Owner-Manager Tax Planning 5 th Annual Tax Planning for the Wealthy Family

Transcription

1 Owner-Manager Tax Planning 5 th Annual Tax Planning for the Wealthy Family James A. Hutchinson Miller Thomson LLP jhutchinson@millerthomson.com Wednesday, September 9,

2 Overview 1. Personal and Corporate Income Tax Rates for Background on Owner-Manager Remuneration 3. Planning Considerations 4. Cases on Owner-Manager Remuneration 5. Technical Interpretations on Owner-Manager Remuneration 2

3 1. Personal and Corporate Income Tax Rates Rates for Individuals Highlights: Income & Capital Gains Decrease in highest marginal income tax rate in New Brunswick by 0.95% (and consequent decrease in capital gains rate by approx 0.48%) Decrease in Newfoundland & Labrador of 0.5% (and consequent decrease on capital gains rate by 0.25%) Eligible Dividends Decreases in Alberta (1.45%), New Brunswick (1.38%), Newfoundland & Labrador (5.22%), and Ontario (0.9%) Increase in British Columbia (1.45%) 3

4 1. Personal and Corporate Income Tax Rates 2009 (cont d) 2009 Rates for Individuals Highlights cont d: Non-Eligible Dividends Decreases in New Brunswick (1.19%), and Newfoundland & Labrador (0.62%) Further decrease by 2.7% in New Brunswick for 2010, to bring highest marginal income tax rate down to 43.3% (assuming no change in top federal rate) Increases in Alberta (1.25%), British Columbia (1.13%), Manitoba (0.81%), and Prince Edward Island (1.52%) 4

5 1. Personal and Corporate Income Tax Rates 2009 (cont d) Income & Interest Capital Gains Eligible Dividends Non-Eligible Dividends Federal 29.00% 29.00% 14.50% 14.50% 14.55% 14.55% 19.58% 19.58% Alberta 39.00% 39.00% 19.50% 19.50% 16.00% 14.55% 26.46% 27.71% British Columbia 43.70% 43.70% 21.85% 21.85% 18.47% 19.92% 31.58% 32.71% Manitoba 46.40% 46.40% 23.20% 23.20% 23.83% 23.83% 37.40% 38.21% New Brunswick 46.95% 46.00% 23.48% 23.00% 23.18% 21.80% 35.40% 34.21% Newfoundland & Labrador 45.00% 44.50% 22.50% 22.25% 28.11% 22.89% 33.33% 32.71% Northwest Territories 43.05% 43.05% 21.53% 21.53% 18.25% 18.25% 29.65% 29.65% Nova Scotia 48.25% 48.25% 24.13% 24.13% 28.35% 28.35% 33.06% 33.06% Nunavut 40.50% 40.50% 20.25% 20.25% 22.24% 22.24% 28.96% 28.96% Ontario 46.41% 46.41% 23.20% 23.20% 23.96% 23.06% 31.34% 31.34% Prince Edward Island 47.37% 47.37% 23.69% 23.69% 24.44% 24.44% 36.63% 38.15% Quebec 48.22% 48.22% 24.11% 24.11% 29.69% 29.69% 36.35% 36.35% Saskatchewan 44.00% 44.00% 22.00% 22.00% 20.35% 20.35% 30.83% 30.83% Yukon 42.40% 42.40% 21.20% 21.20% 17.23% 17.23% 30.49% 30.49% *rates current to June 9,

6 1. Personal and Corporate Income Tax Rates 2009 (cont d) 2009 Rates for CCPCs Highlights: Small Business Limit 2009 Federal budget increased small business limit from $400,000 to $500,000 Applies to qualifying active business income earned by CCPCs eligible for federal income tax rate of 11% Pro-rated for CCPCs whose taxation year does not coincide with calendar year In Manitoba, Nova Scotia and Yukon, small business limit remains $400,000 Enhanced investment tax credit of 35% for CCPCs on up to $3 million of eligible SR&ED expenditures available for up to $500,000 of taxable income (formerly $400,000) Completely phased out after $800,000 of taxable income (formerly $700,000) 6

7 1. Personal and Corporate Income Tax Rates 2009 (cont d) 2009 Rates for CCPCs Highlights cont d: Active Business Income > $500,000 Reduction in federal corporate tax rate on active business income exceeding $500,000 by 0.5% Caused decrease in combined federal and provincial rates in every province and territory Exception: Quebec, which raised its corporate tax rate by 0.5% Ontario to further reduce rate on active business income up to $500,000 by 1.0% Investment Income Decrease in rate on investment income by 1% in Manitoba and New Brunswick Increase in rate by 0.5% in Quebec 7

8 1. Personal and Corporate Income Tax Rates 2009 (cont d) up to $400,000 $400,000-$500,000 General Active Business Investment Income Federal 11.00% 11.00% n/a 11.00% 19.50% 19.00% 34.70% 34.70% Alberta 14.00% 14.00% n/a 21.0/14.0% 29.50% 29.00% 44.70% 44.70% British Columbia 15.5/14.5/13.5% 13.50% n/a 22.00% 31.5/30.5% 30.00% 46.7/45.7% 45.70% Manitoba 13.00% 12.00% n/a 24.0/23.0% 33.5/32.5% 32.0/31.0% 48.7/47.7% 47.7/46.7% New Brunswick 16.00% 16.00% n/a 16.00% 32.50% 32.0/31.0% 47.70% 47.7/46.7% Newfoundland & Labrador 16.00% 16.00% n/a 16.00% 33.50% 33.00% 48.70% 48.70% Northwest Territories 15.00% 15.00% n/a 15.00% 31.00% 30.50% 46.20% 46.20% Nova Scotia 16.00% 16.00% n/a 27.00% 35.50% 35.00% 50.70% 50.70% Nunavut 15.00% 15.00% n/a 15.00% 31.50% 31.00% 46.70% 46.70% Ontario 16.50% 16.50% n/a 16.50% 33.50% 33.00% 48.70% 48.70% Prince Edward Island 15.3/14.2% 14.2/13.1% n/a 14.2/13.1% 35.50% 35.00% 50.70% 50.70% Quebec 19.00% 19.00% n/a 22.9/19.0% 30.90% 30.90% 46.10% 46.60% Saskatchewan 15.50% 15.50% n/a 15.50% 32.5/31/5% 31.00% 47.7/46.7% 46.70% Yukon 15.00% 15.00% n/a 26.00% 34.50% 34.00% 49.70% 49.70% *rates current to June 9,

9 1. Personal and Corporate Income Tax Rates 2009 (cont d) 2009 Rates for General Corporations Highlights: Decrease in federal corporate tax rate on general active business income and investment income by 0.5% Quebec rate increase by 0.5% Ontario proposes further reductions in rates on general active business income and M&P to 10% by

10 1. Personal and Corporate Income Tax Rates 2009 (cont d) M&P General Active Investment Income Federal 19.50% 19.00% 19.50% 19.00% 19.50% 19.00% Alberta 29.50% 29.00% 29.50% 29.00% 29.50% 29.00% British Columbia 31.5/30.5% 30.00% 31.5/30.5% 30.00% 31.5/30.5% 30.00% Manitoba 33.5/32.5% 32.0/31.0% 33.5/32.5% 32.0/31.0% 33.5/32.5% 32.0/31.0% New Brunswick 32.50% 32.0/31.0% 32.50% 32.0/31.0% 32.50% 32.0/31.0% Newfoundland & Labrador 24.50% 24.00% 33.50% 33.00% 33.50% 33.00% Northwest Territories 31.00% 30.50% 31.00% 30.50% 31.00% 30.50% Nova Scotia 35.50% 35.00% 35.50% 35.00% 35.50% 35.00% Nunavut 31.50% 31.00% 31.50% 31.00% 31.50% 31.00% Ontario 31.50% 31.00% 33.50% 33.00% 33.50% 33.00% Prince Edward Island 35.50% 35.00% 35.50% 35.00% 35.50% 35.00% Quebec 30.90% 30.90% 30.90% 30.90% 30.90% 30.90% Saskatchewan 29.50% 29.00% 32.5/31.5% 31.00% 32.5/31.5% 31.00% Yukon 22.00% 21.50% 34.50% 34.00% 34.50% 34.00% *rates current to June 9,

11 2. Background on Owner-Manager Remuneration Overview: Para. 18(1)(a) of the ITA governs the deductibility of salaries, wages, remuneration In accordance with s. 67, salary or bonus paid must be reasonable in the circumstances Bonus/salary must be paid within 179 days of end of taxation year of corporation to be deductible May be reasonable if paid to spouse or children providing services to corporation, depending on circumstances 11

12 2. Background on Owner-Manager Remuneration (cont d) CRA Administrative Policy: Long-standing CRA policy[1] dating back to 1981 that it will not challenge the reasonableness of salaries and bonuses paid to principal shareholder-managers of a corporation where: 1. The corporation s general practice is to distribute profits to shareholder-managers in the form of bonuses or additional salaries; or 2. The corporation has adopted a policy of declaring bonuses to shareholders to remunerate them for profits earned by corporation attributable to know-how or entrepreneurial skills of shareholders [1] See Revenue Canada Round Table in the Report of the Proceedings of the Thirty-Third Tax Conference (Toronto: Canadian Tax Foundation, 1982), Q

13 2. Background on Owner-Manager Remuneration (cont d) CRA Administrative Policy cont d: Acceptable to pay bonuses in such circumstances, even if purpose of paying is to reduce active business income of the corporation to the small business limit On the other hand, bonuses to shareholders who are not principal shareholder-managers, and who do not provide services to corporation will not be considered reasonable (unless to remunerate for special expertise), and will be subject to reasonableness test In Information Circular IC 88-2 at para. 18, CRA stated that it would not apply GAAR in circumstances where CCPC has paid salary to shareholder-manager to reduce ABI to small business limit, so long as salary reasonable 13

14 2. Background on Owner-Manager Remuneration (cont d) CRA Administrative Policy cont d: CRA has been asked to elaborate on its position with respect to regular shareholders on numerous occasions[1] CRA has outlined criteria on reasonableness in Income Tax Technical News No. 22, dated January 11, 2002: 1. Salaries/bonuses paid to managers who are shareholders (either directly or indirectly) of a CCPC; 2. Shareholder-managers are Canadian residents; and 3. Shareholder-managers are actively involved in the day-to-day operations of the business and contribute to the incomeproducing activities from which remuneration is paid [1] See e.g. Revenue Canada Round Table in the Report of the Proceedings of the Thirty- Sixth Tax Conference (Toronto: Canadian Tax Foundation, 1985), Q. 82; Revenue Canada Round Table in the Report of the Proceedings of the Thirty-Seventh Tax Conference (Toronto: Canadian Tax Foundation, 1986), Q. 16; ; Revenue Canada Round Table in the Report of the Proceedings of the Forty-Second Tax Conference (Toronto: Canadian Tax Foundation, 1991), Q. 56; Revenue Canada Round Table in the Report of the Proceedings of the Forty-Fifth Tax Conference (Toronto: Canadian Tax Foundation, 1994), Q

15 2. Background on Owner-Manager Remuneration (cont d) CRA Administrative Policy cont d: Policy of not questioning reasonableness does not apply to: Inactive shareholders (Tech. Int I7); Non-residents (e.g. Tech. Int ); Inter-corporate management fees (Tech. Int ); Income of CCPC derived from management fees or dividends that have flowed through a complex corporate structure (Tech. Int I7) According to Income Tax Technical News No. 30, dated May 21, 2004, CRA s stated intent with respect to its policy is to: provide flexibility to a CCPC and its active shareholder/managers to take advantage of marginal tax rates by reducing the corporation s taxable income to or below the small business deduction limit through the payment of salaries and bonuses from income that is derived from normal business operations, and to provide certainty as to the taxable status of the transactions. 15

16 3. Planning Considerations Remuneration Strategies: Since introduction of eligible dividend regime, the optimal remuneration strategy has been a topic of interest for business professionals and their advisors No longer an automatic decision to bonus down to the small business limit Requires understanding of the concept of integration and consideration of what is most tax effective, given lower corporate tax rates and rates on eligible dividends Also requires consideration of a number of other factors that are not necessarily tax related 16

17 3. Planning Considerations (cont d) Example 1: Effect of Earning Active Business Income up to Small Business Limit and Paying Non-Eligible Dividend in Ontario 2009 Active business income of a CCPC Personal tax paid if income earned directly[1] Corporate tax on active business income up to $500,000[2] Tax deferral by leaving money in CCPC[3] Net cash if earned directly as individual Net cash if earned by CCPC and available to be paid as non-eligible dividend Personal tax paid on non-eligible dividend[4] Tax savings by paying corporate tax and tax on non-eligible dividend vs. earning income directly $100,000 ($46,410) ($16,500) $29,910 $53,590 $83,500 ($26,168.90) $3, [1] Based on the highest marginal income tax rate in Ontario of 46.41% [2] Based on combined federal and provincial corporate tax rate on business income up to $500,000 in Ontario of 16.5% [3] Based on the difference between the highest marginal income tax rate (46.41%) and corporate income tax rate (16.5%) [4] Based on non-eligible dividend tax rate of 31.34% in Ontario 17

18 3. Planning Considerations (cont d) Example 2: Effect of Earning Active Business Income up to Small Business Limit and Paying Eligible Dividend in Ontario 2009 Active business income of a CCPC Personal tax paid if income earned directly[1] Corporate tax on business income up to $500,000 small business limit[2] Tax deferral by leaving money in CCPC[3] Net cash if earned directly as individual Net cash if earned by CCPC available to be paid as eligible dividend Personal tax paid on eligible dividend[4] Tax savings by paying corporate tax and tax on eligible dividend vs. earning income directly $100,000 ($46,410) ($16,500) $29,910 $53,590 $83,500 ($19,255.10) $10, [1] Based on the highest marginal income tax rate in Ontario of 46.41% [2] Based on combined federal and provincial corporate tax rate on business income up to $500,000 in Ontario of 16.5% [3] Based on the difference between the highest marginal income tax rate (46.41%) and corporate income tax rate (16.5%) [4] Based on eligible dividend tax rate of 23.06% 18

19 3. Planning Considerations (cont d) Example 3: Effect of Earning Active Business Income in Excess of Small Business Limit and Paying Eligible Dividend in Ontario 2009 Active business income of a CCPC Personal tax paid if income earned directly[1] Corporate tax on active business income above the small business limit[2] Tax deferral by leaving money in CCPC[3] Net cash if earned directly as individual Net cash if earned by CCPC and available to be paid as eligible dividend Personal tax paid on eligible dividend[4] Tax cost of paying corporate tax and tax on eligible dividend vs. earning income directly $100,000 ($46,410) ($33,000) $13,410 $53,590 $67,000 ($15,450.20) ($2,040.20) [1] Based on the highest marginal income tax rate in Ontario of 46.41% [2] Based on combined federal and provincial corporate tax rate on active business income above the small business limit of 33% in Ontario [3] Based on the difference between the highest marginal income tax rate (46.41%) and corporate income tax rate (33%) [4] Based on eligible dividend tax rate of 23.06% in Ontario 19

20 3. Planning Considerations (cont d) Factors to Consider in Declaring Eligible Dividends: 45% gross-up, as opposed to 25%, for purposes of calculating the dividend tax credit ( DTC ) Enhanced DTC of %, as compared to 13.33% DTC currently calculated as 11/18 ths of 45% gross-up Reductions to gross-up and DTC rate from 2008 Federal Budget 10/17 ths of gross-up for 2010; 13/23 rds of gross-up for 2011; and 6/11 ths for 2012 and later years Can only be paid to extent there is a positive General Rate Income Pool (GRIP) balance at the end of a taxation year Need to determine current and future cash needs of individual Asset protection and creditor-proofing Ability to later claim the capital gains exemption (CGE) (now $750,000) and maintain CCPC status 20

21 3. Planning Considerations (cont d) Factors to Consider in Declaring Eligible Dividends cont d: In Ontario, rate on eligible dividends to go up to 26.57% in 2010, 28.19% in 2011 and 29.54% after 2011 (assuming top marginal income tax rate remains 46.41%) Makes 2009 an attractive year for declaring eligible dividends Rules for declaring an eligible dividend (i.e. dividend designation and written notice to all shareholders) GRIP calculated at the end of the taxation year; potential for making an excessive eligible dividend designation (defined in subsection 89(1), ITA) and incurring penalty tax under subsection 185.1(1) of the ITA But see subsection 185.1(2) of the ITA for making election in respect of excessive eligible dividend designation 21

22 3. Planning Considerations (cont d) Some Advantages of Paying Eligible Dividends: RDTOH recovery No source deductions for taxes, CPP, EI Employer Health Tax ( EHT ) may be avoided No reasonableness of remuneration test Reduces cumulative net investment losses (CNILs), and increases capital gains exemption ( CGE ) claim Creates safe income on hand Income-splitting opportunities 22

23 3. Planning Considerations (cont d) Some Disadvantages of Paying Eligible Dividends: Effect on child tax benefits Effect on amount of medical expenses that can be claimed Old Age Security (OAS) clawback if income too high Possible effect on spousal credit Do not create RRSP contribution room because not employment income No CPP or EI benefits for individual Payment of salaries (not bonuses) can form part of qualified expenditures for SR&ED 23

24 3. Planning Considerations (cont d) Income-Splitting: Before Parent Common Parentco Child A Child B Child C After Parent Fixed-value Pref. shares & New Common Shares Parentco Class A special Class B special Class C special Family Trust 24

25 3. Planning Considerations (cont d) Income-Splitting cont d: Issue of whether dividend sprinkling shares acceptable i.e. whether separate classes of certain types of shares with same attributes on which dividends declared and paid separately acceptable Done in order to retain flexibility with respect to payment of dividends to different shareholders Potential solution to create separate classes of shares that are similar in most regards, but have nominal differences e.g. alterations in voting rights e.g. different rights upon liquidation 25

26 3. Planning Considerations (cont d) Income-Splitting cont d: CRA administrative policy dating back to 1995 that separate classes of shares may exist when shares are identical in all respects (e.g. Class A special, Class B special and Class C special with same attributes, save for name), depending on the applicable corporate legislation See 1995 APFF Round Table, Question 33 (CRA Document No ) Case law interpreting whether subsection 56(2) of the ITA (indirect payment provision) would apply to such dividends: Champ v. The Queen, 83 DTC 5029 (FCTD): terms and conditions of shares did not permit directors to declare and pay dividends selectively McClurg v. MNR, 91 DTC 5001 (SCC): terms and conditions of shares expressly provided that certain classes could receive dividends to the exclusion of others, and other bases for distinguishing classes of shares; sufficient to rebut presumption of equality Neuman v. Canada, [1998] 3 C.T.C. 177 (SCC): 56(2) does not apply to dividends in family income-splitting situation; a shareholder need not contribute services to the corporation to be entitled to a dividend; profits belong to corporation as retained earnings. 26

27 3. Planning Considerations (cont d) Income-Splitting cont d: Subsection 22(7) added to the OBCA providing for two or more classes of shares, or two or more series within a class of shares, having identical rights, privileges, restrictions and conditions To eliminate need to create such artificial distinctions CRA response was that amendment to OBCA appears to sanction the creation of separate classes that each have the same rights, privileges, restrictions and conditions, including right to have dividends declared on one particular class to exclusion of others However, CRA stated that it depends on facts and circumstances of each case and dividend entitlements of shares as set out in articles of incorporation OBCA amendment should not alter the decision in Champ, where dividends declared on one class of shares even though other classes entitled to dividends See e.g. CRA Round Table, 2007 STEP National Conference, Q

28 3. Planning Considerations (cont d) Trust Residence: Generally, trust considered to be resident of province in which the majority of trustees who exercise management and control reside Thibodeau Family Trust v. The Queen, 78 DTC 6376 (FCTD) the leading case on trust residence Other factors to determine trust residence, such as location where legal rights with respect to trust assets are enforceable CRA administrative position that trust residence a question of fact; trustee will generally be found to exercise management and control where trustee has number of powers, such as: responsibility for management of business of trust, investment portfolio, banking and financing, control over trust assets etc. See e.g. CRA Interpretation Bulletin IT-447, Residence of a Trust Overall income tax rate payable by Canadian trust varies from province to province, depending on residence of trust Incentive to establish trust resident in Alberta because it has the lowest income tax rate on regular income and interest i.e. 39% However, recent indications that CRA has created an audit team to look at the issue of trust residence 28

29 3. Planning Considerations (cont d) Incorporating a Professional: Option for lawyers, doctors, engineers, architects and accountants carrying on business of professional practice Must not be precluded by provincial legislation governing relevant professional body CCPC carrying on professional practice may qualify for small business deduction, assuming certain conditions met See CRA Interpretation Bulletin IT-189R2, Corporations Used by Practising Members of Professions for CRA s administrative policy on use of a professional corporation 29

30 3. Planning Considerations (cont d) The Use of a Management Corporation: May be used in tandem with professional practice, in lieu of a professional corporation, or otherwise To provide management and administration services (day-to-day operations of corporation) i.e. planning, direction, control, co-ordination, systems and other functions at managerial level Can charge reasonable management fees in respect of services CRA accepts charge of a reasonable mark-up (15%) on management fees Although there is case law that suggests that reasonable management fees may be more than 15% (e.g. Bertomeu, 2006 TCC 85) To be deductible, there must be a legal obligation to pay the management fees 30

31 3. Planning Considerations (cont d) Advantages of Using a Professional Corporation or a Management Corporation: Access to small business deduction Income-splitting opportunities through paying dividends to family members in lower tax brackets Tax deferral equal to the difference between top marginal income tax rate and low corporate income tax rate on active business income on every dollar of taxable income 31

32 3. Planning Considerations (cont d) Disadvantage Personal Services Business: Concern when exploring possibility of professional corporation or management corporation Defined in subsection 125(7) of the ITA to mean a business of providing services where an individual (or a related person) performing services on behalf of a corporation is a specified shareholder, and could reasonably be regarded as an officer or employee of the corporation or partnership to whom such services are provided but for the existence of the corporation 32

33 3. Planning Considerations (cont d) Personal Services Business cont d: In other words, where: an individual or a related person (called an incorporated employee ) is a specified shareholder of Corporation A, and the incorporated employee provides services on behalf of Corporation A to Corporation B, and but for the existence of Corporation A, the incorporated employee could reasonably be regarded as an employee of Corporation B, then Corporation A will be considered to carry on a personal services business in a taxation year, unless Corporation A employs more than 5 full-time employees, or the amount paid or payable for the services provided by Corporation A to Corporation B is received or receivable from related Corporation C 33

34 3. Planning Considerations (cont d) Personal Services Business cont d: Certain exceptions: corporation employs more than 5 full-time employees throughout the year; or amount paid or payable in the year for services received or receivable from an associated corporation Specified shareholder generally a taxpayer owning not less than 10% of the issued shares of any class of the capital stock of the corporation or a related corporation, whether directly or indirectly, at any time in a taxation year 34

35 3. Planning Considerations (cont d) Personal Services Business cont d: PSB not entitled to small business deduction and limited deductibility of expenses See para. 18(1)(p) of the ITA Whether found to be operating a PSB a question of fact and involves an examination of factors used to distinguish employees and independent contractors i.e. tests established in Wiebe Door Services Ltd. v. M.N.R., 87 D.T.C (FCA); Ontario Ltd. v. Sagaz Industries Canada Inc., 2001 SCC 59 Must examine the entire relationship between the parties to determine whether employer-employee relationship existed 35

36 3. Planning Considerations (cont d) Personal Services Business cont d: Even if found to be operating a PSB, no longer as costly as it once was; tax cost varies from province to province Weigh costs associated with paying general corporate tax rate on PSB income and paying eligible dividends, as opposed to paying salary Obtain deferral of income tax when leave funds in the corporation 36

37 3. Planning Considerations (cont d) Example: Effect of Earning Income through a PSB in British Columbia 2009 Income of a personal services business Personal tax paid if income earned directly[1] Corporate tax paid by a personal services business[2] Tax deferral by leaving money in personal services business[3] Net cash if earned directly as individual Net cash if earned by personal services business Personal tax paid on eligible dividend[4] Tax cost of using personal services business if dividends paid $100,000 ($43,700) ($30,000) $13,700 $56,300 $70,000 ($13,944) ($244) [1] Based on the highest marginal income tax rate in British Columbia of 43.7% [2] Based on top combined federal and British Columbia corporate tax rate of 30% [3] Based on the difference between the highest marginal income tax rate (43.7%) and corporate income tax rate (30%) [4] Based on combined federal and British Columbia rate on eligible dividends of 19.92% 37

38 4. Cases on Owner-Manager Remuneration Reasonableness of Bonuses and Salaries: Safety Boss Ltd. v. The Queen, [2000] 3 C.T.C (TCC) Facts Bonuses paid to president of corporate taxpayer (who was also a major shareholder), and non-resident company of the president Minister disallowed deduction of bonuses because amounts were unreasonable given that the parties were not dealing at arm s length Issue Were bonuses unreasonable in light of non-arm s length relationship? Decision Bonuses paid were fully commensurate with services rendered by the president, given his exposure to dangerous activity (oil & gas), requiring extraordinary skill, endurance and courage Minister s assessment flawed since it failed to take into account the years the president struggled to keep the company running without any remuneration or compensation Amounts paid not arbitrarily determined by the taxpayer Case Importance One of the leading cases on payment of bonuses to owner-managers Often cited for proposition that corporation can usually deducted an unlimited salary or bonus paid to owner-manger once its ordinary profits are attributable to the ownermanager s work for the corporation 38

39 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Bonuses and Salaries cont d: Jastrzebski v. R., 2008 TCC 643 (TCC) Facts Taxpayer was owner of rental property which generated an income of $27,240 in 2004 $15,000 and $10,000 were paid to his spouse and child for their assistance in maintaining and renovating the properties from Minister disallowed portions of rental expenses for 2003 and 2004 taxation years, partially because work of spouse and child not found to have significantly contributed to property Issue Were the amounts paid to the taxpayer s spouse and child from his rental property income reasonable business expenses? Decision Relationship between parties was non-arm s length and due to a lack of sufficient documentary evidence that spouse and child worked in the maintenance of the properties, amounts not reasonably deducted given the gross annual rental income of the property In addition, taxpayer had no obligation to pay amounts to spouse and son 39

40 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Bonuses and Salaries cont d: Manchester Chivers & Associates Insurance Brokers Inc. v. R., [2005] 5 C.T.C (TCC) Facts Corporate taxpayer owned by sole shareholder and employed about 85 employees, including daughter and son of shareholder Substantial bonuses paid to shareholder, daughter and son for taxation years No other employees paid a bonus Minister disallowed deduction of bonuses because not incurred for the purpose of gaining or producing income pursuant to s. 18(1)(a) and not reasonable pursuant to s. 67 of ITA Issue Can bonuses paid to shareholder and two children constitute reasonable business expenses? Decision Yes, bonuses deductible since work performed greatly contributed to the success of the corporation and were for the purpose of gaining or producing income Amounts paid to daughter reasonable given her authority to sign corporate cheques, ability to manage labour relations, and implementation of complex collective agreements Amounts to son reasonable given his availability 24 hours a day, 7 days a week to look after equipment management, manage crisis situations, and negotiate the sales of businesses Amounts to shareholder reasonable given his representation of the corporation relating to complaints made in the purchase of a business, and his efforts in taking care of accounts receivables and settling grievances 40

41 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Bonuses and Salaries cont d: Wedge v. The Queen, [2005] 4 C.T.C (TCC) Facts Taxpayer RW and family owned shares of corporate taxpayer, W Ltd. W Ltd. was the controlling shareholder of a large corporate group of companies, including EDC Ltd., owned also by Taxpayer RW and family Minister disallowed deduction for a $119,000 rollover from W Ltd. to RRSP for taxpayer RW s retiring allowance in 1998, since it did not appear taxpayer RW actually retired Minister disallowed deduction of $519,000 made by W Ltd. for the distribution of assets to its shareholders pursuant to section 67 of the ITA, since it was not reasonable given employees duties Issue Were the deductions made reasonable? Decision The $519,000 deduction was reasonable because it was compensation paid to employees for services rendered in previous years in which they received no remuneration for The $119,000 deduction was not reasonable as a deduction for retiring allowance because taxpayer RW continued to hold significant functions of an officer and director after the allowance was paid 41

42 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Bonuses and Salaries cont d: Mépalex Inc. v. The Queen, [2004] 2 C.T.C (TCC) Facts Husband and wife of corporate taxpayer were sole shareholders and paid children salaries and bonuses from the profits of the corporation Payments to children assessed to be unreasonable and disallowed under s.67 of ITA by the Minister Husband and wife agreed with assessment and thus, requested amounts paid to be added to salaries of managing shareholders pursuant to s.56(2) of ITA, to be deducted in order to avoid double taxation Main Issue Can modifications to a corporate tax plan be made retroactively pursuant to s.56(2) of ITA for the deductibility of payments made to children of shareholders? Decision No, salaries and bonuses initially determined to be unreasonable under s.67 of ITA, cannot be retroactively restructured to be deducted under s.56(2) of ITA Salaries and bonuses were unreasonable and part of income-splitting scheme Children nonetheless entitled to minimal remuneration for their work Case Importance Acknowledges that bonuses could be paid to children, but must be reasonable having regard for actual services performed 42

43 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Management Fees: Nielsen Development Co. v. R TCC 160 (TCC) Facts Individual taxpayer J owned 100% of corporate taxpayer K Corporate taxpayer K owned 100% of corporate taxpayer N Corporate taxpayer N entered into agreement with ManagementCo owned by taxpayer J s wife Taxpayer J s wife had responsibilities including purchasing, making accounting decisions, signing cheques, and budgeting on behalf of ManagementCo Minister disallowed payments of $275,000 and $300,000 in management fees paid in 2003 and 2004 to taxpayer J s wife on the basis that her duties were overstated and the amounts paid were therefore unreasonable in the circumstances Issue Were management fees paid to ManagementCo reasonable under s.67 of the ITA? Decision Yes, the management fees paid were reasonable given the wide range of responsibilities taxpayer J s wife took on, which were above and beyond what was expected of an average general manager (who had subordinate role to taxpayer J s wife) In fact, if a different management company was hired, fees for similar services would have been much greater 43

44 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Management Fees cont d: Bertomeu v. R., 2006 TCC 85 (TCC) Facts Taxpayer was a sole shareholder of a consulting company who provided personnel, administrative and management services to the architect company he worked for Agreement provided that the company s costs and expenses would be billed to taxpayer and his associates at cost plus 15% Agreement provided for an additional payment of 3% of all professional fees billed by architect company Minister disallowed the additional 3% payment to be deducted because the work already reimbursed for in the former fee at cost plus 15% Issue Were the additional fees paid for services rendered by the related consulting company reasonable? Decision Yes, the additional fees paid for services rendered were reasonable Consulting company assumed significant financial risks in the hiring of staff, and the purchase of equipment necessary to provide services to the taxpayer Manner in which income allocated between taxpayer and consulting company justified Case Importance Demonstrates that more than a 15% mark-up may be reasonable in the context of management fees 44

45 4. Cases on Owner-Manager Remuneration (cont d) Reasonableness of Management Fees cont d: Welton v. Canada, [2005] T.C.J. No. 251 (TCC) Facts Real estate agent taxpayer had husband showing homes, attracting potential customers, and offering expertise for her business Management fee of $32,000 paid to husband Minister claimed fee not deductible because fee was not an obligation as required by wording of s.18(1)(a) of ITA Issue Was an expense for management fee to taxpayer s husband truly an obligation and thus, deductible for income tax purposes? Decision No, the expense for management fee paid was not deductible because there was no evidence that the taxpayer had an obligation to pay her husband Payment was nothing more than a domestic arrangement Calculation of fee not supported by any valid documentation 45

46 5. Technical Interpretations on Owner-Manager Remuneration Personal Services Business: Technical Interpretation I7 Complex corporate structure involving individual ( A ) owning 100% of Holdco (management corporation), which had minority interest in Opco and a 98% interest in Partnership, of which A and spouse each held a 1% interest A provided services to Opco on behalf of P (A did not provide services to P on behalf of Opco) Tax avoidance element to entire corporate structure CRA expressed concerns that A was trying to avoid the application of the PSB rules In addition, A trying to avoid application of source deductions by providing services to Opco on P s account, and trying to claim the small business deduction for Holdco Would be suitable situation for apply of GAAR in s. 245 of the ITA 46

47 5. Technical Interpretations on Owner-Manager Remuneration (cont d) Owner-Manager Remuneration: Technical Interpretation E5 Concerned bonus declared and paid by CCPC to deceased shareholdermanager (active in business operations) after death CCPC had established practice of declaring and paying bonuses to shareholder-managers CCPC had year-end of July 31, 2005 Individual died on May 31, 2005; bonus declared on July 31, 2005 and paid to estate of the deceased in January, 2006 CRA stated that its policy did not necessarily apply in such a situation, and it reserved the right to challenge the reasonableness of the amount paid, pursuant to s. 67 An employer may be able to deduct such a bonus paid to a deceased shareholder-manager in circumstances where the deceased had either an enforceable claim (subs. 70(2)) or a right in contract (subs. 70(1)) as at the date of death 47

48 5. Technical Interpretations on Owner-Manager Remuneration (cont d) Summary of some CRA Technical Interpretations: Technical Interpretation E5 Policy does not apply to bonus paid to principal shareholder of Holdco out of proceeds from sale of shares in Opco But see Technical Interpretation R3, where remuneration paid to shareholder-managers out of income triggered from proceeds of sale of a business was deductible Technical Interpretation R3 Bonus paid to shareholder-manager paid for purposes of creating a noncapital loss Non-capital loss carried back to previous years in order to reduce active business income to the small business limit Bonus found to be within scope of CRA s policy and would be deductible by corporation Technical Interpretation E5 Management fees paid by Opco to PSB do not fall within the scope of CRA s administrative policy 48

49 5. Technical Interpretations on Owner-Manager Remuneration (cont d) Summary of some CRA Technical Interpretations cont d: Technical Interpretation Inter-corporate management fees paid by Opcos to Holdcos and then paid to shareholders of Holdcos not within scope of policy Technical Interpretation Normal test of reasonableness applies where bonuses paid by CCPC owned by corporations that are owned by trusts whose beneficiaries include individuals providing services to CCPC; requires consideration of: - duties performed by individuals; - time spent in carrying out duties; - remuneration paid to employees performing similar functions for similar-sized corporation in similar circumstances 49

50 Questions? 50

51 James A. Hutchinson Miller Thomson LLP