6 October 1989 Ministerial Letter 58668 F - Association Rules and Control

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.

October 6, 1989

Dear Sirs:

Re:  Section 256 of the Income Tax Act (the "Act")

We are writing in response to your letter of September 9, 1989 wherein you requested our opinion on the application of section 256 of the Act to the following hypothetical situation.

1.     A owns a service corporation ("A Corp") which has more than 10 employees and which uses other individuals on a subcontract basis.

2.     B is a subcontractor who is not prepared to enter into a contract of employment with A Corp.

3.     A Corp and B would incorporate a corporation ("AB Corp").  A Corp would have up to 50% of the voting, participating common shares of AB Corp.  The remaining common shares would be held by B.

4.     In addition to the common shares authorized by AB Corp, there would be two classes of special shares, Class A and Class B.

5.     Class A special shares would be issued to A Corp and Class B special shares would be issued to B.

6.     B would provide his personal services to AB Corp and A Corp would provide, as required, capital, equipment, management, office space and possibly (occasionally) labour to assist in the provision of services to the customers of AB Corp.

7.     Both classes of special shares of AB Corp would have the same limited entitlement to dividends.  The dividend entitlement would be the equivalent of a fixed percentage of after-tax operating profits (up to 50%).  This entitlement would be decreased by a percentage of remuneration for services taken by the shareholder.

8.     No fees would be paid to a shareholder other than those that would be reasonable in respect of services provided by that shareholder.

9.     Since it is likely that B would exercise his option to take at least a portion of his return on investment as remuneration for services actually provided, the dividends paid on Class A special shares would likely exceed those paid on class B special shares.

You requested our opinion as to whether the differential in dividends would result in the conclusion that Class A special shares would be worth more than Class B special shares with the result that A Corp would be deemed to control AB Corp pursuant to subparagraph 256(l.2)(c)(i) of the Act for the purposes of subsections 256(1) to (5) of the Act.  You also requested our view on whether, if A Corp were to permit former employees to incorporate AX Corp and operate in a similar manner to B, the former relationship of A Corp as employer would create an irrefutable presumption that A Corp controlled AX Corp as a result of the application of subsection 256(5.1) of the Act. Finally, you wondered, if our view on the second issue were in the affirmative, whether our response would be different if A Corp entered into a licensing agreement with AX Corp.

The situation outlined in your letter appears to involve actual contemplated transactions and identifiable taxpayers.  Assurance as to the tax consequences of contemplated transactions can only be given in the context of an advance income tax ruling.  The procedures for requesting an advance income tax ruling are outlined in Information Circular 70-6R, dated December 18, 1978, and the Special Release thereto.  However, we can offer the following general comments.

Whether the Class A special shares of AB Corp would be worth more "than the Class B special shares is an issue of valuation. As a general practice, the Department is not prepared to either express an opinion or give a ruling on such an issue as indicated in paragraph 14(h) of the above mentioned Information Circular.

We would like to point out that the arrangement described in your letter would not appear to satisfy the criteria set out in the Department's response to Question 42 at the Revenue Canada Round Table at the 1981 Canadian Tax Foundation Conference.  The Department made the following comments, which are still applicable to date, on this issue:

     "...Subject to the bounds of reasonableness with respect to both the level of salary and bonus for services performed and the rate of return on investment in shares, the Department generally accepts that a principal shareholder-manager is entitled to determine a mix of salary and dividend that he considered appropriate.  Where there is more than one principal shareholder-manager, the creation of separate classes of shares solely to achieve flexibility would usually lead to a presumption of artificiality ..."

With respect to your second question it is our view that the incorporation of AX Corp to operate in a similar manner to AB Corp where AX Corp is owned 50% by A Corp and 50% by X, a former employee of A Corp, does not necessarily create an irrefutable presumption that A Corp had such a direct or indirect influence on AX Corp that, if exercised, would result in control in fact of AX Corp.  Whether A Corp has a direct or indirect influence on AX Corp such that subsection 256(5.1) of the Act would apply is a question of act which can only be determined by reference to all of the relevant facts and circumstances of a particular case.  In addition, it is also a question of fact whether A Corp and AX Corp are dealing with each other at arm's length.  Therefore, we are not able to express an opinion as to whether subsection 256(5.1) of the Act would apply to the second situation outlined above.

As our response to your second question is neither affirmative nor negative, we refrain from offering any comments on your third question.

The foregoing comments are not rulings and, in accordance with the aforementioned Information Circular, are not binding on the Department.

Yours truly,

for DirectorReorganizations and Non-Resident DivisionSpecialty Rulings DirectorateLegislative and IntergovernmentalAffairs Branch