Management fees may be used to reduce taxes amongst a corporate group and/or to gain access to a greater small business deduction (i.e.: a company with taxable income pays a management fee to reduce its taxable income to a related company with losses that can absorb the management fee income and not pay taxes).
In other cases, management fees are used by an owner-manager as a “lazy” way to pay salaries to the owner.
Sometimes these fees are well thought out and supported with documentation. However, I also see these fees paid recklessly. In either case, the use of management fees have some risk associated with them, as they are often challenged by the Canada Revenue Agency ("CRA") where they are not considered reasonable and justifiable.
Today, Howard Kazdan, a tax expert with BDO Canada LLP, discusses management fees and what kind of support is suggested to strengthen the payer’s case for deducting such fees.
I thank Howard for his excellent post
As noted above, management fees are often used as a tax planning tool. Of course, to be effective, the fees must be deductible to the payer.
The criteria that are required for the management fees to be considered deductible, were established by the courts many years ago:
1. The expense must have been incurred (either actually paid or subject to a legal liability to pay);
2. The fees must have been incurred for the purpose of income from a business and
3. The fees must be reasonable in the circumstances.
In order to make a determination of whether the fees are deductible, the courts may:
1. Require documentation to support the expense, for example an intercompany agreement and/or invoices for work done.
Where the only documentation for intercompany fees is an accounting journal entry, the courts have concluded that such entries are not sufficient to establish that the amount was incurred during the year and represent a true liability at year end.
2. Require evidence from the corporation describing what services were provided and how incurring the expense contributed to the process of earning income.
3. Require evidence of the basis for the amount of fee, since a bona fide fee for service should be based on services performed and not profit. If a payment is based on profit (which may not be known until after year end) the CRA may argue that the payment is a distribution of profit and not a deductible expense.
The CRA has administratively allowed corporations to bonus down to the small business limit and considered such bonuses as reasonable when paid as salary to owner-managers. This administrative position is not available when such amounts are paid as management fees. In the latter case, the CRA will look at the nature of services performed, the time spent to perform those services and whether the fees paid are similar to what would be paid to other arm’s length sources.
Taking the above into consideration, successful claims of management fees that have been subject to CRA review and the courts have the following similarities:
(a) written management fee agreements/service arrangements be in place describing services, fees, responsibilities
(b) documentation of a bona-fide business purpose for the intercompany fee (for example, use of a management corporation to keep compensation of key management confidential).
(c) adequate records to keep track of services provided (time sheets)
(d) periodic invoicing rather than only once at the end of the year
(e) company rendering the servicing invoice should have the staff and ability to provide the services.
(f) the fee should be based on services provided, not profit.
Claims which have not been as successful generally lack the above noted characteristics (for example, there is no agreement; could not provide details of services provided; company earning the income did not have the ability to provide the services; general lack of documentation other than journal entries).
In reviewing management fees, the CRA may send a questionnaire. It is possible that even if the deduction is disallowed in one entity, the company including the fees as income will still be taxed (effectively double taxation). This is why you will want clear documentation that fees are bona-fide management fees and treated consistently each year.
Don’t forget that such fees may be subject to GST/HST unless the entities qualify for the closely related exception and the Form RC4616 has been properly filed.
In addition to the criteria already discussed, an additional reason to issue invoices is GST/HST. An invoice will provide clarity on timing of when GST/HST is payable (i.e. when fee becomes legally enforceable) and ensure there is adequate documentation for the company incurring the expense, in support of any ITCs claimed.
If you or your related companies use management fees as a tax planning tool, ensure you review the criteria noted above with your accountant.
Howard Kazdan is a Senior Tax Manager with BDO Canada LLP. If you would like to engage Howard for tax planning, he can be reached at 905-946-5459 or by email at hkazdan@bdo.ca
In other cases, management fees are used by an owner-manager as a “lazy” way to pay salaries to the owner.
Sometimes these fees are well thought out and supported with documentation. However, I also see these fees paid recklessly. In either case, the use of management fees have some risk associated with them, as they are often challenged by the Canada Revenue Agency ("CRA") where they are not considered reasonable and justifiable.
Today, Howard Kazdan, a tax expert with BDO Canada LLP, discusses management fees and what kind of support is suggested to strengthen the payer’s case for deducting such fees.
I thank Howard for his excellent post
Management Fees – The Importance Of Having Proper Support
By Howard KazdanAs noted above, management fees are often used as a tax planning tool. Of course, to be effective, the fees must be deductible to the payer.
The criteria that are required for the management fees to be considered deductible, were established by the courts many years ago:
1. The expense must have been incurred (either actually paid or subject to a legal liability to pay);
2. The fees must have been incurred for the purpose of income from a business and
3. The fees must be reasonable in the circumstances.
In order to make a determination of whether the fees are deductible, the courts may:
1. Require documentation to support the expense, for example an intercompany agreement and/or invoices for work done.
Where the only documentation for intercompany fees is an accounting journal entry, the courts have concluded that such entries are not sufficient to establish that the amount was incurred during the year and represent a true liability at year end.
2. Require evidence from the corporation describing what services were provided and how incurring the expense contributed to the process of earning income.
3. Require evidence of the basis for the amount of fee, since a bona fide fee for service should be based on services performed and not profit. If a payment is based on profit (which may not be known until after year end) the CRA may argue that the payment is a distribution of profit and not a deductible expense.
The CRA has administratively allowed corporations to bonus down to the small business limit and considered such bonuses as reasonable when paid as salary to owner-managers. This administrative position is not available when such amounts are paid as management fees. In the latter case, the CRA will look at the nature of services performed, the time spent to perform those services and whether the fees paid are similar to what would be paid to other arm’s length sources.
Taking the above into consideration, successful claims of management fees that have been subject to CRA review and the courts have the following similarities:
(a) written management fee agreements/service arrangements be in place describing services, fees, responsibilities
(b) documentation of a bona-fide business purpose for the intercompany fee (for example, use of a management corporation to keep compensation of key management confidential).
(c) adequate records to keep track of services provided (time sheets)
(d) periodic invoicing rather than only once at the end of the year
(e) company rendering the servicing invoice should have the staff and ability to provide the services.
(f) the fee should be based on services provided, not profit.
Claims which have not been as successful generally lack the above noted characteristics (for example, there is no agreement; could not provide details of services provided; company earning the income did not have the ability to provide the services; general lack of documentation other than journal entries).
Don’t forget that such fees may be subject to GST/HST unless the entities qualify for the closely related exception and the Form RC4616 has been properly filed.
In addition to the criteria already discussed, an additional reason to issue invoices is GST/HST. An invoice will provide clarity on timing of when GST/HST is payable (i.e. when fee becomes legally enforceable) and ensure there is adequate documentation for the company incurring the expense, in support of any ITCs claimed.
If you or your related companies use management fees as a tax planning tool, ensure you review the criteria noted above with your accountant.
Howard Kazdan is a Senior Tax Manager with BDO Canada LLP. If you would like to engage Howard for tax planning, he can be reached at 905-946-5459 or by email at hkazdan@bdo.ca
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