2006 Ruling 2006-0189151R3 - 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/manager 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 							2006-018915

XXXXXXXXXX, 2006

Dear XXXXXXXXXX:

Re: Advance Income Tax Ruling Request
XXXXXXXXXX

This is in reply to your letter of XXXXXXXXXX, wherein you requested an advance income tax ruling on behalf of the above named company on the consequences under the Income Tax Act of the proposed transactions described herein.

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.

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

DEFINED TERMS

In this letter, the following terms have the meanings specified:

XXXXXXXXXX;

XXXXXXXXXX;

"active business carried on by a corporation" has the meaning set forth in subsection 125(7);

"ACB" means adjusted cost base as defined in section 54;

"Business" refers to the XXXXXXXXXX;

"business limit" has the meaning set forth in subsection 125(2);

"Canadian-controlled private corporation" has the meaning set forth in subsection 125(7);

"Canadian partnership" has the meaning set forth in subsection 102(1);

"CDA" means capital dividend account as defined in subsection 89(1);

"CNIL" means cumulative net investment loss as defined in subsection 110.6(1);

"Current Taxation Year" is the taxation year of XXXXXXXXXX that commenced on XXXXXXXXXX and ends immediately before the commencement of the Next Taxation Year;

XXXXXXXXXX;

XXXXXXXXXX;

"Key Employees" means XXXXXXXXXX, collectively;

"LP" means XXXXXXXXXX, a newly formed Canadian partnership created pursuant to the laws of XXXXXXXXXX having XXXXXXXXXX as its general partner and XXXXXXXXXX as its initial limited partner;

XXXXXXXXXX;

"Minority Shareholders" means XXXXXXXXXX;

"Next Taxation Year" has the meaning set forth in paragraph 15 below; and

"QSBC Share" means qualified small business corporation share as defined in subsection 110.6(1);

XXXXXXXXXX;

XXXXXXXXXX;

XXXXXXXXXX.

FACTS

1. Each of XXXXXXXXXX is a Canadian-controlled private corporation.

2. The Minority Shareholders are not related to each other or to XXXXXXXXXX. None of the Minority Shareholders, either individually or as part of a group, own any shares or exert any type of control over XXXXXXXXXX. The Minority Shareholders deal at arm's length both factually and under the Act with XXXXXXXXXX.

3. XXXXXXXXXX was incorporated on XXXXXXXXXX pursuant to the Business Corporations Act (XXXXXXXXXX).

4. Since shortly after its incorporation, XXXXXXXXXX has carried on the Business. XXXXXXXXXX.

5. The Business, which is an active business carried on by XXXXXXXXXX, is carried on exclusively in Canada.

6. The principal place of business and head office of XXXXXXXXXX is XXXXXXXXXX.

7. At the commencement of the proposed transactions described below, the shareholders of XXXXXXXXXX and their shareholdings will be as follows:

(a) XXXXXXXXXXXXXX Common Shares and XXXXXXXX Class "A" Preferred Shares; The Class "A" shares are non-voting, redeemable and retractable for $XXXXXXXX per share and carry a XXXXXXXX% non-cumulative dividend entitlement.

(b) XXXXXXXXXXXXXX Common Shares with an ACB of $XXXXXXXX;

(c) XXXXXXXXXXXXXX Common Shares with an ACB of $XXXXXXXXXX; and

(d) XXXXXXXXXXXXXX Common Shares with an ACB of $XXXXXXXXXX.

All of the issued and outstanding shares of XXXXXXXXXX have nominal paid-up capital for purposes of the Act.

8. All the issued and outstanding shares of XXXXXXXXXX are owned by XXXXXXXXXX.

9. Each of the Key Employees has been a long-term employee of XXXXXXXXXX actively engaged in the Business on a day-to-day basis. Their years of service to the company are as follows: XXXXXXXXXX. Each has contributed to XXXXXXXXXX success and each has reported salaries from XXXXXXXXXX in XXXXXXXXXX and previous years.

10. Each of the Key Employees is a resident of XXXXXXXXXX, Canada.

11. Other relevant information pertaining to the Taxpayers is as follows.

	Name		  Address		Account No. / 		Tax Services
						Social Insurance No.	Office

	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX
	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX
	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX
	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX
	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX
	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX
	XXXXXXXXXX   XXXXXXXXXX 	XXXXXXXXXX 			XXXXXXXXXX 

The Tax Services Office for each Taxpayer is shown above. The Taxation Centre for each Taxpayer is XXXXXXXXXX.

12. The shareholders of XXXXXXXXXX had been approached to sell their shares of XXXXXXXXXX to the shareholders of XXXXXXXXXX and XXXXXXXXXX (or an entity controlled by them). In particular, the shares of XXXXXXXXXX are QSBC Shares for each of the Minority Shareholders. None of the Minority Shareholders has or will have a CNIL at XXXXXXXXXX and none of them will have realized an allowable business investment loss since 1984. Furthermore, none of them has previously claimed a capital gains deduction as provided in section 110.6. Each of the Minority Shareholders wishes to benefit from their respective capital gains deduction. The shareholders of XXXXXXXXXX and XXXXXXXXXX do not wish to purchase the shares of XXXXXXXXXX but desire to purchase the Assets and Business. As a consequence, the shareholders of XXXXXXXXXX and XXXXXXXXXX and the Key Employees have been negotiating a sale of the Assets comprising the Business of XXXXXXXXXX and the sale of shares owned by the Minority Shareholders. One of the conditions of the negotiations is that the Minority Shareholders obtain the benefit of the capital gains deduction. The potential purchaser of the Business will be the LP. It is intended that the purchase price will be equal to the fair market value of the Business as negotiated by the parties to such transaction.

13. A final purchase price has not yet been determined and monetary amounts herein are only estimates. However, such purchase price is expected to be in the range of $XXXXXXXXXX.

14. XXXXXXXXXX has a nominal amount in its cumulative eligible capital account. The sale of the Assets will result in an inclusion of business income to XXXXXXXXXX pursuant to subsection 14(1) in the amount of approximately $XXXXXXXXXX.

15. The current fiscal period and taxation year of XXXXXXXXXX would end XXXXXXXXXX. However, XXXXXXXXXX will seek the concurrence of the Minister of National Revenue to change its fiscal period, and therefore its taxation year, to end at some earlier date in XXXXXXXXXX (the taxation year which begins immediately after this earlier date is referred to herein as the "Next Taxation Year").

16. The following summary of proposed transactions is based on estimated tax cost amounts and fair market values of the Assets as follows:

Tax Cost 		Fair Market
Description 		Amount   		Value

Accounts receivable	XXXXXXXXXX 		XXXXXXXXXX
Inventory			XXXXXXXXXX 		XXXXXXXXXX
Prepaid expenses		XXXXXXXXXX 		XXXXXXXXXX
Total current assets	XXXXXXXXXX 		XXXXXXXXXX
Fixed assets		XXXXXXXXXX 		XXXXXXXXXX
Goodwill			XXXXXXXXXX 		XXXXXXXXXX
Total assets		XXXXXXXXXX 		XXXXXXXXXX
Liabilities			XXXXXXXXXX 		XXXXXXXXXX
Net equity			XXXXXXXXXX 		XXXXXXXXXX 

17. The authorized share capital of XXXXXXXXXX was amended in contemplation of the transactions proposed herein by creating a second class of voting, redeemable, retractable preferred shares (the "Pref Shares").

PROPOSED TRANSACTIONS

18. The Minority Shareholders will exchange their common shares of XXXXXXXXXX for a corresponding number of Pref Shares. The stated and paid-up capital of the Pref Shares will be equal to the nominal stated and paid-up capital of the exchanged common shares. The redemption amount of each Pref Share will be $XXXXXXXXXX (being $XXXXXXXXXX in the aggregate for all XXXXXXXXXX Pref Shares). Each Minority Shareholder will jointly elect with XXXXXXXXXX pursuant to the provisions of subsection 85(1) to deem the proceeds of disposition in each case to be an amount equal to the aggregate of the ACB of the exchanged common shares to the particular Minority Shareholder plus $500,000.

19. Each Minority Shareholder will report a capital gain of $500,000 in his personal income tax return as a result of the disposition of the XXXXXXXXXX common shares for Pref Shares described in 18 above. Furthermore, each Minority Shareholder will claim the capital gains deduction on Form T657 in respect thereof.

20. XXXXXXXXXX will borrow at least $XXXXXXXXXX from an arm's length Canadian financial institution.

21. XXXXXXXXXX will subscribe for LP Units in the amount of $XXXXXXXXXX leaving XXXXXXXXXX with at least $XXXXXXXXXX of remaining cash.

22. XXXXXXXXXX will sell the Assets to the LP for the approximate amount of $XXXXXXXXXX. Based on the estimated values outlined above, the consideration given by the LP to XXXXXXXXXX will consist of an assumption of third party debts and units in the LP (hereinafter referred to as "LP Units"), estimated as follows:

Consideration

FMV 		Assume 		Cash 		LP Units
    						Debts

Accounts
Receivable			XXXXXXXX 	XXXXXXXX 		XXXXXXXX 	XXXXXXXX
Inventory			XXXXXXXX 	XXXXXXXX 		XXXXXXXX 	XXXXXXXX
Prepaid
Expenses			XXXXXXXX	XXXXXXXX		XXXXXXXX	XXXXXXXX
Fixed
Assets			XXXXXXXX 	XXXXXXXX 		XXXXXXXX 	XXXXXXXX
Goodwill			XXXXXXXX 	XXXXXXXX 		XXXXXXXX 	XXXXXXXX
Total				XXXXXXXX 	XXXXXXXX 		XXXXXXXX 	XXXXXXXX 

XXXXXXXXXX and the LP will elect pursuant to subsection 97(2) to transfer the fixed assets at an agreed amount equal to their tax cost amount which is estimated to be $XXXXXXXXXX. The sale of the goodwill will result in a business income inclusion of $XXXXXXXXXX and, effective the first day of the Next Taxation Year, an inclusion in its CDA of the same amount.

23. XXXXXXXXXX will sell the $XXXXXXXXXX of LP Units that it received as consideration for its fixed assets to XXXXXXXXXX for $XXXXXXXXXX cash. Based on the estimated agreed amount for purposes of the election pursuant to subsection 97(2) being $XXXXXXXXXX as described above, XXXXXXXXXX will realize a capital gain of $XXXXXXXXXX on this transaction. One-half of this amount will be included in paragraph (a)(i) of the definition of CDA and one-half of this amount will be included in XXXXXXXXXX aggregate investment income as defined in subsection 129(4).

24. The directors of XXXXXXXXXX will declare a dividend on its common shares (consisting of the XXXXXXXXXX common shares owned by XXXXXXXXXX) sufficient to recover all refundable dividend tax on hand created as a consequence of the transaction described in 23 above (estimated dividend to be $XXXXXXXXXX). Transactions 23 and 24 are required to occur in the Current Taxation Year.

25. The board of directors of XXXXXXXXXX will declare bonuses payable (collectively the "Bonus") to the Key Employees prior to the end of the Current Taxation Year, such that XXXXXXXXXX will, at that time, have a legal obligation to pay the Bonus. The aggregate amount of the Bonus will be sufficient to reduce XXXXXXXXXX net income attributable to the Business and the sale of the Assets to a nominal amount. The precise amount of the Bonus will be determined as soon as practicable after the sale of the Assets is completed, which is anticipated to be within XXXXXXXXXX weeks following the receipt of favourable rulings contemplated herein.

26. Assuming the amount of the Bonus is $XXXXXXXXXX, such Bonus is proposed to be allocated among the Key Employees as follows:

XXXXXXXXXX.

27. XXXXXXXXXX will pay the Bonus no later than the 179th day following the end of the Current Taxation Year, which will reduce its taxable income attributable to the Business and the sale of the Assets for its Current Taxation Year to a nominal amount. Appropriate source deductions will be remitted in a timely manner.

28. Pursuant to subsection 5(1), each Key Employee's allocation of the Bonus will be included in the particular Key Employee's employment income for the year in which it is received.

29. Effective the Next Taxation Year, the shareholders of XXXXXXXXXX will pass a special resolution to increase the stated capital (but not the redemption amount) of the Pref Shares. Based on the estimated values herein, it is anticipated that the increase in stated capital will be $XXXXXXXXXX per share or $XXXXXXXXXX in total. This will result in a deemed dividend pursuant to subsection 84(1) in respect of which an election will be made pursuant to subsection 83(2) to deem the deemed dividend to be a capital dividend out of XXXXXXXXXX CDA. The deemed dividend will also increase the ACB of the Pref Shares to the Minority Shareholders pursuant to paragraph 53(1)(b).

30. After the steps in paragraph 29 above have been completed and during the Next Taxation Year, the Minority Shareholders will sell their Pref Shares to XXXXXXXXXX for a cash price equal to their redemption amount (estimated to be $XXXXXXXXXX per share or $XXXXXXXXXX in aggregate). Each Minority Shareholder will report a capital gain equal to the amount by which the sales proceeds exceeds their ACB. It is intended that the ACB of the Pref Shares to each Minority Shareholder will be the aggregate of the ACB of his original common shares (see 7 above) plus the increase of $500,000 pursuant to the "capital gain crystallization" (see 18 above) plus the increase in capital deemed dividend (see 29 above). In order to fund the purchase of the Pref Shares, XXXXXXXXXX will borrow the required cash from XXXXXXXXXX .

31. Each of the Key Employees will sign non-competition agreements as part of the sale transaction. However, the Key Employees will not receive any consideration for signing the non-competition agreements.

32. XXXXXXXXXX will remain as employees for a brief period post-sale in order to assist in the transition to new ownership. XXXXXXXXXX will all remain as employees after the sale transaction is completed.

33. XXXXXXXXXX will declare and pay a dividend to XXXXXXXXXX equal to the balance remaining in its CDA (currently estimated to be $XXXXXXXXXX). An election will be made pursuant to subsection 83(2) to deem the dividend to be a capital dividend. XXXXXXXXXX will in turn declare a capital dividend to its shareholders pursuant to subsection 83(2).

PURPOSES OF THE PROPOSED TRANSACTIONS

34. The purposes of the proposed transactions are to remunerate the Key Employees in a tax efficient manner for their contributions to the success of the Business of XXXXXXXXXX, and enable XXXXXXXXXX to obtain the benefit of the capital gains deduction and for the efficient utilization of the CDA created on the sale of goodwill.

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. Section 67 and paragraph 18(1)(a) will not apply to prohibit XXXXXXXXXX from deducting the amount of the Bonus in computing its income from a business for the Current Taxation Year.

B. The amount of the Bonus will be deductible in computing the income of XXXXXXXXXX from a business for the Current Taxation Year provided it is paid within 179 days of the end of the Current Taxation Year and subsection 78(4) will not apply to prohibit such deduction.

C. Pursuant to subsection 5(1), the amount of the Bonus paid to each Key Employee must be included in calculating his respective employment income in the taxation year in which it is received.

D. Provided that the Minority Shareholders and XXXXXXXXXX deal at arm's length none of the Minority Shareholders will be deemed to have received a dividend pursuant to section 84.1 on the sale of their Pref Shares to XXXXXXXXXX.

E. 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 Canada Revenue Agency provided the proposed transactions are carried out 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, 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
Legislative Policy and Regulatory Affairs Branch