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 CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues:
1. Will cash accumulated in order to pay bonus to shareholder considered to be assets used in an active business?
2. Will interest earned on short-term investment of cash accumulated to pay bonus be income from an active business?
Position:
1. Question of fact, generally where cash/near cash is accumulated to pay bonus per established company policy-yes.
2. As above question of fact-however where we have determined assets are used in an active business, the income so generated would be active business income
Reasons:
1. Previously stated position--unchanged
2. Active business assets generate active business income or income incidental to the active business
2001-009178
XXXXXXXXXX L. Holloway
613-957-2104
March 7, 2002
Dear XXXXXXXXXX:
Re: Technical Interpretation Request -Active Business Income
This is in reply to your letter of July 9, 2001 requesting a technical interpretation regarding:
(i) the meaning of "assets used principally in an active business" for the purposes of the definition of Qualified Small Business Corporation Share ("QSBCS") in subsection 110.6(1) of the Income Tax Act (Canada) (the "Act"); and
(ii) the definition of "income of the corporation for the year from an active business" in subsection 125(7) of the Act.
All references hereunder are to the Act unless otherwise indicated.
In order to illustrate your concerns your letter outlined the following hypothetical scenario:
1. A Canadian controlled private corporation ("CCPC") carries on an active business in Canada. Assume that:
(i) gross revenue is $2,000,000 per annum;
(ii) taxable income before bonus to the shareholder is $1,200,000 per annum; and
(iii) taxable income is comprised of $1,160,000 of revenue generated from the services provided by the shareholder (e.g. health care professional) and $40,000 of interest income.
2. The CCPC has established a policy of accruing a bonus at year-end in an amount necessary to bring its taxable income to the $200,000 business limit. Assume the shareholder's bonus is $1,000,000. Assume the bonus is reasonable because the CCPC's income is directly dependent on the special skills and knowledge of the shareholder. There are no holding companies interposed between the professional and the operating company.
3. The net bonus is paid by the 179th day following the year-end. The related source deductions are remitted within the time period required.
4. During the year, the CCPC's cash is put into short-term investments that earn $40,000 of interest income. Every year, the short-term investments are liquidated and used to pay the annual bonus to the professional and the related source deductions. Immediately subsequent to the payment of the annual bonus and source deductions, the CCPC's cash position is nil. During the next taxation year, the amount of cash grows and is once again put into short-term investments. The annual bonus and source deductions are paid from the short-term investments and the cash is again depleted to nil.
5. The CCPC pays all of its trade debts on time. That is, it is not incurring and deducting interest expense on trade debts and at the same time treating interest income as active business income. Assume the CCPC has no other debts.
Technical Interpretation Requested
You had asked if the Canada Customs and Revenue Agency ("CCRA") would consider the short-term investments to be "assets used principally in an active business" for purposes of the definition of QSBCS in subsection 110.6(1), given that the funds in the above example are used to discharge an actual (vs. a contingent) liability of the CCPC. In addition you inquired whether we would view the interest income as pertaining to or incident to the CCPC's active business for purposes of the definition of "income of the corporation for the year from an active business" in subsection 125(7), given that the interest income relates to the short-term investments.
The particular circumstances in your letter on which you have asked for our views appear to be a factual situation. As explained in Information Circular 70-6R4 issued by CCRA on January 29, 2001, 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. If you wish to obtain a binding commitment with respect to an actual case similar to that outlined in your letter, an advance income tax ruling application should be submitted.
Although we are unable to provide any binding assurance with respect to the interpretations requested, we do provide the following general comments for your information.
The CCRA's general views as to when cash or near cash property held by a corporation will be considered to be used in the course of an active business have been previously published and remain as follows:
1. The question of whether a particular asset is an "asset used principally in an active business" is one of fact which must be determined based on all the relevant facts and circumstances of each case. The relevant circumstances include the actual use to which the cash or near cash properties are put in the course of the business, the nature of the business and the practice in the particular business.
2. Cash or near cash property is considered to be used principally in the business if its withdrawal would destabilize the business.
3. Cash which is temporarily surplus to the needs of the business and is invested in short-term income producing investments could be considered to be used in the business.
4. Cash balances which accumulate and are then depleted in accordance with the annual seasonal fluctuations of an ongoing business will generally be considered to be used in the business but a permanent balance in excess of the company's reasonable working capital needs will generally not be considered to be so used.
5. The accumulation of funds in anticipation of the replacement or purchase of capital assets or the repayment of a long-term debt will not generally in itself qualify the funds as being used in the business.
6. Cash or near cash property is considered to be used principally in the business if its retention fulfils a requirement which had to be met in order to do business, such as certificates of deposits required to be maintained by a supplier.
7. The CCRA recognizes that prudent financial management requires businesses to maintain current assets (including inventories and accounts receivables, as well as cash and near cash properties) in excess of current liabilities and will consider this requirement in assessing whether cash or near cash assets are used principally in a business. In the CCRA's view, cash and near cash assets held to offset the non-current portion of long term liabilities will not generally be considered to be used in the business.
We stress that the above guidelines are necessarily of a general nature and the CCRA will make its determination after a review of all the relevant facts and circumstances, including the actual use to which the cash or near cash property was put in the course of the business, the nature of the business involved and the practice in the particular industry.
Generally, where a corporation has short-term cash reserves or near cash short-term investments as a result of accumulating cash in order to pay bonuses pursuant to the corporation's established policy, and the corporation actually uses the cash reserves and/or converts the short-term investments to cash in order to pay the bonuses, we would consider the cash reserves and/or the short-term investments to be active business assets. Assets determined to be active business assets would generally generate income from an active business.
"Income of the corporation for the year from an active business," is defined by subsection 125(7) of the Act. Under this definition, such income includes income that pertains to or is incident to an active business. The comments in paragraphs 5 and 6 of Interpretation Bulletin IT-73R5 -The Small Business Deduction may be particularly relevant in making a determination of whether or not income can be considered to be incident to the active business of a corporation. These paragraphs are reproduced as follows:
5. Income of a corporation that "pertains to" or is "incident to" the income of the corporation from an active business is referred to in the definition of "income of the corporation for the year from an active business" in subsection 125(7) but those terms are not defined in the Act.
In examining the ordinary dictionary meaning of these words, "incident to" generally includes anything that is connected with or related to another thing, though not inseparably, or something that is dependent on or subordinate to another more important thing. "Pertain to" generally includes anything that forms part of, belongs to or relates to another thing.
The courts have found that, in interpreting the meaning of "pertains to" or "incident to" in context, there has to be a financial relationship of dependence of some substance between the property in question and the active business before the property is considered to be incident to or pertain to the active business carried on by the corporation. In addition, the operations of the business have to have some reliance on the property such that the property is a back-up asset that could support the business operations either on a regular basis or from time to time.
If, for example, a corporation which carries on an active business holds term deposits that are not used or connected to its business operations, the term deposits are not property that is incident to or pertains to an active business carried on by the corporation, nor are the term deposits used or held principally for the purpose of gaining or producing income from an active business by the corporation. Accordingly, a determination is required of whether the source of income (e.g., term deposits) is a separable activity, apart from the corporation's main business activities.
The courts have held that when a corporation derived income from an activity that was inseparable from its normal active business, such income was properly classified as active business income. If the income is part of the normal business activity of the corporation, and it is inextricably linked with an active business, it is considered active business income. For example, in the 1981 case of Supreme Theatres Ltd. v. The Queen, [1981] C.T.C. 190, 81 DTC 5136, it was held by the Federal Court - Trial Division that rental income from hiring out the part of a building that was a motion picture theatre auditorium constituted active business income derived from the company's normal business activity of operating motion picture theatres, while the rental income from hiring out a portion of a parking lot was not.
6. As indicated in 4 above, for the purpose of the small business deduction, income from property does not include income "from any property that is incident to or pertains to an active business" or "from any property that is used or held principally for the purpose of gaining or producing income from an active business." Income from property that is employed or risked in a corporation's business operations is considered to be active business income. This must be distinguished from income from property, which is not connected to or is necessary to sustain a corporation's business operations. It is a question of fact whether a property is used principally in an active business. Factors to be considered in determining whether a property is used in an active business include the actual use to which the asset is put in the course of the business, the nature of the business involved and the practice in the particular industry. The issue of whether property was used or held by a corporation in the course of carrying on a business was considered by the Supreme Court in Ensite Limited v. Her Majesty the Queen, [1986] 2 C.T.C. 459, 86 DTC 6521. The court held that the holding or using of property must be linked to some definite obligation or liability of the business and that a business purpose test for the use of the property was not sufficient. The property had to be employed and risked in the business used to fulfil a requirement which had to be met in order to do business. In this context, risk means more than a remote risk. If the withdrawal of the property would have a decidedly destabilizing effect on the corporate operations, the property would generally be considered to be used in the course of carrying on a business. In other words, the property has to be an integral part of the financing of the business or necessary to the overall business operations in order for the property to fall within the meaning of paragraph 129(4.1)(b).
For example, although a mortgage receivable is an asset whose existence may be relevant to the equity of a corporation, it is not generally an asset used in an active business because the funds tied up in the mortgage are not available for the active business use of a corporation. However, if the corporation could establish that the mortgages are employed and risked in the business such that the mortgages are inextricably tied to or vitally connected with the business, they could be considered to be used in an active business carried on by the corporation.
As the corporation in the scenario presented has an established bonus policy and uses the income generated from the excess funds to finance the payment of the annual bonus it is likely that there exists a "financial relationship of dependence of some substance between the property in question" (the excess funds) "and the active business" as suggested in paragraph 5 above. In addition as the excess funds generate income from property that is employed in the corporation's business operations (i.e. payment of the bonus), such income would likely be considered to be active business income.
The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R4, the above comments do not constitute an income tax ruling and accordingly are not binding on the CCRA.
We trust the above comments are of assistance to you.
Yours truly,
Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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