McGILL LAW JOURNAL
Volume 18
Number 4
Montreal
1972
Distribution of Corporate Surpluses
Under the New Income Tax Act
Frank D. Jones *
I H ISTORICAL PR ECIS
…………………………………………………………………………….
II 1972 IN COM E TAX ACT …………………………………………………………………………..
a. Sm all Business Incentive ……………………………………………………………………
b. Refundable Tax on Ineligible Investments …………………………………….
c. Intercorporate Dividends …………………………………………………………………….
d. Refundable Dividend Tax to Private Corporations ……………………….
e. Acquisition of Canadian Controlled Small Business by Non
f. A m algam ations ……………………………………………………………………………………….
484
493
494
497
499
499
500
501
R esiden t …………………………………………………………………………………………………..
III CORPORATE SURPLUSES ……………………………………………………………………..
501
a. Distribution by Resident Corporations to Individual Shareholders
(i) Distribution of pre 1972 Corporate Surpluses to Residents 501
503
b. A djusted Cost B ase ………………………………………………………………………………
c. Distributions by Non Resident Corporation to Individual Share-
h old ers ……………………………………………………………………………………………………..
505
d. Distributions by Corporate Residents to Corporate Shareholders
(i) Transfer of Special Surplus BetweeD Corporations ……..
(ii) Taxable Dividends Between Resident Corporations ………………..
505
506
e. Distributions by Non Resident Corporations to Corporate Share-
h old ers ……………………………………………………………………………………………………..
506
f. Corporate Distributions on the Winding-Up, Discontinuance or
Re-organization of Business …………………………………………………………………
IV CO N CLU SIO N ……………………………………………………………………………………………..
510
511
* Of the Faculty of Law, University of Alberta.
McGILL LAW JOURNAL
[Vol. 18
I. Historical Precis
During the years 1926 to 1938 many if the features concerning
corporate distributions present in the current income tax act were
enacted. Exemptions of inter-company dividends were allowed to
avoid double taxation at the corporate level and triple taxation if
such funds were paid to the shareholders, loans to shareholders
and deemed dividends thereon, premiums paid to shareholders on
security redemptions with their tax ability as dividends in the hands
of the shareholders were all incorporated into the Income War
Tax Act. In addition, the descretionary provisions of section 32A I
were introduced empowering the Treasury Board if in their opinion
transactions involved tax avoidance to tax such distributions.
In 1948 the Income Tax Act was completely re-written. Under
these provisions corporations were directed to elect the method
whereby they would distribute earned surplus to their shareholders.
Distribution in the form of larger salaries were taxed in the hands
of the recipient at his personal rate, dividends declared would again
be taxed in the recipient’s hands subject to the 20% dividend
tax credit. The final form of distribution was found under section
105. Briefly this section allowed the disbursement of a company’s
earned surplus in the following circumstance:
(a) Upon the payment of 15% tax on pre 1950 earned surplus 2
(b) For every dollar a company declared as a dividend, a similar amount
tax
could be paid out to shareholders upon the payment of 15%
of the amount to be disbursed 3
The government presumably was satisfied with 15% of the corpo-
rations retained income as it was possible through the definition
of a dividend under the old income tax act to declare a non-taxable
stock dividend consisting of redeemable preference shares with the
corporation redeeming these shares which resulted in no additional
tax either to the corporation or the recipient.
A major thrust of the 1948 Act was the elimination of the
descretionary provisions given to the minister under section 32A
of the Income War Tax Act and the introduction of the concept
of designated surplus The consequence of the omission of the
descretionary powers under section 32A of the Income War Tax Act
set the stage for what has virtually been a 15 year battle between
the tax payers and the taxing authorities.
IIncome War Tax Act, S.C. 1938, c. 48 and subsequent amendments.
2 Section 105(1).
3 Section 105(2).
4 Income Tax Act, S.C. 1948, c. 52, s. 28(2).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
Designated surplus was introduced into the 1948 Act to prevent
one of the more obvious methods of “surplus stripping” –
the
distribution or elimination of corporate surpluses in a manner which
avoids the payment of income tax by the person who ultimately
receives the disbursement. Under the concept of designated surplus
the undistributed income of a company became “frozen” if the
company were to become a subsidiary company 6 To the extent
the dividends were paid out of designated surplus by the controlled
corporation, the dividends were subject to ordinary income tax
in the hand of the controlling corporation. 6 Only the surplus on
hand at the time the subsidiary became a controlled corporation
were designated and any subsequent surplus in the subsidiary cor-
poration arose out of “controlled period earnings” and such surplus
was not designated. Therefore dividends could be declared tax free
between the two corporate entities.
The subsections of 28 were designed to prevent the following
surplus stripping technique:
Company A Ltd.
Cash
Other Asset
4,000,000
2,000,000
6,000,000
Cash
1,000
1,000
Incorporate Company B Ltd.
Liabilities
Com. Stock
Surplus
Com. Stock
2,000,000
1,000,000
3,000,000
6,000,000
1,000
1,000
(a) Incorporate a separate Company, B, by the shareholders of A, Ltd.
(b) Shareholders of A, Ltd. sell the shares of A, Ltd. at book value to
B, Ltd. in return for a note or bond liability.
Company B Ltd.
Due to A Ltd. Shareholders 4,000,000
1,000
Common Stock
4,001,000
Cash
Investment A
1,000
4,000,000
4,001,000
G Ibid., s. 28(3).
O Ibid., s. 28(1).
McGILL LAW JOURNAL
[Vol. 18
Company A Ltd. pays a dividend of $3,000,000 to B Ltd.
Company A Ltd.
Company B Ltd.
Cash
Other Assets
1,000,000
2,000,000
Liabilities
Com. Stock
2,000,000
1,000,000
3,000,000
3,000,000
Cash
3,001,000
Invest. in
A 1,000,000
Note Due
4,000,000
Common
1,000
4,001,000
4,001,000
B then redeems $3,000,000 of notes due to A Ltd. Shareholders.
Company A Ltd.
Shareholders
Company B Ltd.
$3,000,000 capital
gain from sale of
their stock of A
Company to B
Company
Cash
1,000,000
Other Assets 2,000,000
Liabilities
2,000,000
Com. Stock
1,000,000
3,000,000
Cash
Invest. in A
1,000
1,000,000
Note Due
A Co.
Com. Stock
1,001,000
1,000,000
1,000
1,001,000
Reconsidering section 28(2), we see section 28(1) has no effect
where:
(a) a dividend was paid by a corporation that was resident in Canada
and that was controlled by the receiving corporation.
(b) the payer corporation had undistributed income (designated surplus)
on hand at the end of its last complete taxation year before control
was aquiced.
In the above circumstances the controlled corporation may not
deduct (a) or (b).
The capitalization-of-earnings approach of surplus stripping was
blocked with the concurrent operation of subsections 81(2)
(3)
and (4). The purpose of these subsections was to specifically place
the earned surplus of a going-concern in the same position as the
earned surplus of a corporation about to be wound-up, discontinued
or reorganized
7 Ibid., s. 81(1).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
Under section 81(3)
blocked:
the following stripping
technique was
Company A Ltd.
4,000,000
Cash
Other Assets 2,000,000
6,000,000
Liabilities
Com. Stock
Surplus
2,000,000
1,000,000
3,000,000
6,000,000
1. Capitalize the surplus into redeemable preferred shares.
Company A Ltd.
4,000,000
Cash
Other Assets 2,000,000
6,000,000
Liabilities
Corn. Stock
Surplus
2,000,000
1,000,000
3,000,000
6,000,000
2. Have the company redeem the preferred shares.
Company A Ltd.
1,000,000
Cash
Other Assets 2,000,000
3,000,000
Liabilities
Com. Stock
2,000,000
1,000,000
3,000,000
$3,000,000, a
Shareholders – by preferred share redemption –
capital gain.
Note that under section 81(3) where the whole or any part of
a corporation’s undistributed income on hand has been capitalized,
a dividend shall be deemed to have been received and prorated
amongst the shareholders who held shares prior to the capitalization.
To skirt the problems of sections 28 and 81, tax consultants
devised a technique that avoided the restriction embodied in con-
trolled corporations. This technique was accomplished in the follow-
ing manner:
Company A – Balance Sheet
4,000,000
Cash
Other Assets 2,000,000
6,000,000
Liabilities
Corn. Stock
Surplus
2,000,000
1,000,000
3,000,000
6,000,000
McGILL LAW JOURNAL
[Vol. 18
1. At the outset, the shareholders of A Company sell the shares to
stockbroker B at book value or fair market value. At this point
then the shareholders have $4,000,000.
2. The company pays a dividend of all its undistributed surplus
to the shareholders (broker).
Cash
1,000,000
Other Assets 2,000,000
Liabilities
Com. Stock
2,000,000
1,000,000
Stockbroker
Dividend
3,000,000
Company A Ltd.
3,000,000
3,000,000
3. The stockbroker then sells the shares to the original shareholders
at book value, $1,000,000, taking a $3,000,000 loss from the sale
of shares.
Company A Ltd.
Cash
1,000,000
Other Assets 2,000,000
3,000,000
Net Cash Position
Shareholders
Sale of Shares 4,000,000
Less purchase
of shares
1,000,000
Net Cash
3,000,000
Stockbroker
Purchase of
Shares
4,000,000
Sale of Shares 1,000,000
Trading Loss 3,000,000
Div. Rec.
3,000,000
Net Cash Flow –
The broker reports a dividend income of $3,000,000 and deducts
his $3,000,000 trading loss; thus he pays no tax.
NOTE: This strip could be effected by:
(a) tax exempt persons (charities)
(b) non-residents
(c) a dealer in securities
In 1955, parliament legislated section 105 B making the pro-
visions of section 28 apply to:
(a) a non-resident corporation
(b) a person exempt from tax under 62 (other than
a personal corporation)
(c) a trader or dealer in securities
As a consequence, if “a” and “b” receive funds (defined in the
Act as designated surplus) they pay a tax equal to 15% of the
disbursement, whereas “c” would be subject to a 20% tax.
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
In 1958, the Income Tax Act was amended to allow for the
amalgamation of certain corporations by way of section 85(1).
In turn, however, the amendment also allowed for the reduction
of undistributed income of the amalgamating companies by what
amounted to “de-designating” the designated surplus that may have
existed prior to the amalgamation. In part, this result was in-
advertently achieved by the fact that the amalgamated corporation
was deemed under the Act to be a new corporation, and from the
fact that designated surplus is measured by the undistributed income
prior to control.”
One method commonly used to strip the surplus of a corporation
was to effect a horizontal amalgamation of two controlled corpo-
rations. The technique proceeded in the following manner:
1. Incorporate a sister company (b), controlled by the same share-
holders as the company whose surplus is being stripped. Then,
amalgamate the two.
Company A
Cash
Other Assets
4,000,000
2,000,000
Liabilities
2,000,000
Com. Stock 1,000,000
Incorporate Company
Cash
1,000
Com. Stock 1,000
6,000,000
Surplus
3,000,000
6,000,000
Amalgamated Company
Cash
Other Assets
4,001,000
2,000,000
6,001,000
Liabilities
Bonds
Com. Stock
2,000,000
3,000,000
1,001,000
6,001,000
2. The company then redeems the bonds of the shareholders.
Amalgamated Company
Cash
1,001,000
Other Assets 2,000,000
Liabilities
Com. Stock
2,000,000
1,001,000
Shareholders
3,000,000 bond
redemption
3,001,000
3,001,000
Note that the bond redemption is non-taxable, thus the un-
distributed surplus is stripped free of tax.
8 Ibid., s. 28(6) (b) (ii).
McGILL LAW JOURNAL
[Vol. 18
Swiftly the minister moved to breach this gap by the 1959
Amendment 105c(1) (b). Prior to this Amendment, section 105c(1) (b)
read that a 20% tax was to be paid on the aggregate amount of
this surplus, calculated under section 82(1)(c), that exceed “the
value of the assets of the new corporation (other than goodwill)
less the liabilities of the new corporation immediately after the
amalgamation. . .”. The wording of the Amendment permitted the
non-taxable redemption of bonds, since bonds are liabilities. A
specific reference to taxable liability (other than any liability for tax
under this part –
is directed toward the reca-
pitalization of undistributed surplus to debentures or bonds by
amalgamated companies. Subsequent bond redemptions of this kind
were taxable.
section 105c)
The tax specialist, however, keeping in stride with the minister,
merely replaced bonds with redeemable preferred shares, and
capitalized the undistributed surplus. The amalgamation then pro-
ceeded as in the previous method:
Amalgamated Company
Cash
4,001,000
Other Assets 2,000,000
6,001,000
Liabilities
Pref. Stock
Com. Stock
2,000,000
3,000,000
1,001,000
6,001,000
The preferred stock was then redeemed, and the shareholders
received cash equal to the undistributed surplus of their original
company, free of tax.
In order to prevent this capitalization technique in the stripping
of surplus of amalgamating companies, the minister, under the 1960
Amendment, section 105c (la) included classes of shares (such as
preferred) to be a liability of the corporation. As a consequence,
the proceeds from the redemption of the aforementioned shares
would be taxable under section 105c(1).
Finally in 1963, parliament legislated the controversial section
138A in what appeared to be an admission of inability to draft legis-
lation wide enough to prevent surplus stripping. Since this section
once again introduced the concept of ministerial discretion, the
Income Tax Act by 1963 had gone the full circle; the elimination
of ministerial discretion was one of the prime objectives of the
new Act of 1948.
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
One final technique, attempted and reported in 1967, D.T.C.
5334, was the Conn Smythe Case. The problem stemmed from Mr.
Smythe’s large holdings in his company, C. Smythe Ltd., and his
wish for estate purposes, to distribute the assets of his company.
Smythe’s alternative methods were three
1. Dividends (section 38)
2. Tax Paid Undistributed Income, section 105 –
two years and two elections, and 50% of undistributed
accumulated since 1949 to be distributed as dividends.
a tax of 15% requiring
income
3. Sale to securities dealer (section 105(b) –
of 162/3% of the undistributed income).
requiring an effective tax
Each of the alternatives was unattractive since the net worth
of the company was:
Undistributed Surplus
Capital Gains (approx.)
$ 728,652
1,800,000 –
1,900,000
To obtain $275,000 net of taxes from the company, Smythe:
1. Incorporated C. Smythe for Sand Ltd., a new company having the
same shareholders, and proportion of shares held as C. Smythe Ltd.
2. Sold all the assets of C. Smythe Ltd. to C. Smythe for Sand Ltd. at
fair market value for a promissory note.
C. Smythe Ltd.
Assets –
promissory note
C. Smythe for Sand
2,611,769
Assets C. Smythe Ltd.
2,611,769
Liabilities (prom. note) 2,611,769
3. Sale of the shares of C. Smythe Ltd. to stockbrokers in B.C. (for
a fee of $41,433) financed through a bank loan.
Stockbrokers
Assets –
C. Smythe Ltd. Shares
2,570,336
Liabilities – Bank Loan 2,570,336
C. Smythe Ltd. Shareholders
Cash
2,570,336
4. C. Smythe for Sand borrows $2,611,769 from a bank to repay the
note to C. Smythe Ltd.
C. Smythe Ltd.
Cash
C. Smythe for Sand
2,611,769
Assets (C. Smythe Ltd.
Liabilities (Bank Loan)
2,611,769
2,611,769
McGILL LAW JOURNAL
[Vol. IS
5. Stockbrokers cause C. Smythe Ltd. to invest in their preferred
shares and from cash realized, they repay their bank loan as
of Step 3.
Stockbrokers
Assets –
C. Smythe Shares
Net Cash
Liabilities
(Preferred Shares)
2,570,336
41,433
2,611,769
C. Smythe Ltd.
Assets –
Preferred
Shares Stockbrokers
2,611,769
6. The shareholders (Conn Smythe) with the $2,570,336 realized in
Step 3, exchange their shares of C. Smythe for Sand book value
$2,611,796, by buying debentures of C. Smythe for Sand Ltd., of
$2,295,000; C. Smythe for Sand Ltd. used the cash from the sale
of debentures and a bank overdraft to repay its bank loan.
C. Smythe Ltd. –
Net Cash Positions
$2,611,769 in preferred shares issued by the
stockbrokers but which are worthless.
C. Smythe for Sand Ltd. – purchased all the assets of C. Smythe
Ltd., incurring a liability for debentures of $2,295,000 and a bank
overdraft.
Stockbrokers – became the sole shareholders of C. Smythe Ltd.
(a shell at this point) at a cost of $2,570,336 and issued their preferred
to C. Smythe for $2,611,769. Thus their net cash flow was $41,433
(their fee).
Original Shareholders of C. Smythe Ltd. –
exchanged C. Smythe
Ltd. shares for book value $2,611,769 for cash of $275,336 and
debentures of C. Smythe for Sand Ltd. worth $2,295,000. They also
own the shares of C. Smythe for Sand Ltd. (which in turn, owns
the assets originally owned by C. Smythe Ltd.).
The reason for this complex maneouvering was to avoid the
surplus stripping amendments of the Income Tax Act. One will
note that the transactions were not amalgamations; also the pro-
visions of section 28 as applied via section 105(B) to brokers do
not apply since no dividends were paid to the broker. Rather it
was an issue of preferred shares issued by the broker bought by
C. Smythe Ltd. Section 81 was not breached by the proceedings
in that, as shareholders, they merely sold their shares of C. Smythe
Ltd. – not a disbursement, distribution, nor dividend. Finally, and
perhaps the most noteworthy feature of the attempt was that the
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
actual business assets of the Toronto Maple Leaf Gardens remained
with the shareholders throught. This retention illustrates the purpose
of surplus stripping, a purpose which is to distribute the earned
surplus to the shareholders while ownership is retained in the
corporation, or in the Smythe case, the assets of the corporation.
Interesting then is the success of the Tax Department in the
Exchequer Court under section 137(2). Section 138A remains as
a threat even though the justification for the implementation of
section 138A was to stop surplus stripping such as in Smythe Case.
The minister had sufficient powers under the then existing Act
without legislation section 138A.
Because of an anomaly in the old Income Tax Act, designated
surplus under section 28 was only created in a controlled corpo-
ration. Accordingly, if a parent company “A” controlling a subsi-
diary “B” was aquired by a Canadian corporation “C”, dividends
paid out of the undistributed income of the subsidiary company “B”
could flow as a tax exempt dividend to company “A”, and in turn
be distributed as a tax exempt dividend to company “C”, the
controlling corporation. The distributions paid to the original parent
company “A” became control period earnings in its hands, and
consequently could flow free of tax to the purchaser “C”.
The enactment of section 138A(1)(c) tended to halt this ploy
of dividend stripping.
II. 1972 Income Tax Act
Under the new legislation the type of corporation which one
deals with will now have a distinct tax effect. Differences between
public and private corporations and between private corporations
and Canadian controlled private corporations exist. This distinction
between corporations constitutes a major departure from the pre-
vious tax legislation in so far as, under the old rules, all corporations
were allowed the preferred rate of 21% on their first $35,000 taxable
income irrespective of that incomes source.
Under the present Act all corporations are treated equally at
the outset, only when the deductions and refunds are catagorized
do the incentives isolate the “favoured corporations”. One of the
main thrusts of the new legislation is oriented towards a reduced
tax rate for small private Canadian controlled corporations. This
was as a result of a concerted public pressure following the release
of the government White Paper on tax reform wherein it was
proposed to abolish any reduced tax rate for small businesses.
Philisophically it is obvious that the government wished to limit
McGILL LAW JOURNAL
[Vol. 18
any such tax favours to small Canadian corporations who needed
the extra incentive in order to compete favourably with larger or
international corporations. Such favour appears well founded con-
sidering the apparent reluctance of major lending institutions to
advance venture capital to small business. It is suggested that under
the assumption that new businesses and small business entities ought
to compete with larger more established firms incentive by taxation
is far more realistic than subsidization. The former sustains ef-
ficiencies and promotes viable growth, the later is little more than
“make work”. Subsidies are but a function of the lack of pro-
ductivity.
One other concept which has partially been retained under the
new legislation is that of integration. The legislation attempts to
be neutral in the area of operating a business through a corporation,
through a partnership or a sole proprietorship. In fact it is not
completely neutral and there are some tax advantages to operating
through a corporation however, not nearly so many now as under
the former legislation. Capital gains, investment income and non
active business income are taxed in a manner which neither benefits
or penalizes those choosing to operate through a private corpo-
ration. The concept of a personal corporation has been removed from
the new legislation.
a. Small Business Incentive
The failure of the White Paper to recognize the special status
of small businesses was remedied by section 125. Whereas section
123 sets out the rates on corporate earnings, section 125 provides,
in addition, for a deduction from taxable income should the company
come under the definition of “Canadian controlled private corpo-
ration” and should the company’s income source come from “active
business”. The section states that a Canadian controlled private
corporation may deduct an amount equal to 25% of the least of:
1. The net profit derived from an act of business in Canada
2. The tax payable exceeding 2.5 times the foreign tax deduction claimed
under section 126(1) on non business income and two times the foreign
tax carry over claimed under section 126(2) on business income earned
in another country by a Canadian resident.
3. The corporations “business limit” when the “cumulative deduction
account” has reached an amount of $50,000.00 or less of the corporations
“total business limit”.9
9 Income Tax Act, S.C. 1970-71, c. 63, s. 125(1), (2) and (3).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
A Canadian controlled private corporation is defined in the Act as
… a private corporation that is a Canadian corporation other than a
corporation controlled, directly or indirectly in any manner whatsoever,
by one or more non resident persons, by one or more public corporations
or by any combination thereof; 10
Therefore it is seen that a Canadian controlled private corporation
is not a public corporation, nor a corporation controlled by a public
corporation, nor a corporation controlled directly or indirectly by non
residents, nor a non resident corporation, nor a company not incorporated
in Canada (unless it was resident in Canada at June 18, 1971 and
continued to be resident to date.
The concept of control means 51% of the issued voting shares.”
The idea of the legislation to apply this small business incentive
only to small corporations is found in the “business limit” concept
in which only $50,000 of profit per year may be eligible for the
deduction and in the concept of a “cumulative deduction account”
in which a maximum limit of $400,000 active business income is
allowed. These concepts will be discussed at a greater
length
shortly. In addition to those two limiting factors there is to be an
amendment to the new act deeming a private company with share-
holders numbering more than 150 persons to be a public corporation.
This of course would eliminate larger corporations from qualifying
for the small business incentive.
To be eligible for the small business deduction a corporation
must demonstrate that the income from which the deduction is
claimed is generated from “active business”. The definition of
“business” is identical under the new act to what it was under
the old.’ 2 In all likelihood the former jurisprudence relating to the
difference between business income and income from property will
appply under the new act. Any income generated from property
will of course qualify for the small business deduction. Consequently
passive income or income from investments will not be eligible for
the deduction. The modifying word “active” is an unknown quantity.
The jurisprudence which had arisen under the personal corporation
concept which was present under the old Income Tax Act may or
may not be definitive in ascertaining what constitutes “active
business income”. One of the criteria in the definition of a personal
corporation was that the corporation “did not carry on an active
financial, commercial or industrial business”. 3 Many tax lawyers
10Ibid., s. 125(6)(a).
“Ibid., s. 112(6)(b).
12Ibid., s. 248(1).
“Income Tax Act, R.S.C. 1952, c. 148, s. 68(l)(c).
McGILL LAW JOURNAL
[Vol. is
feel that some additional activity to the minimal amount which
was apparently applicable under the personal corporation concept
will be needed in order for the income to qualify as coming from
“active business”. Undoubtedly this will be subject to a considerable
amount of litigation and guidelines formulated.
As mentioned previously there are two limitations set upon the
small business incentive. In essence these constitute the govern-
ments definition of what is a small business. The first of these
figures is the “business limit”. A corporation may not claim the
lower tax rate on more than $50,000 of active business profit in any
one year. Therefore corporations whose taxable income exceeds
$50,000 will not be able to claim the lower tax rate on the amount
exceeding $50,000 but do not lose the lower tax rate for the $50,000
amount.
The second criteria which the legislation uses in order to define
what is a small business is found in the concept of a “cumulative
deduction account”. Under section 125(2) (b) the Act uses the word
“total business limit” which is a cumulative amount which, if
exceeded, disqualifies the corporation for the small business in-
centive. This amount is set at $400,000 of active taxable business
income earned subsequently to the implementation of the new act.
The idea of a “cumulative deduction account” enables a corporation
to delay reaching its total business limit indefinitely if the corpora-
tion is willing to declare taxable dividends. The “cumulative deduc-
tion account” is equal to the corporations active, before tax business
income for that year plus four thirds of taxable dividends received
from Canadian corporations, a controlled corporate resident in
Canada and a non resident corporation that from June 18, 1971
has through a “permanent establishment” in Canada carried on a
business throughout that year.–
From this amount may be deducted four thirds of the taxable
dividends paid by the corporation to the shareholders,0 and four
times the amount that the corporations year end refundable dividend
tax on hand 16 exceeds its dividend refund.17 It is seen therefore that
a corporation may declare a taxable dividend and reduce the cumu-
lative deduction account by an amount equaling four thirds of the
amount declared. For every three dollars of taxable dividend paid
the cumulative deduction account may be reduced by four dollars.
14 Income Tax Act, S.C. 1970-71, c. 63, s. 112(2).
‘GIbid., s. 125(6)(b)biii).
1GIbid., s. 129(3).
171bid., s. 129(l).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
Hence, provided three quarters of the eligible corporations after
tax active business earnings are annually declared as dividends, the
corporation may claim its small business deduction indefinitely as
it will continually keep its total business limit below $400,000. This
is consistent with the government policy evidenced in the new Act
of promoting taxable dividends to be declared out of corporations
and not having the corporation build up very large surpluses.
Small business incentives applied as deduction are a major shift
in Canadian tax policy. Under the old rules, all companies were
allowed a reduced rate of taxation for the first $35,000 of taxable
income irrespective of source.
The provisions respecting associated companies remained. Should
the company be associated with one or more Canadian controlled
private corporations, or be deemed by the Minister to be associated 18
(and no allocation has been made either by election or by the
Minister) the corporations business limit for the year is nil. Only
$50,000 of the associated compagnies earnings may be eligible for
the small business deduction and the total business limit will be
determined for the group as a whole. The only departure from the
old policy of determining whether companies are associated is the
concern with the degree of interlocking shareholders held by dif-
ferent related groups before the corporations are considered to be
associated. Under section 39(4) (c) of the old Act, if only one voting
or non voting share was held in the other corporation by a controlling
member, the two companies may be deemed to have been associated.
The extent of ownership has been expanded now to 10% of issued
shares held directly or indirectly by one of the controlling persons. 19
b. Refundable Tax on Ineligible Investments
As stated previously one of the major tenents in the new Act is
to give the small business incentive only to businesses which in fact
are going to use it in the business enterprise itself or as one depart-
mental official has put it to limit it to those companies which
really need it. Therefore, if the tax saving involved due to the
reduction of the tax rate is not employed in the companies active
business or disbursed as taxable dividends to the shareholders the
effect of the tax saving is lost. Should the corporation for instance
invest the savings resulting from the lower tax rate in stocks and
bonds the concept of an “ineligible investment” arises and a special
tax will be payable on the amount of the ineligible investment.
Is Ibid., s. 247(2).
19 Ibid., s. 256(1)(c).
McGILL LAW JOURNAL
[Vol. 18
Ineligible investment is defined in section 189(4) (b) as “property
that was not acquired for the purpose of gaining or producing
income from an active business of the particular corporation” with
certain exceptions relating to cash, government bonds maturing
within one year, controlling shares of another Canadian controlled
private corporation and bonds or debentures of certain other Ca-
nadian controlled private corporations which are dealing with the
tax payer at arms length.
A refundable tax is levied on Canadian controlled private corpo-
rations to the extent that the source of the funds used to acquire
ineligible investments has had the benefit of the small business
deduction. For this reason section 188(1) specifies that the tax of
25% is payable on the lesser of two derivitives. The first 20 is equal
to two times the cost of ineligible investments acquired after 1971
less the cost of ineligible investments acquired in prior years in
respect of which the refundable tax had been paid. The second 21
is equal to the sum of the corporations “preferred rate amount” for
that year which exceeds the cost of ineligible investments acquired
in prior years (after 1971) in respect of which the refundable tax
had been paid. The “preferred rate” amount is computed in section
189(4) (c) and may be said to equal the total income in respect of
which the company has obtained the small business deduction, plus
four thirds of taxable dividend received by a controlling corporation
from its subsidiary. The effect of this section is to prevent a sub-
sidiary which benefits from the small business deduction from
dividending the after tax funds to the parent and having the parent
make the ineligible investment to escape the tax. The effect of this
section is that ineligible investments will be deemed to have been
first acquired from “preferred rate” income. When the cost of the
ineligible investment exceeds the corporations preferred rate amount
and is not subject to the refundable tax in a given year, the excess
is carried forward to be taxed in a year when no taxable dividends
are distributed to the shareholders.
Should a corporation have a portfolio of investments at the end
of 1961 any subsequent changes in the portfolio may revert the
portfolio into ineligible investments subject to tax. Extreme cau-
tion should be exercised in relation to existing portfolios to keep
it untainted and intact so as to avoid all probability of this tax.
2OIbid., s. 188(1)(a).
21 Ibid., s. 188(l) (b).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
c. Intercorporate Dividends
The general rule under the new Act is to provide for a tax free
intercorporate dividend when dividends flow from one tax paying
Canadian controlled corporation to another or to a resident Ca-
nadian controlled corporation to another or to a resident Canadian
corporation from its subsidiary. The dividends flowing may be
deducted from the income of the receiving corporation 22 notwith-
standing this deduction however, private corporations are subject
to a special refundable tax of 331/3% on some dividends received
and deducted under sections 112 and 113. Among the dividends
subject to this special tax are those from Canadian and foreign
affiliate corporations not controlled by the receiving corporation.
The imposition of this special tax on income received from cor-
porations not controlled by the receiving corporatibn reflects the
governments wish that an individual no longer may defer by accu-
mulating dividend investment income in a holding company. Part
of the dividend income received from a controlled corporation is
also taxed at 33%1/% under section 186(1)(b). The amount taxed
indicates the dividend refund received by the payor corporation
in respect to the dividend paid to the controlling corporation.
The receiving corporation may elect to reduce the special tax
payable by deducting any part of the corporations net operating
loss for the year 23 or any residual loss carry over which may have
been claimed against its own income. 24
d. Refundable Dividend Tax to Private Corporations
Keeping with the governments objective of promoting the
distribution of corporate profits, and the attempts at integrating
corporate and individual income tax the Act provides that part
of the tax payable on investment income in the hands of the pri-
vate company, will be refunded to the company when the income
is distributed as a taxable dividend to the shareholders 5 This
refundable tax is considered to be temporary; when the investment
income is in the hands of the shareholders as taxable dividends
the tax has served its purpose. The company has an inducement
to pay out this income and claim the refund and the individual,
22 Ibid., s. 112(1) and 113.
23 Ibid., s. 186(1)(c).
24 Ibid., s. 186(1)(d).
25 Ibid., s. 129(1).
McGILL LAW JOURNAL
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while taxed at his marginal rate may claim a dividend tax credit
on the amount of the dividend received.
The amount to be refunded to private corporations includes one
half of the tax paid on investment income and all of the special
33 1/3% tax paid under section 186 on portfolio dividends. The
refund which need not be applied for is equal to the lesser at
331/3 % of the taxable dividends paid that year or the refundable
tax dividend on hand at the end of the year.20 “Refundable dividend
tax on hand” is defined in section 129(3). This amount incorpo-
rates all taxes previously paid under section 186. In addition, there
are some specific calculations relating to foreign investment in-
come received.
The terms “Canadian investment income” and “foreign invest-
ment income” are defined in section 129(4) (a) and (b) respectively.
In general, all the corporations non active business sources of
income and losses are accounted for when computing the invest-
ment income for the year.
e. Acquisition of Canadian Controlled Small Business
by Non Resident
A non resident may not claim the small business deduction;
indeed when the control of a company which has had benefit of
the deduction is acquired by a non resident the tax saving accu-
mulated by the corporation over the years must be repaid.2 7 The
obvious purpose of these sections are to make small Canadian
controlled business less desirable from the standpoint of foreign
take overs.
Similarily the treatment of capital losses incurred before the
change of control applies to this heading. No part of any capital
loss may be carried forward as a deduction from a capital gain
realized after the change in control 2 8
No repayment is required if any eligible corporation becomes
a public corporation. Should control of the public corporation then
fall into the hands of non residents the company would be required
to repay the tax saving previously derived from the small business
deduction.
26 Ibid., s. 129.
27 Ibid., 190 and 191.
28Ibid., s. 111(4).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
f. Amalgamations
Statutory amalgamations are defined in section 87(1) as “a
merger of two or more corporations, each of which was, immedi-
ately before the merger, a Canadian corporation to form one cor-
porate entity”. The first taxation year of the new corporation is
deemed to have commenced at the date of the amalgamation. 29
For the purposes of the small business deduction special rules
apply; otherwise, by amalgamating, companies whose cumulative
deduction account had reached its total business limit would
merely have to amalgamate to once again qualify for the small
business deduction. The impact of section 87(2)(y) serves to ag-
gregate cumulative deduction accounts of the amalgamating com-
panies. Should the aggregate be under the total business limit,
the new company so formed by the amalgamation may claim a
deduction to the extent of the business limit for that year. How-
ever, the aggregate of the companies refundable dividend tax on
hand may be carried forward to the amalgamated corporation.?,
III. Corporate Surpluses
Under the new Act many streams of after tax income are grouped
under the heading “surplus”. Each class of surplus requires sepa-
rate tax treatment prior to the distribution to the shareholders. It
is obvious therefore that the accounting requirements under the
new act will be much more detailed and the source of the surplus
will be of extreme importance. This is a fundamental shift from
what was the case previously under the old Act.
a. Distribution by Resident Corporations
to Individual Shareholders
(i) Distribution of pre 1972 Corporate Surpluses to Residents
As mentioned previously under the provisions of the old Income
Tax Act extremely large surpluses were built up over the years in
private companies. The new Act permits a corporation to pay a
special 15% tax on the undistributed income accumulated between
the corporations taxation years 1950-1971. 8′ Upon payment of this
tax “tax paid undistributed surplus on hand” is created 2 Dividends
29 Ibid., s. 82(2)(a).
32 Ibid., s. 87(2)(aa).
.” Ibid., s. 196(1).
32Ibid., s. 89(1)(k).
McGILL LAW JOURNAL
[Vol. 18
paid from a corporation to the shareholders out of tax paid un-
distributed surplus on hand attract no further tax to either the
corporation or the individual. “Tax paid undistributed surplus on
hand” is merely the new wording for what was formerly “tax paid
undistributed income” under the old Act. Should a corporation
hold any accumulated tax paid undistributed income this becomes
tax paid undistributed surplus under the new Act and dividends
may be declared which are free of tax. All that is required in
order for these tax free dividends to be declared is a direc-
tors’ resolution indicating that the devidends are paid from this
account. Such a distribution simplifies the procedure previously
required whereby the tax paid undistributed income had to be
paid out by way of redeemable preferred shares later to be re-
deemed by the corporation for cash. Once the “1971 tax paid un-
distributed surplus” has been wholly distributed the corporation
may elect to declare a tax free dividend from its “1971 capital
surplus”.3 3 In this manner the new Act avoids any retroactivity
of capital gains accumulated by the corporation prior to the im-
plementation of the new system.
“1971 capital surplus on hand” is defined in section 89(1)(1)
and represents the corporations book surplus less its 1971 undis-
tributed income on hand (updated to include any capital gains or
losses having been realized by the end of the company’s fiscal
period and or December 31, 1971). Pre 1950 undistributed income
is treated in a similar manner to 1971 capital surplus.
When a corporation elects to pay out a larger tax free disburse-
ment then the amount to which it is entitled under section 83(1)
the company becomes subject to a special tax on the excess. The
tax equals the amount of the excess or 100%.34 When it is consid-
ered that a corporations tax paid undistributed surplus on hand
could be changed by virture of a reassessment sometime in the
future which would then result in an excess amount having been
paid which then becomes subject to a 100% penalty tax it is ob-
vious that some frightening possibilities can occur from this penalty
provision. Quite aside from a change to an assessment process it
is extremely difficult to calculate with precise accuracy the 1971
tax paid undistributed surplus. It is understood however, that
under certain conditions the Department of National Revenue will
confirm a figure arrived at by the firms accountants as being the
amount acceptable to the Department and certainly such steps
33Ibid, c. 82(1)(1).
341Ibid., s. 184(l).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
should be taken prior to any further distribution which could be
subject to the 100% penalty tax.
b. Adjusted Cost Base
The concept of “adjusted cost base” is a creature of the capital
gains tax. A capital gain is calculated from the increment of
appreciation from a base value or cost base of property set at
valuation day. Should a corporation pay out tax exempt (section
83) distributions, any future capital gains realized of that capital
stock would be artificially low without the subsequent adjustment
of the shares cost base. As a result section 83(1)(d) and section
53(2)(a)(i) demand that any distribution “other than a taxable
dividend or capital dividend” 35 must be accompanied by an equal
deduction from the adjusted cost base of the corporations capital
stock.
It is seen therefore, that if tax fee dividends referred to pre-
viously are paid the potential taxable gain is increased due to the
fact that the adjusted cost base has been reduced by the amount
of the tax free dividend paid. Where a company’s worth is valued
on assets alone this would not have a significant consequence due
to the fact that if the surplus is taken out via the tax free dividend
route the worth of the company will be reduced any hence the
potential capital gains are roughly the same. If however a corpo-
ration is valued ont its earnings and a surplus is taken out via
the tax free route it would not have a substantial effect on the
value of the shares and yet the adjusted cost base of the shares
would be reduced and upon disposition an increased taxable capital
gain would arise.
Another consideration ties into the difficulty of small business
gaining dependable low cost source of venture capital. Due to the
“liquidity squeeze” that many small corporations find themselves in,
it may be unlikely that they will pay out any 1971 undistributed
income. Most of a company’s surplus is usually bound up in working
capital which dictates that the only way a company can pay out
its earned surplus is either to liquidate the company’s current
assets or to borrow the amount intended to be distributed (thereby
replacing surplus account as a means of financing with long or
short term debt). These alternatives are uniattractive. Since the
1971 capital T.P.U.S. must be paid out fully before any 1971 capital
surplus can be distributed a small company which remains a going
concern probably will not take advantage of the section 83 election.
35, bid., s. 53(2)(a)(i).
McGILL LAW JOURNAL
[Vol. 18
The personal corporation provisions under sections 67 and 68
of the old Act have not counterpart in the 1972 Income Tax Act.
Corporations formerly qualifying as personal corporations will
now be taxed as private corporations with one exception. Should
a personal corporations fiscal year stradle the 1972 taxation year
the company will retain its personal corporation status until the
year end of its 1971-1972 taxation year as long as the company
remains a personal corporation as defined under section 68(1)
of the old Act during the period 6
With respect to 1971 undistributed income, section 57(8) allows
the same section 83 election as private corporations. If the 1971
tax paid undistributed surplus is disbursed the company may then
declare any of its 1971 capital surplus as a non taxable distribution.
Since the personal corporations income is deemed as a taxable
dividend to the shareholder the corporation’s 1971 undistributed
income would consist of tax paid undistributed income and be
paid out as a non taxable distribution to the shareholders.
Dividends in the new Act include any distribution deemed or
actually paid out of corporate surplus. Included are stock dividends
and deemed dividends arising out of corporate reorganizations
or by virtue of stock redemptions.
In place of the old section 105(2) election (enabling the corpo-
ration to pay out undistributed income tax free to the shareholders
upon payment of a 15% tax –
to the extent that dividends previously
were declared and paid), the new Act states that shareholders
receiving dividends paid from post 1971 surplus are to be granted
a larger dividend tax credit (now 331/3%). This however, is some-
what illusionary in that they have changed the method by which
the amount of dividend tax credit is to be calculated. Under the
old Act the dividend tax credit was deducted from the income tax
payable. Under the new system there is a gross up and credit
concept in which not only the dividend paid but the dividend credit
is initially included as income and the credit taken from that
increased amount. The arithmetic works out to the effect that
shareholders who have a personal marginal rate of under 40% gain
a greater benefit under the new Act, shareholders in the 40%
bracket get the same benefit as under the old Act, shareholders
whose personal marginal rate is over 40% get a reduced benefit
under the new Act.
36 Section 57 Income Tax Application Rules 1971.
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
c. Distributions by Non Resident Corporations to
Individual Shareholders
Under the old Act any disbursement received or deemed to
have been received by a resident, non corporate shareholder was
fully included in the tax payer’s income. In return a full foreign
tax credit was allowed in respect of any foreign withholding tax
levied on the dividend. Under the new Act the rules are roughly
the same with one major exception that is the equivalent of section
81 of the old Act (section 84)
is applicable only to corporate
residents in Canada. After 1975 by the combined effect of section
20(11) and 126(7)(c) non business income tax i.e. foreign with-
holding tax may be deducted from tax payable for that year only
to a maximum of 15%. Any additional amount paid as a foreign
tax may be deducted from income alone. The apparent purpose of
this limitation is to make Canadian investments more attractive.
For purposes of adjustments to the cost base of shares of non
resident corporations, the amount to be deducted is determined as
if the non resident corporation were an “affiliate” of the share-
holder.37
A foreign affiliate is defined in section 95(1)(b) as a foreign
corporation “controlled directly or indirectly in any manner what-
soever by the tax payer or the tax payer and other tax payers
with whom the tax payer was not dealing at arms length”. Control
in this instance refers to a minimum 25% voting participation
not less than 50% equity participation or a 10% minimum voting
participation if the tax payer elects to have the corporation regarded
as a foreign affiliate.3 s
d. Distributions by Corporate Residents to Corporate Shareholders
(i) Transfer of Special Surplus Between Corporations
Provided a company which is paying a special dividend is not
a controlled subsidiary of the receiving corporate shareholder the
recipient may incorporate the amount of the special dividend in
its own 1971 tax paid undistributed income account.
Of more difficulty is the treatment accorded the payment of
special dividends between parent corporations and its subsidiary,
or where a corporation controls more than 50% of the voting shares
of another corporation. Upon receipt of a special dividend the
37lncome Tax Act, S.C. 1970-71, c. 63, s. 53(2)(b).
38 Ibid., s. 95(1)(b)(ii)(iii) and (iv).
McGILL LAW JOURNAL
[Vol. 18
controlling corporation by application in writing to the minister
within two years from the end of the calendar year in which the
dividend was paid shall receive a refund in respect of the 15%
special tax paid by the controlled corporation. The refund equals
15/85ths of the special dividend paid.3 9 Unless that special dividend
exceeded the ccontrolled corporation’s controlled period earnings
or unless the extent of the undistributed income on which the 15%
tax paid by the subsidiary represents pre 1972 designated surplus.
Should the corporate parent be structured in a way as to control
a chain of subsidiaries each controlling other subsidiaries in turn
the transfers along the corporate chain require individual payment
and refund of the section 83 special tax. The amount finally received
by the parent company is included in the parent’s 1971 undistributed
income on hand whereupon payment of the special 15% tax under
section 196(1) the undistributed income on hand may be disbursed
free of tax to the individual shareholder.
Should the special dividend be paid out of designated surplus
that consists partly of 1971 undistributed income the recipient
controlling corporation may elect to pay 15%
tax under section
196(1) and distribute the 1971 tax paid undistributed income as
a non taxable distribution by way of the section 83 election.
Adjustments to the cost base of corporate shares in respect
of dividends received or deemed to be received are calculated in
the same manner as adjustments made to the cost base of shares
held by individual shareholders.
(ii) Taxable Dividends Between Resident Corporations
The amount to be included in a resident corporations income
from dividends received from another resident corporation is de-
termined as if the shareholder were an individual. The corporation
may deduct an amount equal to the dividend for the purpose of
computing its taxable income. The new Act has no similar pro-
visions as contained in section 28(2) of the old Act.
e. Distributions by Non Resident Corporations to
Corporate Shareholders
The deemed dividend provisions of section 84 pertaining to the
issuing of stock dividends or the revaluation upward or downward
of existing capital stock is only applicable to resident corporations.
Now to be assessed as income however, are stock dividends.40
39Ibid., s. 196(2)(a).
40 Ibid., s. 248(l).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
This provision is a major departure from the old act in which a
stock dividend was expressly excluded from income.
With respect to distributions from foreign affiliates all dividends
actually received from the affiliate are naturally considered as the
company’s income. In addition, section 91 includes the resident
corporations participating percentage of foreign accrual property
income and “any amount received by a foreign affiliate.., as on
account or in lieu of payment of or unsatisfaction of a dividend
from another foreign affiliate of the tax payer during the taxation
year”. Participating percentage refers to the extent of participating
equity of the affiliate held by the corporate resident; foreign accrual
property income includes the new income from property (other
than from another foreign affiliate of the tax payer) and net taxable
capital gains. The company may claim a reserve respecting the
deemed income provisions of section 91(1) if monetary restrictions
or exchange controls imposed by a foreign country would result
in undue hardship to the Canadian corporation. But, this reserve
must be carried forward in the following year as income 41
The concept of “designated surplus” which was first introduced
in the 1948 Income Tax Act has been retained and indeed expanded
under the new act. Designated surplus has been defined as a
controlled corporation’s undistributed income on hand at the end
of its last complete taxation year before control was acquired.42
The meaning of control is extended under the new Act to embrace
ownership by the controlling corporation of more than 50% of
issued voting share capital. It incorporates the concept of non arms
length dealings between the controlled corporation and other in-
dividuals or corporations.4 3 The actual calculation of designated
surplus involves several steps depending upon the year that control
is to be acquired. When a company has been acquired before the
end of its 1972 taxation year designated surplus is calculated using
the old rules set out in section 192(13) (a) (i) of the new Act. When
control is acquired in the company’s 1972 taxation year section
192(10), the new subsection dealing with the national designation
of surpluses through a chain of Canadian corporations, becomes
operative; dividends from the subsidiary of the controlled corpo-
ration become incorporated into the parent’s designated surplus.44
From the amounts calculated in section 192(13) (a) (i) and (ii) the
41 Ibid., s. 91(3) and 91(4).
421ncome Tax Act, S.C. 1970, c. 43, s. 28(2).
43Income Tax Act, S.C. 1970-71, c. 63, s. 192(4).
44Ibid., s. 192(13)(a)(ii).
McGILL LAW JOURNAL
[Vol. 18
amount elected to be dispersed under section 196(1) by the payment
of a special tax of 15% may be deducted. When control is acquired
in 1973 and subsequent taxation years designated surplus is the
aggregate of the corporation’s 1971 undistributed income on hand,
the post-1971 undistributed surplus at the end of its last taxation
year before control was acquired and all taxable dividends received
by the controlled corporation’s subsidiaries either from designated
surplus or from tax paid undistributed surplus.i Excluded from
this amount are losses experienced, investment income subject to
refundable tax as well as the controlled period earnings of the
controlled corporation. 40
All dividends, even those dispersed from designated surplus,
will be deductable in computing taxable income of the recipient
Canadian corporation (except a trader or dealer in securities).
Should the dividend be paid from designated surplus the recipient
controlling corporation is liable for the payment of a 25% tax on
the amount, should the controlled corporation’s designated surplus
consist in part of 1971 undistributed income on hand or 1971 capital
surplus via appropriate elections under section 83(1) the controlled
company may make a non taxable distribution to the controlling
corporation with respect to these amounts.
Section 194 is the counterpart of section 105(8) of the old Act.
Unlike section 105(B), section 194 stipulates that tax is payable
only on dividends from designated surplus. The tax payable is only
effected should the dividend be paid to a controlling non resident
corporation (whereupon a tax of 15% is payable) or a controlling
tax exempt person as defined in section 149 whereupon a tax of
331/3 % is payable. The payor corporation is required to pay the
necessary tax.
Under the old Act an amalgamation of two or more companies
got rid of any designated surplus on the books of one or more of
the predecessor corporations. The designated surplus did not flow
to the amalgamated company. This de-designation of the designated
surplus did not have further tax consequences provided the net
asset value of the combined companies was not exceeded by the
combined undistributed incomes of the amalgamating companies.
Otherwise section 105(C)(1) of the old Act demanded a tax of
20% be paid on the excess.
The new Act has made the designated surplus provisions ex-
tremely effective to the extent that whenever one Canadian corpo-
40Ibid., s. 192(13)(b)(i)(i)(ii).
46 Ibid., s. 192(13) (b) (iv) (vi).
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
ration acquires control over another the two cannot amalgamate
without incurring a 25% tax on the controlled corporations desig-
nated surplus. Prior to amalgamation designated surplus is effected
by the parents control of the subsidiary. Once the two corporations
amalgamate, section 87(2)(gg) (i) insures that where the prede-
cessor corporation was immediately before the amalgamation con-
trolled by a corporation that immediately after the amalgamation
controlled the new corporation, the controlled ccorporation’s design-
ated surplus will be included in the amalgamated corporation’s
designated surplus.
With respect to vertical amalgamations section 192(3) provides
that “when one or more of the corporations were controlled by
another or others of those corporations … each controlling corpo-
ration shall be deemed to have received a taxable dividend im-
mediately before the amalgamation of each corporation controlled
by it at that time”. This dividend is judged to have been paid out
of designated surplus of the controlled corporation and is con-
sequently subject to a 25% tax under the general rule contained
in section 192(1). The amount deemed to be dividend to each
controlling corporation is the greater of: the amount made payable
on a hypothetical winding-up after the subscribed capital has been
repaid or the amount realized by the shareholders if the corpo-
ration has declared and paid out a dividend from the designated
surplus.4 7
Therefore extreme caution must now be exercised with respect
to amalgamations and the old practice must be thoroughly re-
examined in the light of the new tax legislation.
Section 182 is the successor of section 105A of the old Act.
The effect of both these sections is to impose a special 20% or
30% tax on premiums paid upon the redemption or acquisition
of a company’s own capital stock. The dealings with common
shares are expressly excluded. Under the new Act there is no
equivalent to section 105A(3) of the old Act. Section 105A(3)
permitted a corporation to deduct the premium paid from a tax
paid undistributed income if any to thereby avoid tax consequences.
The new Act demands tax on premiums paid irrespective of the
company’s tax paid undistributed income position.
47 Ibid., s. 192(3)(c)(i)(ii).
McGILL LAW JOURNAL
[Vol. 18
f. Corporate Distributions on the Winding-Up,
Discontinuance or Re-organization of Business
Corresponding with section 81 of the old Act, section 84 con-
tinues the policy that a dividend is deemed to be paid to the
shareholders when the corporation undertakes one of the following
events:
(a) increases the paid up capital without increasing the net assets
(b) distributes or appropriates benefits to the shareholders on the winding-
up, discontinuance or re-organization of business
(c) redeems, acquires or cancels any class of shares
(d) reduces its paid up capital in any class of shares comprising its
capital stock. 48
The old Act stated that when a corporation undertook one of
the aforementioned events the undistributed income of the corpo-
ration was to be paid out first. Under the new Act the shareholder
in similar circumstances is first allowed the return of his investment
in the company. The return of capital is limited to the “paid up
capital limit” defined in section 89(1) (e) as “the amount if any,
by which the paid up capital of the corporation at that time in
respect of all the shares of its capital stock exceeds the corpo-
rations paid up capital deficiency at that time”. Paid up capital
deficiency has been termed the negative equivalent of the 1971
capital surplus on hand .4 To arrive at either of the two terms the
tax equity of the corporation must be defined and calculated.
Tax equity of a corporation at the end of its 1971 taxation year
may be summarized as the aggregate of a company’s;
(a) undepreciated capital cost of depreciable property
(b) other capital property (other than depreciable property) minus pre
1972 income deductions respecting that property
(c) inventory at 1971 closing tax value
(d) accounts receivable less bad debts
(e) cash on hand
(f) property not described above which under the old rules were not
deductable in computing income
Less:
(a) liabilities of the company
(b) reserves deducted for the 1971 taxation year
Good will is not included in the computation of tax equity.
Neither are other intangibles such as exploration rights. Conse-
4s Ibid., s. 84.
40 Canadian Tax Reports, No. 84 Extra Edition, at p. 127.
No. 4]
DISTRIBUTION OF CORPORATE SURPLUSES
quently tax equity can be broadly described as the company’s book
or balance sheet net work less good will and other nothings.
Paid up capital deficiency arises when paid up capital plus
1971 undistributed income exceeds the company’s “tax equity”. The
dividends declared under section 84 to be paid and received are
the amounts distributed or capitalized minus the lesser of the
company’s paid up capital as well as paid up capital deficiency.
Because of this limitation the company may return tax free only
the paid up capital allowed on the above rules.
IV. Conclusion
From the above it is seen that in order to advise corporate
clients lawyers must have a working knowledge of what are es-
sentially accounting concepts with respect to various corporate
accounts. Under the new Act the source of income is extremely
important and an analysis must be made in any given situation
as to the corporations position in relation to each of the accounts
mentioned above. These are difficult areas and ones in which lawyers
have traditionally not involved themselves. It is to be hoped that
efforts will be made by the profession as a whole to acquaint them-
selves with these new concepts and not to let another facit of legal
practice go by default. Indeed it is imperative that extra efforts
be made if sound legal advice is to be given corporate clients with
respect to almost all facits of their corporate existence.
