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 a corporation's income derived from sale of franchises and royalties is eligible for the small business deduction.
2. Whether the corporation's shares meet the 'active business' test in the definition of qualified small business corporation shares in ITA 110.6(1).
Position: General comments
Reasons: 1 &2 Insufficient information to determine whether the corporation's business is a specified investment business.
XXXXXXXXXX 2001-011293
S. Parnanzone
March 6, 2002
Dear XXXXXXXXXX:
Re: Technical Interpretation Request: Income from Franchise Business
This is in reply to your letter of November 29, 2001 regarding the above-noted subject.
You have described the following situation:
Corporation A runs a business in Canada of franchising restaurants. Corporation A employs less that 6 full-time employees. In consideration for providing a turn-key operation for a restaurant by providing leased premises, training, equipment and supplies, the franchisee pays an up-front franchise fee as well as ongoing contributions towards the operation of the franchise (such as contributions to an advertising fund) and also pays a monthly royalty payment based on its gross sales.
Your question is whether the franchise fees and the royalty income would be treated as active business income eligible for the small business deduction in subsection 125(1) of the Income Tax Act ("Act"). It would appear that, given your reference to the less than 6 full-time employees, your concern is that Corporation A's business may be classified as a "specified investment business" within the meaning of this expression in subsection 125(7) of the Act.
You also ask us to confirm that, in the event the shares of Corporation A are sold, the shares would be considered to meet the active business test in the definition of "qualified small business corporation shares" in subsection 110.6(1) of the Act.
The particular circumstances in your letter on which you have asked for our views appear to be a factual situation involving a specific taxpayer. As explained in Information Circular 70-6R4, 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 a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate tax services office for their views. However, we are prepared to offer the following general comments, which may be of assistance.
The following comments pertain to your enquiry concerning the small business deduction.
The small business deduction in subsection 125(1) of the Act is claimed in respect of income from an active business carried on in Canada by the corporate taxpayer. The expression "active business carried on by a corporation" is defined in subsection 125(7) of the Act for purposes of the small business deduction as any business carried on by the corporation (including an adventure or concern in the nature of trade) other than a "specified investment business" or a "personal services business". "Specified investment business" and "personal services business" are two expressions also defined in subsection 125(7).
In general terms, "specified investment business" is defined as a business (other than a business carried on by a credit union or a business of leasing property other than real property) the principal purpose of which is to derive income (including interest, dividends, rents and royalties) from property. However, it does not include a business where the corporation employs in the business throughout the year more than 5 full-time employees. Neither does it include a business in respect of which any associated corporation provides (in the course of carrying on an active business) managerial, administrative, financial, maintenance or other similar services that could reasonably be expected to require more than 5 full-time employees if those services had not been provided by the associated corporation.
The determination as to whether a particular activity constitutes an active business, or pertains to or is incident to an active business, is a question of fact which cannot be made until all of the relevant facts are known and reviewed. Unfortunately, there are few details available in your correspondence on which to base an opinion. For instance, no details are given concerning the number of employees, except that there are fewer than six full-time employees. Also, nothing is known of the employees' expertise and the actual services which they provide. It could also be relevant if Corporation A were to provide significant management services to persons other than franchisees.
It is unclear whether Corporation A is involved in more than one business or an associated corporation provides services to it that otherwise would require more than five full-time employees. We shall assume that there is only one business, which could be described as the phase of selling franchises and the phase of earning royalties, and there is no associated corporation providing services to Corporation A. We also assume that Corporation A is not entitled to amounts from an associated corporation, such that subsection 129(6) of the Act is not applicable, and that the above situation does not involve an adventure or concern in the nature of trade.
Based on the limited information, since the selling of franchises appears to be part of Corporation A's business, the proceeds from those sales is properly included in its determination of income. Income from this source would be business income rather than income from property.
It is unclear whether Corporation A provides ongoing service (and the extent of such service) to franchisees in return for monthly royalties. It is a question of fact as to whether this income is from property or whether it is from a business.
If it were determined that the monthly royalties constitute income derived from property, it would still be necessary to determine the principal purpose of Corporation A's business since, according to the definition of "specified investment business" in subsection 125(7) of the Act, one must consider the principal purpose of the business as a whole. As stated in paragraph 14 of Interpretation Bulletin IT-73R5, The Small Business Deduction, the principal purpose of a corporation's business must be determined annually after all the facts relating to that business carried on by that corporation in that year have been considered and analyzed. Included in this evaluation should be such things as:
(a) the purpose for which the business was originally commenced;
(b) the history and evolution of its operations, including changes in its mode of operation and purpose of existence; and
(c) the manner in which the business is conducted.
The phrase "principal purpose" is not defined in the Act and therefore must be given its ordinary meaning, with the result that this determination can only be made on the basis of all the relevant facts of a particular situation. As noted in paragraph 12 of IT-73R5, the "principal purpose" of a business is considered to be the main or chief objective for which the business is carried on. Since it is a "purpose" test which is involved in this provision, all the relevant factors concerning the income earning process of a particular situation
would have to be considered. The actual sources of Corporation A's revenue would not necessarily be the only relevant factor. Some other factors, to note a few, would be the amount and type of work required in each income earning phase, reasonable projections regarding the number of franchises which Corporation A can expect to sell each year, and projections of profit from each of its two income earning phases.
The definition of "specified investment business" in the Act contemplates that there may be significant work required to earn property income. For example, the corporation may employ up to five full-time employees, providing services involving, for instance, the collection of rents, the pursuance of unpaid rents, the inspection of premises, and the provision of maintenance and repair services. Thus, the fact alone that there may be substantial work involved is insufficient grounds to determine the business to be an active business rather than a business which earns income from property. It is important to review the franchise agreement in order to determine what service is to be provided in return for the monthly royalties. It is also important to review the services actually provided to ensure that they conform to the agreement. If no significant service is required or provided, this would indicate that the monthly royalties are income from property. On the other hand, the provision of significant services would indicate that Corporation A is carrying on a business.
In conclusion, the sale of the franchises would likely be regarded as business income. However, if Corporation A is found to be carrying on a specified investment business, none of its income from that source would be income from an active business. The ongoing generation of royalty income from the franchises may yield property income or business income, depending on the facts. Whether the business is a specified investment business depends on the principal purpose of the business as a whole -- i.e. whether the principal purpose is to derive income from property or to derive income from business. We are not in a position to be able to make that determination.
The following comments pertain to your second question which we understand to be whether the active business tests in the definition of "qualified small business corporation share" ("QSBCS") in subsection 110.6(1) of the act would be met in the situation of Corporation A's shares.
The definition of QSBCS includes more than one reference to active business. For instance, in order for shares to be considered QSBCS, they must be shares of a small business corporation ("SBC") at the determination time. As defined in subsection 248(1) of the Act, a SBC, at any particular time, generally means a particular corporation that is a Canadian-controlled private corporation all or substantially all of the fair market value of the assets of which at that time is attributable to either (or a combination of) assets that are used principally in an active business carried on primarily in Canada by the particular corporation (or a corporation related to it) or shares or indebtedness of any SBC connected with the particular corporation. In our view, the wording "all or substantially all" means that at least 90% of the fair market value of the assets must be attributable to assets used in the active business. Thus, if more than 10% of the assets are not used in the business, the corporation is not a SBC.
"Active business" is defined in subsection 248(1) for purposes of the Act as any business carried on by a corporation other than a "specified investment business" or a "personal services business". The definitions in subsection 125(7) of these two latter expressions equally apply for purposes of the Act.
Whether a particular asset is used principally in an active business is a question of fact, which must be determined with reference to the circumstances of the case under review. The relevant circumstances include the actual use to which the asset is put in the course of the business, the nature of the business and the practice in the particular business.
Based on the facts provided, we are unable to confirm that the active business tests in the definition of QSBCS would be met in the situation of the shares of Corporation A. For instance, as previously explained, we are unable to determine whether Corporations A's business is a specified investment business or, if it is found that its business is an active business, what proportion of its assets are used in an active business. We are unable to determine if Corporation A meets the definition of SBC.
We trust that the foregoing comments are of assistance.
Yours truly,
Milled Azzi, CA
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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