2021-0884691E5 Remuneration received by sole shareholder of Corp

Principal Issues: Does section 87 of the Indian Act and paragraph 81(1)(a) of the Income Act apply to exempt the income received by a sole shareholder-employee of a professional corporation which holds an interest in a limited partnership?

Position: Question of fact.

Reasons: In Bell v. the Queen (2018 FCA 91), the court commented that where an employee is receiving income from a company that the employee controls, it would be relevant to examine the business that the company is carrying on, to determine if the income received is situated on a reserve. In the case provided, the business of the professional corporation appears to be limited to the holding of an interest in the limited partnership. As such, determining whether the income received by the sole shareholder-employee is property situated on a reserve, requires a review of the relevant connecting factors applied at the partnership level to determine whether that income is situated on- or off-reserve.

Author: Gauthier, Michel
Section: Indian Act s87; 81(1)(a)

XXXXXXXXXX                                                                  2021-088469
                                                                                          M. Gauthier

September 20, 2023

Dear XXXXXXXXXX:

Re: Income received by the sole shareholder-employee of a professional corporation

This is in reply to your email dated March 10, 2021, requesting our comments on whether section 87 of the Indian Act and paragraph 81(1)(a) of the Income Tax Act exempts from income tax, the income received by the sole shareholder-employee of a professional corporation (Prof Corp). We apologize for the delay in our reply.

Based on the information you have provided, it is our understanding that:

* The sole shareholder-employee (Taxpayer) is registered under the Indian Act.

* Prof Corp holds an interest in a professional limited partnership (Limited Partnership).

* The Limited Partnership has over 40 partners and provides legal services to clients in numerous industries, including First Nations governments and First Nations individuals.

* The Taxpayer is the sole employee of Prof Corp and works 75% of the time from an office located on-reserve, providing legal services to First Nations governments and First Nations individuals.

* Prof Corp annually pays the total distribution it receives each year from the Limited Partnership, to the Taxpayer.

Our Comments

This technical interpretation provides general comments about the provisions of the Income Tax Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations.

Employment or business income earned by an individual who is registered or entitled to be registered under the Indian Act, is exempt from income tax under section 87 of the Indian Act and paragraph 81(1)(a) of the Income Tax Act, only if the income is situated on a reserve. The courts have established that determining whether income is situated on a reserve, and thus exempt from tax, requires identifying the various factors connecting the income to a reserve and weighing the significance of each factor. This is referred to as the “connecting factors test”.

To simplify the application of this “connecting factors test” to employment income, the Canada Revenue Agency (CRA), together with interested Indigenous organizations, developed the Indian Act Exemption for Employment Income Guidelines (Guidelines). You asked whether the Guidelines apply to the income received by the Taxpayer from Prof Corp. Whether the income received by the Taxpayer is received qua employee or qua shareholder is a question of fact. If the income is received qua shareholder, the Guidelines would not apply as the income would not be employment income.

Even if the income is received qua employee (i.e., employment income), the Guidelines are an administrative tool meant to apply to common employment situations. Employment income received by a sole shareholder-employee, is not considered a common employment situation. Therefore, it is our view that the Guidelines do not apply and it is necessary to apply the connecting factors test as established by the courts.

Bell v. the Queen (2018 FCA 91) concerned bonuses paid by a corporation to a controlling shareholder of the corporation. In Bell, the court looked at the connecting factors of the related business income when determining if the bonus was situated on a reserve, and stated:

“In my view, in determining whether employment income that is paid by a corporation that is controlled by the employee is exempt under section 87 of the Indian Act, it would be appropriate to look at the particular business that is being carried on by that company to determine the relevant connecting factors.” (footnote 1)

Under the Income Tax Act, partnership income is first calculated as if the partnership were a separate person. Each partner’s share of the partnership income from each source will retain its characteristics as to source and nature. Therefore, in order to determine whether the Taxpayer’s income received from Prof Corp is situated on a reserve, the connecting factors test needs to be applied at the Limited Partnership level since Prof Corp’s sole source of income appears to be distributions from the Limited Partnership.

The connecting factors test is a two-step analysis. First, all potentially relevant factors that connect the property to a location are identified and then each factor is given weight in light of three considerations: the purpose of the income tax exemption, the type of property, and the taxation of that property.

When applying the connecting factors test to business income the courts have indicated that the most significant connecting factors (footnote 2) are:

* where the income earning activities of the business take place

* the type of business and the nature of the business activities

* where the management and decision-making activities of the business take place

* where the customers are located

Other connecting factors that the courts have found to be less significant (footnote 3) are:

* whether or not the business owner lives on a reserve

* whether the business maintains an office on a reserve or take business orders from a location on a reserve

* whether the books and records are kept on a reserve

* whether the administrative, clerical, or accounting activities take place on a reserve

The above connecting factors are not exhaustive, since there are other potential connecting factors that could apply depending on the fact situation. In addition, a connecting factor will have different relevance and weight depending upon the specific facts of each case. As a result, there is no standard test that can be used to determine if partnership (business) income is situated on a reserve. This can only be determined by a review of all the relevant facts at the end of each year and is beyond the scope of a technical interpretation.

However, we can offer the following general comments to assist you in making that determination. In the facts provided, the Limited Partnership income is comprised of income earned by all partners (in excess of 40). Except for the Taxpayer, the other partners’ business activities appear to take place off-reserve. As a result, it would appear that a significant portion of the business income earning activities of the Limited Partnership takes place off-reserve. As noted above, one of the most significant connecting factors used by the courts to connect business income to a reserve is where the income earning activities take place. Therefore, most of the Limited Partnership income likely will not be situated on a reserve.

As the income tax exemption under section 87 of the Indian Act may be prorated and some of the Limited Partnership’s revenue-generating activities take place on-reserve and the rest off-reserve, part of the partnership’s income will be taxable, and part will be exempt from tax. In such a case, the partnership’s business expenses will generally be allocated to the taxable part of its income in the same ratio, unless another allocation can be shown to be more reasonable.

Consequently, when Prof Corp pays its share of the Limited Partnership income to the Taxpayer, the income will not be fully tax-exempt. Only the part of the Limited Partnership’s income that arises from the partnership’s business activities on-reserve would be situated on a reserve and tax-exempt. For example, if 5% of the Limited Partnership’s income is determined to be situated on a reserve, only 5% of the income the Taxpayer receives from Prof Corp would be tax-exempt.

You also asked whether our comments would be different if the Taxpayer directly held the interest in the Limited Partnership, instead of through Prof Corp. The courts have considered the legal structure of a business and the Indian Act tax exemption and concluded that the exemption should not be dependent on the legal form:

“The exemption under the Indian Act should not be dependent on the legal form or structure that the particular person choses to carry on his or her business, but rather on the substance of the activities and transactions that gives rise to the income in question.” (footnote 4)

Therefore, it is our view that the Indian Act tax exemption should apply the same way regardless of whether the partnership interest is held by Prof Corp or the Taxpayer. In both cases, the connecting factors test should be applied to the business income earned by the Limited Partnership.

We trust that these comments will be of assistance.

Yours truly,

Ms. Nerill Thomas-Wilkinson, CPA, CA
Manager
Non-Profit Organizations and Indigenous Issues
Specialty Tax Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Par. 22, Bell v. the Queen (2018 FCA 91)

2 https://www.canada.ca/en/revenue-agency/services/indigenous-peoples/information-indians.html#hdng5

3 https://www.canada.ca/en/revenue-agency/services/indigenous-peoples/information-indians.html#hdng5

4 Par. 24, Bell v. the Queen (2018 FCA 91)

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