income was calculated. It was the appellant’s position that CRA applied its administrative policy retroactively.[51]

Holding

Justice Dussault (TCC) read into the principal argument of the retroactive application of the administrative policy to also consider the policy itself as not being established by parliament, but rather CRA’s own fallible interpretation.  He determined that Parliament has indicated adjustments to safe income were contained in subsection 55(5)(c) to only include adjustments related to paragraph 20(1)(gg) or section 37.1.  As such, the negative adjustments based on ‘phantom income’ for the second and third adjustments made by the CRA was specifically rejected.  He noted if Parliament intended other adjustments to safe income, it would have noted this in the legislation.[52]

Justice Dussault also referenced several cases that resulted in adjustments to safe income for amounts on hand that included amounts for taxes paid, dividends paid, non-deductible expenses and losses of foreign affiliates.  However, of significance was the adjustments in these cases reflected cash flow from the balance sheet and not adjustments to the calculation of income. [53]

Finally, Justice Dussault noted the adjustments made by the CRA would have resulted in a double taxation, once as regular income to Kurgar and then as a capital gain to Kruco.  He noted this is not in the spirit and letter of the provisions of section 55.[54]

Rationale

The is a line between administrative practice and actual legislation as well as a finer line between legislation and its interpretation by the courts.  At paragraph [111] of his ruling, Justice Dussault explains this.  “In considering the reasons for enacting section 55, the Court, while attempting to construe legislation and regulations in light of that purpose, cannot properly make determinations beyond a reasonable interpretation of same.  To do otherwise would be tantamount, not to interpreting, but to rewriting, legislation.”[55]

The Kruco case specifically limits any adjustments to safe income to what has been legislated in paragraph 55(5)(c), citing a deviation from this would-be rewriting legislation.[56]

Ate the same time, Kruco allows for the deduction from safe income the taxpayers share of the $2,000,000 loan.  This transaction will be reviewed in the subsequent chapter.

CRA Position Subsequent to Kruco

The CRA continues a policy to require adjustments to the safe income calculation outside of those included in paragraph 55(5)(c).  Of particular significance is the deduction of non-deductible expenses from safe income.  However, this policy was reversed and then reclaimed as a result of the CRA interpretations of Kruco.[57]

Kruco was largely successful for the taxpayer at the TCC and FCA which resulted in CRA initially changing its position on calculating safe income outlined in Income Tax Technical News No. 33 on September 16, 2005[58] and again in ITTN No. 34 on April 27, 2006[59].  Those positions highlighted safe income will be determined by a corporation’s net income for tax purposes or with adjustments only specifically set out in paragraphs 55(5)(b) or (c) and abandoned its “phantom income” adjustments.  However, that position was then revised in Income Tax Technical News No. 37 with a position taken that non-deductible expenses must be deducted in computing safe income on hand attributable to shares on which the dividend is paid.  As a reversal of its previously reversed position, CRA reviewed the FCA reasons for judgement in Kruco, citing separate calculations were required for safe income and safe income on hand.

ITTN 33 and 34 abandoned the CRA safe income calculation policies in favor of using the court’s interpretation of income earned or realized to include net income for tax purposes.  Adjustments to safe income would use net taxable income of the corporation as a starting point and limit adjustments to those specified in paragraph 55(5)(b), (c), and (d) of the Act.  Specifically, the “phantom income” deduction was agreed to no longer hold relevance because this was overturned by the Kruco decisions.[60]

This safe income calculation would continue to be required to be “on hand” to be distributable without being subject to subsection 55(2) deemed capital gains.  The “on hand” calculation would reduce safe income by the taxes paid or payable and the dividends paid or payable as by citing the obiter in Kruco by Noel J. at paragraph 41 “the decision that cash outflows which occur after the determination of a corporation’s income earned or realized, but before the dividend is paid (such as taxes and dividends) and that reduce the income to which the capital gain may be attributable can also be deducted in computing safe income on hand.”[61]  The CRA also included in the statements that non-deductible expenses would generally not reduce a corporation’s safe income on hand.[62]

On February 15, 2008, CRA then reconsidered its interpretation of the Kruco decision outlined in ITTN 33 and 34 in relation to non-deductible expenditures in calculating safe income on hand by issuing ITTN No. 37, specifically re-reversing its policy on non-deductible expenditures.[63]

ITTN No. 37 specifically cited Gestion Jean-Paul Champagn for its turnaround, citing this as the only case that explicitly addresses non-deductible expenditures and was accepted in the Kruco decision.  The bulletin also states the Gestion Jean-Paul Champagn decision requires the deduction from safe income to include previously distributed profits and non-deductible expenditures.[64]

ITTN No. 37 further explains the first adjustment required by the CRA in Kruco that was accepted by the courts was a transaction that resulted in a cash outlay that was equivalent to a non-deductible expense.  Recall this adjustment was for a $2,000,000 debt that cost the taxpayer $4,000,000.  The taxpayer received a $2,000,000 scientific research and experimental development tax credit for this debt, and the remaining $2,000,000 was not deducible for tax purposes.[65]

Both examples seem to equate the deduction of non-deductible debt from safe income on hand to non-deductible expenses.

At paragraph 84 of the Kruco decision (TCC), it is acknowledged that the courts have approved adjustments to safe income on hand to include taxes paid, dividends paid, non-deductible expenses and losses of foreign affiliates.  “However, all these elements reflect cash flow shown on the balance sheet which in no way affects the calculation of income for the purposes of the Act.  Moreover, to the extent the adjustments sought to be made have the direct effect of altering that calculation and of subtracting form what is understood by safe income elements which are part of the income for tax purposes which has been established as a tax base, I find that… they go directly against the wording of paragraph 55(5)(c).”[66]

At paragraph 86 of the Kruco decision (TCC), in referring to the deduction of the unclaimed capital cost allowance, justice states “This, in short, is an attempt to create income for tax purposes which would be real in addition, obviously, to being disposable within the manding determined by the courts to date, that is to say, by subtraction of taxes paid, dividends paid and non-deductible expenses.  In my view, this does not follow from a reasonable interpretation of subsection 55(2) of the Act.”[67]

ITTN No. 37 emphasizes the safe income calculation is the first of two steps. The second step being the safe income on hand.  Both the courts and the CRA are agreeable that safe income on hand necessitates a deduction to safe income for taxes and dividends paid.  The remaining area of discrepancy is the deduction of non-deductible expenses.  So, then it would be important to understand what the deduction in Kruco pertained to.  Krugar had purchased debt of $2,000,000 and a tax credit for scientific research and experimental development of $2,000,000 for a total sum of $4,000,000.  The additional $2,000,000 paid by Krugar in this transaction was a non-deductible expense per subsection 127.3(6) and 194(4).  The court found the $4,000,000 cash payment to receive a $2,000,000 deduction would logically decrease funds available for the safe income dividend by $2,000,000 and as such allowed that amount to be added to the safe income on hand calculation.  The remaining $2,000,000 was a debt receivable on the balance sheet that did not affect taxable income.[68]  However, since the $2,000,000 had been lent out (and was receivable), this amount was not available for distribution as a dividend.  The functioning of subsection 127.3(6)[69] would require the debt obligation deemed nil.  The balance sheet transaction is at a point in time.  Once the debt is repaid, those funds would be available for distribution and the adjustment to safe income would no longer be required.  The nil cost base would necessitate an income inclusion on receipt of the debt repayment, which would also satisfy the inclusion into safe income.

ITTN No. 37 announces the CRA re-revised position that non-deductible expenses must be deducted in computing safe income on hand.[70]  This is done without defining non-deductible expenses for purposes of the safe income on hand calculation.

The Kruco case clearly overturned the CRA assessment to include deductions not taken for CCA under the phrasing “phantom income” with the premise that deducting these amounts from safe income would be tantamount to re-writing the legislation and result in a double taxation that was not the intended purpose of subsection 55(2).  Allowing the CRA to deduct the general understanding of what are non-deductible expenses from the safe income on hand would have a similar affect.  This is not what has been legislated and this would result in a double taxation that is not inten

[1] Supra Note 21

[2] Gestion Jean-Paul Champagne Inc. V. Minister of National Revenue, 1995 TCC 155

[3] Supra Note 5

[4] Part I

Division B

Paragraph 22(2.1)(c)

[5] Supra

[6] Supra

[7] Supra Note 32

[8] Supra Note 36

[9] Supra

[10] Supra Note 21

[11] Supra Note 21

[12] Supra Note 32

[13] Canada v. Nassau Walnut Investments Inc., 1996 CanLII 4097 FCA 279

[14] Supra Note 6

[15] Canada v. Brelco Drilling Ltd., 1999 CanLII 8151 FCA 35

[16] Supra Note 32

[17] 454538 Ontario Limited and 454539 Ontario Limited v. Minster of National Revenue, 1993 CarswellNat 911 TCC 427

[18] Supra

[19] Supra

[20] Canada v. Placer Dome Inc., 1996 CanLII 4094 FCA 780

[21] Supra

[22] Supra Note 9

[23] Supra Note 52

[24] Supra

[25] Supra Note 45

[26] Supra

[27] Crowe Soberman LLP, Inter-corporate Dividends: Are they Still Tax Free? October 25, 2015

[28] Supra Note 34

[29] Part I

Division B

Paragraph 55(5)(e)

[30] Supra Note 34

[31] Supra

[32] Supra

[33] Supra

[34] Deuce Holdings Limited, V. Her Majesty the Queen, 1997, CarswellNat 1240 TCC 786

[35] Supra

[36] Supra

[37] Supra

[38] Supra

[39] Supra Note 47

[40] Supra

[41] Supra

[42] Supra Note 6

[43] Supra

[44] Supra

[45] Supra

[46] Supra

[47] Supra

[48] Supra

[49] Supra

[50] Supra

[51] Supra

[52] Supra

[53] Supra

[54] Supra

[55] Supra

[56] Supra

[57] Supra Note 5

[58] Canada, Canada Revenue Agency, Income Tax Technical News No. 33 (Archived), Income Earned or Realized – the Kruco Case, September 16, 2005

[59] Canada, Canada Revenue Agency, Income Tax Technical News No. 34 (Archived), Safe Income Calculation – the Kruco Case, April 27, 2006

[60] Supra Note 90 and 91

[61] Supra Note 6

[62] Supra Note 90

[63] Supra Note 5

[64] Supra

[65] Supra Note 6

[66] Supra Note 6

[67] Supra Note 6

[68] Supra

[69] Part I

Division E

Subsection 127.3(6)

[70] Supra Note 5

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