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Management Fees... Easier Said Than Done!

30/11/2009


It is not surprising these days that many businesses use a multi-company structure to conduct business.  Be it for estate planning, risk management, cross border ventures, etc. etc., there is, in many instances, times where one company has profits and one has losses that cannot be utilized in the current or previous years.  It is not uncommon for business owners to say “just pay a management fee equal to the loss”.  This sounds easy enough to do; just write a cheque and make a journal entry.  All done.

Unfortunately, this rarely is within the scope of the tax laws.  Should the CRA come knocking, it would likely not pass muster and the paying company will be denied the deduction.  The worst part is that the receiving company will still have to include the income and pay tax on it.

Management fees continue to be an area of scrutiny by the taxing authorities. The courts have in many cases ruled in favour of the CRA where companies have paid arbitrary management fees to related companies. Why is this?

The simple answer is that the management fee did not pass the three tests making it deductible. However, the more in-depth answer is:

  1. The payment of the management fee was not for the purpose of gaining or producing income from a business or property.  This is the first test for determining the deductibility of any expenditure and is found in paragraph 18(1)(a) of the Canadian Income Tax Act (“The Act”) and contrary to popular belief, doing something to save tax is not for the purposes of gaining or producing income.
  2. The payment was probably not reasonable in the circumstances.  To be considered reasonable, it must be based on what a reasonable business would pay to a third party for similar services under similar circumstances.  This rule is covered in section 67 of the Act.  In many cases the amount that would be paid does not amount to very much if anything.
  3. There probably was little to no documentation and no legal obligation to actually pay the amount.  In the recent case of Les Enterprises Rejeans Goyette Inc. v. Her Majesty the Queen, the court denied the deduction of management fees specifically because of this shortcoming.

The good news is that there are two steps you can take to ensure that management fees that are paid will remain deductible. 

  1. You can structure your operations so that a company that may be marginally profitable or in loss positions can have all the employees and equipment that are needed in the profitable company.  The services performed and the equipment used can be charged back to the profitable company at reasonable market rates. 

  2. The fees can be based on actual time charges for employees and market costs for use of equipment.  But most importantly, there needs to be documentation for the calculation of the management fees and a legal agreement between the two companies setting out the scope of the services, how the fees are calculated, how billings are conducted and the payment terms for the services.

If you follow these steps, you will reduce the chance of having your fees denied their deduction for income tax purposes. If you have any questions about management fees and your business, feel free to contact your local MNP advisor.