4 February 2014 External T.I. 2013-0489791E5 - Indian Business Income Conversion to Employment

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 the employment income of an Indian sole proprietor would be exempt income under Guideline 2?

Position: Likely not.

Reasons: Residence of employer may not be strong connecting factor in this case.

XXXXXXXXXX
2013-048979
Lori Merrigan
(613) 957-9229

February 4, 2014

Dear XXXXXXXXXX:

Re: Exemption from Taxation Pursuant to Section 87 of the Indian Act

This is in reply to your e-mail of May 22, 2013, in which you requested a technical interpretation as to whether the income of an Indian, as that term is defined in section 2 of the Indian Act (the "IA"), would be considered to be situated on a reserve and thus exempt from tax for purposes of section 87 of the IA and paragraph 81(1)(a) of the Income Tax Act (the "Act").

In particular, you have asked us to comment whether the income of a professional corporation, that might otherwise be considered taxable business income, paid out in its entirety as salary to the owner operator or sole shareholder, could be considered exempt employment income situated on a reserve by applying the Indian Act Exemption for Employment Income Guidelines (the "Guidelines").

The situation outlined in your email appears to relate to a factual one, involving a specific taxpayer. Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, "Advance Income Tax Rulings". This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. However, we are prepared to provide the following general comments.

The location of the duties of employment is usually the key factor in determining whether an Indian's employment income is situated on a reserve and exempt from tax. However, the courts have recognized that employment income may be situated on a reserve, even where many or all of the duties of employment are carried on off-reserve, as long as other connecting factors of significant weight connect the employment income to a reserve. These factors may include the circumstances surrounding the employment, the residence of the employer and the residence of the employee.

In consultation with other government departments as well as interested Indian groups and individuals, the Canada Revenue Agency (the "CRA") identified a number of connecting factors that can be used to determine whether a person's employment income is situated on a reserve. This initiative resulted in the development of the Guidelines. The Guidelines are an administrative tool intended to approximate the "connecting factors test" described by the Supreme Court of Canada in Williams v. The Queen, 92 DTC 6320. The Guidelines were intended to apply in common employment situations to assist Indian employees to determine whether their employment income was taxable. Unlike the connecting factors test, each Guideline relies on only 2 or 3 elements, which are implicitly given significant weight, in determining whether the employment income is exempt.

The Guidelines have always expressly stated that there may be situations in which employment income appears to fall within a particular Guideline but is determined not to be exempt. The extent to which the Guidelines apply in specific business situations is a question of fact that can only be determined after an examination of all of the relevant facts, generally in the course of an audit.

It is our opinion that if the Indian owner-operator's salary received for employment duties performed, in his or her capacity as an employee, is reasonable, his or her employment income may fall within the application of the Guidelines. The determination of the amount of salary that is reasonable for the duties performed is always a question of fact.
Guideline 2 is the Guideline that is most often referred to with respect to situations where duties of employment are completed off-reserve. Guideline 2 relies on only two factors: the residence of the employer and the residence of the employee. The courts have concluded that although an employer's residence on a reserve is a connecting factor to a reserve, that factor will have minimal weight if the location of the employer has no tangible significance to the reserve.

Generally, the courts have indicated that weight should be given to the location of an employer on a reserve only where the scope of the employer's activities on a reserve, or the direct benefits flowing to a reserve, indicate a clear nexus between the employer and the reserve (see Shilling v. The Queen, 2001 FCA 178, Horn et al v. The Queen et al, 2007 FC 1052, GooGoo v. The Queen, 2008 TCC 589, McIvor et al v. The Queen, 2009 TCC 469, etc.). Therefore, Guideline 2 is a reasonable approximation of the connecting factors test only where the location of the employer on a reserve provides direct, significant benefits to the reserve. In determining whether a benefit to a reserve is provided, the CRA will take into account whether the location of the employer benefits the particular reserve or reserves where the employees reside.

Furthermore, the courts have also stated that connections that are artificial should not be given weight in determining the location of income for purposes of the exemption. In the Supreme Court of Canada ("SCC") decision Bastien Estate v. Canada, 2011 SCC 38, the judge stated in paragraph 62 that,

"Of course, in determining the location of income for the purposes of the tax exemption, the court should look to the substance as well as to the form of the transaction giving rise to the income. The question is whether the income is sufficiently strongly connected to the reserve that it may be said to be situated there. Connections that are artificial or abusive should not be given weight in the analysis..."

Similarly, the Federal Court of Appeal agreed and commented on the SCC decision in Bastien in Her Majesty the Queen and Ronald Robertson and Roger Saunders, 2012 FCA 94, noting in paragraphs 41 and 42 that,

"The Crown has not suggested that the Appellants have attempted an artificial manipulation of the connecting factors in order to bring their fishing income within the exemption from tax provided by section 87. The various connections between the Reserve and the Appellants' income from fishing are indisputably bona fide and not motivated by tax avoidance considerations. This was also the situation in Bastien (see para. 62).

However, in order to avoid potentially abusive or artificial manipulation of the connecting factors in other cases, a degree of flexibility must be maintained in the selection and weighing of the connecting factors, and in the emphasis given to those that provide a substantive basis for situating property on a reserve."

Consequently, in determining whether Guideline 2 will apply, weight will only be given to the employer being resident on reserve where the employer is in fact resident on reserve and there is clear nexus with the reserve, that is, it is not simply a manipulation of the connecting factors test or the Guidelines. It is not clear in the situation you have described whether the employer would in fact be resident on the reserve or has a clear nexus to the reserve. Whether the employer or the employee is resident on a reserve is a question of fact to be determined after a review of the relevant facts.

We trust that these comments will be of assistance.

Yours truly,

Roger Filion, CPA, CA
Manager
Non-Profit Organizations and Aboriginal Issues
Financial Industries Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch