28 April 1993 Internal T.I. 9301657 F - Franchise Royalty Income - Active Business

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.

XXXXXXXXXX

Rulings Directorate

Attention:  XXXXXXXXXX

Eligibility of Royalty Income for Small Business Deduction

We are writing to you in reply to your facsimile memorandum dated January 12, 1993 (received January 21, 1993) in which you requested our opinion as to whether a taxpayer's royalty income would qualify as income from an active business for purposes of the small business deduction.

Facts

XXXXXXXXXX

XXXXXXXXXX

Your Opinion

It is your opinion that the business of XXXXXXXXXX should be classified as a specified investment business within the meaning of paragraph 125(7)(e) of the Income Tax Act, thereby denying XXXXXXXXXX the small business deduction.

You referred us to a previous opinion letter identified as E51734 and queried whether XXXXXXXXXX acquisition of the right to sell franchises would be considered to constitute "originating property". If so,XXXXXXXXXX income could be viewed as income from an active business.

You also pointed out that there would be a short-term reduction in income tax payable if the Department were to deny the small business deduction, since a refundable dividend tax on hand pool would be created forXXXXXXXXXX

Representative's Opinion

In a letter to you dated January 6, 1993, XXXXXXXXXX stated that, with respect to the lump-sum payments, XXXXXXXXXX provides to the licensees various management and administrative services which he described briefly. He stated his opinion that the lump-sum payments represented active business income.

With respect to the ongoing royalty payments, he stated that XXXXXXXXXX provides various types of managerial and administrative assistance although he did not describe these. He also pointed out that various duties are imposed on XXXXXXXXXX including such matters as collecting monthly fees, periodically inspecting franchisees' premises, and undergoing training. The representative argued that only a portion of the recurring fees represent a royalty payment, since the principal purpose is to earn income from the provision of management and supervisory assistance.

Our Comments:

The determination as to whether a particular activity constitutes an active business, or pertains to or is incident to an active business, is a question of fact which cannot be made until all of the relevant facts are known and reviewed. Unfortunately, there are few details available on which to base an opinion. For instance, there are no details concerning the number of employees except that there are fewer than five full-time employees. Also, nothing is known of the employees' expertise and the actual services which they provide. It could also be relevant if XXXXXXXXXX were to provide significant management services to persons other than franchisees.

Although the representative has discussed the two phases of XXXXXXXXXX business separately, it is apparent that there is only one business, which could be described as the selling and overseeing of franchises.

It is apparent that the selling of franchises is part of XXXXXXXXXX business, and thus the proceeds from those sales is properly included in its determination of income. Income from this source would be business income rather than income from property. With respect to the ongoing service provided to franchisees in return for monthly royalties, it is a question of fact as to whether this income source is from property or whether it is from a business.

If it were determined that the monthly royalties constitute income derived from property, it would still be necessary to determine the principal purpose of XXXXXXXXXX business since, according to the definition of specified investment business in paragraph 125(7)(e) of the Act, one must consider the principal purpose of the business as a whole. As stated in paragraph 13 of IT-73R4, the principal purpose of a corporation's business must be determined annually after all the facts relating to that business carried on by that corporation in that year have been considered and analyzed. Included in this evaluation should be such things as:

(a)     the purpose for which the business was originally commenced;

(b)     the history and evolution of its operations, including changes in its mode of operation and purpose of existence; and

(c)     the manner in which the business is conducted.

The phrase "principal purpose" is not defined in the Act and therefore must be given its usual meaning with the result that this determination can only be made on the basis of all the relevant facts of a particular situation. As noted in paragraph 2 of Interpretation Bulletin IT-290 the word "principal" is considered synonymous with the words "chief" and "main", however for the purposes of paragraph 125(7)(e) it is the principal purpose of the business which must be considered rather than the "principal business" as discussed in IT-290. Since it is a "purpose" test which is involved in this provision, all the relevant factors concerning the income earning process of a particular situation would have to be considered to determine whether or not the income derived constitutes income from property; i.e. the sources of XXXXXXXXXX revenue would not necessarily be the only relevant factor in determining whether or not the revenue would constitute income from property. Some other factors, to note a few, would be the amount and type of work required in each phase, reasonable projections regarding the number of franchises which XXXXXXXXXX can expect to sell each year, and projections of profit from each of its two phases.

The definition of specified investment business in the Act contemplates that there may be significant work required to earn property income.

For example, the corporation may employ up to five full-time employees, providing services involving, for instance, the collection of rents, the pursuance of unpaid rents, the inspection of premises, and the provision of maintenance and repair services. Thus the fact alone that there may be substantial work involved is insufficient grounds to determine the business to be an active business rather than a business which earns income from property. It is important to review the franchise agreement in order to determine what service is to be provided in return for the monthly royalties. It is also important to review the services actually provided to ensure that they conform to the agreement. If no significant service is required or provided, this would indicate that the monthly royalties are income from property. On the other hand, the provision of significant service would indicate that XXXXXXXXXX is carrying on a business.

Regarding the issue as to whether XXXXXXXXXX acquisition of the right to sell franchises would be considered to constitute "originating property", we note that this phrase was used in paragraph 11 of IT-73R3 (it is not mentioned in IT-73R4). An example of this situation would be where a corporation designs computer software and then releases it to the public via licences. The licence fees could pertain to the corporation's research and manufacturing business and thereby be considered to be earned as active business income. Another example would be where a soft drink company develops a new product, creates a trade-mark for the product and develops public demand for the product, then licences other persons to manufacture and sell the product under that trade-name. The licence fees could pertain to the company's active business of manufacturing and marketing. By way of contrast, we note that XXXXXXXXXX has merely purchased the right to sell franchises so it would not be viewed as originating the property which it franchises.

In conclusion, it is apparent that XXXXXXXXXX is carrying on one business. The sale of the franchises would be regarded as business income (however if XXXXXXXXXX is found to be carrying on a specified investment business, none of its income from that source would be income from an active business), while the ongoing generation of royalty income from the franchises may yield property income or business income, depending on the facts. Whether the business is a specified investment business depends on the principal purpose of the business as a whole i.e. whether the principal purpose is to derive income from property or to derive income from business. We are not in a position to be able to make that determination.

We trust that our comments are of assistance.

E. Wheeler for DirectorBusiness and General DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch