6 September 2002 Internal T.I. 2002-0155637 - JOINT VENTURE&SMALL BUSINESS DEDUCTION

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. Do we have concerns about the incorporation of an operating company in a particular joint venture, with the resultant additional small business deduction on income from the project?

PositionS:

1. Question of fact. Numerous factors to be considered before it can be said that there is an additional small business deduction claim allowed as a result of the incorporation of the joint venture operating company.

Reasons:

1. Reading of the relevant legislation.

		September 6, 2002

	XXXXXXXXXX 	HEADQUARTERS
	Business Audit	Allan Nelson, CMA
	XXXXXXXXXX  TSO	(613) 443-7253

		2002-015563

Joint Venture and the Small Business Deduction

We are writing in response to your memorandum to us dated August 2, 2002, and our telephone conversations on August 21 and 27 (Nelson/XXXXXXXXXX), wherein you asked for our comments concerning small business deductions in a joint venture scenario.

FACTS

The facts as we understand them are as follows:

? in XXXXXXXXXX a Canadian-controlled private corporation ("CCPC") (hereafter referred to as "JVCo") was incorporated to be the operating company to carry out a joint venture project between two existing arm's length CCPCs ("J1" and "J2");

? the shares of JVCo are owned XXXXXXXXXX by J1 and J2, and J1 and J2 are not related or associated;

? the arrangement involved a XXXXXXXXXX project XXXXXXXXXX. JVCo had the XXXXXXXXXX contract and received payment for its XXXXXXXXXX services from the XXXXXXXXXX owners. JVCo then paid J1 for labour and materials provided to JVCo. At the end of each year JVCo paid management fees to J1 & J2 (XXXXXXXXXX) and expensed these amounts before reporting its income. JVCo ensured that its net income, after paying the management fees, did not exceed $200,000, in respect of which it claimed the small business deduction. J1 & J2 also claimed the available small business deduction for their respective incomes;

? J1 is a corporation from XXXXXXXXXX. 1 person owns 100% of J1. It is in the business of XXXXXXXXXX. J1 provided the material and labour for the project. In the year XXXXXXXXXX, it had labour expense on its financial statements of approximately $XXXXXXXXXX. It billed JVCo on the basis of "cost of materials and labour + XXXXXXXXXX%". J1 is not related to J2 and there are no crossover shareholdings between J1 and J2;

? J2 is a corporation from XXXXXXXXXX. It is part of a group of companies, some of which are in the business of XXXXXXXXXX. 1 person owns 100% of J2. J2 lists XXXXXXXXXX as its business. It has minimal assets (i.e., land and building) and its labour expense for XXXXXXXXXX was approximately $XXXXXXXXXX. It is your understanding that this amount was paid to a few employees and was not paid to the owner of J2. The owner was paid from another company in its corporate group. Apparently, J2's contribution to the project was the fact that it was successful in obtaining the XXXXXXXXXX contract and it also shared expertise in completing the project; and

? you are concerned that by incorporating JVCo to carry out the project, the parties have, perhaps unfairly, gained access to 3 small business deductions instead of 2 (i.e., a small business deduction for each of JVCo, J1 and J2. If J1 &J2 had done the same project through a joint venture, without incorporating JVCo, then the income from the joint venture would have been shared between J1 &J2 and subject to only 2 small business deduction claims).

As discussed with you during our telephone conversation on August 27, 2002, we do not have all the relevant facts concerning this file in order to reach conclusions, however we will provide you with the following comments for your consideration and follow-up where appropriate.

Personal Services Business ("psb")

Income from a psb does not qualify for the small business deduction. A corporation would be carrying on a psb, within the meaning of that term in subsection 125(7) of the Income Tax Act (the "Act"), if it is in the business of providing services and

(a) an individual who performs the services provided to another person or partnership (the entity) on behalf of the corporation (referred to as an "incorporated employee") would, if it were not for the existence of the corporation, reasonably be regarded as an officer or employee of the entity to which the services were provided,

(b) the incorporated employee or any person related to the incorporated employee is a "specified shareholder" of the corporation (as defined in subsection 248(1) of the Act),

(c) the corporation employs in the business in the year fewer than six full-time employees including incorporated employees and other employees, and

(d) the fee for the services is not received or receivable by the corporation from a corporation with which it was associated in the year.

It is a question of fact whether any of J1, J2 or JVCo was carrying on a psb for the relevant years.

From the limited facts provided, it appears that J1 employed numerous employees in providing services to the project [so long as they were employed directly by J1 and not by JVCo] and therefore was not carrying on a psb in respect of the project.

There is one owner of the shares of J2 and perhaps only a few employees. The requirements in (b) and (d), above appear to have been met (subject to the comments below about associated corporations). To see if the requirements of (a) and (c) were met, the following questions should be addressed:

1. Could the individual owner of J2, or a person related to the owner, reasonably be considered to be an officer or employee of JVCo (i.e., the entity to which the services were provided), but for the existence of J2? For assistance in this determination, reference is made to the comments in paragraph 19 of Interpretation Bulletin IT-73R6; and

2. Did J2 employ in the particular business more than 5 full-time employees throughout the year? In this regard, see paragraphs 15-17 of Interpretation Bulletin IT-73R6.

If the answer to 1, above is yes and the answer to 2 is no, then it appears that J2 was carrying on a psb and would not have qualified for the small business deduction.

JVCo would probably not meet the requirements of (a) above [i.e., if the individual owners of J1 and/or J2 were incorporated employees of JVCo, they probably would not reasonably be regarded as an officer or employee of the entity to which JVCo provided services (i.e., the XXXXXXXXXX) and therefore JVCo would not be carrying on a psb. Again, this issue involves a question of fact that can only be determined after reviewing all of the pertinent information. Reference is made to the comments in paragraph 19 of Interpretation Bulletin IT-73R6].

Management Fees to J1 & J2

The amount of the management fees paid by JVCo to J1 & J2, in order to get JVCo's income below $200,000, would have had to have been reasonable in the circumstances (section 67 of the Act) in order for JVCo to be allowed to expense the amount. In this regard, reference is made to our position as stated in response to Question 25 at the 1991 Canadian Tax Foundation Round Table [see Appendix A, below] and also to our response to Question 6 on page 8 of Technical News No. 22, dated January 11, 2002 [see Appendix B, below for excerpts].

Associated Corporations - Section 256

Section 256 of the Act contains the association rules. Section 125 of the Act provides for a sharing of the business limit between associated corporations, for the purposes of computing their respective small business deductions. With this in mind, consideration could be given to the following two possibilities:

1. Was JVCo controlled in fact (as contemplated by subsection 256(5.1) of the Act) by J1 or J2, or by either of the owners of J1 or J2? If so, JVCo would be associated with the relevant company and the amount of the respective small business deductions would have to be shared. For additional discussion on this issue, please refer to paragraphs 19-23 of Interpretation Bulletin IT-64R4 and in particular to paragraphs 23(d) and (e).

2. Subsection 256(2.1) of the Act contains an anti-avoidance rule which deems two or more corporations to be associated with each other if one of the main reasons for the separate existence of those corporations is to reduce the amount of income taxes otherwise payable (or to increase the amount of refundable investment tax credits available under section 127.1 of the Act). In your case, can it be reasonably considered that one of the main reasons for the separate existence of JVCo, for example, was to reduce the amount of taxes that would otherwise be payable under the Act? If so, then subsection 256(2.1) of the Act would apply to deem the companies to be associated and the small business deductions would have to be shared.

We hope the above will be of assistance to you.

If you have any additional queries on this matter please feel free to contact us.

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 (613) 994-2898. A copy will be sent to you for delivery to the client.

Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate

APPENDIX A

1991 Round Table
Management Fees and Bonuses

Q.25 Deductibility of Intercorporate Management Fees

Provided that amounts paid to shareholders in their capacity as employees of a company meet the guidelines of the department given at the 1981 (question 42) and 1984 (question 82) round tables, the amounts will likely be deductible by the company. What is the department's position where the shareholders are employees of Holdco, which in turn provides management services to Opco? In a technical interpretation dated December 31, 1990, the Business and General Division noted that the above practice would not extend to intercorporate management fees. In order to be fully deductible by Opco, such fees must be reasonable in the light of the services actually rendered by Holdco through its employees. Assuming that it is the practice of Holdco to distribute corporate profits to its shareholders, would a management fee from Opco to Holdco be deductible should it be determined that the fee was not "reasonable in the light of the services rendered"?

Department's Position

The department's administrative position set out at the 1984 round table does not appear to apply to Opco in a situation such as the one described above. Any fees and/or bonuses paid to corporate shareholder-managers by Opco must be reasonable in the light of the services actually rendered by Holdco through its employees in order to be fully deductible. The resulting profits of Holdco may be distributed to the shareholder-employees of Holdco where the general practice of the corporation is to distribute profits of the company to shareholder-employees in the form of bonuses or additional salary. If the management fee from Opco to Holdco was not reasonable in the light of the services rendered, the portion that was unreasonable would not be deductible by Opco.

APPENDIX B

No. 22
January 11, 2002
Income Tax -- Technical News

Question 6

Let me complicate this a little bit. Would the CCRA challenge the reasonableness of inter-corporate management fees paid by Opco to Holdco (assuming they are both CCPCs)?

Response 6

Yes. Our position is limited to salaries and bonuses paid directly to individuals resident in Canada who are active shareholder/managers of a CCPC. We therefore reserve the right to challenge the reasonableness of any inter-corporate management fees.