2004 Ruling 2004-0084311R3 - Incorporating a Partnership

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.

Principal Issues: Whether a professional corporation, providing XXXXXXXXXX services to another corporation, will be carrying on a "personal services business" within the meaning thereof in subsection 125(7) of the Act.

Position: No.

Reasons: The former partners that are providing services through a "Contracting Company" do not provide services to Newco in his/her capacity as an employee or officer of Newco.

XXXXXXXXXX 2004-008431

XXXXXXXXXX, 2004

Dear XXXXXXXXXX:

Re: XXXXXXXXXX
Advance Income Tax Ruling

This is in reply to your letter dated XXXXXXXXXX, in which you requested an advance income tax ruling on behalf of the above noted individuals and partnership. We acknowledge receipt of the additional information in your XXXXXXXXXX letter and the revised advance income tax ruling request dated XXXXXXXXXX. We also acknowledge receipt of the additional information provided in our various telephone conversations (XXXXXXXXXX).

We understand that, to the best of your knowledge, none of the issues involved in the ruling request:

(i) is in an earlier return of the taxpayer or a related person,

(ii) is being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayer or a related person,

(iii) is under objection or appeal by the taxpayer or a related person,

(iv) is before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired, and

(v) is the subject of a ruling previously issued by the Canada Revenue Agency.

Unless otherwise stated, all references to a statute are to the Income Tax Act R.S.C. 1985 (5th Supplement), c.1, as amended, (the "Act") and all terms and conditions used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.

Our understanding of the facts, proposed transactions and the purpose of the proposed transactions is as follows:

Definitions

(a) "CRA" is the Canada Revenue Agency;

(b) "Province" is the Province of XXXXXXXXXX;

(c) "Partnership" is a reference to the existing partnership of "XXXXXXXXXX";

(d) "Partnership Agreement" is the memorandum of agreement entered into on XXXXXXXXXX by the parties, practicing as XXXXXXXXXX and as a partnership, at that time;

(e) "Partner" is a reference to each of, or any of, XXXXXXXXXX and, collectively, they are referred to as the "Partners";

(f) "Newco" is a new company to be incorporated under the Canada Business Corporations Act;

(g) "Contracting Company" means each of the companies that will be incorporated for the benefit of an existing Partner of the Partnership to carry on an independent XXXXXXXXXX practice and, collectively, they are referred to as the "Contracting Companies";

(h) "Contracting Professional" means any of the existing Partners of the Partnership who may choose to enter into contractual relations with Newco for the provision of professional services as an independent contractor and, collectively, they are referred to as the "Contracting Professionals";

(i) "Practice" means the provision of XXXXXXXXXX services currently provided by the Partnership;

(j) "Professional" refers to each individual XXXXXXXXXX who currently provides professional services to the Partnership as required in the Practice;

(k) "Business Limit" has the meaning assigned by subsection 125(2) of the Act;

(l) "Canadian-controlled private corporation" ("CCPC") has the meaning assigned by subsection 125(7) of the Act;

(m) "Cost amount" has the meaning assigned by subsection 248(1) of the Act;

(n) "Personal services business" has the meaning assigned by subsection 125(7) of the Act;

(o) "Related persons" has the meaning assigned by subsection 251(2) of the Act;

(p) "Specified partnership income" has the meaning assigned by subsection 125(7) of the Act;

(q) "Taxable Canadian corporation" ("TCC") has the meaning assigned by subsection 89(1) of the Act.

Facts

1. The Practice is currently carried on by the Partnership as a limited liability partnership. The Partners are the only partners of the Partnership. The Partners of the Partnership have been carrying on business pursuant to the Partnership Agreement. The Partners provide XXXXXXXXXX services (the "Professional Services") to the Partnership.

2. The Partnership's business number is XXXXXXXXXX. The Partnership files its information returns with the XXXXXXXXXX Taxation Center and deals with the XXXXXXXXXX Tax Services Office.

3. There are a number of XXXXXXXXXX who are employed by the Partnership and a number of self-employed XXXXXXXXXX who provide various XXXXXXXXXX services to the Partnership. These self-employed XXXXXXXXXX are not Partners of the Partnership. These independent contractors are paid a percentage of the Partnership's billings for the professional services provided to the Partnership or are paid on an hourly rate basis. None of the independent contractors or none of the employees will participate in the proposed transactions.

4. The terms of the Partnership Agreement include the following:

(a) Any income earned by a Partner is treated as Partnership income;

(b) Each Partner's share of the profits of the Partnership is based on a formula that takes into account their contributions to the overall revenue of the Partnership. Each Partner's share of the profits of the Partnership is expressed as a number of units and is determined at the beginning of each fiscal year, based upon the Partner's previous years' performance and the budgeted profit for the Partnership for the current year;

(c) Each Partner shall have a capital account to which shall be credited the amount of all contributions and the amount of income allocated to a Partner and to which shall be debited the amount of any loss allocated to a Partner and any withdrawals pursuant to section XXXXXXXXXX of the Partnership Agreement;

(d) Each of the Partners must employ themselves diligently and exclusively in the business of the Partnership and must use the utmost endeavors to promote the interests of the Partnership;

(e) Each Partner is entitled to receive an amount, to be determined at the time, upon the death, retirement, withdrawal or expulsion of the Partner.

5. All of the Partners are residents of Canada. None of the Partners are related persons.

6. Subsection XXXXXXXXXX of the Partnership Agreement provides for the appointment of a "Management Committee". The Management Committee currently consists of XXXXXXXXXX Partners. It is the duty of the Management Committee to manage the affairs of the Partnership, including the sole right to allocate the profits of the Partnership amongst the Partners, or any other individual providing services to the Partnership, in accordance with the provisions of section XXXXXXXXXX of the Partnership Agreement. In so allocating the profits of the Partnership amongst the Partners, the Management Committee takes into account a number of different factors which, taken together, enable the Management Committee to properly assess each Partner's contribution to the Partnership. These factors include, but are not limited to:

a) hours billed and collected at the designated billable rate;

b) hours billed and collected at rates greater or less than the designated billable rate;

c) billings created by the introduction of new clients and retention of existing clients;

d) timely billing and collection of accounts with current clients; and

e) professional competence and reputation, academic achievement, visibility, training of other XXXXXXXXXX in the Practice and community involvement.

The Management Committee's allocation of the Partnership's profits is final and binding upon all of the Partners and all of the independent contractors.

Proposed Transactions

7. Newco will be incorporated as a CCPC and a TCC.

8. Upon incorporation, Newco will be authorized to issue an unlimited number of voting common shares without nominal or par value. Newco will issue one such common share to the Partnership for future consideration.

9. The Partnership will sell all of its assets to Newco at fair market value. In exchange, Newco will assume all of the liabilities of the Partnership, issue an additional XXXXXXXXXX common shares (the "Additional Shares"), as described in paragraph 12 below, and issue a demand, non-interest bearing promissory note (the "Promissory Note"), as described in paragraph 13 below. The amount of the Promissory Note will be equal to the cost amount of the assets transferred to the Partnership less the amount of the liabilities assumed by Newco and the paid-up capital attributable to the Additional Shares. Newco and each of the Partners will jointly elect, pursuant to subsection 85(2) of the Act, in prescribed form and within the time permitted by subsection 85(6) of the Act, to have the provisions of paragraphs 85(1)(a) to (i) of the Act apply, with such modifications as the circumstances require. The "agreed amount" for the assets transferred to Newco will not be less than the lesser of the amounts specified in subparagraphs 85(1)(c.1)(i) and (ii) of the Act, will not be less than the least of the amounts specified in subparagraphs 85(1)(d)(i), (ii) and (iii) of the Act, and will not be less than the least of the amounts specified in subparagraphs 85(1)(e)(i), (ii) and (iii) of the Act. Furthermore, the "agreed amount" will not exceed the respective fair market value of each asset transferred to Newco nor will it be less than the amount permitted by paragraph 85(1)(b) of the Act.

10. The Partnership and Newco will file an election pursuant to the provisions of section 22 of the Act in respect of the accounts receivable transferred to Newco.

11. Newco will redeem the initial common share issued to the Partnership, following which Newco will only have the Additional Shares issued and outstanding.

12. For legal simplification, the Additional Shares shall be issued in the name of each Partner (based on a pro-rata share) instead of the name of the Partnership. The Partnership, not the individual Partners themselves, will be the beneficial owner of the Additional Shares.

13. For legal simplification, the Promissory Note issued by Newco shall be issued in the name of each Partner (based on a pro rata share) instead of the name of the Partnership. The Partnership, not the individual Partners themselves, will be the beneficial owner of the Promissory Note.

14. On the day immediately following the transfer of all of the assets of the Partnership to Newco, the Partnership will wind-up its affairs in accordance with subsection 85(3) of the Act. Immediately before this winding-up, the Partnership will have no property other than the property received from Newco as consideration for the disposition to it of the Partnership's assets. Specifically, the only property in the Partnership will be the Shares of Newco and the promissory note received from Newco as consideration for the assets transferred. Each Partner will receive, in complete satisfaction of his or her respective interest in the Partnership, a pro-rata number of Shares of Newco and a pro-rata share of the promissory note issued to the Partnership by Newco.

15. The shareholders (the "Shareholders") of Newco will elect Newco's directors (the "Directors").

16. The Shareholders will enter into an agreement (the "Shareholder's Agreement") that will provide, but not be limited to, the following:

(a) The business of Newco will be the carrying on of the existing Practice;

(b) Newco will carry out its business by entering into contracts with independent contractors and employees to provide the Professional Services;

(c) Each Shareholder may, if he/she so requests, be a member of the board of directors of Newco (the "Board of Directors");

(d) The officers of Newco will be elected by the Directors;

(e) The directors of Newco will appoint a Management Committee to manage the affairs of Newco. The activities of the Management Committee will be similar to those of the existing Management Committee of the Partnership;

(f) At the sole discretion of the Management Committee, the net profits of Newco will, from time to time, be available for distribution in the form of dividends on the outstanding shares of Newco;

17. Newco will carry on the Practice by providing the Professional Services in the following ways:

(a) Through individuals licensed to practice XXXXXXXXXX in the Province and employed by Newco to provide various Professional Services;

(b) Through individuals engaged by Newco to provide various Professional Services as independent contractors. These independent contractors will be licensed to practice XXXXXXXXXX in the Province and will provide such Professional Services on behalf of Newco; and

(c) Through Contracting Companies engaged by Newco to provide various Professional Services as independent contractors. The Contracting Companies will provide such Professional Services on behalf of Newco. Each Contracting Company will employ an individual licensed to practice XXXXXXXXXX in the Province.

18. Each Partner will have the option of providing Professional Services to Newco in one of the following ways:

(a) As an employee of Newco;

(b) As a Contracting Professional; or

(c) As a Contracting Company entering into a contract for service with Newco.

19. The Partners who choose to enter into a contractual relationship with Newco agree to provide certain Professional Services as a Contracting Professional and will receive a fee as compensation for the Professional Services provided to Newco. The amount of the fee will be negotiated on a case-by-case basis and will vary with the number and type of Professional Services to be provided by the Contracting Professional. This arrangement will be evidenced by a written contract which will provide that the fee for Professional Services performed will be based upon the total number of billable and non-billable hours provided to Newco during the year multiplied by a stipulated hourly rate. The Management Committee may adjust this hourly rate at any time during the year.

20. So long as a Contracting Professional fully discharges his/her responsibilities under the services contract with Newco, he/she will not be restricted from providing services to other persons or otherwise prohibited from competing with Newco. Likewise, on the termination of a Contracting Professional's association with Newco, the Contracting Professional shall not be prohibited in any way from competing with Newco.

21. The Partners who choose to enter into a contractual arrangement with Newco through a Contracting Company will be required to enter into a signed written agreement with Newco. The agreement between Newco and each Contracting Company will provide that the fee for services performed by the Contracting Company will be determined in a manner similar to that determined for a Contracting Professional, as described in paragraph 19 above. There will not be any other contractual relations between or among any of Newco and the Contracting Companies.

22. A Partner who provides services for the benefit of his or her Contracting Company will be entitled, if he or she so desires, to receive a salary from his or her Contracting Company for such services provided.

23. Each Contracting Company will be controlled by the respective Partner who will be the legal and beneficial owner of all of the voting shares of the Contracting Company. If any voting shares of a Contracting Company are owned by another corporation, all of the voting shares of that corporation will be owned by the Partner. The sole officer and director of a Contracting Company will be the respective Partner that incorporated the Contracting Company.

Non-voting shares of each Contracting Company may be owned by members of the Partner's family. However, none of these non-voting shares will be issued as part of the proposed transactions described herein.

All persons legally or beneficially owning shares of a Contracting Company will be residents of Canada.

24. A legal or beneficial shareholder of a Contracting Company will not be a legal or beneficial shareholder of another Contracting Company.

25. The sole officer and director of a Contracting Company will be an employee of the Contracting Company and will provide Professional Services for the benefit of the Contracting Company pursuant to the terms of its contract with Newco. The employment relationship between the Partner and his/her respective Contracting Company will be evidenced by a written employment agreement.

26. Each Partner will not be an employee, officer, director or shareholder, either legally or beneficially, of more than one Contracting Company. Related persons of a Partner may only be a shareholder of the Contracting Company in which that Partner owns shares.

27. Newco will require that each Contracting Company be a TCC and a CCPC.

28. Only Partners of the Partnership will have the option to choose which contractual arrangement they will establish with Newco.

29. After payment of all expenses, including fees payable to employees, Contracting Professionals and Contracting Companies for Professional Services, it is anticipated that Newco will, in any given taxation year, earn less than the business limit. To the extent Newco's taxable income for any particular taxation year exceeds the business limit, the excess will likely be distributed, in the absolute discretion of the Management Committee, as fees, bonuses or similar payments.

Purpose of the Proposed Transactions

30. The purpose of the proposed transactions is to restructure the Practice of the Partnership without adverse tax consequences. The Partners will continue to provide the Professional Services of the Practice but with the following advantages:

(a) Eliminate joint and several liability inherent in providing the Professional Services through a partnership and to benefit from the recent amendment by the Province which permits XXXXXXXXXX in the Province to render professional XXXXXXXXXX services through a corporation;

(b) Provide each Partner with an increased level of control over their participation in the Practice through individual management of personal practice preferences;

(c) Permit each Partner to have control over expenditures, where such expenditures may not be in the interest of all participants in the Practice;

(d) Provide each Partner with more options and more control in arranging estate planning; and

(e) to provide an incentive to Professionals and future recruits to the Practice to strive to become Partners.

Rulings

Provided that:

(a) the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and the purpose of the proposed transactions;

(b) the proposed transactions are completed in the manner described above; and

(c) there are no other transactions which may be relevant to the rulings requested;

our rulings are as follows:

A. Subject to sections 18 and 67 of the Act, the fees payable by Newco to a Contracting Professional or a Contracting Company for Professional Services, as described in paragraphs 19 and 21 above, will be deductible by Newco in computing the profit or loss from its business pursuant to section 9 of the Act.

B. Provided that a Partner providing Professional Services to Newco through a Contracting Company would not, but for the existence of the Contracting Company, be an officer or employee of Newco in respect of those Professional Services, then each such Contracting Company will not be considered to be carrying on a personal services business.

C. Provided that a partnership does not exist between Newco and any Contracting Company, the income earned by Newco or any Contracting Company will not be specified partnership income.

D. As a result of the proposed transactions, in and by themselves, the provisions of subsection 245(2) of the Act will not be applied to re-determine the tax consequences confirmed in the rulings given above.

Comments

In accordance with paragraph 2 of Interpretation Bulletin - IT 378R "Winding-up of a Partnership" ("IT-378R"), it is the CRA's view that issuing the Additional Shares in the name of each Partner, instead of the Partnership, as described in paragraphs 9 and 12 above, will not invalidate the application of subsection 85(2) of the Act nor the subsequent application of subsection 85(3) of the Act.

In accordance with paragraph 2 of IT-378R, it is the CRA's view that issuing the Promissory Note in the name of each Partner, instead of the Partnership, as described in paragraphs 9 and 13 above, will not invalidate the application of subsection 85(2) of the Act nor the subsequent application of subsection 85(3) of the Act.

The attribution rules in sections 74.1 to 74.4 of the Act apply in situations where property is transferred or lent, directly or indirectly, to a spouse or child. These rules may apply to any income received by a spouse or a child who has not attained the age of 18 years before the end of a particular taxation year. Whether or not these rules will apply in respect of the ownership of any non-voting shares of a Contracting Company, as described in paragraph 23 above, is a question of fact that can only be determined at the time that the shares are issued or property is lent or transferred to such a shareholder. Furthermore, subsection 56(2) of the Act may apply to any amounts paid by a Contracting Company to a spouse or child of the Partner who owns the voting shares of the Contracting Company.

Whether or not a Contracting Professional is an employee of Newco or is an independent contractor who has entered into a contract for services with Newco is a question of fact that can only be determined after a review of the actual agreement entered into between the Contracting Professional and Newco. This review and determination is the responsibility of the Contracting Professional's local tax services office.

These rulings are given subject to the limitations and qualifications set out in Information Circular 70-6R5 issued by the CRA on May 17, 2002, and are binding on the CRA provided that the proposed transactions are implemented on or before XXXXXXXXXX.

These rulings are based on the Act in its present form and do not take into account any proposed amendments to the Act which, if enacted, could have an effect on the rulings provided herein.

Except as expressly stated, this advance income tax ruling does not imply acceptance, approval or confirmation of any income tax implications of the facts or proposed transactions.

Yours truly,

XXXXXXXXXX
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch