26 June 1997 External T.I. 9600175 - DIVIDEND & BONUS PAID TO INDIAN SHAREHOLDER

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:

1. Whether dividends payable to an Indian living on reserve will be exempt from income tax.

2. Whether there is any limit as to the amount of bonus that can be paid by a corporation to its shareholder/employee.

Position:

1. No, not under the circumstances.

2. Yes -- as per section 67 of the Income Tax Act.

Reasons:

1. The dividends are to be paid out from the retained earnings of the corporation, and thus it is reasonable to consider where the corporation earns its income. The mere location of a corporation's administrative office on reserve is not sufficient to enable one to conclude that income arising from the corporation's business is connected to a reserve. Instead, what is more important is the location of the revenue-generating activities of the corporation that enables the corporation to earn income and pay dividends. The location of the corporation's clients is another significant factor.

2. The Department has had a long-standing general practice of not challenging the reasonableness of salaries or bonuses paid to a principal shareholder under certain conditions does not extend to various scenarios that could result in inappropriate tax consequences, such as where the shareholder is a non-resident. Where a shareholder/employee lives on reserve and is, by virtue of paragraph 87(1)(b) of the Indian Act, exempt from tax on employment income from a corporation based on reserve, it would be a question of fact as to whether section 67 of the Income Tax Act would apply to limit the amount which the corporation could deduct for bonuses in computing its income.

	                            		960017
XXXXXXXXXX		                                J.D. Brooks

June 26, 1997

Dear XXXXXXXXXX:

Re: Indian Act Exemption

This letter is in reply to your letter of December 21, 1995 in which you requested our opinion concerning the application of the Indian Act to a hypothetical situation which is restated here more generally. We apologize for the delay in replying.

A corporation is situated off reserve and has been operating off reserve for some time, generating retained earnings. The corporation's revenue-generating activity takes place off reserve and its customers are located off reserve. An Indian who lives on a reserve purchases all of the outstanding shares of the corporation and moves the corporation's administrative office to the reserve. You query the tax consequences of the corporation distributing its retained earnings as dividends to the new shareholder. You also query whether the corporation could, in future years, pay out all of its annual net income in the form of a bonus to its new shareholder on a tax-exempt basis.

Our Comments

The situation you described appears to involve specific taxpayers and specific contemplated transactions. As explained in Information Circular 70-6R3 dated December 30, 1996, assurance as to the tax consequences of proposed transactions is provided by the Rulings Directorate but only on an advance income tax rulings basis and only with respect to the taxpayers identified in such rulings. Although we are unable to provide any opinion in respect of the specific case you have described, we have set out below some comments of a general nature.

Dividend income is an income stream from the shares owned by the taxpayer, and such income will be exempt to the recipient if it is earned on a reserve. In Interpretation Bulletin IT-62 (Indians), which is now cancelled, it was stated that dividends on shares from a company whose head office, principal business activity and share register were on a reserve would normally be considered to be earned on the reserve. Thus, where the company's principal business activity was carried out off reserve, it was the Department's view that dividends from that company would be taxable in the hands of the recipient. The Supreme Court of Canada considered, in the Williams case (92 DTC 6320; (1992) 1 CTC 225), the issue as to where income is earned. Although that case concerned unemployment insurance benefits, the general application of the case is that one needs to consider the factors that serve to connect income to a location that is either on or off reserve. Following the decision in the recent Recalma case (1996 DTC 1520; (1996) 3 CTC 2272) which concerned investment income, the connecting factors pointing to the location of shares are not to be given as much weight as other, more significant factors. Similarly, the mere location of a corporation's administrative office on reserve would not be sufficient to enable one to conclude that income arising from the corporation's business is connected to a reserve. Instead, what is more important is the location of the revenue-generating activities of the corporation that enables the corporation to earn income and pay dividends. The location of the corporation's clients is another significant factor. It was also pointed out in Williams that the purpose of the Indian Act is not to provide an economic advantage to Indians conducting business in the commercial mainstream.

In the hypothetical situation described above, it is our view that the dividend income received by the new shareholder would be subject to tax since the corporation's income has been earned off reserve in the commercial mainstream. This is the same conclusion that would have been reached based on the comments in IT-62.

As to the payment of bonuses by corporations, the Department has had a long-standing practice of not challenging the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation's business where the corporation has established either a practice of distributing profits to such shareholder/employee in this manner or a policy of declaring bonuses to shareholders to remunerate them for the profits the corporation has earned that, in fact, are attributable to special know-how or skills of the shareholder/employee. This position was adopted largely for administrative ease and because the overall tax effect did not vary significantly whether the corporate profits were drawn out as salaries or as dividends. However, as stated at the 1991 Canadian Tax Conference Round Table, that practice does not extend to various scenarios that could result in inappropriate tax consequences. For instance, the practice does not apply to remuneration paid to spouses of the shareholder nor to shareholders who are non-residents. Where a shareholder/employee lives on reserve and is, by virtue of paragraph 87(1)(b) of the Indian Act, exempt from tax on employment income from a corporation based on reserve, it would be a question of fact as to whether section 67 of the Income Tax Act would apply to limit the amount which the corporation could deduct for bonuses in computing its income. Section 67 denies the deduction in respect of an expense that is otherwise deductible, except to the extent that the expense was reasonable in the circumstances.

We trust that our comments will be of assistance to you.

Yours truly,

R. Albert
for Director
Business and Publications Division
Income Tax Rulings and Interpretations Directorate
Policy and Legislation Branch