2023-0959371E5 Salary received by a sole shareholder-employee

Principal Issues: Whether salary paid to a sole shareholder-employee of a corporation qualifies for the tax exemption under the Indian Act.

Position: Depends on the factors related to the income-earning activities of the corporation.

Reasons: The Indian Act tax exemption is not dependent on the legal form or structure of a business but on the activities that generated the income.

Author: Townsend, Ann
Section: Paragraph 81(1)(a) - ITA, Section 87 - Indian Act

                                                                                           September 20, 2023

XXXXXXXXXX                                                                     Ann Townsend
                                                                                             2023-095937

Dear XXXXXXXXXX:

RE: Salary paid to a sole shareholder-employee and the tax exemption under section 87 of the Indian Act

This is in response to your enquiry about the tax exemption under section 87 of the Indian Act and paragraph 81(1)(a) of the Income Tax Act, and the salary paid to the sole shareholder-employee of a corporation. You provided the following hypothetical situation:

* The individual owns 100% of the shares of a Canadian controlled private corporation (Corporation) and is the only employee of the Corporation (Shareholder-Employee).

* The Shareholder-Employee is registered under the Indian Act.

* The Corporation has taxable income of $100,000 for the year.

* There are sufficient connecting factors to situate 25% of the Corporation’s income on a reserve.

You have asked if a salary paid to the Shareholder-Employee, which is equal to the amount of Corporation’s business income that is determined to be situated on a reserve, would be fully exempt from tax under section 87 of the Indian Act.

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.

The income of an individual who is registered or entitled to be registered under the Indian Act, is exempt from income tax under paragraph 81(1)(a) of the Income Tax Act and paragraph 87(1)(b) of the Indian Act, only if the income is situated on a reserve. However, it is important to note that the Indian Act tax exemption does not apply to corporations, even if they are owned by, or controlled by a band or an individual that is registered or entitled to be registered under the Indian Act.

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”. In Bell vs. the Queen, (footnote 1) the courts considered whether the bonuses received by a controlling shareholder of a corporation were income situated on a reserve and exempt from tax under the Indian Act. The Federal Court of Appeal 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.
…

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 2)

Another relevant case involving distributions from a corporation to a controlling shareholder is the Estate of Charles Pilfold v. the Queen. (footnote 3)   In this case, the Tax Court of Canada (TCC) attached the most weight to the off-reserve business activities that generated the distributions paid to the shareholder when determining if the distributions were situated on reserve and eligible for the tax exemption under the Indian Act. The TCC stated:

“As emphasized by Justice Evans in Robertson, with respect to business income, most weight must be attached to the business activity generating that income. Taking into account the off-Reserve planning and preparation, the actual fishing activity and the post-fishing processing and sales, and weighing that against the part-time residence of Charles Pilfold on the Musqueam Reserve, where the books and records of the Pilfold companies were kept, I conclude Charles Pilfold's business income was not intimately connected to the Musqueam Reserve and therefore not eligible for exemption under the Indian Act.” (footnote 4)

In the Pilfold case, the TCC also considered whether the Indian Act tax exemption applied to dividends received by the controlling shareholder and stated:

“... Here we have dividends from a closely held family corporation, the dividends from earnings from the very fishing activity constituting Charles Pilfold's business income. It would be an odd result indeed if the business income flowing out to Charles Pilfold through the various Pilfold companies is located off-Reserve, while it flowed out by way of dividends would be considered on-Reserve. No, in this type of situation, it is necessary to review the same underlying factors. In doing so, I would therefore characterize the dividend income as likewise off-Reserve.” (footnote 5)

Consistent with the case law and based on the hypothetical situation you described, the connecting factors relevant to the income-earning activities of the Corporation must be considered in determining whether the salary received by the Shareholder-Employee qualifies for the Indian Act tax exemption. Assuming that 25% of the Corporation’s income-earnings activities are determined to be situated on a reserve, then 25% of the salary paid to the Shareholder-Employee would also be situated on a reserve. In the situation described, the Corporation will pay a salary of $25,000 to the Shareholder-Employee, and although this is equal to the amount of the Corporation’s income that would be situated on a reserve, only 25% of the salary (i.e., $6,250) will be exempt from income tax under paragraph 87(1)(b) of the Indian Act and paragraph 81(1)(a) of the Income Tax Act. Similarly, if the Corporation pays a dividend to the Shareholder-Employee out of its remaining after-tax income, only 25% of that dividend will be exempt from income tax.

We trust that these comments will be of assistance.

Yours truly,

Ms. Nerill Thomas-Wilkinson, CPA, CA
Manager
Non-Profit Organizations and Indigenous Issues Section
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 Bell v. the Queen, 2016 TCC 175, affirmed Bell v The Queen, 2018 FCA 91

2 Bellv. the Queen, 2018 FCA 91, Par. 22, 24

3 Estate of Charles Pilfold v. the Queen (2013 TCC 181)

4 Ibid. Par. 72

5 Ibid. Par. 73

All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without the prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5.

© His Majesty the King in Right of Canada, 2023

Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistribuer de l'information, sous quelque forme ou par quelque moyen que ce soit, de façon électronique, mécanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.

© Sa Majesté le Roi du Chef du Canada, 2023