The Subsection 55(2) Purpose Test – An Overview

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.