What is a dividend strip and why does the CRA challenge it?

A dividend strip, sometimes called surplus stripping, is a transaction designed to convert what would be a taxable dividend into a capital gain or other lower-taxed amount. Because dividends from a CCPC are taxed at higher personal rates than capital gains, some taxpayers have structured transactions to extract corporate surplus at capital gains rates instead of dividend rates, reducing their personal tax.

Common structures involve selling shares to a related party, creating a high adjusted cost base through a series of transactions, or using redemptions and subscriptions in a way that triggers a capital gain rather than a deemed dividend. The Income Tax Act contains specific anti-avoidance rules targeting surplus stripping, and the general anti-avoidance rule also applies. The CRA actively audits these transactions and has won significant cases challenging them.

The consequences of a failed strip can include reassessment to include the full surplus as a dividend, penalties for gross negligence, and interest going back years. The cost of a failed transaction far exceeds the original tax saved. Any transaction that seems to convert a dividend into something else at a lower rate should be reviewed carefully by a tax lawyer. If a promoter is charging a fee based on a percentage of the tax saved, treat that as a red flag.