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 creation of an associated corporation could be used to convert specified investment business income into active business income.
Position: No.
Reasons: We would apply Section 67 to the inter-company management fees. We would also consider applying GAAR.
Charles Rafuse
XXXXXXXXXX (613) 957-8967
2005-014600
October 3, 2005
Dear XXXXXXXXXX:
Re: Specified Investment Business, Active Business Income
We are writing in response to your letter of August 8, 2005, concerning an interpretation of the application of the Income Tax Act (the "Act") in a proposed scenario.
Specifically, you have indicated that the current structure is:
1. Aco is a corporation wholly owned by Mr. A.
2. Aco is in the business of lending money and earns interest income on mortgages to various non-arm's length parties.
3. Aco is a specified investment business as defined in the Act.
4. Mr. A manages Aco's mortgage portfolio and receives a salary from Aco.
5. Mr. A annual salary from Aco equals the annual profit in Aco thereby leaving no income in Aco for each taxation year.
The proposed scenario is as follows:
1. Mr. A will incorporate a new company Bco through which he will provide the management services to Aco.
2. Mr. A will be the sole employee of Bco.
3. Bco will be wholly owned by Mr. A.
4. Mr. A will roll his shares of Aco into Bco after which Aco will be wholly owned by Bco and the corporations will be associated corporations as defined by the Act.
5. Mr. A will no longer receive a salary from Aco. Instead Aco will pay a management fee to Bco calculated on the same basis of the previous salary paid to Mr. A.
6. Bco will have no other source of income other than the management fees from Aco.
7. Bco will not be a personal services business because of paragraph (d) of the definition in Section 125(7) of the Act.
You have asked the following questions:
1. Will the management fees earned by Bco be classified as active business income?
2. Will Bco be entitled to claim the small business deduction?
3. Would the General Anti-avoidance Rules (GAAR) apply to this transaction?
4. Would the answers be different if the management fee was less than the annual profit of Aco?
5. Would the answers be different if the rollover did not take place but instead Aco and Bco were sister corporations both wholly owned by Mr.A?
6. Would the answers be different if Bco received part of the payment from Aco as management fees and part as finding fees for arranging mortgages?
7. Is GST payable on any mortgage finding fees paid by Aco to Bco?
An "active business carried on by a corporation", as defined in subsection 125(7) of the Act, means any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade. A "personal services business" as defined in subsection 125(7) does not include a business of providing services where the amount paid or payable to the corporation in the year for the services is received or receivable by it from a corporation with which it was associated in the year. Accordingly, it is our opinion that Bco would not be a personal services business and would be therefore carrying on an active business.
A reasonable management fee paid by Aco to Bco would be considered to be active business income and Bco would be able to claim the related small business deduction. However, as explained at the Canadian Tax Foundation's Annual Conference of 2001 and confirmed in Income Tax Technical News Issue No. 30, the Canada Revenue Agency reserves the right to challenge the reasonableness of any inter-corporate management fees under Section 67 of the Act. We would consider it inappropriate for Aco to pay Bco a management fee that included amounts earned from the capital employed by Aco in its mortgage business. Accordingly, it is our view that a reasonable management fee should not exceed the income that Aco earned in a taxation year that was in excess of that which would have been earned where its mortgage capital was employed without the benefit of Mr. A's active management.
The transactions that you have proposed would have the effect of converting the income of a specified investment business into active business income. Accordingly, we would also considering applying the GAAR provisions of the Act, however, it is more likely that we would apply section 67 as explained above.
Our opinion would not be changed where the rollover did not take place and there were two sister corporations with a management fees being paid or where Aco paid Bco a management fee and a mortgage finder's fee.
With respect to the application of the goods and services tax (GST) to services provided by Bco to Aco, we are only able to provide general comments without additional information about these services. Finding fees are generally consideration for a supply of a referral service. If this is the nature of the supply provided by Bco to Aco, GST would generally be payable on the finding fees. In addition, a supply of a management service is also taxable.
We trust this information is helpful.
Yours truly,
Charles Rafuse
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch
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