16 July 1996 Internal T.I. 9613507 - NATURE OF AMOUNTS RECEIVED BY SHAREHOLDER-EMPLOYEE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether an amount paid to an employee-shareholder and initially characterized as salary can be recharacterized at year end as a shareholder's loan repayment.

Position:

No, unless it can be shown to be correcting an inaccuracy in the books and records.

Reasons:

The characterization of a payment is a question of fact and should reflect the intent of the parties at the time of the payment.

			July 16, 1996
Montreal Taxation Services Office	J. A. Szeszycki
	Revenue Collections	(613) 957-2135
	Robert Miron - Coordinator
			961350

XXXXXXXXXX
Nature of Amounts Received by Employee-Shareholder

This is in reply to your enquiry of April 3, 1996 in which you asked for our assistance in responding to a submission (dated April 2) made by XXXXXXXXXX involving payments made by XXXXXXXXXX an employee-shareholder. We regret the delay encountered in providing a reply.

Facts

The facts, as we understand them, are that XXXXXXXXXX The amounts were recorded on the books of the corporate employer as payments on account of salary. The payments were made on a periodic basis and amounts were withheld at source, amounts that, presumably, were required to be withheld under paragraph 153(1)(a) of the Income Tax Act (the "Act") and section 102 of the Income Tax Regulations. XXXXXXXXXX the accounting for the payments was changed to delete the payments on account of salary and establish, in its place, that the amounts were paid on account of the outstanding shareholder loan.

Taxpayer's Submission

It is the taxpayer's view, as expressed in XXXXXXXXXX submission, that the taxable income of a taxpayer is not determined until the end of the taxation year and, as a result, it is the characterization of the payments at the end of the taxation year that counts in the determination of taxable income and tax payable. It is argued that XXXXXXXXXX effectively reimbursed the amount paid to him as salary and was then paid an amount on account of the loan.

Our Comments

It is our view that the nature of a transaction is a question of fact. The characterization of a payment should reflect its intent at the time the payment was made, as that intent is understood by both parties at that time. It is not something that is determined at the end of the year. All relevant documents, including loan agreements, employment agreements, shareholder minutes of meetings and other books and records should be examined in order to make the proper characterization. If the books of the company, as indicated in the facts set out above, record the payments as salary (with appropriate withholdings for income tax and other employment deductions) at the time they were being made, that would constitute strong evidence of the intent at that time. XXXXXXXXXX It is one thing to correct an inaccuracy and quite another to rewrite history.

In the case cited by XXXXXXXXXX, the Queen v. Lageaux & Frères 74 DTC 6569, the court agreed with the Minister's assessment of a transaction, which was given the appearance of a leasing transaction, as a sales transaction. The Minister had determined that even though the transaction had been presented, through the use of properly worded agreements, as a leasing transaction, the purchase rights granted the "lessee" effectively made it a sale transaction and that such was clearly the taxpayer's intent from the beginning. We would contend that the case illustrates the principle that the first step in properly assessing a transaction is to determine its intent at the outset. In the case at hand, the intent at the time of the payments would be to fulfil a mutual agreement to provide a salary.

In the other case discussed in the submission, Rossman and Rosenberg v. M.N.R. 67 DTC 273, the substantive evidence presented to the court in the form of books and records, minutes of shareholder meetings, etc. which all pointed to the payments to the shareholder-employees as being on account of salary, placed the onus squarely on the taxpayer to refute the evidence. The court concluded that the amounts were paid as salary and "no process of accounting subsequently employed by the company's auditors could change the quality of income that had attached to the money that came into the appellants' hands."

Another argument that can be offered relates to the actual provision of services by XXXXXXXXXX It would be reasonable to assume that an individual employed as president of the company, and who provides services to the company in that capacity, would be compensated for those services in the form of a salary.

One would normally expect that an agreement would be in place, whether oral or written, before the year begins, that would set out the terms of annual compensation. This would be so regardless of whether the employee-shareholder also has a loan receivable or payable with that company. If, at the time they were made to the employee, the payments were made pursuant to the terms of such an agreement, then it would not be in order to change the characterization of the payments to something else. As well, in changing the characterization of the payment to a loan repayment, it means that the employee was not compensated for services rendered in his capacity as the president of the company. Such a result does not seem reasonable and an explanation would be in order to establish that as being the intent.

In addition, if an employee is in receipt of amounts that are properly characterized as salary and required to be included in income under section 5 of the Act, paragraph 8(1)(n) of the Act permits the deduction of a reimbursement of salary only in circumstances where the payment of the amount by the employer was in respect of a period throughout which the taxpayer did not perform the duties of the employment. On the assumption that XXXXXXXXXX performed his duties as president of XXXXXXXXXX throughout the year, a deduction under paragraph 8(1)(n) of the Act would not, in our view, be available to him.

We trust that our comments will assist you in responding to the taxpayer's representatives.

John F. Oulton
Section Chief
Business, Property & Personal Section
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

c.c. Claude Bergevin

Policy & Technical Services Section
Trust Accounts Division