28 August 2000 External T.I. 2000-0016035 - REASONABLENESS OF EMPLOYEE BONUS

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

(1) Whether income arising from the disposition of eligible capital property constitutes active business income.

(2) Shareholder-Manager Bonus Policy. Does the Agency's general position as set out in answer to question 42 at the Revenue Canada Roundtable at the 1981 Canadian Tax Foundation Annual Conference apply where shareholders hold shares in operating company through 100% owned holding companies?

Position TAKEN:

(1) Yes.

(2) Generally, yes.

Reasons:

(1) See IT-73R5 paragraph 9.

(2) Owning shares through 100% owned holding company does not lead to a different result than holding shares directly.

XXXXXXXXXX 2000-001603
T. Young
August 28, 2000

Dear sir:

Re: Reasonableness of Employee Bonus

This is in reply to your letter of March 20, 2000, requesting our opinion on issues related to the payment of bonuses to shareholder-managers.

In your letter, you describe the following hypothetical situation:

1. Messrs. X, Y and Z are Canadian resident taxpayers.

2. Messrs X, Y and Z each own a one-third interest in a Canadian-controlled private corporation ("Opco").

3. Mr. X, Y and Z are principal shareholder managers of Opco and are active in the business.

4. Opco earns active business income.

5. Opco sells eligible capital property used to earn its active business income which results in a negative balance in its eligible capital expenditure pool.

6. Opco pays a bonus to each of Mr. X, Y and Z which reduces Opco's income resulting from the sale of eligible capital property.

7. Opco pays salaries or bonuses to Messrs. X, Y and Z depending upon profitability.

You requested our opinion on the following questions:

1. If Opco pays a salary or bonus resulting from the negative balance in its eligible capital expenditure pool, would the Agency permit the deduction of these amounts?

2. Would the Agency's view change if the shares of Opco were held by the holding companies of each of Messrs. X, Y and Z instead of by the individuals directly?

Our Comments

The particular circumstances in your letter on which you have asked for our views appear to be a factual situation involving specific taxpayers. As explained in Information Circular 70-6R3, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. Should your situation involve specific taxpayers and completed transactions, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. However, we are prepared to provide the following general comments which may be assistance to you.

The Agency's general position on the classification of income resulting from the disposition of eligible capital property is included in IT-73R5, The Small Business Deduction. Paragraph 9 states, in part:

The Small Business Deduction

9. Income related to a business that arises after cessation of that business cannot qualify as income from a business except when it arises from:

(d) the disposition of eligible capital property of the business and the income is the amount of the excess described in subsection 14(1);

(e) the recapture of capital cost allowance;

As you noted in your letter, Revenue Canada's answer to question 56(b) at the November 1990 Canadian Tax Foundation Round Table Discussion stated:

The distribution of income will ordinarily be accepted as long as the salaries/bonuses meet the normal test of reasonableness provided at the 1981 Round Table. Paragraph 6 of Interpretation Bulletin IT-73-R4 provides that the recapture of capital cost allowance which arises after cessation of a business, will be considered to be income sourced from the business in which the asset was employed.

Correspondingly, the answer given to question 56(b) above would apply equally to income of a corporation that was essentially attributable to the disposition of eligible capital expenditure used in active business. Whether a property disposed of by a taxpayer is an eligible capital property is a question of fact and can only be determined based on the actual circumstances of the particular situation.

As you noted in your letter, Revenue Canada's answer to question 42(3) at the 1981 Canadian Tax Foundation Round Table Discussion stated, in part:

In general, the Department will not challenge the reasonableness of salaries and bonuses paid to the principal shareholder-managers of a corporation when

(a) the general practice of the corporation is to distribute the profits of the company to its shareholders-managers in the form of bonuses or additional salaries; or

(b) the company has adopted a policy of declaring bonuses to the shareholders to remunerate them for the profits the company has earned that are, in fact, attributable to the special know-how, connections, or entrepreneurial skills of the shareholders.

Bonuses paid to shareholders other than the principal shareholders-managers will be subject to the normal test of reasonableness that is set out in a) above.

With respect to your second question, the Agency's position would, generally, not change if the shares of Opco were held through 100% owned holding companies. This would be true only in circumstances involving "principal shareholder-managers" where the existence of the holding company or companies does not result in a different relationship between the shareholder-managers and Opco.

We trust our comments will be of assistance to you.

Yours truly,

Roberta Albert, C.A.

for Director
Business and Publications Division
Income Tax Rulings Directorate

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