12 July 2000 Internal T.I. 2000-0024537 - INDIAN TAXATION - EMPLOYMENT INCOME

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: 1. Is the employment income of an Indian exempt from taxation. 2. Are bonuses received by an Indian employee exempt from taxation. 3. How is the reasonableness of the bonuses determined when the corporation has investment income and business income.

Position: 1. Cannot determine. 2. Yes. Once the bonus is found to be reasonable, it forms part of employment income. 3. Question of fact.

Reasons: 1. Guideline 2 applies if the employee lives on reserve and the corporation is resident on reserve. If the employee lives off reserve and no other guideline applies, the proration rule applies to exempt the employment income earned on reserve. The employee has two residences and it is a question of fact if he has a principal residence on reserve and lives there. 2. Bonuses are included in employment income and are exempt if one of the guidelines are met. 3. There are no specific guidelines in determining the reasonableness of bonuses. The fact s of each particular case should be examined. Question 42 of the 1981 Round Table Conference Table suggested comparisons with like services performed in the same or similar businesses of the duties performed by the employee and the time expended in carrying out these duties, the remuneration of other employees of the same business who have similar types of responsibilities, experience, and skills, the remuneration paid by other businesses of a similar size to employees who render services corresponding to those of the employee concerned."

		July 12, 2000

	XXXXXXXXXX 	HEADQUARTERS
	XXXXXXXXXX 	David Shugar
		957-2134
	Attention: XXXXXXXXXX
		2000-002453

Status Indian Issue - Paragraph 81(1)(a) of the Income Tax Act (the "Act")

This is in reply to your correspondence of April 27, 2000 requesting our comments on the taxability of employment income and bonuses paid to an Indian shareholder/employee of a corporation. The information you provided us include the following:

• The taxpayer, Mr. G, is a status Indian.
• Mr. G is the sole shareholder of XXXXXXXXXX (the "Corporation"), and is an employee of the corporation.
• Mr. G received employment income of $XXXXXXXXXX per year, plus bonuses of XXXXXXXXXX; the bonuses paid to Mr. G were based upon the corporate profit levels and you are not challenging their reasonableness under section 67 of the Act.
• The corporation is in the business of XXXXXXXXXX; its revenue-generating activities take place entirely off reserve, for customers who are located off reserve.
• The corporation's business office is located on the reserve; its books and record are kept and maintained on the reserve, except for its minute books, which are kept off reserve at the company's lawyer's office, where the annual Directors meetings are also held; its equipment is stored and serviced on the reserve; and, the corporation does its banking at a branch located off reserve.
• Mr. G has living quarters available above the corporation's shop on the reserve, and owns a home off the reserve, where he spends the occasional weekend, and two weeks in the summer.

Our Comments

Paragraph 81(1)(a) of the Act and section 87 of the Indian Act provide a tax exemption for the personal property of an Indian or band situated on a reserve. Since a corporation is not an "Indian" or "band," as defined in the Indian Act, it does not qualify for this exemption. Therefore, the corporation will be taxable on its income unless otherwise exempt from taxation under another provision of the Act.

Employment Income

Since the courts have determined that employment income is personal property, the taxability of employment income earned by an Indian depends on whether such income is situated on a reserve. The courts have also directed that connecting factors must be considered when making this determination. The Indian Act Exemption for Employment Income Guidelines (the "Guidelines") incorporate the various connecting factors, that describe employment situations covered by section 87 of the Indian Act.

Guideline 2 of the Guidelines will apply to exempt all of the employment income of Indian employees who live on reserve, provided that the employer is in fact resident on a reserve. The condition that the "employer is resident on a reserve" means that the reserve is the place where the central management and control over the employer organization is actually located. The central management and control of an organization is usually considered to be exercised by the group that performs the function of a board of directors of the organization. It is a question of fact where the central management and control is exercised. Usually management and control exists where the members of the Board of Directors meet and hold their meetings. In your letter you stated that the annual meeting of Directors is held off the reserve, at the lawyer's office in XXXXXXXXXX, a fact which, based on paragraph 15 of Interpretation Bulletin IT 391R, Status of Corporations, would indicate that the corporation resides off the reserve. However, you have not asked us to comment on the residency of the corporation, therefore, we are assuming you have gathered additional information to satisfy yourselves that the corporation is resident on the reserve. Our comments that follow are based on that assumption, although if there is any uncertainty regarding the residency of the corporation, the residency issue could be raised along with the other contentious issues mentioned in the conclusion to this letter.

The meaning given to the phrase "Indian lives on the reserve" is that "the Indian lives on the reserve in a domestic establishment that is his or her principal place of residence and that is the centre of his or her daily routine." The information you provided does not state whether you have seen the living area above the shop and are satisfied that it contains the facilities that would be expected in a principal place of residence, such as a kitchen, bathroom and sleeping area. An indication that the living area may not be suitable as a principal place of residence is the comment in the representative's letter of April 18, 2000, that Mr. G is presently developing a new residence/commercial building to improve living conditions and shop facilities.

If the living area above the shop is, in fact, suitable as a domestic establishment, Mr. G would have two residences. A determination must be made regarding which of the two is his principal place of residence. This situation is distinguishable from the situation in the Williams case, upon which the Guidelines are based, in which the determination of the Indian's residence was not an issue. This situation may be unusual enough such that Guideline 2 may not apply when the Indian has residences on and off the reserve.

In your correspondence, you suggest that the bonuses may not be exempt from tax in Mr. G's hands because the corporate income is earned off the reserve, from customers who are located off the reserve. However, when applying Guideline 2 to employment income, the relevant connecting factors are whether the employer and the employee reside on a reserve. In determining whether employment income is exempt from tax, it is those factors, rather than the location of the revenue-generating activities of the corporation, that are the most important factors connecting the employment income to a reserve.

You stated that you believe the bonuses do not represent employment income to Mr. G because the bonuses are based on corporate profits rather than work performed for the company. Subsection 5(1) of the Act states that a taxpayer's income for a taxation year from an office or employment is the salaries and wages and other remuneration, including gratuities, received by the taxpayer in the year. Employment income includes all salary, wages, bonuses, vacation pay, tips and gratuities, honorariums, directors' fees, commissions, taxable allowances, the value of taxable benefits and any other payments actually received during the year for services during the year as an officer or employee.

In addition, subsection 6(3) of the Act deems certain payments, for purposes of section 5, to be remuneration for services rendered during the period of employment unless, inter alia, it can be established that the amount can reasonably be regarded as other than a payment received under the contract of employment. This includes a payment received by a person pursuant to a contract of employment which provides that part of his remuneration will be payable on a deferred basis, and may refer either to a portion of his regular salary, wages, commissions, etc., while he was employed, or to some special amount such as an annual bonus.

In our view, therefore, bonuses are employment income, and the guidelines apply to bonuses in the same way they apply to salary and wages.

Reasonableness of Bonuses

The Canada Customs and Revenue Agency (the CCRA) has had a long-standing practice of not challenging the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation's business where the corporation has established either a practice of distributing profits to such a shareholder/employee in this manner, which appears to be the case in the present situation, or a policy of declaring bonuses to shareholders to remunerate them for the profits the corporation has earned that, in fact, are attributable to special know-how or skills of the shareholder/employee. This position was adopted largely for administrative ease and because the overall tax effect did not vary significantly whether the corporate profits were drawn out as salaries or as dividends. However, that practice does not extend to various scenarios that could result in inappropriate tax consequences. For instance, the practice does not apply to remuneration paid to spouses of the shareholder nor to shareholders who are non-residents. Where a shareholder/employee lives on reserve and is, by virtue of paragraph 87(1)(b) of the Indian Act, exempt from tax on employment income from a corporation based on reserve, it would be a question of fact as to whether section 67 of the Act would apply to limit the amount which the corporation could deduct as bonuses in computing its income. Section 67 denies the deduction in respect of an expense that is otherwise deductible, except to the extent that the expense was reasonable in the circumstances.

In your letter you stated that you are satisfied that the bonuses are reasonable, based on the company practice of paying bonuses based on the corporate profit levels. That conclusion is based upon CCRA's policy of not challenging the reasonableness of bonuses. However, in our view, the determination whether the bonuses are reasonable, in this case, should be based on the facts of the case, taking into consideration the guidelines in Question 42 of the 1981 Round Table Conference, reproduced below.

The Corporation may also have earned investment income on its bank account balances held in a bank located off the reserve. The reasonableness of bonuses paid out of investment income was addressed in Question 26 of the 1991 Revenue Canada Round Table and states:

"Q.26: Shareholder-Manager Bonus Paid out of Investment Income or Capital Gain

What is the Department's position on the situation in which a shareholder-manager receives a large salary/bonus some or all of which may be attributable to investment income rather than active business income?

Department's Position

As stated in Question 42 of the 1981 Round Table, and Question 56 of the 1990 Round Table, there are no guidelines to determine the reasonableness of salaries/bonuses paid out of investment income. The amount, if any, that is considered to be reasonable will be based on the facts of each particular case."

Question 42 of the 1981 Round Table, went on to say:

"In general, when determining whether salaries paid to employees-shareholders are reasonable, comparisons with like services performed in the same or similar businesses are required. In making this evaluation the following information is usually obtained:

a) the duties performed by the employee and the time expended in carrying out these duties,

b) the remuneration of other employees of the same business who have similar types of responsibilities, experience, and skills,

c) the remuneration paid by other businesses of a similar size to employees who render services corresponding to those of the employee concerned."

As stated above, the amount of a bonus, if any, that is considered to be reasonable, in a situation where the corporation earns investment income, will be based on the facts of each particular case. In our view, however, once it is determined that the bonuses are reasonable in the circumstances, the fact that a portion of the bonus payments are paid out of the corporation's income from investments earned off the reserve would not change the nature of the bonus as employment income to Mr. G. The Guidelines would still apply to the bonuses without regard to whether the corporation earned the income from investments on or off the reserve, or from its business activities.

Dividend Income of a Shareholder

In contrast to the most important factors described above connecting employment income to a reserve, the most important factor in connecting investment income of an Indian to a reserve is the location of the revenue-generating activities of the corporation. Dividend income is an income stream from the shares owned by the taxpayer, and such income will be exempt to the recipient if it is earned on a reserve. Following the decision in the Recalma case (1996 DTC 1520; (1996) 3 CTC 2272) which concerned investment income, the connecting factors pointing to the location of shares are not to be given as much weight as other, more significant factors. Similarly, the mere location of a corporation's administrative office on reserve would not be sufficient to enable one to conclude that income arising from the corporation's business is connected to a reserve. Instead, what is more important is the location of the revenue-generating activities of the corporation that enables the corporation to earn income and pay dividends.

The location of the corporation's clients is another significant factor. In our view, dividend income received by the shareholder would be subject to tax since the corporation's income has been earned off reserve, in the commercial mainstream.

Business Income - Sole Proprietor

In your correspondence, you referred to the case of Mitchell v. Peguis 1990(2) S.C.R. 85, regarding an Indian entering the commercial mainstream, and our letter E990177, which stated that where an Indian's business income is derived from activities carried on off reserve for customers located off reserve, the business income would generally not be exempt from taxation. That letter was in respect of an unincorporated business carried on by an Indian. The location where a self-employed Indian lives is not a determining factor in connecting the business income to the reserve. While it may carry some weight, the most important considerations are the location of the revenue-generating activities, and the location of the customers of the business. In situations where a portion of the revenue-generating activities of the business are performed on the reserve, then a similar portion may be exempt from tax. This position was upheld in the Federal Court of Appeal case of Southwind v. The Queen (98 DTC 6084) which is the leading case dealing with the business income of an Indian. While certain activities may be carried on in an on reserve office (i.e. maintaining of books and records), the actual revenue generating activities would be more significant in determining whether business income is connected to a reserve.

Conclusion

We cannot reach any definitive conclusions regarding the residency of Mr. G or the Corporation, or the reasonableness of the bonuses, based on the facts provided in the above situation. Such determinations must be made at the audit stage. However, we can provide you with the following views.

If you find that Mr. G. lives off the reserve, or the corporation is not resident on the reserve, Guideline 2 would not apply, but the proration rule under Guideline 1 may apply to exempt only that portion of employment income related to the duties performed on a reserve. However, since all the income earning activities of the corporation takes place off reserve, the employment duties performed on the reserve may be nominal. Mr. G's duties on reserve may be mostly in the capacity of director.

XXXXXXXXXX

Yours truly,

Jim Wilson
for Director
Business and Publications Division
Income Tax Rulings Directorate
Policy and Legislation Branch

- 7 -