2004 Ruling 2004-0086191R3 - Reasonableness Shareholder Manager Remuneration

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: The deductibility of shareholder/manger remuneration that is paid out of income triggered from the proceeds of a sale of business assets.

Position: Remuneration is deductible.

Reasons: Amount is reasonable and incurred for the purpose of earning business income.

XXXXXXXXXX 2004-008619

XXXXXXXXXX, 2004

Dear XXXXXXXXXX:

Re: Advance Income Tax Ruling Request
XXXXXXXXXX
XXXXXXXXXX
XXXXXXXXXX

This is in reply to your letters of XXXXXXXXXX, wherein you requested an advance income tax ruling in respect of the above-noted companies as it pertains to the deductibility of shareholder/manager remuneration. We also acknowledge the additional information supplied in various e-mails (XXXXXXXXXX).

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

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

(iii) is under objection by a 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 Directorate.

Unless otherwise stated, all references to a statute are to the Income Tax Act R.S.C. 1985 (5th Supp.), 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.

Definitions

1. XXXXXXXXXX.

2. "Opco 1" refers to XXXXXXXXXX.

3. "Opco 2" refers to XXXXXXXXXX.

4. "Opco 3" refers to XXXXXXXXXX.

5. "Holdco 1" refers to XXXXXXXXXX.

6. "Holdco 2" refers to XXXXXXXXXX.

7. "Employee 1" refers to XXXXXXXXXX.

8. "Employee 2" refers to XXXXXXXXXX.

9. "Employee 3" refers to XXXXXXXXXX.

10. "Employee 4" refers to XXXXXXXXXX.

11. "Employee 5" refers to XXXXXXXXXX.

12. "Employee 6" refers to XXXXXXXXXX.

13. "Mr. A" refers to XXXXXXXXXX.

14. ACO is XXXXXXXXXX.

15. BCO is XXXXXXXXXX.

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

Facts

16. Opco 1 was incorporated under the XXXXXXXXXX, is a CCPC, and has carried on business for more than XXXXXXXXXX years. Opco 1 has a taxation year-end of January 31 and deals with the XXXXXXXXXX Tax Services Office.

17. The shareholdings of Opco 1 are as follows:

Shareholder
Number & Class
Employee 1
XXXXXX Class A Common Voting
XXXXXX Class G Common Non-Voting
Employee 2
XXXXXX Class C Common Non-Voting
Employee 3
XXXXXX Class E Common Non-Voting
Employee 4
XXXXXX Class H Common Non-Voting
Employee 5
XXXXXX Class F Common Non-Voting

Mr. A

XXXXXX Class J Preferred Non-Voting

18. Opco 1 has carried on the business of XXXXXXXXXX .

19. Opco 2 was incorporated under the XXXXXXXXXX , is a CCPC, and has carried on business for approximately XXXXXXXXXX years. Opco 2 has a XXXXXXXXXX taxation year-end and deals with the XXXXXXXXXX Tax Services Office.

20. Opco 2 has carried on the business of XXXXXXXXXX.

21. The shareholdings of Opco 2 are as follows:

Shareholder
Number & Class
Holdco 1
XXXXXX Class A Common Voting
Opco 1
XXXXXX Class A Common Voting

22. Opco 3 was incorporated under the XXXXXXXXXX, is a CCPC, and has carried on business for more than XXXXXXXXXX years. Opco 3 has a XXXXXXXXXX taxation year-end and deals with the XXXXXXXXXX Tax Services Office.

23. Opco 3 owns the XXXXXXXXXX utilized by Opco 1 in its active operations. This XXXXXXXXXX is rented to Opco 1.

24. The shareholdings of Opco 3 are as follows:

Shareholder
Number & Class
Opco 1
XXXXXX Class A Common Voting
Holdco 2
XXXXXX Class A Common Voting

25. Holdco 1 was incorporated under the XXXXXXXXXX and is a CCPC, and deals with the XXXXXXXXXX Tax Services Office.

26. The shareholdings of Holdco 1 are as follows:

Shareholder
Number & Class
Employee 6
XXXXXX Class A Common Voting
XXXXXX Class B Common Voting

27. Holdco 2 was incorporated under the XXXXXXXXXX and is a CCPC, and deals with the XXXXXXXXXX Tax Services Office.

28. The shareholdings of Holdco 2 are as follows:

Shareholder
Number & Class
Employee 1
XXXXXX Class A Common Voting
XXXXXX Class G Preferred Non-Voting
Employee 2
XXXXXX Class G Common Non-Voting
Employee 3
XXXXXX Class G Common Non-Voting
Employee 4
XXXXXX Class G Common Non-Voting
Employee 5
XXXXXX Class G Common Non-Voting

Mr. A

XXXXXX Class J Preferred Non-Voting

29. Employees 1 to 5 and Mr. A are related pursuant to subsection 251(2) of the Act. Employee 1 is the father of Employees 2 to 5.

30. Employee 6 is not related to any of Employees 1 to 5 or Mr. A under subsection 251(2) of the Act.

31. Employees 1 to 6 are all residents of Canada, have filed their income tax returns with the XXXXXXXXXX Taxation Centre and have the XXXXXXXXXX Tax Services Office as their local tax services office.

32. Opcos 1 and 3 and Holdco 2 are associated corporations pursuant to section 256 of the Act and share the small business deduction pursuant to section 125 of the Act.

33. Opco 2 and Holdco 1 are not associated with each other, nor are they associated with Opcos 1 and 3 or Holdco 2.

34. Employees 1 to 5 are employees of Opco 1 and are currently active in the day-to-day operations and management of Opco 1. Their responsibilities include all management and operational decisions relating to the business. Such decisions include, financial decisions and review of such information, human resources and dealing with all issues surrounding employees, major asset purchases and other procurement decisions, negotiation of contracts and long term agreements, collection of accounts receivable and opening of daily mail, all decisions relating to the XXXXXXXXXX with Opco 1's clients. There are no other managerial or upper level employees involved in the business.

35. Employees 1 to 6 are employees of Opco 2 and are currently active in the day-to-day operations and management of Opco 2. The operational and managerial responsibilities are similar to those described in paragraph 34 above.

36. Employees 1 to 5 are employees of Opco 3 and are currently active in the day-to-day operations and management of Opco 3. The operational and managerial responsibilities are similar to those described in paragraph 34 above, but also include coordination and maintaining equipment available for use by Opcos 1 and 2.

37. Without the special know-how, connections and entrepreneurial skills provided by Employee's 1 to 6 as described in paragraphs 34 to 36 above, the historical and current success that Opco 1, 2 and 3 has enjoyed would not have been possible.

38. Opcos 1 to 3 have a history, policy and general practice of paying bonuses to its active shareholder/managers in taxation years where their respective taxable income is in excess of the small business deduction.

39. BCO is a wholly owned subsidiary of ACO. BCO and ACO are corporations that are at arms length from Opcos 1 to 3, Holdco 1 and Holdco 2.

40. On XXXXXXXXXX, Opcos 1 to 3 sold to BCO, depreciable property, which consisted generally of XXXXXXXXXX equipment, and goodwill, for total proceeds as follows:

Opco 1
Opco 2
Opco 3

XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX

XXXXXX

XXXXXX

XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX
XXXXXX

TOTAL
XXXXXX
XXXXXX
XXXXXX

Proposed Transactions

41. As a result of the disposition of depreciable property referred in paragraph 40 above,

(a) The estimated recaptured capital cost allowance included in income under subsection 13(1) of the Act, will be $XXXXXXXXXX for Opco 2 and $XXXXXXXXXX for Opco 3.

(b) The estimated capital gain pursuant to section 39 of the Act will be $XXXXXXXXXX for Opco 2 and $XXXXXXXXXX for Opco 3. The estimated taxable capital gain included in income pursuant to section 38 of the Act, will be $XXXXXXXXXX for Opco 2 and $XXXXXXXXXX for Opco 3. An amount equivalent to the taxable capital gain will be added to the capital dividend account of Opcos 2 and 3. Opco 2s and 3 intend on paying a capital dividend in respect of this amount on a pro-rata basis in respect of all classes of outstanding common shares.

42. The total consideration received in respect of the disposition of goodwill referred to in paragraph 40 above consisted of both cash and share consideration. Opco 1 received cash consideration of $XXXXXXXXXX and XXXXXXXXXX Class A common shares of BCO with a value of $XXXXXXXXXX. Immediately following the issuance of the BCO shares, Opco 1 exchanged the BCO shares on a one-for-one basis for shares of ACO. Opco 2 received cash consideration of $XXXXXXXXXX and XXXXXXXXXX Class A common shares of BCO with a value of $XXXXXXXXXX. Immediately following the issuance of the BCO shares, Opco 2 exchanged the BCO shares on a one-for-one basis for shares of ACO. Opcos 1 and 2 will elect pursuant to section 85 of the Act to defer the inclusion in income under subsection 14(1) of the Act of any amount in respect of the share consideration.

43. The cash consideration received for goodwill, specifically $XXXXXXXXXX for Opco 1 and $XXXXXXXXXX for Opco 2, will be deducted from the cumulative eligible capital account of Opcos 1 and 2 pursuant to the definition thereof in subsection 14(5) of the Act. This will result in an estimated income inclusion under subsection 14(1) of the Act of $XXXXXXXXXX for Opco 1 and $XXXXXXXXXX for Opco 2. An amount equivalent to the income inclusion under subsection 14(1) of the Act will be added to the capital dividend account for Opcos 1 and 2. Opcos 1 and 2 intend on paying a capital dividend in respect of this amount on a pro-rata basis in respect of all classes of outstanding common shares.

44. The estimated taxable income realized on the sale of assets referred to in paragraph 40 above may be summarized as follows:

Subsection 13(1) Income
Taxable Capital Gain
Subsection 14(1) Income
Total Taxable Income
Opco 1
XXXXXXX
XXXXXXX
XXXXXXX
XXXXXXX
Opco 2
XXXXXXX
XXXXXXX
XXXXXXX
XXXXXXX
Opco 3
XXXXXXX
XXXXXXX
XXXXXXX
XXXXXXX

45. The estimated taxable income realized on the sale of assets referred to in paragraph 44 above will be the only income earned by the companies from the sale of business assets. Opcos 1 to 3 will also have operating income from the normal business operations up to and including XXXXXXXXXX.

46. Opco 1 will accrue and expense bonuses, sufficient in amount to reduce taxable income for its XXXXXXXXXX taxation year to the small business deduction limit. It is estimated that the bonuses payable to Employees 1 to 5 will be as follows:

Employee 1
XXXXXXX
Employee 2
XXXXXXX
Employee 3
XXXXXXX
Employee 4
XXXXXXX
Employee 5
XXXXXXX

XXXXXXX

47. Opco 1 will pay the bonuses to Employees 1 to 5 on or before the XXXXXXXXXX.

48. Opco 2 will accrue and expense bonuses, sufficient in amount to reduce taxable income for its XXXXXXXXXX taxation year to the small business deduction limit. It is estimated that the bonuses payable to Employees 1 to 6 will be as follows:

Employee 1
XXXXXXX
Employee 2
XXXXXXX
Employee 3
XXXXXXX
Employee 4
XXXXXXX
Employee 5
XXXXXXX
Employee 6
XXXXXXX

XXXXXXX

49. Opco 2 will pay the bonuses to Employees 1 to 6 on or before the XXXXXXXXXX.

50. Opco 3 will accrue and expense bonuses, sufficient in amount to reduce taxable income for its XXXXXXXXXX taxation year to the small business deduction limit. It is estimated that the bonuses payable to Employees 1 to 5 will be as follows:

Employee 1
XXXXXXX
Employee 2
XXXXXXX
Employee 3
XXXXXXX
Employee 4
XXXXXXX
Employee 5
XXXXXXX

XXXXXXX

51. Opco 3 will pay the bonuses to Employees 1 to 5 on or before the XXXXXXXXXX.

Purpose of the Proposed Transactions

52. The purpose for paying the bonuses is to remunerate, in a tax efficient manner, Employees 1 through 6 for their efforts and contributions to the success of Opcos 1 to 3.

Rulings Given

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;

(c) There are no other transactions, which may be relevant to the ruling requested; and

(d) Opcos 1 to 3 withholds source deductions from the amount of the bonuses paid to each of Employees 1 to 6 in accordance with prescribed rules and remits the source deductions to the Receiver General within the prescribed time,

our rulings are as follows:

A. Paragraph 18(1)(a), section 67 and subsection 78(4) of the Act will not apply to prohibit:

a. Opco 1 from deducting the amount of the bonuses described in paragraph 46 above in computing its business income for the taxation year ended XXXXXXXXXX,

b. Opco 2 from deducting the amount of the bonuses described in paragraph 48 above in computing its business income for the taxation year ended XXXXXXXXXX, or

c. Opco 3 from deducting the amount of the bonuses described in paragraph 50 above in computing its business income for the taxation year ended XXXXXXXXXX.

B. Pursuant to subsection 5(1) of the Act, the amount of the bonuses paid to each of Employees 1 to 6, must be included in calculating their respective employment income in XXXXXXXXXX.

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

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 the Proposed Transactions related to the payment of bonuses by Opcos 1 to 3 are carried out within the respective time frames described in paragraphs 47, 49 and 51 above.

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, these rulings do 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