Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Whether: (1) management wages paid by Holdco are reasonable and (2) management fees earned by Holdco for services provided to Opco are reported properly.
Position: (1) Yes. (2) No.
Reasons: (1) Wages are within the scope of our policy on the reasonableness of shareholder/manager remuneration. (2) Holdco did not report the management fee income properly under the "earned method" in accordance with subsection 9(1) of the Act, or for greater certainty, the "receivable method" in accordance with paragraph 12(1)(b).
February 20, 2004
Mr. Michael Schwantes HEADQUARTERS
Verification & Enforcement Division Randy Hewlett, B.Comm.
Toronto Centre Tax Services Office 613-957-8973
2004-005406
Technical Interpretation - Section 67 of the Income Tax Act (the "Act")
We are writing in response to your letter of December 17, 2003, wherein you asked for our opinion on the above-noted issue. We also acknowledge the additional information supplied in your letter of January 14, 2004.
Facts
Our understanding of the relevant facts is as follows:
1. XXXXXXXXXX ("Holdco") is a Canadian-controlled private corporation ("CCPC"). Holdco has a XXXXXXXXXX taxation year-end.
2. The shareholders of Holdco are XXXXXXXXXX ("Mr. A"), XXXXXXXXXX ("Mrs. A") and the XXXXXXXXXX Family Trust.
3. Holdco owns a subsidiary corporation ("Opco") XXXXXXXXXX. Opco has an XXXXXXXXXX taxation year-end.
4. On XXXXXXXXXX, Opco and Holdco entered into a written management services agreement (the "Agreement"), under which Holdco provides Opco with management services.
5. The Agreement indicates that Holdco is retained by Opco for the purpose of providing the management services, including providing the services of individuals to carry out the duties of the President and CEO of Opco and the general management of Opco.
6. Mr. and Mrs. A mainly provide these management services to Opco on behalf of Holdco. Both Mr. and Mrs. A are directors of Opco. Mr. A is the President of Opco and Mrs. A is the Corporate Secretary.
7. The Agreement indicates that in consideration for the management services, Opco "shall pay to [Holdco] a management fee per annum equal to the total of (i) XXXXXXXXXX% of the net merchandise sales of [Opco], before taxes; and (ii) out-of-pocket costs and expenses incurred by [Holdco] from time to time in providing the services herein contemplated other than the costs and expenses incurred by [Holdco] in providing the services of [Mr. A]".
8. The Agreement further provides that the management fee "shall be payable by [Opco] monthly or at such other time as may be agreed upon by the parties hereto".
9. Holdco did not bill Opco on a monthly basis for the management services rendered under the Agreement or for the out-of pocket costs and expenses incurred in providing those services.
10. On XXXXXXXXXX, a journal entry was made in the books and records of both Opco and Holdco to record the management fees for the period XXXXXXXXXX. Opco expensed this amount in its XXXXXXXXXX corporate tax return. Holdco reported this amount as income in its XXXXXXXXXX corporate tax return, but offset the income with an accrual of an expense for management wages, payable mainly to Mr. and Mrs. A. Holdco paid the management wages in XXXXXXXXXX, within the time limit specified in subsection 78(4) of the Act. Mr. and Mrs. A reported the management wages they received as employment income in their individual personal tax returns for XXXXXXXXXX.
11. On XXXXXXXXXX, a journal entry was made in the books and records of both Opco and Holdco to record the management fees for the period XXXXXXXXXX. Opco expensed this amount in its XXXXXXXXXX corporate tax return. Holdco reported this amount as income in its XXXXXXXXXX tax return, but offset the income with an accrual of an expense for management wages, payable mainly to Mr. and Mrs. A. Holdco paid the management wages in XXXXXXXXXX, within the time limit specified in subsection 78(4) of the Act. At the date of your referral, the XXXXXXXXXX personal income tax returns of Mr. and Mrs. A were not filed.
12. On XXXXXXXXXX, a journal entry was made in the books and records of both Opco and Holdco to record management fees for the period XXXXXXXXXX. Opco expensed the amount in its XXXXXXXXXX corporate tax return. At the date of this referral, the XXXXXXXXXX corporate income tax return of Holdco was not filed. You anticipate that Holdco will report the management fees as income in its XXXXXXXXXX corporate tax return and offset the income with an accrual of an expense for management wages, which will be paid to Mr. and Mrs. A in XXXXXXXXXX within the time limit specified in subsection 78(4) of the Act and reported by them in their XXXXXXXXXX personal income tax returns.
Your concern is that, overall, there is a deferral in the taxation of the income earned by Opco until the management wages received by Mr. and Mrs. A are ultimately reported as employment income. In your view, the "extended time of the deferral" is not reasonable. You requested our opinion on whether section 67 of the Act could be applied to disallow the management wages expensed by Holdco.
The policy of the Canada Revenue Agency ("CRA") on when, for purposes of section 67 of the Act, shareholder/manager remuneration will be considered reasonable, is contained in Income Tax Technical News No. 22. It is the CRA's general policy not to challenge the reasonableness of shareholder/manager remuneration under section 67 of the Act when it is paid by a CCPC to an individual who is a shareholder of the corporation, provided the individual is active in the business operations and resident in Canada. Assuming Mr. and Mrs. A are both active in the business operations of Holdco and resident in Canada, we are of the view that the management wages paid to them by Holdco are within the scope of the policy and therefore, reasonable for purposes of section 67 of the Act.
In our opinion, however, there would be no tax deferral issue if Holdco reported the management fee income in accordance with subsection 9(1) of the Act. Under the terms of the Agreement, the management fees are payable on a monthly basis. Notwithstanding the fact that the amounts are not journalized in the books and records of Holdco until XXXXXXXXXX, we are of the view that subsection 9(1) of the Act requires Holdco to include in its income for each taxation year the proportion of the management fees that were actually earned as of XXXXXXXXXX. As a result, Holdco must report the management fee income earned from XXXXXXXXXX, in its taxation year ended XXXXXXXXXX. Since this is the initial year of the Agreement, Holdco would only report XXXXXXXXXX months of management fee income that was earned under the Agreement in the taxation year ended XXXXXXXXXX. In its taxation years ended XXXXXXXXXX and XXXXXXXXXX, Holdco would report XXXXXXXXXX months of management fee income that was earned under the Agreement. In our opinion, the "earned method" of reporting income provides a truer picture of Holdco's profit for purposes of subsection 9(1) of the Act (See Canderel Ltd v The Queen, 1998 DTC 6100).
For greater certainty, it is also our opinion that paragraph 12(1)(b) of the Act applies to ensure that Holdco reports in its income for each taxation year, the management fees that are receivable as of XXXXXXXXXX. Paragraph 12(1)(b) of the Act requires a taxpayer to include in business income for a taxation year any amount receivable by the taxpayer in respect of services rendered in the course of the business in the year, notwithstanding that the amount or any part thereof is not due until a subsequent year. An amount is receivable by a taxpayer when there is a clear, legal (though not necessarily immediate) right to receive the amount. This is so notwithstanding that the taxpayer has not billed the amount, the exact amount due is not known (provided the amount earned can reasonably be ascertained) or the amount is payable by installments. Further, for purposes of paragraph 12(1)(b) of the Act, an amount is deemed receivable in respect of services rendered in the course of a business on the day that is the earlier of the day on which the account in respect of the services was rendered, and the day on which the account in respect of those services would have been rendered had there been no undue delay in rendering the account. Since under the terms of the Agreement the management fees are payable on a monthly basis, the amount related to the services rendered for each taxation year that is receivable to Holdco as of XXXXXXXXXX, is the same as the amount of income that must be reported by Holdco as described above under the earned method.
We trust our comments are of assistance.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch
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