Principal Issues: [TaxInterpretations translation] (1) Is the arrangement in place to provide benefits to officers of the Corporation a retirement compensation arrangement? (2) Are the amounts paid to the trust governed by this arrangement deductible in computing the Corporation's income? (3) Is the interest on the loan received by the Corporation from the trust deductible? (4) Do the costs of setting up the RCA qualify as a current expense?
Position: (1) No. (2) No. (3) No. (4) No.
Reasons: (1) The benefits to be paid would not be reasonable in the circumstances. Position stated at the 2005 APFF and CTF Conferences. (2) The amounts paid were not paid to earn income. Further, the amounts are not reasonable. We must establish what a reasonable businessman would have agreed to pay with only the interests of the corporation in mind. In assessing the reasonableness of an expense, one must look for an objective element. (3) The money borrowed is not used for the purpose of earning income. (4) The expense would have been incurred in connection with an appropriation of funds.
January 4, 2006
XXXXXXXXXX Tax Services Office Headquarters
Audit Division
Income Tax Rulings Directorate
Attention: XXXXXXXXXX Michel Lambert
(613) 957-8962
2005-011580
XXXXXXXXXX - Retirement Compensation Arrangement
This is in response to your memorandum of February 10, 2005, asking whether contributions made by XXXXXXXXXX under a retirement compensation arrangement are reasonable expenses.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Designation of Parties
For the purposes hereof, the names of the taxpayers are replaced by the following names
XXXXXXXXXX: the Corporation
XXXXXXXXXX: Consultants
XXXXXXXXXX: Entity B
XXXXXXXXXX: Mr. A
XXXXXXXXXX: Mr. B
XXXXXXXXXX: Mr. C
XXXXXXXXXX: Shareholder A
XXXXXXXXXX: Shareholder B
XXXXXXXXXX: Shareholder C
XXXXXXXXXX: Entity C
XXXXXXXXXX: Entity D
The Facts
1. The Corporation operates in the field of XXXXXXXXXX. The current shareholders of the Corporation are Shareholder A, Shareholder B and Shareholder C.
The shareholder of Shareholder A is Entity C whose shares are held by Mr. A
The shareholder of Shareholder B is Mr. B.
Shareholder C's shareholder is Entity D whose shares are owned XXXXXXXXXX% by Shareholder A and XXXXXXXXXX% by Shareholder B.
2. On XXXXXXXXXX, the Corporation set up an arrangement for Mr. A and Mr. B that it referred to as a retirement compensation arrangement (the "Arrangement"). A trust was then created to manage and fund the Agreement. On that date, the Corporation made a contribution to the retirement compensation arrangement of $XXXXXXXXXX of which $XXXXXXXXXX was paid to the trust on XXXXXXXXXX and the balance to the Agency as Part XI.3 tax. Under subsection 153(3), for purposes of the Act, the amount remitted to the Agency was deemed to be received by the trust on XXXXXXXXXX.
3. On XXXXXXXXXX, the Corporation borrowed from the Trust an amount of $XXXXXXXXXX. That loan bears interest at the rate of XXXXXXXXXX% per annum and is secured by a first ranking movable hypothec of XXXXXXXXXX dollars. According to a bank statement, the loan was made on XXXXXXXXXX.
4. In XXXXXXXXXX, the Corporation made an additional contribution of $XXXXXXXXXX under the Agreement. An amount of $XXXXXXXXXX was remitted to the Agency.
5. In XXXXXXXXXX, the Corporation borrowed from the trust an amount of $XXXXXXXXXX. That loan bears interest at the rate of XXXXXXXXXX% per annum and is secured by a movable hypothec.
6. The Corporation deducted contributions of $XXXXXXXXXX as a current expense in computing its income in XXXXXXXXXX and XXXXXXXXXX, respectively. Since XXXXXXXXXX, the Corporation has deducted interest on the above loans in computing its income.
7. In order to establish the Arrangement, the Corporation incurred professional fees, which it deducted in computing its income.
8. Clause XXXXXXXXXX of the Indenture that was created on XXXXXXXXXX in connection with the Arrangement provides as follows: "XXXXXXXXXX."
9. Mr. C is the General Manager of the Corporation. He is responsible for the day-to-day management of the Corporation.
10. Mr. A is a resident of Canada. XXXXXXXXXX
XXXXXXXXXX
Mr. A's employment income, according to his tax returns, is broken down as follows:
Year Total employment income Income from the Corporation
XXXXXXXXXX
The Corporation reports that it paid a salary to Mr. A XXXXXXXXXXX
11. Mr. B is a non-resident of Canada.
XXXXXXXXXX
XXXXXXXXXX
Mr. B reported employment income in Canada of XXXXXXXXXX. All of this income is from the Corporation. Mr. B did not report any employment income in Canada between XXXXXXXXXX and XXXXXXXXXX.
12. According to a report by the Consultant's actuaries of XXXXXXXXXX, a contribution of $XXXXXXXXXX to the RCA trust was necessary to provide Mr. A with a retirement benefit of $XXXXXXXXXX per year. That contribution was calculated based on assumptions regarding XXXXXXXXXX, the principal ones being:
(a) Mr. A had XXXXXXXXXX years of service, being XXXXXXXXXX years with the Corporation and XXXXXXXXXX years in an industry related to the Corporation;
(b) His average annual income for the last three years was $XXXXXXXXXX;
(c) Mr. A is a male born in XXXXXXXXXX and will retire at age XXXXXXXXXX or one year after the calculation date, whichever is later;
(d) The pension will be XXXXXXXXXX% of the best three years' average salary multiplied by the number of years of service. The maximum limit will be XXXXXXXXXX% of the three-year average salary;
(e) The annuity will be a life annuity with a payment guarantee of XXXXXXXXXX years and the wife will be entitled to an annuity of XXXXXXXXXX% after Mr. A's death with a guaranteed period of XXXXXXXXXX years;
(f) The annuity will be indexed at an annual rate of XXXXXXXXXX%.
The Corporation has obtained another unsigned report requesting the following contributions based on an average salary of $XXXXXXXXXX or $XXXXXXXXXX for the years XXXXXXXXXX to XXXXXXXXXX:
Average salary $XXXXXXXXXX $XXXXXXXXXX
Contributions Mr. A $XXXXXXXXXX $XXXXXXXXXX
Contributions Mr. B $XXXXXXXXXX $XXXXXXXXXX
13. On XXXXXXXXXX, the Corporation transferred to Shareholder C the land, building and machinery that were used for its XXXXXXXXXX operations in consideration for a number of shares of its capital stock.
The following is a summary of the Corporation's financial position as at XXXXXXXXXX.
XXXXXXXXXX XXXXXXXXXX XXXXXXXXXX
Current assets $XXXXXXXXXX $XXXXXXXXXX $XXXXXXXXXX
Total assets $XXXXXXXXXX $XXXXXXXXXX $XXXXXXXXXX
Current liabilities $XXXXXXXXXX $XXXXXXXXXX $XXXXXXXXXX
Advance from shareholders $XXXXXXXXXX $XXXXXXXXXX $XXXXXXXXXX
Pension fund advances $XXXXXXXXXX $XXXXXXXXXX
Shareholders’ equity $XXXXXXXXXX $(XXXXXXXXXX) $(XXXXXXXXXX)
14. Among other things, the Corporation paid equal dividends to Shareholder A and Shareholder B between XXXXXXXXXX and XXXXXXXXXX. You have determined the amount of dividend each shareholder received from the Corporation from the shareholders' tax returns for the years XXXXXXXXXX through XXXXXXXXXX. The following table summarizes the amounts received by calendar year for each shareholder.
Shareholder A Shareholder B Shareholder C
XXXXXXXXXX
Your Questions
15. Are the contributions of $XXXXXXXXXX to the trust deductible as current expenses in computing the income of the Corporation?
16. Is the interest rate of XXXXXXXXXX% reasonable?
17. Are the professional fees deductible as current expenses in computing the Corporation's income?
Your Opinion
18. With respect to the deduction of the $XXXXXXXXXX contributions, and the reasonableness of the interest expense, you do not express an opinion in your request. With respect to the professional fees, it is your opinion that they were not incurred to earn income.
Our Opinion
19. The Corporation claims to have in place a "retirement compensation arrangement" within the meaning of that term in subsection 248(1). Under the Act, a retirement compensation arrangement is generally a plan or arrangement under which an employer or former employer of a taxpayer makes contributions to another person in connection with benefits that are to be or may be received or enjoyed by any person on, after or in contemplation of any substantial change in the services rendered by the taxpayer, the retirement of the taxpayer or the loss of an office or employment of the taxpayer. The Act provides for certain exceptions, including plans or arrangements (other than athlete’s plans) that are maintained primarily for the benefit of non-residents in respect of services rendered outside Canada (see paragraph (l) of the definition of retirement compensation arrangement).
20. Paragraph 20(1)(r) allows a deduction for contributions made in a year by an employer in respect of services rendered by an employee or former employee. Contributions that do not satisfy those conditions are not deductible by virtue of paragraph 18(1)(o.2). Furthermore, the provisions of section 67 must be complied with.
21. The first issue to be resolved is whether the Arrangement between Mr. A, Mr. B, the Corporation and the Trustee constitutes a retirement compensation arrangement within the meaning of the Act.
At the Financial Products Roundtable at the 2005 Association de planification fiscale et financière Conference, the Agency indicated that it considers non-registered pension plans or supplementary retirement plans to be retirement compensation arrangements generally where the arrangements are pension plans and the benefits provided are reasonable.
According to the CRA, benefits are not reasonable where, for example, they exceed what an employee would expect to receive based on the employee’s position, salary and services rendered, or where they do not take into account benefits that have otherwise been provided under one or more registered plans.
22. For taxation years prior to XXXXXXXXXX, the Corporation did not pay any salary to Mr. A and Mr. B. The decision to pay them a salary was effective from XXXXXXXXXX. Mr. A was no longer President of the Corporation as of XXXXXXXXXX. However, it is not clear whether he continued to hold any office or employment after that date in light of his duties to Entity B that would justify the compensation paid. As for Mr. B, the description of the duties he allegedly performed does not appear to justify the compensation paid to him.
The Corporation's retained earnings are minimal. According to the financial statements for the years XXXXXXXXXX and XXXXXXXXXX, the Corporation paid dividends equal to net earnings. Those facts alone would indicate that the Corporation was distributing its net earnings as dividends. The contributions to the trustee generated deficits of $XXXXXXXXXX and $XXXXXXXXXX for the fiscal periods XXXXXXXXXX and XXXXXXXXXX, respectively, which were offset by loans from the RCA trust totaling $XXXXXXXXXX.
The Corporation provided actuarial reports to support the disbursements of $XXXXXXXXXX. We cannot rely on such reports. First, the calculation in the Consultants' report for Mr. A is based on the assumption that he has XXXXXXXXXX years of service, which does not reflect reality; years in an industry related to that of the Corporation should not be considered. In addition, the calculation assumes an average income based on the best three years of service (i.e. XXXXXXXXXX to XXXXXXXXXX) at $XXXXXXXXXX. In our view, this amount of $XXXXXXXXXX does not seem appropriate in the circumstances considering that there was no salary paid prior to XXXXXXXXXX. The calculations in the other report submitted are based on average salaries of $XXXXXXXXXX and $XXXXXXXXXX for the years XXXXXXXXXX to XXXXXXXXXX, and years of service totaling XXXXXXXXXX and XXXXXXXXXX years respectively for Mr. A and Mr. B.
23. It appears to us that the benefits to be paid under the Arrangement are not reasonable in light of the following:
(a) Mr. A and Mr. B rendered services to the Corporation either on a part-time or as-needed basis;
(b) the payment of contributions was made possible by loans from the trust and without such loans the arrangement would not have been possible;
(c) prior to XXXXXXXXXX, the Corporation did not have a practice of compensating Mr. A and Mr. B;
(d) as of XXXXXXXXXX, Mr. A's role in the Corporation is not known;
(e) the actuaries' calculations are invalid because they are based on assumptions that are inappropriate in the circumstances (see the preceding paragraph);
(f) in XXXXXXXXXX and XXXXXXXXXX, significant dividends were paid to shareholders;
(g) the Corporation had no retained earnings because it had distributed its net earnings as dividends.
Accordingly, it is our opinion that the plan that the Corporation has in place is not a "retirement compensation arrangement" within the meaning of that term in subsection 248(1).
24. Having determined that the Arrangement would not be a retirement compensation arrangement, it is necessary to consider whether it is a salary deferral arrangement within the meaning of subsection 248(1). Generally, in relation to a taxpayer, it is a plan or arrangement that entitles a person in a taxation year to receive an amount after the year, where it is reasonable to consider that one of the main purposes for the creation or existence of the right is to postpone tax payable under the Act by the taxpayer in respect of an amount that is, or is on account of or in lieu of salary or wages for services rendered. The Act provides for certain exceptions which do not apply in this case.
In this case, it is our view that the contributions to the trustee would not relate to amounts accruing to Mr. A and Mr. B as salary or wages. Consequently, the Arrangement would not constitute a salary deferral arrangement.
25. It is also necessary to consider whether the Arrangement is an employee benefit plan within the meaning of subsection 248(1). Generally, it is an arrangement under which contributions are made to another person by an employer and under which payments are to be made to employees or former employees (other than a payment that would not be required to be included in computing the recipient's income without reference to subparagraph 6(1)(a)(ii) and paragraph 6(1)(g)). The Act provides for certain exceptions which do not apply in this case.
In this case, it is our view that the Corporation did not make the contributions to the Trustee qua the employer of Mr. A and Mr. B. Therefore, the Arrangement would not constitute an employee benefit plan.
26. In light of the facts submitted to us, it appears to us that the intention of the Arrangement was not to ensure the payment of an amount to Mr. A and Mr. B upon their retirement or loss of employment. It appears that the transactions significantly diminished the value of the Corporation by benefiting Mr. A and Mr. B.
In our view, the conditions for the application of subsection 56(2) are satisfied and apply to the shareholders of the Corporation. That subsection applies to a taxpayer where the following conditions are satisfied:
(a) There is a payment or transfer of property to a person other than the taxpayer;
(b) The payment or transfer is made pursuant to the direction of, or with the concurrence of, the taxpayer;
(c) The payment is made for the benefit of the taxpayer or as a benefit that the taxpayer desired to confer on the other person;
(d) The payment or transfer would be taxable to the taxpayer under another provision of the Act if the amount or transfer had been made directly to the taxpayer.
We conclude that each of the conditions for the application of subsection 56(2) would be satisfied for the following reasons:
(a) Payments have been made to the Trustee and the Agency.
(b) Such payments were made with the concurrence of the shareholders of the Corporation. The taxpayer's concurrence to the conferring of the benefit need not be active. It may be passive or implied and may be inferred from the particular circumstances. This position is consistent with that set out in paragraph 3 of IT-335R2. In that regard, the jurisprudence has established that an active role by the taxpayer in question is not necessary to determine that a payment or transfer of property was in fact made with the taxpayer's concurrence under subsection 56(2). With respect to the above, you may refer to Smith v. The Queen, 93 DTC 5351 (F.C.A.) and 86 DTC 6196 (F.C.T.D.), The Queen v. Allan Bronfman, 65 DTC 5235 (F.C.T.D.) and Simon-Carves of Canada Ltd. v. M.N.R., 89 DTC 98 (T.C.C.).
Shareholder A, Shareholder B and Shareholder C are the three shareholders of the Corporation. In this capacity, they are legally entitled to receive all of the property owned by the Corporation upon its winding-up. In addition, it is clear that the contributions of $XXXXXXXXXX reduce the value of the shares of the capital stock of the Corporation held by the three shareholders. In light of the foregoing, it seems appropriate in the circumstances to conclude that the contributions made under the Arrangement required the concurrence of the three shareholders of the Corporation, either expressly, passively or by implication.
(c) The payments were made as a benefit conferred on the Trustee as desired by the shareholders of the Corporation. The Trustee will be able to use the amounts paid to it to fulfill its obligations under the Trust Indenture.
(d) The amounts of $XXXXXXXXXX would have been taxable to the shareholders of the Corporation pursuant to subsection 15(1) if the amounts had been paid directly to them.
27. By virtue of paragraph 18(1)(a), a taxpayer may not deduct in computing income from a business any expenses except to the extent that they were made or incurred by the taxpayer for the purpose of gaining or producing income from the business. Based on the facts provided to us, we are of the view that the corporation did not make the contributions to the trustee for the purpose of gaining or producing income from a business, as they were made in the course of appropriating funds. Consequently, we are of the view that the $XXXXXXXXXX that was contributed to the trustee cannot be deducted in computing the business income of the corporation because of the application of paragraph 18(1)(a).
28. Paragraphs 18(1)(o.2) and 20(1)(r) generally limit the deduction of contributions made in a year by a taxpayer under a retirement compensation arrangement to contributions that relate to services rendered by an employee or former employee of the taxpayer. While we are of the view that amounts paid to the trustee under the Arrangement are not amounts paid under a retirement compensation arrangement, we are of the view that those paragraphs would apply if it were determined that the Arrangement was a retirement compensation arrangement.
In addition, if it is determined that a portion of the contributions made under the Arrangement constitute a contribution to a retirement compensation arrangement rather than an appropriation of funds notwithstanding our view to the contrary, it is our view that such portion of the contributions made may not be deductible from the corporation's income pursuant to section 67. That section provides that no deduction may be made in respect of an expense in respect of which an amount is otherwise deductible under the Act except to the extent that the expense is reasonable in the circumstances. For an analysis of the reasonableness of an expense we refer you to Appendix A.
In addition, the matters referred to in paragraph 23 should be considered when applying paragraphs 18(1)(o.2), 20(1)(r) and section 67.
29. With respect to interest deductibility, we must refer to paragraph 20(1)(c). Under subparagraph 20(1)(c)(i), for interest expense to be deductible, it must relate to borrowed money used for the purpose of earning income from a business or property.
The Corporation contributed $XXXXXXXXXX in XXXXXXXXXX and $XXXXXXXXXX in XXXXXXXXXX under the Arrangement. As noted above, we are of the view that those contributions are an appropriation of funds and not an expenditure incurred to earn income from a business or property. Consequently, the borrowed money of the Trustee that was used to partially fund the Arrangement is not, in our view, borrowed money used to earn income from a business or property. Consequently, we are of the view that the interest on the borrowings of $XXXXXXXXXX is not deductible in computing the income of the Corporation as the borrowed money is not used for the purpose of earning income from a business or property.
30. With respect to the deduction of professional fees paid for preliminary studies and for the creation of the Arrangement, we are of the view that those are not expenses made or incurred by the Corporation for the purpose of gaining or producing income from a business or property since those fees were incurred in the course of appropriating funds. Consequently, those expenses cannot be deducted in computing the income of the Corporation by virtue of the application of paragraph 18(1)(a).
Note
31. We have noted that some of the documents you have provided to us from the Corporation are unsigned. We have assumed that these documents are consistent with the original duly signed documents and that they constitute probative documents.
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.
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ANNEX A
Determining the reasonableness of an expense
1. Section 67 provides that, in computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under the Act, except to the extent that the outlay or expense was reasonable in the circumstances.
2. The jurisprudence that provides a starting point for section 67 is often referred to by the courts. The Federal Court of Appeal recently referred to those cases in Petro-Canada v. Canada, (2004 FCA 158, 2004 DTC 6329). We reproduce here paragraphs 62 to 64:
[62] The leading case on the statutory predecessor to section 67 is Gabco Limited v. Minister of National Revenue, [1968] 2 Ex.C.R. 511, [1968] C.T.C. 313, 68 D.T.C. 5210 (Ex. Ct.). In that case, Cattanach J. stated the following test for the application of this provision:
It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind.
[63] Section 67 was considered by this Court in Mohammad v. Canada (C.A.), [1998] 1 F.C. 165, [1997] 3 C.T.C. 321, 97 D.T.C. 5503. The issue was the deductibility of interest paid by a person on a debt used to finance 100% of the purchase price of a rental property. Robertson J.A., writing for the Court, said this at paragraph 28:
[28] When evaluating the reasonableness of an expense, one is measuring its reasonableness in terms of its magnitude or quantum. Although such a determination may involve an element of subjective appreciation on the part of the trier of fact, there should always be a search for an objective component. When dealing with interest expenses, the task can be objectified readily. For example, it would have been open to the Minister to challenge the amount of interest being paid on the $25,000 loan had the taxpayer agreed to pay interest in excess of market rates. The reasonableness of an interest expense can thus be measured objectively, namely, by reference to market rates. [... ]
[64] Reasonableness, like value, is a question of fact. In this case, it is a fact upon which the Judge made no finding. While it may be true, as suggested in Mohammad, that paying fair market value for something is prima facie reasonable, I am unable to agree with the Crown that it necessarily follows that paying more than fair market value is unreasonable. There may be circumstances in which a decision to pay more than fair market value for something is a reasonable decision. Considering the test stated in Gabco, I am not persuaded that this is an appropriate case for the application of section 67.
3. In considering this jurisprudence, we are of the view that in order to establish the reasonableness of the expense, one must establish what a reasonable business person would have undertaken to pay as a contribution to a retirement compensation arrangement with only the business considerations of the Corporation in mind. In addition, when assessing the reasonableness of an expense, an objective element must be sought.
4. In determining the reasonableness of the amounts paid into the RCA trust, a first approach is to compare the work performed by Mr. A and Mr. B with that of other key employees of the Corporation. In that regard, the role of Mr. C must be considered. Next, the total compensation of the shareholders and key employees in question must be compiled. That compensation must be established by taking into account, inter alia, the value of all fringe benefits and pension plan entitlements. Consideration should be given to the compensation received by each of the two shareholders during the years in which amounts were paid under the RCA and in prior years. The reasonableness of the RCA payments can then be assessed by comparing the data for the two groups
5. The Tax Court of Canada adopted this approach in Ambulance B.G.R. v. Her Majesty the Queen, 2001-1712(IT)G, 2004 DTC 2583. In that decision, the Court had to determine whether a portion of the bonuses paid by the corporation to the shareholder's children was a reasonable expense that could be deducted in computing the corporation's income. To determine the reasonableness of the expense, the Court made comparisons between the children's work and that of persons unrelated to the corporation, and did the same for their respective remuneration.
6. In this situation, we considered the salaries paid by the Corporation to Mr. A and Mr. B, as well as the information you provided to us regarding the work performed by each. Based on the salaries of approximately $XXXXXXXXXX paid to Mr. A and Mr. B and the work performed for the Corporation, we are of the view that a reasonable business person would not have committed to any additional amounts under a retirement compensation arrangement. That leads us to conclude that the total contributions to the trustee are not reasonable in the circumstances.
This opinion is based on the information you have provided to us. We suggest that you thoroughly document your audit file in that regard and obtain as much information and supporting documentation as possible to properly support your assessment. Please do not hesitate to contact us if you have any questions.
7. Another approach is to consider the borrowing capacity of the Corporation. In order to pay the $XXXXXXXXXX amounts, the Corporation had to borrow from the trust governed by the RCA in the amount of $XXXXXXXXXX. Under that approach, it would be necessary to determine how much the Corporation would have been able to borrow from a financial institution with appropriate collateral. In our view, the excess of XXXXXXXXXX over the corporation's borrowing capacity is an amount that is not reasonable since “no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind”.