6 November 2008 Internal T.I. 2008-0292561I7 F - DAPE multiple -- translation

Principal Issues: [TaxInterpretations translation] Five individuals have each set up their own management corporation. An operating corporation pays them an annual management fee. Can each of the management corporations claim the small business deduction?

Position: Probably not.

Reasons: Question of fact.

November 6, 2008

Multiplication of small business deduction

This is further to your email of September 2, 2008 in which you requested our opinion regarding a situation involving the multiplication of the small business deduction ("SBD").

More specifically, you set out the following facts:

• Five individuals, A, B, C, D and E (the "Individuals") are engaged in projects for the construction of XXXXXXXXXX.
• A, B, C and D are brothers, while E is unrelated to them.
• Each Individual has established a management corporation for which he and his spouse are employees.
• For each XXXXXXXXXX construction project, the Individuals create an operating corporation (the "Operator") for operations relating to the construction and sale of units in XXXXXXXXXX. When a project is completed, the corporation becomes inoperative. Each Individual holds only shares of the management corporation he has incorporated and does not hold any shares of the other management corporations or the Operator.
• Each management corporation owns 20% of the voting shares of the Operator (being the only shares that were issued).
• The Operator has no employees. The Operator leaves all construction activities to subcontractors.
• The tasks of the Individuals include administration and supervision, contacts with banks and the sales of XXXXXXXXXX for the Operator.
• For each XXXXXXXXXX construction project, once the profit is known to the Operator at the end of the year, a management fee is paid to the management corporations, equivalent to 20% of sales.

The management corporations treat this income as active business income and claim the maximum amount of the SBD on this income. In your view, the tests in subsection 256(1) do not apply.

Unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act (the "Act").

Our Comments

In light of the above scenario, we believe that the Individuals are attempting to unduly multiply the SBD. Thus, we believe that the following arguments can be made against this scheme:

• assert that each of the Individuals' management corporations carries on a personal services business within the meaning of subsection 125(7);
• under subsection 256(2.1), assert that one of the main reasons for the existence of the separate management corporations is to reduce taxes payable under the Act.

Our first comment relates to the concept of personal services business as defined in subsection 125(7) and reiterated in Interpretation Bulletin IT-73R6 (the "Bulletin").

It would not be correct to consider that the characterization of management corporations is confined merely to the employee-employer relationship between the incorporated employee and the corporation to which the services are provided. A taxpayer's corporation may be considered a personal services business if the taxpayer is a specified shareholder of the corporation and the taxpayer would reasonably be regarded as an officer or employee of the corporation to which the services are provided, but for the existence of the corporation. However, a corporation that employs more than five full-time employees in its business throughout the year is not considered to be a personal services business.

In this case, the qualification of the management corporations as corporations each operating a personal services business is most probable. Each of the Individuals carries on the day-to-day management of the Operator as would an officer or employee. In addition, each management corporation does not employ more than five full-time employees. Finally, the Individuals are all specified shareholders of their management corporation since they all directly or indirectly hold at least 10% of the issued shares of those corporations.

We confirm that the question of whether an Individual can be considered an employee of the Operator but for the existence of his management corporation is a factual one. Normally, an employer-employee relationship must be assessed in the light of the following criteria:

• the level of control exercised by the payer;
• the ownership of tools and equipment;
• the ability of the worker to enter into a subcontracting agreement or to hire assistants;
• the financial risk assumed by the worker;
• the worker's responsibility for investment and management;
• the opportunity for the worker to make a profit;
• any other relevant factors.

Based on the information we possess, and although we do not express a formal opinion in this respect, it is possible that each Individual may be considered an employee of the Operator in the absence of his management corporation. It is therefore plausible that the management corporations of the Individuals could be characterized as personal services businesses.

We also believe that the application of subsection 256(2.1) may be relevant. It deems corporations to be associated where one of the main reasons for their separate existence in a taxation year is to reduce taxes that would otherwise be payable under the Act.

Based on the facts provided, it seems most probable that the existence from the outset of the management corporations was for the multiplication of the SBD. According to the jurisprudence (Hughes Homes Inc. v. The Queen, 98 DTC 1082), taxpayers have the burden of demonstrating that the fundamental reasons for the existence of the corporations are not tax-related. In this case, for the following reasons, it seems unlikely that the corporate structure was put in place by the Individuals for reasons other than tax:

• the fact that an operating corporation is created and used for each of the projects involving a real business risk;
• the payment of management fees to the management corporations instead of the payment of dividends (if the Operator had paid dividends, the management corporations would have been specified investment business corporations);
• the fact that 4 out of 5 of the individuals are related by blood.

Access to Information

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

We hope that these comments are of assistance.

François Bordeleau, LL.B.

Manager
Business and Partnerships Section
Business and Partnerships Division
Income Tax Rulings Directorate.