9 May 1990 Income Tax Severed Letter RRRR376 - Deductibility of bonuses in a hypothetical situation

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.

xxxxx 5-9583
R.A. Primeau
(613) 957-2060

Attention xxxxx

May 9, 1990

Dear Sirs:

This is in reply to your letter of February 9, 1990. We apologize for the delay in our response.

You have asked for our views regarding the deductibility of bonuses in the following hypothetical situation.

An operating company is a wholly owned subsidiary of a holding company. Fifty percent of the common shares of the holding company are owned by employees of the operating company, and the other 50% of the common shares and all of the preference shares of the holding company are owned by a corporate investor.

Corporate      Opco
Investor       Employees
100%           50%       50%
pfd            com       com
sha            sha       sha
Holdco
100%
Opco

The operating company distributes half of its pre-tax pre-bonus income by way of bonuses to employees who are also shareholders of the holding company. The employees receiving the bonus all render services with respect to the day to day operations of the operating company. The aggregate of the bonuses paid by the operating company are divided proportionately among these employees based on their relative shareholdings in the holding company.

The operating company distributes all of its remaining income (after- tax and after-bonus) by way of a dividend to the holding company. The holding company in turn distributes its income, equal to the dividend received from the operating company, by way of a dividend on the preference shares to the corporate investor.

It is your view that, except for the interposition of a holding company, the hypothetical situation which you have given is the same as that described in Question 82 of the revenue Canada "Round Table Session" at the 1984 Canadian Tax Foundation Conference. It is your further view that implicit in the situation described in Question 82 was the fact that the bonus was allocated to the employees based on their relative shareholdings. As a result, it appears to you that, in the hypothetical situation which you have given, the bonus paid to the shareholder- employees should be deductible for tax purposes by the operating company.

Our Comments

We do not agree that the hypothetical situation which you have given is essentially the same as the one in the above-mentioned Round Table question, since in the latter the individuals (other than the inactive shareholder were employees and shareholders of the same corporation whereas in the former they are employees of one corporation and shareholders of another corporation. The issue in a question regarding the deductibility of bonuses is essentially the reasonableness of the bonuses, since any portion thereof which is not "reasonable in the circumstances" would be disallowed by section 67 of the Income Tax Act. This is a question of fact which must be determined for each particular actual case, based on a thorough review of all its relevant circumstances. Such a review is generally performed by the local District Taxation Office. We are therefore unable to confirm that the bonuses paid in the hypothetical situation which you have given would be deductible.

We can, however, provide you with the following general guidelines. A determination of the reasonableness of the amount of remuneration paid to any particular shareholder-employee or employee of a corporation requires consideration of the duties performed by the individual, as well as the time spent in carrying out those duties. Furthermore, where possible, comparisons should be made between the remuneration paid to the individual and the remuneration paid to employees who perform similar services for corporations of similar size and in similar businesses.

In accordance with the answer to the above-mentioned Question 82 of the 1984 Round Table Discussion, the Department will generally give recognition to a corporation's practice of distributing its profits to shareholder-employees or employees in the form of bonuses, or to a corporation's policy of recompensing its shareholder-managers for profits that are attributable to their special knowledge, skills, connections or other contributions. It would not be considered reasonable for a shareholder-employee or employee who provides services of relatively minor value or which have little or no impact on the amount of the corporation's profits to receive a large salary or bonus. Also, the reasonableness of a salary or bonus to a shareholder-employee or employee who is the spouse of, or a member of the immediate family of, another shareholder-employee or employee (especially of the principal shareholder-manager) would be subject to question where it is felt that income-splitting is involved.

Although we are unable to give you a definitive reply to your question, we trust that the above comments will be helpful.

Yours truly,

for Director
Business and General Division
Specialty Ruling Directorate
Legislative and Intergovernmental
Affairs Branch