2014-0520721I7 Indian Tax Exemption - Business Income

Principal Issues: Whether capital gain on disposition of shares in family business is taxable?

Position: Yes, pro-rated.

Reasons: See below.

Author: Meers, Rob
Section: 81(1)(a); 87 of the Indian Act

                                                                                                                                        February 4, 2015

      XXXXXXXXXX Tax Services Office                                                                          Headquarters
                                                                                                                                        Income Tax Rulings Directorate
                                                                                                                                        Rob Meers
                                                                                                                                        613-957-2100

      Attention: XXXXXXXXXX                                                                                         2014-052072

      Indian Tax Exemption – Business Income

This is in response to the e-mail we received from your predecessor inquiring as to whether the capital gain on the disposition of shares by an Indian, as that term is defined in section 2 of the Indian Act, would be situated on a reserve and thus exempt from tax for purposes of section 87 of the Indian Act and paragraph 81(1)(a) of the Income Tax Act (the “Act”). In particular, you would like to know if the gain on the sale of the shares of XXXXXXXXXX (the “Corporation”) by XXXXXXXXXX and XXXXXXXXXX (the “Taxpayers”) would be exempt from tax.

Our understanding of the facts is that an arm’s length party acquired a XXXXXXXXXX% interest in a group of XXXXXXXXXX companies that included the Corporation. The Taxpayers owned the shares of the Corporation personally. The shares of the other XXXXXXXXXX companies were owned by a family trust. You want our views with respect to the sale of the shares of the Corporation only. 

In Bastien Estate v. Canada (SCC) 2011 SCC 38 (“Bastien”), the Supreme Court of Canada examined investment income arising from a contractual debt obligation (such as a term deposit) and identified three significant connecting factors, considered fundamental, in determining whether this type of investment income is property situated on a reserve, and therefore exempt.  The three connecting factors are as follows:  the location where the investment instrument is bought and the investment contract is signed by the parties, the location of the bank branch that has issued the investment instrument (residence of the debtor financial institution), and the location where the investment income payment must be made (place of performance of the debt). In its decision, the Court held that the place the income is generated was not a relevant connecting factor. However, it has been our view that for Bastien to apply there must be a contractual debt obligation. In the situation under review, there is not. We are addressing the disposition of shares. In a recent interpretation we stated that to the extent the investment income does not arise directly from a contractual debt obligation between a client and an on-reserve financial institution but rather from events and activities occurring off the reserve, the investment income would likely be taxable.

In Murray v. The Queen (TCC) 2013 TCC 253, the judge indicated that it was her view that the place where the income was generated was an important connecting factor in that case as they were not dealing with passive income, as was the case in Bastien, but business or active income. The judge also emphasized that it was important not to confuse the activities of Mr. Murray to earn management fees with the activities of the companies. In the case at hand, it is equally important not to confuse the Taxpayers’ share ownership and resulting capital gain on the disposition of those shares with the activities of the corporation. However, as we outline below, it is our view that when determining if a capital gain is exempt one must look to the income yielded by the investment and whether it would be exempt.

It is our view that the capital gain on an investment of an Indian will be exempt from tax if the income yielded by the investment would have been exempt from tax. The investments in question are the common shares of the Corporation. As they are common shares, the income yielded by the investment would be dividends. The Information for Indians page on the CRA website provides the following with respect to dividend income:

“If you are a shareholder of a corporation that operates only on a reserve, any dividends you receive from the corporation will be eligible for the tax exemption under section 87 of the Indian Act. This applies when the head office, management, and principal income-generating activities of the corporation that pays your dividends are situated on a reserve.”

It is our understanding from the information provided in the incoming correspondence and discussions with XXXXXXXXXX that the Corporation’s head office and management are located on a reserve. The issue then becomes whether the principal income-generating activities of the Corporation are situated on a reserve. Prior to Dickie v The Queen (TCC) 2012 TCC 242 (“Dickie”), we would have relied on the factors described in the Federal Court of Appeal’s decision in Southwind v Canada, CTC 265 (FCA). However, in the Dickie case, the judge decided that the labour activities and capital components were undeterminative of the issue having regard to the nature of the business while the management component was highly indicative of setting the situs of the business activities on a reserve. The judge stated that when the nature of the business is performing contracts obtained on a competitive bid process, it must be acknowledged that a great deal of effort is expended in bringing in the work. In Mr. Dickie’s particular case, the nature of the business was such that the management services and duties of the business were far more than merely incidental to the labour component and were in fact an essential and significant part of its operations. It is important to note the managerial activities of the business considered in Dickie were in addition to the myriad of general administrative duties. Ultimately, the decision was that the income was earned on a reserve despite the fact that 99% of the work was conducted off the reserve.

The facts of this case appear to have similarities to those of Dickie with a couple of notable exceptions. First, in the current case we are dealing with a corporation. Dickie was a self-employed individual. Generally, income of a corporation is taxable. Corporations are not eligible for the exemption under section 87 of the Indian Act. Second, in the current case it has been determined that historically the CEO, one of the Taxpayers, spends approximately XXXXXXXXXX% of his time off the reserve at job sites. In Dickie, he worked almost exclusively at the office on the reserve.

It was unclear from our discussions as to the extent that the managerial activities of the business were performed primarily on a reserve. It was unclear as to where and by whom the bids were prepared, where and by whom the contracts were negotiated and what other managerial activities were performed on a reserve. It was noted that management fees were paid to a related corporation but generally these types of arrangements are for general and administrative duties. It was also noted that the CFO, the spouse, spent almost all of her time on a reserve and the CEO spent approximately XXXXXXXXXX% of his time on a reserve. The extent to which the managerial activities, not just those of the Taxpayers, were performed on a reserve will need to be considered.

In light of the court’s decision in Dickie and given the similarities between that case and the current situation (with the possible exception noted above), it would be reasonable to determine that a portion of the income-generating activities were situated on a reserve given the nature of the business and managerial activities performed. As such, it is our position that the exemption should be pro-rated to reflect the portion of the income-generating activities located on a reserve. If, upon further review, it is determined that significant managerial activities are not performed on a reserve, the full amount of the gain should be taxable.

We trust that these comments will be of assistance.

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, following a 90-day waiting period (unless advised otherwise to extend this waiting period), 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: LPRA-PLAR ITR-DDI Access Team-Équipe d'Accès. In such cases, a copy will be sent to you for delivery to the taxpayer.

Roger Filion, CPA, CA
Manager
Non-Profit Organizations and Aboriginal Issues
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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