Professional corporations: Who, how and why?

Business owners have a few options when choosing the legal structure for providing goods and services – most commonly sole proprietorships, partnerships and corporations.

Of those, a corporation is clearly distinguished as a separate legal entity from those who own and operate it. This opens the door to potential tax advantages, enhanced creditor protection, extended business continuity and sharing of ownership. However, not every business is entitled to unbridled use of a corporation, particularly in the case of professional services.

The availability and constraints placed on “professional corporations” varies from one profession to another and across provinces. Navigating the rules can be challenging, but doing so will allow a professional to make an optimal decision on how to best structure a practice. This article outlines the key issues that are explored in greater depth in our Tax & Estate InfoPage titled Professional corporations.

Corporations, liability and malpractice

To repeat, a corporation is a separate legal entity from its owner/shareholders. To the extent that shareholders have not given guarantees, their personal exposure is generally capped at – or “limited” – to losing their initial investment.

This characteristic is also true of professional corporations in general business dealings, but there is no shield against malpractice claims. The professional remains personally responsible for the professional services and advice given, for which appropriate liability insurance is invariably required as a condition of the licence to practice.

Tax aspects of incorporation

Our tax system is set up so that roughly the same amount of tax is paid whether income is earned personally or through a corporation then paid as a dividend to a shareholder. The accompanying table illustrates how this integration of corporate and personal taxation works.*

Professional income earned personally

  • Income                                          $1,000
  • Personal tax (45%)                  ($450)
  • After-tax cash                             $550

Professional income earned by corporation

  • Income (A)                                  $1,000
  • Corporate tax (15.3%) (B)      ($153)
  • Net income                                   $847
  • Dividend to shareholder         $847
  • Gross-up (18% rate)                 $153
  • Taxable dividend                    $1,000
  • Personal tax (45%)                ($450)
  • Dividend tax credit                   $153
  • Net personal tax (C)              ($297)
  • After-tax cash (A – B – C    $550

* Model tax rates are used for illustration purposes and rounded for ease of display.  Actual rates will vary by province, but there is no material difference in the comparative after-tax cash, being on average less than a quarter of a percentage point across the provinces.

Still, the use of a corporation may enable both tax savings and tax deferral.

Simply put, tax savings arise where the rate of tax is lower than would otherwise apply. Personal tax rates for an unincorporated professional may be 50% or more depending on province, whereas the corporate small business tax rate ranges from 11% to 19%. Comparatively, a corporation will usually have significantly more to reinvest in building the business than will an unincorporated professional.

Tax deferral is the ability to push taxation to a later point in time. If the professional does not need all the earnings of the business for current personal needs, the excess could be left in the corporation, thereby deferring tax otherwise applying to a dividend. That excess may be invested by the corporation (though some professions are limited in this respect), with the earnings and originally invested principal paid out as dividends when desired in future.

As you may expect, the actual tax operation of a corporation is more complex than this high-level outline. Our Tax & Estate InfoPage titled Illustrated corporate-personal tax integration explains these concepts step by step, and our Tax & Estate InfoCard titled Personal and corporate tax integration –  2015 summarizes the current effective rates by province and income type.

Qualifying professionals and shareholders

To one degree or another, incorporation is available to the traditional professions: accountants, doctors, dentists, engineers and lawyers. As well, those who provide services subject to provincial licencing are often able to incorporate, for example in health care support and a variety of financial services. Normally this is achieved through a combination of a provincial regulation and a bylaw passed by the particular profession’s governing body.

Beyond the professional personally, other individuals may also be allowed as shareholders, though without voting control. At the least, that usually means a spouse and children, but it may extend to parents, siblings, other blood relatives and possibly beyond. Those other shareholders will be able to receive dividends and may be entitled to some amount of the proceeds of the future sale of the practice.

Our Tax & Estate InfoPage titled Professional corporation – Shareholder rules 2015 provides details on who can incorporate, who can be shareholders and what restrictions may apply to operation and ownership. 

CRA compelled to assess tax return claiming credit in alleged gifting tax shelter

At issue

A person who owes tax may be pleased if the Canada Revenue Agency (CRA) delays assessing a tax return.  On the other hand, such delay can obviously be costly to someone who is anticipating a significant refund. 

This is the tactic employed by the CRA in recent years in the ongoing cat and mouse game over gifting tax shelters.  But it will need to be revisited in light of a Federal Court ruling last month.

Section 152(1) of the Income Tax Act (ITA)

The ITA specifically empowers and obliges the Minister National Revenue (MNR), through the CRA, to assess tax returns:

152. (1) The Minister shall, with all due dispatch, examine a taxpayer’s return … and determine … (a) the amount of refund … ; or (b) the amount of tax
[emphasis added – See McNally below]

CRA on “Tax Shelters”

The CRA maintains a page on its website warning of the dangers of investing in tax shelters.  In addition to outlining the nature of tax shelters and potential implications for taxpayers participating in them, there is a brief history of CRA’s efforts to curtail them and an inventory of Tax Alerts from as far back as 1998.  

Not mentioned on the page is the audit policy the agency began applying around 2010.  Where a taxpayer claims a credit through an organization that is (or is to be) audited as a potential gifting tax shelter, the return will not be assessed until after the audit is completed.  Audits of this nature may take a year or more to complete.

McNally v. MNR, 2015 FC 767

Mr. McNally filed his 2012 tax return on time in April, 2013, in it claiming a donation to EquiGenesis.  In June 2013 he received a letter from the CRA advising him that his return would not be assessed until an audit of EquiGenesis could be completed, which “can take up to two years to complete.”  He was given the option to withdraw the claim (for the time being), in which case CRA would assess the return without further delay. 

 Mr. McNally instead initiated the present application seeking an order of mandamus requiring the Minister to assess his return.

EquiGenesis had been audited and had charitable tax credits denied in 2003, 2004 and 2009, but allowed in 2005 and 2006.  The 2010, 2011 and 2012 programs are currently under audit.

Interestingly, Mr. McNally conceded that the “outcome of his assessment is a forgone conclusion [that] his credit will be disallowed.”  Still, he sought the current order so that he could proceed with his appeal rights under the ITA.

With regard to the audit policy, the MNR stated that the “purposes in implementing this change were to deter participation in such tax shelters.” 

With such a clear statement of the policy purpose, the judge concluded that “it is plain and obvious that Mr. McNally’s rights have been trampled upon for extraneous purposes.”  While there may be circumstances when an assessment may legitimately need to await an audit of a third party, the stated purpose of discouraging gifting tax shelters leads to the conclusion here “that the audit is an excuse for delay, not a reason for delay.”

On the central issue of the MNR’s statutory duty to assess a return “with all due dispatch”, the judge sided with Mr. McNally.  His return was to be examined and a Notice of Assessment issued within 30 days of the judgment.

Practice points

  1. Though McNally may be appealed, participants in gifting tax shelters may try to use this ruling to press CRA to assess presently-delayed returns. 
  2. Bear in mind that this is a procedural issue, having no impact on the legitimacy of a given gifting tax shelter, nor on the ultimate validity of any claimed credits.
  3. Along a related line of litigation, in McNally it was mentioned that the 2009 EquiGenesis program is before the Tax Court in October this year.

Provincial trust residency tested – Taxpayer prevails

A trust is not a legal entity, but rather the expression of a relationship where legal ownership of property is in the hands of a trustee, and beneficial entitlement lies with the trust’s beneficiaries.  Still, a trust is a taxable entity – so where should it be taxed?

Prior to 2012, it was not uncommon to hear it suggested that a trust is resident where the trustee is resident.  Assuming this to be correct, a settlor of a trust could potentially achieve tax savings merely by appointing a trustee in a favourable jurisdiction.  

SCC clarifies trust residency

Then came the Supreme Court of Canada (SCC) in Fundy Settlement.  In that case, Canada sought tax jurisdiction over a trust with almost half a billion dollars of capital gains, Canadian-resident beneficiaries and a trustee resident in Barbados.  It probably goes without saying that the Barbados tax system was much more generous to the taxpayer.

The SCC ruled that there is no legal rule that the residence of a trust invariably must be the residence of the trustee.   Instead, the court held that, akin to corporations, residence should be determined based on where the central management and control of the trust actually takes place.  On the facts, it was ruled that the purported trustee was simply directed from Canada.

While the substance of Fundy Settlement addressed jurisdiction between two sovereign nations, the principles apply similarly at a sub-national or inter-provincial level.  This past June, a judgment from Newfoundland and Labrador took guidance from this earlier case, though coming to a much different result for the trust taxpayer.   

From Newfoundland to Alberta

In 1987, Craig Dobbin founded CHC Helicopter Corporation, a transportation company servicing the oil and gas industry in Canada and abroad.  

The business was very successful, sufficiently so that in 2002 an estate freeze was implemented, a central component of which was a transfer of shares into the newly settled “Discovery Trust”.  The beneficiaries and trustees were Mr. Dobbin’s five adult children, most or all of whom were residents of Newfoundland and Labrador. 

In 2006 the trust was amended, including appointment of a successor trustee Royal Trust (RT), a corporation resident in Alberta.  Mr. Dobbin had been experiencing health issues at that time, and died later that year.  From his death through 2008 a series of transactions were undertaken to wind up the corporate interests held by the estate.  RT filed its 2008 trust tax return as a resident of Alberta.  

In 2012, the Canada Revenue Agency reassessed the trust as being resident in Newfoundland, calculating the shortfall of provincial tax at $8.8 million, plus arrears interest of almost $1.5 million.  The trust appealed the reassessment to court.

Improper tax motivation?

CRA’s position was that the Dobbin children made all trust decisions, instructing RT which merely served an administrative function.  The principle investigator’s report went so far as to conclude that RT was appointed “solely” to resituate the trust to Alberta.

This last point the judge considered to be irrelevant.  Referring to the oft-cited 1936 case of the Duke of Westminster, it is a person’s right to order affairs to reduce taxes.  It was Mr. Dobbins’ prerogative to amend the trust as he did, intentionally bringing it under Alberta tax jurisdiction.

Still, there remained the matter of whether Royal Trust factually exercised central management and control.  After reviewing the material transactions, the judge concluded that it had fulfilled its obligations.  Though some documents and processes were initiated by others, RT acted independently in reviewing all transactions in order to make informed decisions that protected the best interests of the beneficiaries.  

As to the assertion that the taxpayer had an improper tax motivation, the judge found on the contrary that the investigator’s negative view compromised the integrity of the review and in turn the foundation for the reassessment.