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: Can the employees of a partnership be considered employees of an individual corporate partner for the purposes of meeting the exclusion in paragraph (a) of the definition of "specified investment business" found in subsection 125(7) of the Act?
Position: No.
Reasons: Consistent with the reasoning found in Lerric Investments Corp. [2001 DTC 5169], the statutory wording "the corporation employs" connotes a direct relationship between the corporation as employer and the employees. In the case of a partnership, the employees are considered employees of the partners collectively, but not of any of them individually.
January 23, 2008
HELEN PRICE HEADQUARTERS
Estates & Trusts Section Income Tax Rulings Directorate
Montreal TSO James Atkinson CGA
Montreal, QC (519) 457-4832
Ref: 2007-025801
Qualified Small Business Corporation Shares
This is in response to your email dated October 31, 2007, requesting our views concerning whether the shares of a corporation (Aco) meet the definition of "qualified small business corporation share" (QSBCS) in subsection 110.6(1) of the Income Tax Act (Act).
The facts as you have described them are that:
1. Aco is a Canadian-controlled private corporation as defined in subsections 125(7) and 248(1) of the Act.
2. Aco's assets consist of XXXXXXXXXX rental properties, which are apartment complexes, and an interest in a partnership.
3. The partnership was originally formed by Aco together with two related individuals to carry on the business of property management and provides these services solely to Aco.
4. The partnership employs more than 5 full-time persons at the time of disposition of the Aco shares and throughout the 24 months preceding the disposition.
5. There is no written partnership agreement. However, the partners allocate the profits of the partnership reflecting the co-ownership interests of the partners in one of the rental properties. In this respect, Aco is allocated XXXXXXXXXX% of the profits and the other two related individuals are allocated XXXXXXXXXX% of the profits each.
6. The partnership was formed in the province of Quebec. Thus, the provisions of the Civil Code of Quebec governing partnerships apply.
7. The fair market value (FMV) of the rental properties held by Aco, at the time of disposition, represents more than 90% of the FMV of all the assets of Aco. The fair market value (FMV) of the rental properties held by Aco, throughout the 24 month preceding the disposition, represents more than 50% of the FMV of all the assets of Aco.
Your question is whether the shares of Aco meet the definition of QSBCS. The answer to this question depends on whether the rental properties of Aco are used in an active business.
Tax Services Office Position
In your opinion, the rental properties held by Aco are used to earn rental income, which is prima facie property income, and not income earned from a business. In order for the shares of Aco to qualify as QSBCS, the rental properties of Aco must have been used in an "active business." The expression "active business", as defined in subsection 248(1) of the Act, specifically excludes, inter alia, a "specified investment business" (SIB). In your view, Aco's business is properly described as a SIB and the rental properties cannot be considered to have been used in an "active business" due to the specific exclusion of a SIB from the definition of "active business". Consequently, no capital gains deduction pursuant to subsection 110.6(2.1) would be permissible in respect of a disposition of Aco shares by an individual.
Taxpayer Position
The taxpayer's representative, XXXXXXXXXX, submits that Aco is carrying on an active business and is not carrying on a SIB because Aco satisfies one of the two conditions in the definition of SIB. The condition being met is that Aco employs more than five employees; that is, the employees of the partnership are considered employees of Aco because the partnership is not an entity capable of employing persons and the employee-employer relationship exists only between the employees and the partners. The representative cites in support of his position the rules governing partnerships found in the Civil Code of Quebec, and the cases of Madsen v. The Queen, 2001 DTC 5093 (FCA), Norco Developments Ltd. v. The Queen, 85 DTC 5213 (FCTD) and Klein v. The Queen, 2001 DTC 433 (TCC). Accordingly, since the rental properties, constituting all or substantially all of the assets of Aco, were used in an active business, Aco's shares are QSBCS.
In order for a share of a corporation to meet the definition of QSBCS, three tests must be satisfied: a small business corporation test, a 24-month holding period test, and an asset use test. If one of these tests is not satisfied, the share does not meet the definition of QSBCS. In Aco's situation, only the first and third tests, both of which depend on a finding that Aco's rental operations are an active business, are of concern. As explained below, the first and third test of the definition of QSBCS are not met because Aco's rental operations are not considered an active business but constitute a SIB.
One of the three tests is that the corporation must be a "small business corporation" (SBC), as defined in subsection 248(1), at the time of disposition of the shares. Based on the facts, Aco would qualify as a SBC if it were to be found that assets accounting for all or substantially all (i.e., at least 90%) of the fair market value of the total assets of Aco are used principally in an active business carried on primarily in Canada. More specifically, this would mean that the rental properties, which account for more than 90% of the value of Aco's total assets, must be used in an active business or, stated in another way, that Aco's rental operations constitute an active business. In general terms, "active business" is defined in subsection 248(1) of the Act as any business carried on by a taxpayer resident in Canada, other than a SIB or a "personal services business". These latter two terms are defined in subsection 248(1) of the Act and derive their meanings from definitions in subsection 125(7) of the Act. In the case of Aco, of relevance is whether or not its business is a SIB.
A SIB, as defined in subsection 125(7) of the Act, generally means a corporation's business whose principal purpose is to derive income from property, such as rental income, unless the corporation meets one of two conditions:
(a) the corporation employs in the business throughout the year more than 5 full-time employees, or
(b) any other corporation associated with the corporation provides, in the course of carrying on an active business, managerial, administrative, financial, maintenance or other similar services to the corporation in the year and the corporation could reasonably be expected to require more than 5 full-time employees if those services had not been provided.
Aco's business is, prima facie, a SIB because its primary purpose is to derive income from property (i.e., rents). However, Aco's business would not be considered to be a SIB if Aco satisfies one of the two mentioned conditions.
Aco does not meet the second condition because, based on the facts, there is no other associated corporation providing services to Aco such that if the services had not been provided, Aco would have required more than 5 full-time employees.
Based on the facts, whether Aco meets the first condition mentioned above would revolve on whether Aco can be found to employ the employees of the partnership.
Whether or not what has been described in the facts above as a partnership is really a partnership at law is a question of fact, as discussed in Interpretation Bulletin IT-90, What is a Partnership? We will assume that it is in fact a partnership at law.
General comments of the CRA relating to "active business" and SIBs, where a corporation carries on a business as a member of a joint venture or partnership, are found in Interpretation Bulletin IT-73R6 - The Small Business Deduction. Of relevance in the case at hand are the following comments in paragraph 17 of IT-73R6:
"If a corporation carries on a business as a member of a joint venture, employees working for the joint venture are the employees of its members collectively, but not of any of them individually. In other words, such employees, if full-time, cannot be counted as the full-time employees of the corporation, either in whole or in proportion to its interest in the joint venture. Only those persons (if any) who are employed full-time in the business directly and solely by the corporation can be counted as its full-time employees for the purpose of the "more than five full-time employees" exception in the definition of "specified investment business". The same would apply for other forms of co-ownership of a business. See Lerric Investments Corp. v. The Queen, [2001] 2 CTC 84, 2001 DTC 5169."
In our view, the principle in Lerric, which involved co-owners or joint venturers and is referred to in paragraph 17 of IT-73R6, could be extended to partnerships.
In Lerric, the taxpayer had interests in eight apartment projects, which it owned with other co-owners or joint venturers. The principal purpose of taxpayer's business was to derive income from property in the form of rents. The sole issue was whether the taxpayer's business was a SIB. The question was whether the words "the corporation employs in the business throughout the year more than five full-time employees" could be used by the taxpayer to include as its employees the employees of a joint venture or co-ownership in which the corporation was a joint venturer or co-owner. The Tax Court Judge (Bowman, T.C.J.) rejected the approach set forth in former IT-73R5, concluding that to allocate fractions of employees to a joint venturer or co-owner fell outside the realm of reality.
The Federal Court of Appeal (FCA) also dismissed the subsequent appeal by the taxpayer. The FCA held that the operative legislative wording "the corporation employs" connotes a direct relationship between the corporation as employer and the specified employees. The FCA accepted the CRA's argument that the co-owners or joint venturers employ the employees together, but not independently; they are responsible for a percentage of each employee's wages in accordance with the co-ownership or joint venture agreement.
Although Lerric concerned a joint venture, in our opinion, it is not possible to limit its application to its facts. This decision stands for the proposition that a direct relationship must exist between the corporation as employer and the employees in order for the corporation to come within the wording "the corporation employs ...more than 5 full-time employees" requirement in the definition of SBI.
It is our opinion that where a corporation carries on a business as a member of a partnership, employees working for the partnership are the employees of its partners collectively, but not of any of them individually. Accordingly, for the purpose of determining whether Aco's rental operations are a SIB, Aco is not considered to employ the employees of the partnership of which it is a partner, since such employees are considered to be employed by the partners collectively.
In summary, since Aco's rental operations are not an active business but are a SIB, Aco does not qualify as a SBC and as such the first test of QSBCS is not met. In addition, based on the facts, the third test (i.e., the asset use test) for QSBCS is also not met because more than 50% of the FMV of Aco's assets are not attributable to assets used primarily in an active business carried on in Canada, for analogous reasons discussed above.
We trust that these comments will be of assistance.
S. Parnanzone
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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