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Next Time Maybe An Announcement?

 

by Michael Goldberg, tax partner
Minden Gross, a member of MERITAS Law Firms Worldwide[1]

It’s what I don’t know that really scares me.

 Just the other day I was working on a file when I came across Technical Interpretation 2007-0258011I7 QSBC Shares - Partnership Interest (the “2007 TI”).[2]  Seemed innocuous enough but, as it turns out, the 2007 TI appears to have very quietly reversed the CRA’s 20 year administrative position about the application of the specified investment business (“SIB”) rules to employees of partnerships, which, prior to the release of the 2007 TI, most practitioners would have considered to be employees of the partners of the partnership for all purposes (whether the partners were general or limited partners).[3]  Apparently this is no longer the case in all circumstances – though it seems that the CRA has been of this view for quite some time.

 The SIB Rules

 For those of you who are unfamiliar with the SIB rules, subject to two exceptions (described below), a SIB is defined in paragraph 125(7) of the Act as a business carried on by a corporation, the principal purpose of which is to derive income from passive investments.  In the past the SIB definition was primarily seen to be a mechanism to restrict access to income tax benefits available to qualifying CCPCs, including the small business deduction, capital gains exemption[4] and various incentives relating to SR&ED.  However, due to reductions in the general corporate tax rate and the introduction of the eligible dividend rules the ability to avoid the SIB rules has become an increasingly relevant topic. 

 The first exception to the SIB rules is for a corporation that “employs in the business [i.e., the business that would otherwise be a SIB] throughout the year more than 5 full-time employees”.[5]  The second exception to these rules applies to “a corporation that is associated with the corporation [i.e., the corporation that would otherwise earn SIB income] that provides, in the course of carrying on an active business, managerial, administrative, financial, maintenance or other similar services to the corporation in the year and the corporation could reasonably be expected to require more than 5 full-time employees if those services had not been provided”.[6] 

 The 2007 TI, Lerric and Other CRA Administrative Positions

 The 2007 TI only deals with paragraph (a) of the SIB definition.  The facts of the 2007 TI involve a corporation (Aco) that owns rental properties.  Aco is also a partner of a partnership involving 2 related individuals that provides management services solely to Aco and employs more than 5 employees.  If Aco had employed the employees of the partnership directly it appears that the shares of Aco would have otherwise qualified as qualified small business corporation shares and the CRA was asked whether the fact that the partnership employed the employees had any effect on the QSBC status of Aco’s shares.  The CRA determined that based on an extension of the reasoning in Lerric Investments Corp. v. The Queen, 2001 DTC 5169 (FCA), a case that dealt with the treatment of employees of joint ventures, Aco would not be considered to employ the employees of the partnership in its own passive business.  As a result of not being able to claim the partnership’s employees as its own employees, Aco’s passive business would be a SIB and the shares of Aco would not be QSBC shares.

 The issue in Lerric was whether Lerric Investments Corp. (“LIC”), which was a member of a number of passive joint ventures could be considered to employ all of the employees of the joint ventures it was involved in, its pro rata share of those employees based on its ownership in each respective joint venture or none of the employees.  The FCA did not accept that each employee of a joint venture could be treated as an employee of each joint venturer since this could result in significant arbitrary double counting of employees and would not be “consistent with the words of subparagraph 125(7)(e)(i) in their context.”[para. 13]

 Regarding proportionate sharing of employees the FCA held that: 

…There are no words in the provision that imply that a proportional or sharing approach of the same employee by different employers is contemplated. [para 17]

 ….

 …it is the co-owners or joint venturers together, but not independently, who employ the employees. No co-owner or joint venturer can say that it individually employs the employees or portions of the employees. They can say that, in accordance with the co-ownership or joint venture agreement, they are responsible for a percentage of each employee's wages. However, this does not give rise to the allocation of fractional employees and the aggregation of these fractions to meet the “more than five full-time employees” test in subparagraph 125(7)(e)(i). [para 20] 

Based on the foregoing analysis, the FCA concluded that:  

The Minister says [what is now paragraph (a) of the SIB definition] is an arbitrary proxy for an active business and it may not accommodate every deserving situation. I am forced to agree with the Minister. It is not difficult to construct anomalies which demonstrate that either the application or non-application of subparagraph 125(7)(e)(i) [now paragraph (a) of the SIB definition] to co-ownerships or joint ventures leads to illogical results. However, applying an arbitrary rule to situations not contemplated by the rule will have that effect because it is arbitrary. Be that as it may, it is the duty of the Court to take the statute as it finds it. 

Consequently, LIC did not employ the required amount of employees and was a SIB as assessed. 

Although the decision pointedly commented that LIC was a joint venturer not a partner,[7] the FCA did not specifically comment on how the decision in Lerric might impact on a similar analysis in respect of partnerships.  Nonetheless, at Trial,[8] Bowman, TCCJ made his opinion about the distinction known in the following obiter comments at paragraph 18 of the decision: 

The first approach is to consider whether the distinction drawn in paragraph 16 of IT-73R5 between a partnership and a joint venture is correct. If corporations A and B are partners and the partnership owns an apartment building and employs six full-time employees IT-73R5 says each partner employs six full-time employees. If they are joint venturers, IT-73R5 says they each employ only three full-time employees. It is somewhat difficult to rationalize this distinction. The legal rationale, rightly or wrongly, is probably that a relationship of agency exists between partners but not generally between joint venturers. This is not, however, an answer. Where two joint venturers or co-owners hire a full-time employee for a project that person is an employee of both of them regardless of the absence of agency. It is inaccurate to say that one-half of the employee is employed by one co-owner or joint venturer and one-half by the other.  

Still, notwithstanding the possibility that the distinction between joint venturers and partners might be a fine one, in 2002, following the FCA decision in Lerric, Interpretation Bulletin IT-73R5 (the “IT”) was reissued and, while it was thought that any changes to the administrative position in respect of partners merely represented a “watering down” of the pre-Lerric position, based on the 2007 TI and informal discussions with Rulings, it appears that the distinction has almost completely been eliminated (apparently since the date the IT was issued).  To this end, the following comments are set out in the 2007 TI: 

Although Lerric concerned a joint venture, in our opinion, it is not possible to limit its application to its facts.  This decision stands for the proposition that a direct relationship must exist between the corporation as employer and the employees in order for the corporation to come within the wording "the corporation employs ...more than 5 full-time employees"[9] requirement in the SIB definition.  

It is our opinion that where a corporation carries on a business as a member of a partnership, employees working for the partnership are the employees of its partners collectively, but not of any of them individually.  Accordingly, for the purpose of determining whether Aco's rental operations are a SIB, Aco is not considered to employ the employees of the partnership of which it is a partner, since such employees are considered to be employed by the partners collectively.  

At first blush, these comments seem to be a complete repudiation of paragraph 20 of the IT, which was not referred to in the 2007 TI and reads as follows: 

20. A business carried on by a corporation as a member of a partnership is not a "specified investment business" if the partnership employs more than five full-time employees. In other words, the corporation's share of income from the business can be included in the calculation of its "specified partnership income". 

However, based on informal discussions with the CRA, it seems that the CRA is of the view that the position set out in paragraph 20 of the IT is only applicable to the determination of the tax treatment of a corporate partner’s otherwise passive partnership income earned by the partnership where the partnership itself employs the employees.  This is to be distinguished from the example in the TI where the passive income was being earned by the corporate partner not the partnership.  Still it would have been nice if the CRA had at least noted the existence of paragraph 20 of the IT in the 2007 TI and specifically commented on its application or lack thereof to the 2007 TI. 

It appears that the administrative position in paragraph 20 may actually represent a concession by the CRA since based on Lerric, presumably the corporate partners would still not be considered to employ the employees of the partnership and it appears that the provision permits each corporate partner to treat its share of the particular partnerships income as non-SIB income, in effect permitting them to “double count” the employees of the partnership. 

A comparison of paragraph 20 of the IT with paragraph 16 of Interpretation Bulletin IT-73R4 (the “Old IT”) appears to highlight the change in position by the CRA.  In particular, paragraph 16 of the Old IT read: 

If, for example, two corporations carry on a business in partnership as equal partners with the partnership business employing more than five full-time employees, each partner would, for the purpose of paragraph (a) of the definition of “specified investment business” in subsection 125(7), be considered to employ more than five full-time employees. 

Whereas the language of paragraph 16 of the Old IT appears to have the effect of causing the employees of the partnership to flow-through to the partners as the employees of the partners the wording in Paragraph 20 of the IT seems to merely indicate that the partnership itself will not be a SIB provided the partnership employs more than 5 full-time employees. 

So how does all this affect my clients? 

The discussion below contains some practical examples that will hopefully be helpful to appreciate the impact of the CRA’s change in administrative position. 

In the examples that follow it will initially be assumed that the scenario involves a single wholly owned corporate real estate limited partnership involving a corporate general partner (“GP”) with a nominal interest and a single corporate limited partner (“LP”) whose only asset is its interest in the limited partnership.  The partnership employs more than 5 full-time employees throughout the year and owns all of the real estate assets that give rise to income that might be considered to be SIB income.   

It appears that even though based on general principles both general and limited partners are deemed to carry on the business of a partnership,[10] if the 2007 TI is applied strictly to this situation then based on its reliance on Lerric, the employees of the partnership would not be considered to be employees of the LP; therefore, but for the administrative concession under paragraph 20, income earned by LP and GP from the partnership would be SIB income under paragraph (a) of the SIB definition.[11]  In the past the administrative position in paragraph 16 of the Old IT avoided this result by resulting in the partners of a partnership being considered to employ the employees of the partnership.  It also appears that the administrative position in paragraph 20 of the IT should also avoid this result by deeming the income of a partnership employing more than 5 full-time employees to not be SIB income in the hands of its partners.[12]  It also appears that, based on both the Old IT and the IT, this conclusion would be unchanged even if the facts were modified so that there were multiple corporate LPs. 

If the limited partnership did not employ any employees but any particular partner (LP or GP[13]) directly employs more than 5 full-time employees whose purpose is to carry on the limited partnership’s business then that particular partner’s income from the limited partnership would also appear to not be SIB income under both the Old IT and the IT.[14]  Of course, the income of the other partners who do not employ the requisite number of employees “in the business” of the limited partnership would not escape treatment as SIB income under paragraph (a) of the SIB definition.[15] 

However, because paragraph (a) of the SIB definition requires that employees be employed throughout the year in the “business”, where a corporation owns and manages its own passive investments and/or it is a partner in a number of partnerships that own passive investments[16] it may be considered to be carrying on more than one business, in which case, establishing that the employees of the corporation are being used full-time in any particular business may be difficult.   

For example if LP employs 5 or less employees in a passive business it directly carries on and the limited partnership carries on a similar business employing 5 or less employees then based on the words of the SIB definition and the administrative position in the Old IT and provided the businesses could be considered to be the same business then all of the income earned by the corporation would have been non-SIB income since it was widely believed that the employees could have been aggregated.  However, based on the administrative position in paragraph 20 of the IT when read in conjunction with the 2007 TI, it seems that LP would not be able to add the employees of the limited partnership nor any portion of those employees to its own employees, such that the income from the business it directly carries on would be SIB income[17] – even if both businesses were substantially the same type of business.   

The (b) Plan 

Notwithstanding the CRA’s restrictive interpretation of paragraph (a) of the SIB definition, based on Technical Interpretation #2005-0120751E5 (the “2005 TI”), dated February 21, 2006, it appears that the CRA takes a more liberal view of the application of paragraph (b) of the definition.[18]  The facts of the 2005 TI involved Aco, a corporation holding passive real estate that received services from a partnership employing more than 5 full-time employees.   

Since Bco, a corporation associated with Aco, was one of the partners of the partnership, Aco’s passive investment income was determined not to be SIB income.  Apparently, the keys to this interpretation were that the associated corporation (i.e., Bco) was deemed to carry on the active business of the partnership based on the Robinson decision and that paragraph (b) of the SIB definition does not require the associated corporation to actually employ the employees – only that the “in the year” Aco would have required 5 or more full-time employees to service its business in the absence of the services having been provided by the associated corporation (Bco).   

This interpretation should provide some comfort to associated corporate groups where there is one central management corporation providing services to a number of passive holding corporations.  Of course, the factual determination that any particular passive corporation would have needed 5 or more employees in the absence of services being provided by the management corporation must still be met.  However, since the language of paragraph (b) of the SIB definition seems to require that the services must be provided “to the corporation”, query whether Rulings would have come to the same conclusion had Aco been a member of a partnership that received the services rather than the services being received by Aco itself. 

Wrap-Up 

The effect of the “change” of the CRA’s administrative position in paragraph (a) of the SIB definition may be to significantly affect how corporate groups that involve partnerships will be forced to operate.  It will certainly cause such groups to analyze where the employees in the group are employed to ensure that each entity (partnership or corporation) that would otherwise earn material amounts of SIB income employs more than 5 employees.  In some situations, this may result in some entities becoming SIBs where there are insufficient employees to staff all of the entities, unless paragraph (b) of the SIB definition can be satisfied, which, as was discussed previously, may be problematic in the case of corporate groups that operate through a number of partnerships.  Where the “(a) and (b) plans” both fail group consolidation may need to be considered – though advisors should carefully consider whether the business cost of attaining preferable tax rates is acceptable.