26 May 1998 External T.I. 9805745 - SALARY / BONUS - REASONABLENESS

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:

Reasonableness of bonuses paid to shareholders / employees

Position:

As stated in question 42 of the 1981 Round Table (as clarified in Insights into the 1991 Revenue Canada Round Table Discussion), the Department will not challenge the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation’s business and the corporation has either established 1) a practice of distributing profits to such employee/shareholder in this manner, or 2) 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.

The position does not extend to remuneration paid to spouses or other family members of the principal shareholder or to principal shareholders that are non-residents.

Reasons:

Position adopted for administrative ease and because overall tax effect does not vary significantly whether corporate profits are drawn out as salaries or as dividends.
		980574
XXXXXXXXXX 	N. Mondou, M.Fisc.
(613) 957-8961

Attention:  XXXXXXXXXX 

May 26, 1998

Dear Sir:

Re: Bonus Out of Rental Income

This is in reply to your letter dated March 3, 1998, in which you requested that we clarify our position with respect to the reasonableness of bonuses paid out of rental income.

The first example you provide is the situation of a taxpayer who owns all the outstanding shares of a holding corporation, which is the sole shareholder of a corporation that carries on an active business. In your example, the holding corporation earns rental income from the operating corporation. Because the two corporations are associated, the rental income is deemed to be active business income under the provisions of the Income Tax Act (the “Act”). The holding corporation intends to pay a large bonus to its sole shareholder to reduce its active business income to $200,000.

In your second example, you clarified in a telephone conversation (XXXXXXXXXX/Mondou) that the taxpayer’s spouse would own 40% of the shares of the holding corporation whereas the taxpayer would own the remaining 60%. The taxpayer would be the sole shareholder of the operating corporation. As a result, the corporations would also be associated. The bonuses paid by the holding corporation to each shareholder would be determined on the basis of their respective interest in the company. You also indicated that the taxpayer’s spouse would not be active in the company.

Our comments

The facts you set out are quite specific and appear to relate to a particular contemplated transaction. Assurance as to the tax consequences of contemplated transactions can only be given in response to a request for an advance income tax ruling. The procedure for requesting an advance income tax ruling is outlined in Information Circular 70-6R3, published by Revenue Canada on December 30, 1996.

However, rulings are rarely given on questions of fact except where all the facts and other pertinent information can be obtained and those facts and information are expected to prevail. Moreover, the reasonableness of a salary or bonus is a question of fact which can only be determined by a thorough review of the circumstances of each particular situation. However, we offer the following general comments.

In a panel discussion titled “Insights into the 1991 Revenue Canada Round Table Discussion” which was held as part of the Bottom Line Trade Show in Toronto on July 29, 1992, the Department stated that it has a long standing practice not to challenge the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation’s business and the corporation has either established 1) a practice of distributing profits to such employee/shareholder in this manner, or 2) 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.

This general administrative position was first stated in reply to question 42 of the 1981 Canadian Tax Foundation Conference Round Table. The 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, in the panel discussion mentioned above, the Department clarified that it is not prepared to extend this position to bonuses paid out of a corporation’s investment income or to inter-corporate management fees since to do so could lead to inappropriate tax planning. Investment income that is deemed active business income under the Act will be treated as active business income for the purpose of this administrative position.

The position does not extend to remuneration paid to spouses or other family members of the principal shareholder or to principal shareholders who are non-residents. In such cases, the Department reserves the right to require evidence that the remuneration is reasonable in the circumstances.

Finally, bonuses should relate to the expertise, skills and services provided to the corporation and should not be determined on the basis of each shareholder’s holdings in the company. Where the shareholders/employees do not render any services to the corporation, it is our view that the deduction would not be allowable.

We trust that these comments are of assistance.

Yours truly,

P. Spice
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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