The good news is that First Nations can easily set up community owned businesses so that no income tax is paid on profits earned by those businesses. The bad news is that there are some rules that must be followed to keep the tax man away. Here are 5 simple rules Chief and Council need to know when setting up First Nation businesses.
Rule No. 1: The tax exemption under section 87 of the Indian Act does not apply to a corporation.
This exemption only applies to “Bands” or individual Band members. A corporation owned by a First Nation is not entitled to this exemption and may have to pay taxes on income earned.
What this means to you: People set up corporations to protect themselves from lawsuits. Employees, suppliers, customers and others may sue a business if they are wronged somehow. Where the business is run by a corporation the owners of the corporation cannot be sued personally. If a First Nation sets up a corporation to protect itself from lawsuits, the income earned by the corporation is not exempt from tax.
Bottom line: Don’t set up a corporation owned directly by the First Nation to carry on a business.
Rule No. 2: The tax exemption under section 87 of the Indian Act does not apply to income earned outside a reserve.
This exemption only applies to income earned on a Reserve and not to income earned from business activities outside a reserve.
What this means to you: If a First Nation is not concerned about getting sued and sets up a business in its own name and not through a corporation, income earned by the business may be taxable unless it is earned completely on a Reserve. Most businesses will be carried out outside a reserve at least in part and so section 87 will be of little help in avoiding taxes.
Bottom Line: Don’t carry on business directly as a First Nation as some of the income earned is likely to be taxed.
Rule No. 3: The tax exemption under 149(1)(c) of the Income Tax Act applies to income earned by most First Nations whether earned on or off a reserve.
This tax exemption applies to all public bodies that perform a function of government in Canada including a First Nation that provides services such as roads, housing, firefighting, education, healthcare, social assistance, garbage disposal, sewage and water, among others, to its citizens. A First Nation’s tax exempt status can be made stronger if it has passed by-laws governing activities on the reserve, especially taxation and land assessment by-laws.
What this means to you: Your First Nation is likely tax exempt from all income it receives, even if that income comes from profits in a business operated by your First Nation outside the boundaries of the reserve. This makes section 149(1)(c) your best friend when it comes to avoiding taxes on business income earned by your First Nation.
Bottom Line: Set up your businesses so that your First Nation takes advantage of this valuable tax exemption.
Rule No. 4: The tax exemption under 149(1)(c) of the Income Tax Act does not apply to income earned by a corporation unless 90% of the business is conducted on a reserve.
What this means to you: While your First Nation is tax exempt as a government, a corporation owned by your First Nation is not tax exempt if more than 10% of its income is earned from activities outside the boundaries of the reserve. Most likely some aspect of the business be conducted off the reserve.
Bottom Line: Don’t carry on a community owned business through a corporation owned by your First Nation.
Rule No. 5: Your funding agreement with Canada may allow Canada to reduce payments to your First Nation if the First Nation receives business income.
What this means to you: After all the hard work of setting up a business and earning non-taxable business income, Canada may reduce the program money it pays to your First Nation by 50% or more of the business income received from community owned businesses. This works the same way as a social assistance payments to individuals who work part-time – their social assistance payments are reduced according to the amount they earn.
Bottom Line: Set up your community businesses so that the income is not received by your First Nation until it is absolutely necessary. Keep surplus income safe and use it to invest in new or existing businesses without a claw back based on “own source” revenue.
Based on these rules you may be wondering what to do. Some rules seem to be in conflict: Don’t operate a business directly. Don’t set up a corporation. Sorry about the confusion. There is a way to set up your business to avoid taxes by following all of these rules using a “limited partnership”. I’ll explain more about that soon in another post “Why the Limited Partnership is a First Nation’s Best Friend”.