16 April 2003 Internal T.I. 2002-0168867 - Small business deduction; FTC Calculation

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. Can a "penalty" amount for terminating a supply contract paid to a Canadian business by a U.S. resident be included in computing the limit for the Canadian business' small business deduction?

2. If the answer to 1. is yes, what is the effect on the SBD of a FTC for U.S. taxes paid with respect this income.

Position: 1. Based on the facts as presented, yes.

2. It is not clear that a foreign tax credit should be available in the circumstances of this case - why was the U.S. entitled to tax this income if it was income from a Canadian business with no PE in the U.S.? Assuming that the U.S. tax is not contrary to the Convention, then, since we consider this to be business income from a business carried on in Canada, it is the non-business income tax credit that is available (pursuant to the administrative position set out in IT-270). This means that it is subparagraph 125(1)(b)(i) that applies (i.e., the applicable fraction is 10/3 not 10/4 - the taxpayer's calculation used the 10/4 fraction from subparagraph 125(1)(b)(ii)).

Reasons: 1. 1. The income from the U.S. supplier appears to be income pertaining to or incidental to the business.

2. Administrative position from IT-270R2 and application of subparagraph 125(1)(b)(ii).

		April 16, 2003

Mr. David Larsen Eliza Erskine

Appeals Division International Section I
Sudbury Tax Services Office 952-1361
1050 Notre Dame Avenue
Sudbury ON P3A 5C1

2002-016886

Active Business Carried on in Canada and the Small Business Deduction ("SBD")

We are writing in reply to your memo to us of October 11, 2002, regarding the above-noted subject matter. In particular, you requested our opinion regarding the appropriate calculation of income from an active business carried on in Canada, pursuant to paragraph 125(1)(a) of the Income Tax Act (the "Act"), where the business has income from a U.S. supplier in respect of the termination of a contract between the Canadian business and the U.S. supplier, and that income has been subject to U.S. income tax. Unless otherwise specified, any references to sections, subsections, paragraphs and subparagraphs are references to the Act.

Facts

? The taxpayer is a corporation that is a Canadian-based XXXXXXXXXX.

? The taxpayer's sales, warehousing and distribution facilities are located in Canada. All foreign sales are conducted through the Canadian office.

? The taxpayer does not have a permanent establishment ("PE") outside Canada.

? In 2001, the taxpayer received a payment of $XXXXXXXXXX (the "Payment") from a U.S. supplier as compensation for the termination of a contract with that supplier.

? Approximately 12% of the gross amount of the Payment (i.e., $XXXXXXXXXX) was withheld as U.S. federal tax.

? The taxpayer claimed and was allowed a foreign tax credit ("FTC") for the full amount of the U.S. tax withheld in respect of the Payment.

? In calculating its SBD, the taxpayer subtracted 10/4 of the FTC from its taxable income of $XXXXXXXXXX, pursuant to subparagraph 125(1)(b)(ii), to arrive at an adjusted taxable income of $XXXXXXXXXX (the "Adjusted Taxable Income").

? The taxpayer claimed that it's taxable income of $XXXXXXXXXX (which included the amount of the Payment) was also the taxpayer's active business income ("ABI") for purposes of paragraph 125(1)(a).

? The taxpayer's business limit for purposes of paragraph 125(1)(c) was $XXXXXXXXXX.

? As the Adjusted Taxable Income was the lowest of the three amounts (i.e., from paragraphs 125(1)(a), (b) and (c)), the taxpayer used this amount as the base for its SBD.

? On assessment, the assessing system subtracted the Payment from the ABI, which reduced the paragraph 125(1)(a) amount to $XXXXXXXXXX. The system then calculated the taxpayer's SBD using $XXXXXXXXXX as the base amount.

Issue

It seems to you that although the Payment was not income from the taxpayer's usual source of revenue, the contract with the supplier was integral to the normal business activities of the taxpayer and, therefore, the Payment represents income that was incidental to the taxpayer's business activities and would form part of the taxpayer's ABI. You ask us to confirm that the Payment should be part of the ABI of the taxpayer and to provide further comments as to how the FTC should be incorporated in determining the taxpayer's SBD.

Our Comments

We do not have all the details of the case (for example, we have assumed that the taxpayer is not trying to argue that the Payment is a windfall or a capital receipt), however, based on what you have told us, we agree that the Payment is reasonably included in the taxpayer's ABI for purposes of calculating its SBD as income pertaining to or incident to the business of the taxpayer: see the definition of "income of the corporation for the year from an active business" in subsection 125(7). We note that although we have not previously addressed this particular situation in writing, the majority of the situations where we have discussed what income is "income pertaining to or incident to the business" have been borderline cases where income that is originally generated by the business has been invested in property in some manner and that property is itself generating income. As you know, income from property is generally excluded from being income from an active business. In our view, based on what you have told us, this is not such a "borderline" case; the Payment is not income from property and, generally, we do not see any reason why the Payment should not be included in the taxpayer's ABI. For reference purposes, the leading cases in this area are Canadian Marconi Co. v. R., 86 D.T.C.6526 (S.C.C.), R. v. Ensite Ltd., 86 D.T.C. 6521 (S.C.C.), and Ben Barbary Co. v. Minister of National Revenue, 89 D.T.C. 242 (S.C.C.).

With respect to the FTC claimed by the taxpayer, because the taxpayer did not carry on business in a country other than Canada (according to the given facts), the taxpayer was not eligible for a business-income foreign tax credit under subsection 126(2). In fact, as it appears that the Payment was income from an active business carried on in Canada, and therefore generally could not be foreign-source income for Canadian tax purposes, the tax paid to the United States with respect to the Payment is technically not eligible for a FTC under subsection 126(1) either. This means that the only way that the taxpayer could claim a FTC in this situation would be if the situation fell within the bounds of the administrative position set out in subparagraph 12(d) and paragraph 24 of Interpretation Bulletin IT-270R2, Foreign Tax Credit ("IT-270R2"). As you will see from a review of these paragraphs from IT-270R2, the present situation appears to qualify for the administrative position, and consequently the taxpayer was entitled to a non-business-income FTC in respect of the U.S. tax paid.

The importance of this in calculating the taxpayer's SBD is that subparagraph 125(1)(b)(i), rather than subparagraph 125(1)(b)(ii), is applicable, which means that 10/3 of the taxpayer's FTC should have been deducted from the taxpayer's taxable income from the year, rather than the 10/4 that the taxpayer appears to have deducted. To sum up, the taxpayer should have been allowed to include the full amount of the Payment in its ABI, resulting in an ABI of $XXXXXXXXXX (which is also the taxpayer's taxable income, according to the given facts). The taxpayer's SBD should have been based on an amount determined as follows:

$XXXXXXXXXX (taxable income) - 10/3 of $XXXXXXXXXX (the allowed FTC) = $XXXXXXXXXX.

Thus, the taxpayer's Adjusted Taxable Income was actually $XXXXXXXXXX , not $XXXXXXXXXX as calculated by the taxpayer.

We have two final comments with respect to the facts of this case as a whole. First, it is unclear to us why the United States was entitled to tax the Payment at all, if the Payment was business income and the taxpayer was not carrying on business in the United States. Under the Canada-United States Tax Convention (the "Convention"), the United States is only allowed to tax the business income of a resident of Canada if the income is from a business carried on in the United States through a PE. In the present situation, according to the stated facts, there isn't even a business carried on in the United States, let alone a PE. It may be, however, that the nature of the payment is such that the United States does have a right to tax the payment in accordance with the Convention. We have insufficient facts to determine if this is the case, however, you may wish to inquire into what provision of the Convention permitted the United States to impose tax on a resident of Canada in this particular case. If the United States was not entitled to impose the tax, then the taxpayer should claim a refund from the U.S. tax authority for the amount of tax withheld (in which case there would be no FTC).

XXXXXXXXXX

We hope that our comments are helpful to you. If you have any questions regarding the issues discussed in this memorandum, please contact the officer noted above. As you requested, we have attached two recent documents (docs. #2001-0105567 and #2001-0114175), in which we discuss a situation somewhat similar to the one discussed in this memo.

Yours truly,

Jim Wilson
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

Attachments
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