Mr. and Mrs. X (both over 25) incorporate XCo, subscribe a nominal amount for non-voting and voting common shares, respectively and lend the proceeds of a mortgage on their home to XCo as start-up capital (the “Loan”). Mr. X has no involvement in XCo’s business, which is highly speculative. Several years later, XCo repaid the Loan and they repaid the mortgage.
1. Notwithstanding such repayment, can Mr. X continue to look to the reasonable return exception having regard to the risks he initially assumed on the start-up of XCo’s business?
2. Can Mr. X look to the undistributed retained earnings of XCo as capital that is at risk for purposes of the reasonable return exception, assuming that he did not receive any dividends?
Respecting Q.1, CRA stated:
If the terms and conditions of the Loan were not sufficient to adequately compensate Mr. X and Mrs. X for the risk they assumed when mortgaging their home and providing the Loan to XCo, the relative risk that was assumed by each of them in mortgaging their home and providing the Loan could be taken into account in determining whether a dividend received by Mr. X after the repayment of the Loan is a reasonable return in respect of Mr. X (among the other factors noted above). …
[T]he CRA does not intend to generally substitute its judgment of what would be considered a reasonable amount where the taxpayers have made a good faith attempt to do so … .
Re Q.2:
The focus of the inquiry into whether an amount is a reasonable return in respect of a specified individual is on the relative contributions of the specified individual and each source individual in respect of the specified individual. Since the undistributed retained earnings of XCo would not, in the scenario presented above, represent capital contributed directly or indirectly by either Mr. X or Mrs. X, the existence of such undistributed retained earnings would not be relevant in assessing their relative contributions to the related business carried on by XCo.