2005 Ruling 2004-0104681R3 - Partner Creating Professional Corporation

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: When a partner of a partnership (while remaining a partner) creates a professional corporation through which professional services will be provided to the partnership, will the professional corporation be eligible for the small business deduction?

Position: Yes

Reasons: Legislation.

XXXXXXXXXX 							2004-010468

XXXXXXXXXX, 2005

Dear XXXXXXXXXX:

Re: XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX
Advance Income Tax Ruling

This is in reply to your letter dated XXXXXXXXXX, in which you requested an advance income tax ruling on behalf of the above noted partnership. We acknowledge receipt of the additional information in your XXXXXXXXXX letter.

We understand that, to the best of your knowledge, none of the issues involved in the ruling request:

(i) is in an earlier return of the taxpayer or a related person,

(ii) is being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayer or a related person,

(iii) is under objection or appeal by the taxpayer or a related person,

(iv) is before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired, and

(v) is the subject of a ruling previously issued by the Canada Revenue Agency.

Unless otherwise stated, all references to a statute are to the Income Tax Act R.S.C. 1985 (5th Supplement), c.1, as amended, (the "Act") and all terms and conditions used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.

Our understanding of the facts, proposed transactions and the purpose of the proposed transactions is as follows:

DEFINITIONS

(a) "Partner C" means XXXXXXXXXX.

(b) "Partner M" means XXXXXXXXXX.

(c) "Cco" means XXXXXXXXXX.

(d) "Mco" means XXXXXXXXXX.

(e) "Partnership" means the XXXXXXXXXX.

(f) "Practice" means the provision of XXXXXXXXXX services currently provided by the Partnership.

FACTS

1. The Partnership is a limited liability partnership of XXXXXXXXXX, the sole office of which is in the XXXXXXXXXX and the CRA identifying number of which is XXXXXXXXXX for the purpose of income tax filings other than those for which the business number of XXXXXXXXXX is used (for example accounting for income taxes withheld from employees).

2. The Partnership is a continuation, through numerous changes in membership, of a partnership of XXXXXXXXXX. The continuation had been effected by a series of written agreements between the partners. The Partnership is bound by a written current partnership agreement ("the Agreement") that reflects the philosophy of perpetuation and collegiality - in the form of an equitable democracy - which has been preserved for at least the last XXXXXXXXXX years through profit sharing based upon communal effort and protection of disabled or retired members with a continuing share of profits. These features of the Agreement are also designed to attract new partners for the continuity of the business.

3. All XXXXXXXXXX individual residents of XXXXXXXXXX who are the current members of the Partnership and their social insurance numbers are:

XXXXXXXXXX

4. No member of the Partnership is related to any other member.

5. The Agreement values the professional expertise of all members equally and requires that it be made available to the Partnership to conduct its business, but it also recognizes the cumulative effort in the business from the ongoing responsibility of each partner - as a business owner - to provide all the administrative, marketing, staff management, operational and customer retention efforts expected from anyone who is a principal in a service business. There is no element of profit sharing that is dictated by the expertise or even by the professional performance of the partner. On the other hand variations in profit share between one partner and another are exclusively dictated by the length of time since becoming a member and, for the last few years of membership, during which diminished business efforts are anticipated, the length of time to retirement.

6. XXXXXXXXXX

7. XXXXXXXXXX

8. In XXXXXXXXXX, Partner C incorporated Cco as its sole shareholder and subsequently registered Cco as a professional corporation with the XXXXXXXXXX. In XXXXXXXXXX Partner M incorporated Mco as its sole shareholder and subsequently registered Mco as a professional corporation with the XXXXXXXXXX.

PROPOSED TRANSACTIONS

9. If an appropriate advance income tax ruling is received, at least XXXXXXXXXX days before the first day of a calendar month not more than one year after receipt of the income tax ruling (such first day of a calendar month being the day on which the amendments and agreements described below are intended to come into effect), Partner C and Partner M will deliver written notice to the Partnership that they wish to exercise the option described in paragraph 10 below.

10. On or before the first day of the first calendar month commencing after implementation of the steps described in paragraph 9 above, the Agreement will be amended to allow partners to provide their professional expertise in XXXXXXXXXX services through professional corporations. This will be effected by recognizing three functions that each partner performs: professional, promotional and management. As stated in the Agreement: "XXXXXXXXXX" Each partner shall have the option, exercisable by notice in writing to be delivered XXXXXXXXXX days prior to the effective date of the notice, to perform the Professional Function through a professional corporation controlled by that partner and licensed to carry on the practice of XXXXXXXXXX.

Upon receipt of such notice, the Partnership is required to enter into an agreement with the professional corporation for an amount to be agreed between the Partnership and the professional corporation. This amount will not exceed the fair market value for the services of the Professional Function. Initially this compensation is to be set at a fixed fee of $XXXXXXXXXX per month. The Agreement will also be amended to prohibit the performance of the Promotional and Management functions by anyone other than the partners themselves and to prohibit the transfer or other conveyance of any interest in the partnership to a professional corporation.

Consequential amendments to the Agreement will provide for adjustments to the calculation of a partner's share of profits for any year during which a professional corporation performs part or all of his or her Professional Function so that the fees charged by the professional corporation will reduce the profit share of the partner who owns the corporation. However the determination of any amount payable to a partner as a result of his or her retirement will remain unaffected.

11. At the same time as the time at which the implementation of the steps described in paragraph 10 above takes place, Cco and Partner C and Mco and Partner M, respectively, will enter into contracts under which Cco obtains the right to provide Partner C's professional services and Mco obtains the right to provide Partner M's professional services. In both cases the professional services to be provided are those to enable the professional corporation to meet its obligations under the professional services agreement described in paragraph 12 below. Compensation from Cco to Partner C and from Mco to Partner M will be by remuneration to be set annually as mutually agreed. The contract between Cco and Partner C and between Mco and Partner M will terminate when the corresponding contract between the Partnership and either Cco or Mco described in paragraph 12 below terminates.

12. At the same time as the time at which the steps described in paragraphs 10 and 11 above take place, the Partnership will enter into professional service agreements with Cco and with Mco pursuant to which Cco and Mco will provide the professional services of Partner C and Partner M, respectively, to the Partnership as required by the Partnership to satisfy the professional service requirements of the clients of the Partnership. The amount to be charged by Cco and Mco for their professional services to the Partnership will not exceed the fair market value for their professional services. Initially this compensation is to be set at a fixed fee of $XXXXXXXXXX per month. Either the Partnership or the professional corporation providing the service to the Partnership can terminate the professional agreements on XXXXXXXXXX days notice.

PURPOSE OF THE PROPOSED TRANSACTIONS

13. The primary objective of all of the proposed transactions is to allow Partner C and Partner M to use a professional corporation to earn professional income derived from the Partnership practice both without forcing the entire partnership to forgo the limited protection offered by limited liability partnership status as a result of any violation of the constraints on registration of professional corporations announced by the XXXXXXXXXX and without disruptive perturbations in the business arrangements between the partners of the Partnership which have cost a lot of time and money to refine in the Agreement in order to achieve the elaborate mechanisms for profit sharing as they stand in the current Agreement. It would be very time consuming, expensive and difficult, if not impossible, for these business arrangements between the partners of the Partnership to fit into the requirements of share classes as would be required in articles of incorporation.

Other purposes of the proposed transactions are:

a. To allow a professional partner to benefit from the amendments discussed in paragraph 7, which permits XXXXXXXXXX to render professional services through a corporation.

b. To provide a professional partner with an increased level of control over their participation in the Practice through individual management of personal practice preferences.

c. To permit a professional partner to have control over expenditures where such expenditures may not be in the interest of all participants in the Practice.

d. To provide the professional partner with more control over his/her own estate and financial planning.

e. To enhance the Partnership's ability to retain current and recruit additional professionals.

None of the reasons for the separate existence of Cco and Mco is to reduce the amount of taxes that would otherwise be payable under the Act or to increase the amount of any investment tax credit under section 127.1.

RULINGS

Provided that:

(a) the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and the purpose of the proposed transactions;

(b) the proposed transactions are completed in the manner described above; and

(c) there are no other transactions which may be relevant to the rulings requested;

our rulings are as follows:

A. The execution and implementation of the proposed transactions described above, of and by themselves, will not constitute a disposition of part or all of an interest in the Partnership by any partner of the Partnership.

B. Sharing of income between the partners of the Partnership will not be subject to adjustment pursuant to subsection 103(1) of the Act solely as a result of the application of the proposed amendments to the Agreement.

C. The execution and implementation of the proposed transactions, of and by themselves, will not be sufficient to create a non-arm's length relationship between the individual partners of the Partnership with regards to sharing of Partnership profits for income tax purposes.

D. Subject to sections 18 and 67 of the Act, the fees payable by the Partnership to Cco and Mco as described in the proposed transactions will be deductible by all the partners of the Partnership in their respective calculations of their share of the Partnership income for purposes of the Act.

E. Subsection 56(2), 56(4) and subsection 246(1) of the Act will not apply to cause any amount to be taxed as income in the hands of any individual partner as a result of the execution and implementation of the proposed transactions nor will subsections 56(2), 56(4), or 246(1) of the Act apply to cause any amount to be taxed in the hands of a partner's professional corporation in the event that a proposed agreement is terminated.

F. Any income derived from charges to the Partnership by Cco and by Mco as described above will be income from an active business within the meaning of "active business carried on by a corporation" as defined in subsection 125(7) of the Act and will not fall within the meaning of "specified partnership income" as defined in subsection 125(7) of the Act.

G. Implementation of the proposed transactions, in and by themselves, will not result in the application of the provisions of subsection 245(2) of the Act to re-determine the tax consequences confirmed in the rulings given above.

COMMENTS

We are unable to rule that subsection 256(2.1) of the Act will never apply to Cco or Mco since the application of that subsection must be determined on a year-to-year basis and the reasons for the separate existence of Cco and Mco could change over time.

In general, where a function of a professional partnership that was previously carried on by the partnership is subsequently carried on by a partner's professional corporation for bona fide reasons other than for income tax reasons, this fact, in and by itself, would generally not cause us to consider that subsection 256(2.1) of the Act would be applicable. The determination of the particular reasons for the separate existence of two or more corporations or the reasons for a change in a partnership function would remain a question of fact that could only be determined on a case by case basis.

However, based on our understanding of the facts, proposed transactions and purposes of the proposed transactions described in this letter, nothing has come to our attention that would, in and of itself, cause us to consider that subsection 256(2.1) of the Act would be applicable to the incorporation of Cco and Mco, as described in paragraph 9, for the purpose of providing services to the Partnership, as described in paragraph 11.

CAVEAT

These rulings are given subject to the limitations and qualifications set out in Information Circular 70-6R5 issued by the CRA on May 17, 2002, and are binding on the CRA provided that the proposed transactions are implemented on or before XXXXXXXXXX

These rulings are based on the Act in its present form and do not take into account any proposed amendments to the Act which, if enacted, could have an effect on the rulings provided herein.

Except as expressly stated, this advance income tax ruling does not imply acceptance, approval or confirmation of any income tax implications of the facts or proposed transactions.

Nothing in this letter should be construed as implying that the CRA has agreed to or accepted:

(i) the fair market value of the services referred to in this letter;

(ii) the accuracy of any amounts referred to in this letter;

(iii) the GST implications of any of the proposed transactions.

Yours truly,

XXXXXXXXXX
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch