Owner-Manager Remuneration: Characterization of Payments
The Background
The recent case involving Malamute Contracting Inc., a small Ontario business specializing in kitchen and bathroom renovations, highlights a common challenge faced by owner-managed businesses: correctly characterizing payments to shareholders.
Owned by David and Danielle Lynch, Malamute initially issued biweekly payments to the couple labeled as “payroll,” varying slightly with each cheque. These variations appeared similar to net payroll amounts after typical tax and Canada Pension Plan (CPP) deductions. Initially, Malamute even remitted payroll taxes to the Canada Revenue Agency (CRA). However, after March 2018, the company ceased these remittances and reclassified these payments internally as shareholder advances or dividends instead.
Upon audit, the CRA reassessed Malamute, treating these payments as salary and demanding back taxes, CPP contributions, and penalties for failure to remit payroll deductions.
The Court’s Findings
Justice Cook of the Tax Court of Canada clarified a critical principle: the nature of a payment (salary vs. dividend) is determined by the intention at the time of payment. Although Malamute mistakenly labeled these payments as payroll initially—due to Danielle’s lack of bookkeeping experience—the evidence showed the Lynches consistently intended the payments as dividends, not salary.
Importantly, the Court rejected CRA’s argument of an “after-the-fact” reclassification. Justice Cook emphasized that genuine bookkeeping corrections are permissible if they reflect the original intent and financial reality. He criticized the CRA for narrowly focusing on early bookkeeping mistakes rather than considering the broader business context and intent demonstrated throughout the year.
Ultimately, the Court ruled in favor of Malamute. The payments were recognized as dividends to shareholders rather than salary, negating the obligation for payroll deductions, CPP contributions, and associated penalties.
Key Takeaways
- Precision in Bookkeeping: Maintaining accurate and detailed financial records is essential. Casual notations can lead to misunderstandings and be cause for concern in the future.
- Professionals Advice: Engaging a professional accountant can help ensure that financial practices are in accordance with tax regulations.
- Intent Matters: Clearly define the nature of payments at the outset to avoid retroactive complications.
Malamute underscores the necessity of careful financial management and record-keeping for owner-managed businesses. It also provides valuable insights into how intentions and business realities can influence tax outcomes.
***Disclaimer: This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions, you should consult a lawyer.
Sources:
https://taxinterpretations.com/content/954284
https://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/521419/index.do?q=malamute
Elias Zafiridis