Application Policy

Number: FAS 2008-03

Date: March 26, 2008

Subject: Related Party Transactions

Purpose

The purpose of this policy paper is to inform stakeholders in the film industry of the Film Advisory Services' approach regarding related party transactions.

Application

This approach is used by Canada Revenue Agency (CRA) auditors in the Film Services Units when auditing related party transactions for purposes of the federal Canadian Film or Video Production Tax Credit and Film or Video Production Services Tax Credit.

It may also apply to the provincial tax credits that are administered by the CRA, providing the provincial legislation allows for such treatment.

Production costs

The following conditions (in addition to other conditions) must be met to qualify as a cost of production:

• The expenditure must be reasonably attributable to the Canadian Film or Video Production (CFVP). This is a question of fact and the onus is on the producer of the qualified corporation to demonstrate this fact.
• The amount of the expenditure must be reasonable in the circumstances.

Our position is that a mark-up on the cost between related party transactions may be added, as long as it is reasonable in the circumstances. To establish if the mark-up is reasonable in the circumstances, the auditor shall consider the following:

• Whether the marked up amount is within an acceptable fair market value (FMV) range. This is used as a benchmark to establish reasonableness. In principle, a convincing and persuasive third party comparable should be sufficient to establish a FMV range. In such cases, the taxpayer need not provide a breakdown between cost and mark-up. It is a question of fact whether the transaction reflects FMV and this will be considered on a case-by-case basis.
• In cases where the FMV cannot be established (i.e., where there is no convincing and persuasive third party comparable), the auditor may consider the value added service(s) that resulted from the related party transaction and the benefit derived by the production company. In doing so, the auditor will determine if the amount of mark-up is warranted in the circumstances. For example, a mark-up may be reasonable if the amount represents a service charge for administrative or technical advice. If the charge is only for the management of resources (i.e., for the rental of equipment held by the related party) or expenditures made by the parent company on behalf of the production company (i.e., paid to third parties), the mark-up should be minimal.

Labour expenditures

The following conditions (in addition to other conditions) must be met to qualify as a labour expenditure (LE):

• The expenditure must be directly attributable to the CFVP.
• The amount of the expenditure must be reasonable in the circumstances.
• The expenditure must also be included in the cost or capital cost of the CFVP.

To determine the reasonableness of the LE, we adopt the position outlined in the CRA's Guide RC4164, Claiming a Canadian Film or Video Production Tax Credit, which is consistent with the definition of "labour expenditure" in subsection 125.4(1) of the Income Tax Act.

When payments are made to a self-employed individual, a taxable Canadian corporation, or a partnership carrying on a business in Canada for the services of their employees, the look-through approach may be used to determine the reasonableness of the LE. This approach limits the amount of remuneration that may qualify as an LE to the amount that would have been incurred by the qualified corporation (QC) had it directly employed the individuals.

In applying this approach:

• the QC must obtain from the service provider the amount of salary or wages paid to the employee. This amount should qualify as an LE directly attributable to the production; or
• if the QC cannot get the amount of salary or wages paid to the employee from a service provider, we will accept 65% of the labour part of an invoice amount as a reasonable estimate of the LE directly attributable to the production. The remaining 35% represents overhead and the profit of the service provider.

In cases where non-labour amounts (such as rental fees, goods provided by the service provider, and travel and living expenses) are included in a payment to a service provider, but no breakdown is provided on the invoice, it will be necessary to estimate the labour part of the invoice before applying the 65% rate.

The 65% administrative position does not prevent us from auditing a third party to determine amounts paid to employees. If a QC has claimed an amount greater than 65%, it must provide enough evidence to support that percentage.

The look-through approach will not apply to payments made by a QC to a taxable Canadian corporation if the following apply:

• all the issued and outstanding shares of the capital stock of the company belong to an individual; and
• the activities of the company consist principally of providing the individual's services, to the extent that the amount paid is directly attributable to services rendered personally by the individual for the production of the property.

Original signed by
Pierre Mercier
Manager
Film Advisory Services
Small and Medium Enterprises Directorate