2006 Ruling 2006-0170321R3 - Partners Creating Professional Corporations

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: Where a partner of a professional partnership creates a professional corporation through which professional services will be provided to the partnership, will the corporation be eligible for the small business deduction?

Position: Yes.

Reasons: As long as the partner in his or her role of an employee of the professional corporation providing the services of the "professional function" would not, but for the corporation, be considered an employee of the partnership, then the business of the corporation is not a personal services business. Also, provided that the professional corporations are not themselves carrying on business in partnership, there is no specified partnership income. This ruling is the same as previous rulings given.

XXXXXXXXXX 								2006-017032

XXXXXXXXXX, 2006

Dear XXXXXXXXXX:

Re: XXXXXXXXXX (the "Partnership")
XXXXXXXXXX (the "Partners")
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 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, or

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

XXXXXXXXXX

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) "Province" is the Province of XXXXXXXXXX;

(b) "Partnership Agreement" is a reference to a "XXXXXXXXXX" partnership agreement entered into between the Partners, practicing as XXXXXXXXXX and as a partnership, more fully described in paragraph 4 below;

(c) "Partner" is a reference to each of, or any of the Partners;

(d) "Contracting Corporation" means each of the corporations that has been incorporated for the benefit of an existing Partner of the Partnership to carry on a independent XXXXXXXXXX and, collectively, they are referred to as the "Contracting Corporations";

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

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

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

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

(i) "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 general partnership. The Partners are the only partners of the Partnership. The Partners have been carrying on business pursuant to a "XXXXXXXXXX" Partnership Agreement which has not been formalized in writing. 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. None of these 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) XXXXXXXXXX

(c) XXXXXXXXXX - thus each Partner has a certain number of units of Income Capital.

(d) Each Partner has a Tangible Capital Account to which is credited the amount of all contributions and the amount of income allocated to a Partner and to which is debited the amount of any loss allocated to a Partner and any withdrawals made by a Partner.

(e) Each Partner's share of the profits and losses of the Partnership is calculated as follows:

(i) each Partner is allocated an amount equal to a percentage (determined annually by the Partners based on the rate of interest on the line of credit of the Partnership plus a discretionary amount typically equal to XXXXXXXXXX%) of the amount of his or her Tangible Capital Account;

(ii) after deducting the share of profits of all Partners in transition, and deducting the total remuneration on Tangible Capital, any remaining profits or losses are allocated to the Partners based on their units of Income Capital.

(f) Each Partner has a Goodwill Account which represents his or her share of the goodwill of the Partnership. XXXXXXXXXX

(g) 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.

(h) Each Partner is entitled to receive the amounts of his Tangible and Goodwill Accounts upon death, retirement, withdrawal or expulsion of the Partner, the terms of payment to be determined at that time.

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

6. Each of the Partners has recently incorporated a Contracting Corporation but to date, no shares have been issued and the corporations are inactive.

Proposed transactions

7. The Partnership will be continued as a Limited Liability Partnership XXXXXXXXXX.

8. The Partnership Agreement will be amended to allow Partners to provide their professional expertise in XXXXXXXXXX services through professional corporations. This will be effected by recognizing three functions that each Partner performs: professional, promotional and management. Each Partner shall have the option, exercisable by notice in writing to be delivered XXXXXXXXXX days prior to the effective date of the notice, to perform the Professional Function through a professional corporation controlled by that Partner and licensed to carry on the practice of XXXXXXXXXX.

Upon receipt of such notice, the Partnership will be required to enter into an agreement with the professional corporation for an amount to be agreed between the Partnership and the professional corporation. This amount will not exceed the fair market value for the services of the Professional Function. Initially this compensation is to be set at a fixed fee per month. The Partnership Agreement will also be amended to prohibit the performance of the Promotional and Management Functions by anyone other than the Partners themselves and to prohibit the transfer or other conveyance of any interest in the partnership to a professional corporation.

Consequential amendments to the Partnership Agreement will provide that the calculation of a Partner's share of profits for any year during which a professional corporation performs that Partner's Professional Function will be dependent solely on the Partner's capital contribution and factors connected to the Promotional and Management Functions. In particular, the calculation of the Partner's share of profits for that year will not depend on hours billed and collected.

9. Each Contracting Corporation will be required to enter into a written contract for service (the "Contract") with the Partnership. The Contract will provide that the amount of the fee for the Professional Services provided by the Contracting Company to the Partnership 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 Corporation. The amount of the fee will be equal to the fair market value for the professional services provided by the Contracting Corporation to the Partnership. The contract may be renewed each year and either party upon XXXXXXXXXX notice may also terminate it.

10. So long as the Contracting Corporation fully discharges its responsibilities under the agreement with the Partnership, the Contracting Corporation will not be restricted from providing services to other persons or otherwise prohibited from competing with the Partnership.

11. All payments received by the Partnership from clients in respect of services provided by the Contracting Corporations will be for the benefit of the Partnership.

12. The Partnership will supply certain supplies, personnel, facilities and equipment that are required to provide professional services to the clients of the Partnership. A Contracting Corporation will be responsible for the following expenses:

(a) professional membership fees and insurance;
(b) continuing education;
(c) transportation;
(d) communication;
(e) maintaining the professional standards set by the Partnership or by the XXXXXXXXXX; and
(f) expenditures on personal practice preferences of the Contracting Corporation.

13. The sole officer and director of each Contracting Corporation will be the Partner, who will be an employee of that Contracting Corporation and will provide professional services for the benefit of the Contracting Corporation pursuant to the terms of the Contract with the Partnership. The employment relationship will be evidenced by a written employment agreement.

14. A Partner who provides services for the benefit of his or her Contracting Corporation will be entitled to receive a salary from his or her Contracting Corporation for such services provided.

15. Each Contracting Corporation will be controlled by the respective Partner who will be the legal and beneficial owner of all of the voting shares of the Contracting Corporation. Non-voting shares of a Contracting Corporation or of a Corporation holding shares may be owned by members of the Partner's family. For purposes of this paragraph, "family" means individuals connected by blood relationship, marriage, common-law partnership or adoption, as those terms are described in subsection 251(6) of the Act. All persons legally or beneficially owning shares of a Contracting Corporation will be residents of Canada.

16. A legal or beneficial shareholder of a Contracting Corporation will not be a legal or beneficial shareholder of another Contracting Corporation.

17. No Partner will be an employee, officer, director or shareholder, either legally or beneficially, of more than one Contracting Corporation. Related persons of a Partner may not be shareholders of any Contracting Corporation other than the Contracting Corporation in which that Partner owns shares.

18. Each Contracting Corporation will be a TCC and CCPC.

Purpose of the proposed transactions

19. The primary objective of all of the proposed transactions is to allow the Partners to use professional corporations to earn professional income derived from the Practice with minimal disruption to the business arrangements between the Partners of the Partnership. These arrangements have cost significant time and money to refine into the mechanisms for profit sharing as they stand in the current Partnership Agreement.

Other purposes of the proposed transactions are:

(a) To allow the Partners to benefit from recent legislative amendments by the Province, which permit XXXXXXXXXX to render professional services through a corporation.

(b) To provide each Partner with an increased level of control over his or her participation in the Practice through individual management of personal practice preferences.

(c) To permit each Partner to have control over expenditures where such expenditures may not be in the interest of all participants in the Practice.

(d) To provide the professional Partner with more control over his or her own estate and financial planning.

(e) To enhance the Partnership's ability to retain and recruit professionals.

None of the reasons for the separate existence of the Contracting Corporations is to reduce the amount of taxes that would otherwise be payable under the Act or to increase the amount of any investment tax credit under section 127.1 of the Act.

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

our rulings are as follows:

A. The execution and implementation of the proposed transactions described above, of and by themselves, will not constitute a disposition of part or all of an interest in the Partnership by any Partner.

B. Sharing of income between the Partners will not be subject to adjustment pursuant to subsection 103(1) of the Act solely as a result of the application of the proposed amendments to the Partnership Agreement described in paragraph 8.

C. The execution and implementation of the proposed transactions, of and by themselves, will not be sufficient to create a non-arm's length relationship between the Partners with respect to sharing the Partnership profits for income tax purposes.

D. Subject to sections 18 and 67 of the Act, the fees payable by the Partnership to the Contracting Corporations described in paragraph 9 will be deductible by the Partnership in calculating its income pursuant to subsection 96(1) of the Act.

E. The transactions undertaken in paragraphs 8 and 9, and in particular the payments described in paragraph 9, will not in and of themselves cause subsections 56(2), 56(4) or 246(1) of the Act to apply so as to cause an amount to be taxed as income in the hands of a Partner.

F. Provided that a Partner providing the services of the Professional Function to the Partnership through a Contracting Corporation would not, but for the existence of the Contracting Corporation, be an officer or employee of the Partnership in respect of those services, then each such Contracting Corporation will not be considered to be carrying on a personal services business as defined in subsection 125(7) of the Act.

G. Provided that a partnership does not exist between any of the Contracting Corporations, the income earned by a Contracting Corporation as described above will not be specified partnership income as defined in subsection 125(7) of the Act.

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

Comments

The application of subsection 256(2.1) of the Act is determined on a year-to-year basis. We are therefore unable to rule that this provision will never apply to the Contracting Corporations. In general, where a particular function of a professional partnership that was previously carried on by the partnership is subsequently carried on by a partner's professional corporation, and no longer in partnership, for bona fide reasons other than income tax, this fact, in and of itself, would generally not cause subsection 256(2.1) of the Act to be applicable. The reasons for the separate existence of two or more professional corporations or the reasons for a change in the functions performed directly by the partners of the professional partnership is a question of fact that can only be determined on a case-by-case basis. However, based on the facts and proposed transactions described herein, it is our view that the incorporation of the Contracting Corporations to provide the services of the Professional Function to the Partnership will not, in and of itself, cause subsection 256(2.1) of the Act to be applicable to the Contracting Corporations.

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
Legislative Policy and Regulatory Affairs Branch