Canada: CRA Tax Rulings Allow Multiplication of Small Business Deduction For Professional Partnerships

Last Updated: June 14 2006
Article by Greg J. Best

In light of the recent amendments to the Business Corporations Act (Ontario) and the Regulated Health Professions Act (Ontario) permitting doctors and dentists to split income with family members through professional corporations, Ontario doctors and dentists will want to take note of two rulings (2004-0104681R3 and 2005-0130131R3) recently released by the Canada Revenue Agency ("CRA").

Both rulings address the issue of whether a professional corporation is eligible for the small business deduction when a partner of a professional partnership (while remaining a partner) creates a professional corporation in order to provide professional services to the partnership. CRA ruled favourably in both cases, and allowed for multiple access to the small business deduction among the members of the professional partnerships in question.

The tax advantages of multiple access to the small business deduction are significant. For example, in Ontario, the highest marginal tax rate for individuals is approximately 46%. When compared to the effective rate of 18.6% on income eligible for the small business deduction, there is currently a potential tax deferral of about 27% on professional income that is retained in a corporation.

Prior to the proposed business reorganizations described in the rulings, the taxpayers were carrying on business as a partnership (the "Partnership"). All of the partners were individuals who provided their professional services through the Partnership.

The taxpayers proposed a reorganization of their existing business structure, whereby the Partnership agreement would be amended to allow each partner to provide his or her professional services to the Partnership through a professional corporation which he or she controlled (the "Contracting Companies").

The Contracting Companies would then enter into a written agreement with the Partnership to provide professional services as independent contractors. In both rulings, the amount of the fee paid by the Partnership to the Contracting Companies for the professional services provided was not to exceed the fair market value of such services. Both rulings also provided that the fees charged by a particular Contracting Company would reduce the profit share of the partner who controlled that Contracting Company.

Under the 2005 ruling, each partner would be an employee of his or her particular Contracting Company, and would provide professional services for the benefit of the Contracting Company pursuant to the terms of its agreement with the Partnership. The employment relationship would be evidenced by a written employment agreement, under which the partner/employee would receive a salary from his or her Contracting Company for the services provided.

In contrast, the 2004 ruling was not clear on whether the partners would be providing services to their respective Contracting Companies as employees or independent contractors.

According to the taxpayers involved, the purposes of the proposed transactions included increasing control over each partner's participation in the practice, certain expenditures that may not be in the interest of all participants in the practice (i.e. continuing education, transportation and expenses on personal practice preferences) and personal estate and financial planning.

The enhancement of the Partnership's ability to retain current and recruit additional members was also cited in both rulings as an objective of the proposed business structure. It is interesting to note that only the 2004 ruling stated that none of the reasons for the separate existence of the Contracting Companies was to reduce the amount of tax that would otherwise be payable under the Income Tax Act (Canada) (the "Act").

In both instances, CRA ruled that the business carried on by a Contracting Company would not be considered a "personal services business", as that term is defined in subsection 125(7) of the Act, and that fees received from the Partnership by each of the Contracting Companies would constitute active business income eligible for the small business deduction.

In this regard, CRA's comments in a recently released technical interpretation [2005-0160891E5], which dealt with circumstances similar to those in the 2004 and 2005 rulings, 1warrant attention. The views expressed by CRA in this technical interpretation raise the possibility that, in making the above determination, CRA will consider whether the Contracting Companies (and their controlling shareholders) are allowed to compete with the Partnership. If not, CRA may consider this to be one of the indicators that a Contracting Corporation is carrying on a personal services business.

The 2005 ruling specifically stated that as long as a Contracting Company fully discharged its responsibilities under the agreement with the Partnership, the Contracting Company would not be restricted from providing services to other persons or otherwise prohibited from competing with the Partnership. The 2004 ruling, however, was silent on this issue.

With respect to the fees paid by the Partnership to the Contracting Companies, CRA confirmed that such fees were deductible by all partners in calculating their share of partnership income.

CRA also provided rulings on the possible application of various anti-avoidance provisions to the proposed transactions. Specifically, CRA noted that subsections 56(2), 56(4) and 246(1) of the Act would not apply to tax the income received by the Contracting Companies in the hands of the partners, and that Partnership income would not be reallocated among the partners pursuant to subsection 103(1) of the Act. Finally, CRA stated that it would not apply the general anti-avoidance rule in section 245 of the Act to re-determine the tax consequences of the proposed transactions.

CRA was unable to rule (in either ruling) on whether subsection 256(2.1) of the Act was applicable in the circumstances. Subsection 256(2.1) is an anti-avoidance rule that effectively requires the small business deduction to be shared among two or more corporations, where it can reasonably be considered that one of the main reasons for the separate existence of those corporations was to achieve a reduction in tax.

However, CRA did comment that where a function of a professional partnership that was previously carried on by the partnership is subsequently carried on by a partner's professional corporation for bona fide reasons other than to achieve a tax benefit, this fact, in and by itself, would generally not cause subsection 256(2.1) of the Act to apply.

Given the favourable response from CRA in these rulings, professionals currently operating as a professional partnership will want to consult their tax advisor to discuss the merits and feasibility of engaging in similar tax planning for their business.


1. In the above referenced technical interpretation, the Contracting Corporations provided services to a professional corporation, albeit in the same manner as the Contracting Corporations in the 2004 and 2005 rulings provided services to the Partnership.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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