The Subsection 55(2) Purpose Test ' An Overview

Published date14 February 2022
Law FirmSpenceDrake Tax Law
AuthorMr Cris Best

According to subsection 112(1) of Canada's Federal Income Tax Act, if a corporation receives a taxable dividend from a Canadian resident corporation or taxable Canadian corporation, the recipient can deduct the amount of the dividend from taxable income. Pursuant to subsection 112(2), a dividend from a non-resident Corporation carrying on business in Canada through a permanent establishment can be deducted from income by the recipient corporation.

The phrase "capital gains stripping" refers to the use of the intercorporate dividend deduction to convert capitals gains to deductible dividends to gain preferential tax treatment. Subsection 55(2) specifically targets the abuse of the tax-free intercorporate dividend. In part, for it to apply, the corporation must have received a taxable dividend deductible pursuant to subsections 112(1), 112(2) or 138(6) of the Income Tax Act. The latter permits the deduction of intercorporate dividends by insurance corporations.

There are three exceptions to the application of subsection 55(2). Safe income, or income already taxed, is excepted, and can be paid out as a tax-free dividend. Paragraph 55(3)(b) allows an exception for the receipt of dividends pursuant to select corporate reorganizations and paragraph 55(3)(a) provides an exception for some related-property transactions.

The Subsection 55(2) Purpose Test

The provision applies to a Canadian resident corporation in receipt of a taxable dividend "as part of a transaction or event or a series of transactions or events." Pursuant to subparagraph 55(2.1)(b)(i), one of the purposes must have been to achieve a "significant reduction" in the capital gain due...

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