Surplus stripping: We need to fix Canada’s tax rules

Allan Lanthier

Part I of this two-part series discussed the recent enactment of a private member’s bill to accommodate intergenerational transfers of family businesses, and the government’s response to the bill. This, Part II, addresses surplus stripping more generally, outside the context of such transfers. After revisiting surplus stripping – what it is and how it works – this piece suggests legislative options to address these tax-avoidance schemes.

As discussed in Part I of this article, the recent legislative fiasco involving a private member’s bill – Bill C-208 – that was intended to facilitate intergenerational transfers of smaller family businesses has put surplus stripping back in the spotlight.

Bill C-208 will now remain in force until new restrictions are finalized later this year with safeguards to address surplus stripping. Outside of intergenerational transfers, we will then be back to old-fashioned surplus strips – shuffling paper around to convert dividend tax rates to capital gains rates, but without access to the lifetime capital gains exemption (LCGE). These tax-avoidance schemes are the focus of Part II.

How does surplus stripping work?

In Canada, individuals pay lower tax rates on capital gains than on dividends. Surplus stripping involves an individual receiving after-tax earnings of a corporation as a capital gain rather than as a taxable dividend. Here’s the example that was used in Part I.

Mrs. A is a top-rate taxpayer resident in Ontario. Mrs. A owns 100 percent of the shares of Co. A, a corporation that carries on an active business. Mrs. A’s tax basis of the shares is nominal. She would like to take a cash dividend of $100,000 from Co. A, but her tax accountant says her federal-provincial tax rate would be 47.7 percent. However, he has a plan.

In simplified terms, Mrs. A sells shares of Co. A worth $100,000 to one of Co. A’s wholly owned subsidiaries for cash. She has a capital gain – not a dividend – and the capital gain is taxed at a rate of 26.7 percent. This surplus strip saves Mrs. A $21,000 in personal income tax.

If the Canada Revenue Agency challenged this scheme using the general anti-avoidance rule, it is not at all clear that the challenge would succeed.[1]

The anti-avoidance rule: section 84.1

Unless cash is extracted from a business as part of an intergenerational transfer to which the new rules apply, section 84.1 of the federal Income Tax Act[2] prevents Mrs. A from completing the surplus strip described above to the extent that she claims the LCGE.[3]

Under section 84.1, if an individual sells shares of a corporation (the “subject corporation”) to another corporation (the “purchaser corporation”) with which the individual does not deal at arm’s length, and the purchaser corporation owns more than 10 percent of the share capital of the subject corporation immediately after the sale, the amount of cash or other non-share consideration received by the individual is taxed as a deemed dividend to the extent the tax cost of the subject shares includes an amount for which the LCGE was claimed.[4] However, if the sale is properly structured, section 84.1 should not apply if the LCGE is not claimed.

The underlying problem is the differential that exists today between personal tax rates on taxable dividends as opposed to capital gains. There will always be an incentive to try to convert dividends into capital gains if dividend tax rates are significantly higher than capital gains tax rates — and in 2021 they are.

It wasn’t always like this. There was a time when capital gains rates were actually higher than dividend rates. For example, throughout the 1990s: (1) the capital gains inclusion rate was 75 percent; (2) there was no distinction between eligible and non-eligible dividends – there was a single dividend tax credit, based on the small business rate for Canadian-controlled private corporations (CCPCs)[5]; and (3) because the small business rate was much higher in the 1990s than it is today, the additional personal tax that applied on the receipt of taxable dividends was less.

In 1999 for example, the tax rate on capital gains for a top-bracket individual in Ontario was 36.6 percent (based in part on the 75 percent capital gains inclusion rate that applied at that time), and the rate on taxable dividends 32.9 percent.[6] There was therefore no incentive to surplus strip. But today, with a 50 percent capital gains inclusion rate and higher effective dividend rates, the numbers are very different.

Our example above with Mrs. A (and her savings of $21,000 on a surplus strip of $100,000) assumes that, without the strip, Co. A would have paid a “non-eligible dividend” – a dividend paid out of earnings that have benefited from the small business deduction (SBD).[7] The SBD is available for up to $500,000 of business income earned by a CCPC, or by an associated group of CCPCs, each year.[8] As noted, a top-rate taxpayer in Ontario is taxed at a federal-provincial rate of 47.7 percent on receipt of such dividends, versus a rate of 26.7 percent for capital gains.

The savings are not as great for “eligible dividends” – dividends paid out of earnings that have been taxed at the general corporate tax rate. Because the corporate tax rate is greater, the additional tax to the individual on the receipt of dividends is less. A top-rate taxpayer in Ontario is taxed at a rate of 39.3 percent on eligible dividends, compared with the capital gains rate of 26.7 percent. While the savings from a surplus strip are therefore not as great for eligible dividends, savings still exist. Converting an eligible dividend of $100,000 into a capital gain will save the individual $12,600, instead of the savings of $21,000 that apply to a non-eligible dividend.

Is there a legislative fix?

There are at least two possible legislative approaches to address surplus stripping. One would be to tighten the anti-avoidance rule in section 84.1 of the Act. Another would be to focus on the underlying causes – the taxation of only 50 percent of capital gains, and the high personal tax rates that apply to dividends received from private corporations.

Section 84.1 of the Act

As discussed, section 84.1 of the Act applies when an individual sells shares of a corporation to another corporation with which the individual does not deal at arm’s length. The individual’s capital gain is deemed to be a taxable dividend to the extent that the individual receives cash or other non-share consideration. However, subject to new relief for intergenerational transfers, this rule applies only to capital gains that benefit from the LCGE. So one approach would be to extend section 84.1 to all capital gains, even if the LCGE is not claimed.

Finance Minister Bill Morneau proposed this change as part of the 2017 private corporation tax proposals but, in the face of stiff criticism from the tax community, the government abandoned the proposed amendment. In this author’s view, this retreat was largely due to the fact that Finance Department officials had not given sufficient thought to the impact of the amendment on post-mortem tax planning. However, it would be a simple matter to proceed with the amendment with an exception for dispositions by the legal representative of a deceased taxpayer.[9] With this simple legislative change, many surplus stripping plans would become a matter of historical interest.

Address the underlying causes

Another approach – not nearly as simple or effective – would be to address the underlying causes: the differential that exists today between personal tax rates on capital gains versus taxable dividends.

For example, as my colleague Michael Smart has argued, the capital gains inclusion rate could be increased to 75 percent. For a top-rate taxpayer resident in Ontario, this would mean a rate of 40.1 percent on capital gains, very close to the rate of 39.3 percent that applies to eligible dividends.

However, this approach would not adequately address the issue of non-eligible dividends – dividends paid by CCPCs out of income that has benefitted from the SBD. A top-bracket individual resident in Ontario pays a rate of 47.7 percent on such dividends, and an increase to 75 percent in the capital gains inclusion rate – and an effective rate of 40.1 percent on capital gains – would significantly reduce, but not eliminate, the incentive to convert such dividends into capital gains.


On balance, the most simple and effective approach would be to tighten the rules in section 84.1 so that they apply to all related-party transfers that convert dividends into capital gains, except for intergenerational transfers, even if the LCGE is not claimed.

Part I: Surplus stripping and the new, costly tax loophole for intergenerational transfers

[1] Canadian courts have said there is no general policy in Canadian tax legislation that prohibits surplus stripping. For a discussion of plans that are being used at this time, and comments on the possible reaction of the courts to these plans, see Eytan Dishy and Chris Anderson; “The Permissibility of Surplus Stripping: A Brief History and Recent Developments”; 2021 Canadian Tax Journal; Canadian Tax Foundation.

[2] Referred to herein as the “Act”.

[3] The LCGE for shares of a qualified small business corporation is $892,218 (2021 indexed limit) and $1 million for shares of a family farm or fishing corporation.

[4] See subparagraph 84.1(2)(a.1)(ii) of the Act.

[5] The definition of “eligible dividends” – with an enhanced dividend tax credit – was introduced in 2006 in a futile attempt to address a wave of public company conversions from corporate to trust status, conversions that eliminated all corporate-level tax. The tax-credit enhancement did not adequately address the issue, so a new tax on “specified investment flow-through entities” (SIFTs) was introduced later that year. However, the concept of eligible dividends was never repealed.

[6] The federal-Ontario tax for a CCPC on income that was eligible for the small business deduction was 21.6 percent in 1999. In 2021, that rate is only 12.2 percent, and so personal rates on dividends are higher to compensate for this low corporate rate.

[7] Dividends paid out of after-tax investment income are also non-eligible dividends. However, taxable dividends must be paid for the corporation to receive a refund from its “refundable dividend tax on hand” (RDTOH) account. As a result, there will generally be no attempt to convert such dividends into capital gains.

[8] The small business rate is phased out if taxable capital is between $10 million and $15 million, or if passive investment income is between $50,000 and $150,000 in the preceding year.

[9] While there is no compelling tax policy reason to allow surplus strips after the death of a taxpayer as opposed to inter-vivos strips, a disposition as a result of death is involuntary of course, and other rules in subsection 164(6) of the Act to address double taxation on death leave much to be desired.

About Allan Lanthier

Allan Lanthier is a retired partner of EY Canada and has been an advisor to both the Department of Finance and the Canada Revenue Agency.