5 July 2011 External T.I. 2010-0376541E5 - Indian Act Exemption

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: 1. Interaction between documents 2000-002453 and 2004-007417. 2. Does the CRA policy with respect to owner/operator corporations apply to Indians? 3. Would the Guidelines apply to a bonus received by an Indian owner/operator?

Position: 1. See discussion. 2. In many cases, yes. 3. See discussion.

Reasons: 1. See discussion. 2. Depends on the facts. 3. See discussion

XXXXXXXXXX 			2010-037654
				L. Zannese
				(613) 957-2747
July 5, 2011

Dear XXXXXXXXXX :

Re: Indian Act Exemption for Employment Income Guidelines

This is in response to your letter of July 26, 2010, in which you enclosed a copy of a letter your firm sent to Indian and Northern Affairs Canada ("INAC"), as well as a copy of the response received from that Department. We understand that you seek our comments regarding your initial letter to INAC (the "Letter"). In our response, below, references to "you" are references to your firm or to XXXXXXXXXX of your firm who signed the Letter.

In the Letter you expressed the view that the Canada Revenue Agency (the "CRA") is providing conflicting information with respect to the application of the Indian Act Exemption for Employment Income Guidelines (the "Guidelines") to Indians (as defined in section 2 of the Indian Act) who are owner-operators of a corporation. Specifically, you suggested that the CRA has been unfairly denying Indian owner-operators the application of CRA's policy with respect to payments made to owner-operators by their wholly-owned Canadian-controlled private corporations ("CCPCs"), often referred to as CRA's "bonusing down" policy.

Prior CRA Interpretations

Your Letter referred to two interpretations provided by the Income Tax Rulings Directorate regarding amounts paid to owner-operators; in your view, these interpretations are inconsistent. Document 2000-002453 sets out the position that bonuses are considered to be employment income for purposes of the Income Tax Act (the "Act"), and suggests that the Guidelines could, therefore, apply to the receipt of such bonuses. Document 2004-007417 specifically comments that the Guidelines do not apply where a bonus is paid to an Indian owner-operator by his or her corporation to reduce the corporation's income either to nil or to the small business deduction limit.

After reviewing both documents, it is our view that the positions contained in the documents are not inconsistent. Document 2000-002453 states that "... the guidelines apply to bonuses in the same way they apply to salary and wages." Document 2004-007417 expressly precludes the application of the Guidelines where bonuses are paid to Indian owner-operators to reduce the income of a corporation; however, this exception relates to the nature of the employment situation and not to the nature of the bonus as employment income. As discussed in more detail below, while the Guidelines may generally apply to bonuses, the Guidelines do not apply in all employment situations.

With respect to the deductibility of bonuses, document 2000-002453 expresses the view that although normally the CRA will not review the reasonableness of bonuses paid by a CCPC to an owner-operator, this policy does not apply to all cases. The document specifically states that a bonus paid by a corporation to an Indian owner-operator which is exempt from tax under section 87 of the Indian Act may be reviewed to determine whether the amount paid was reasonable. Whether the amount paid is found to be reasonable is a question of fact in each particular case. The CRA's policy with respect to payments made to owner-operators is discussed below in more detail. Document 2004-007417 does not discuss the application of the bonusing down policy, although the document does discuss the taxation of bonuses paid to Indian owner-operators.

Reasonableness of Payments to Owner-Operators

As you mentioned in your Letter, the CRA has a long-standing policy that allows a CCPC to "bonus" or "pay down" all or part of its income to its owner-operator, without the CRA questioning the reasonableness of the bonus or fees paid. This policy relates specifically to the deduction of the expense to the corporation, rather than the taxation of the amount in the hands of the recipient, and only applies if certain conditions are met. The conditions include:

• the payments must be made to an individual owner-operator of the corporation;
• the owner-operator must have been actively involved in the business; and
• the income paid must be a result of ordinary business operations.

As discussed in document 2000-002453, this policy was adopted in large part to address situations where "...the overall tax effect did not vary significantly whether corporate profits were drawn out as dividends or as employment income." The policy was also based on the assumption that there would be little difference in overall tax effect between retaining the income in the corporation and paying the income out to the owner-operator. Situations where these assumptions are invalid are generally described as having "inappropriate tax consequences", and the policy does not apply.

In your Letter, you referred to various situations where the CRA has explicitly stated that the bonusing down policy does not apply. You suggested that because the Indian Act exemption situation has not been expressly excluded in the past, it is reasonable to assume that the policy applies to such situations. In our view, it was expressly indicated in document 2000-002453, referred to in your Letter, that the bonusing down policy did not apply to situations involving the Indian Act exemption; document 2000-002453 specifically stated that reasonableness should be reviewed in the situation described. Moreover, we do not agree that the examples given to date by the CRA as excluded situations form an exhaustive list.

In any event, it is important to note that even where the bonusing down policy does not apply, the CRA is merely reserving the option of examining whether an amount paid to an owner-operator is reasonable. The fact that the policy does not apply in a particular situation does not preclude a corporation from "bonusing down" in order to reduce or eliminate taxable income. In many cases, a large amount paid to an active owner-operator will be considered to be reasonable (i.e., wholly deductible), whether or not the recipient is tax-exempt; the determination will usually depend on the nature of the business and the owner-operator's involvement with the business. All of the relevant jurisprudence will be taken into account.

In conclusion, if an Indian owner-operator is in receipt of a bonus (or similar employment income) from his or her corporation, and the bonus is taxable (i.e., the Indian Act exemption does not apply to the amounts paid out to the individual), then the CRA's bonusing down policy will generally apply and the CRA will not review the reasonableness of the amount paid to the Indian owner-operator. However, if an amount paid to an Indian owner-operator is exempt or partially-exempt from tax, then the policy will not apply and the CRA may review the reasonableness of the amount. While the tax-exempt status of an owner-operator may affect whether the bonusing down policy applies, it is not a factor in determining whether an expense is reasonable. There is no difference between an Indian owner-operator and any other owner-operator in this regard.

The Guidelines

The Guidelines are an administrative tool adopted by the CRA in 1994 after consultations with Indian organizations. The Guidelines were 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 determination that can only be made by the CRA's Compliance Programs Branch. Generally, the views of the CRA with respect to owner-operator situations are reflected in document 2004-007417.

We hope that these comments are of assistance.

Yours truly,

Eliza Erskine
Manager
Non-Profit Organizations and Aboriginal Issues Section
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch