Section 55 — stop converting income into capital gains through dividends
Deemed proceeds — anti-avoidance for capital gains strips
Section 55 prevents a corporation from using intercorporate dividends to artificially reduce the gain on a share sale. It can recharacterize an intercorporate dividend as a capital gain (deemed proceeds) or as proceeds of disposition rather than a tax-free dividend.
Plain-language explanation
Section 55 is a corporate anti-avoidance provision targeting "capital gains strips" — transactions designed to extract corporate surplus as a tax-free intercorporate dividend (under s.112) rather than as a taxable capital gain on a share sale.
The problem s.55 solves: Corporation A holds shares of Corporation B with an ACB of $100 and FMV of $1,000,000 (accrued gain: $999,900). If A sells the shares, there is a large capital gain. Instead, B pays A a dividend of $999,900 before the sale, reducing B's FMV to $100. Now when A sells B's shares for $100 (= new FMV), there is no capital gain. The dividend was tax-free under s.112 (connected corporation dividend deduction). This is a capital gains strip.
How s.55 stops this: If the "purpose" of the dividend was to reduce the capital gain on a subsequent share sale (to a non-affiliated person), the dividend can be recharacterized as either: (a) a capital gain to the dividend recipient, or (b) proceeds of disposition of the shares.
Safe income on hand: The amount of the dividend attributable to the corporation's "safe income" (after-tax retained earnings) is exempt from s.55 recharacterization — only dividends paid out of unrealized appreciation ("unsafe income") are caught.
Post-2015 expansion: Budget 2015 significantly expanded s.55, now applying it even to non-arm's-length transactions between connected corporations, reducing the role of purpose planning and requiring careful safe income analysis in all corporate reorganizations.
Example
HoldCo owns OpCo shares with ACB $100, FMV $2,000,000. OpCo has safe income of $200,000 and unrealized appreciation of $1,800,000. OpCo pays HoldCo a dividend of $1,800,000. Under s.55, the $1,800,000 (attributable to the unrealized gain, not safe income) is recharacterized — HoldCo has a deemed capital gain on its OpCo shares instead of a tax-free intercorporate dividend.
Amendment history
Significant changes to this provision. Older versions help you understand rules that applied in prior tax years.
Major s.55 expansion — Budget 2015 replaced the "purpose" test with a broader two-part test (purpose OR gain reduction), applying s.55 to connected-corporation dividends and substantially expanding the scope beyond pre-2015 planning expectations.
Common questions
What is "safe income" for section 55 purposes? +
Safe income is broadly the corporation's after-tax retained earnings — the portion of corporate surplus that has already borne corporate tax. Dividends paid out of safe income represent a distribution of taxed earnings and are not treated as capital gains strips. Safe income on hand must be carefully calculated to include only income earned and retained after all taxes.
Does s.55 apply to all intercorporate dividends? +
After the 2015 Budget expansion, s.55 can technically apply to any dividend received by a corporation from a connected corporation, not just in gain-reduction transactions. In practice, s.55(2.1) applies when the dividend either reduced a capital gain, or there would be a capital gain on a notional sale of the shares.
Key terms
Source: Income Tax Act, RSC 1985, c. 1 (5th Supp.), section 55. — Read the official text on Justice Canada
These summaries are for educational purposes only and do not constitute legal or tax advice. Speak with a CPA for advice on your specific situation.