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Tax Traps & Tips: Why the Deductibility of Intercorporate Management Fees Should Be on Your Radar
Beyond Numbers · April 2010

By David Badalucco, CA

Intercorporate management fees are commonly used in business and tax planning strategies. One example involves the payment of management fees from an operating company to its parent company, with the former claiming a tax deduction and the latter reporting income from active business. Although this strategy is sometimes used to bring the taxable income from the operating company’s active business down to the small business deduction threshold, saving income taxes is not the intent if the operating and parent companies are associated, because the income will be taxed in the parent company at the high rate for active business income. This strategy is usually employed as a risk management strategy to keep excess cash out of the operating company or achieve a tax deferral.

Another common business and tax planning strategy is to create a management company that is not associated with the operating company, and have the latter pay management fees to the former. This strategy can be used to mitigate risk, and it can also lead to income tax savings if both companies can avail themselves of the full small business deduction. (Granted, multiplying the small business deduction only results in a tax deferral, as a result of the eligible dividend rules.)

The potential tax trap when dealing with intercorporate management fees is the possibility of the Canada Revenue Agency (CRA) asserting that these fees are not deductible for income tax purposes. This would actually be a double trap, as the management fees paid would not be deductible to the operating company, but they would almost certainly remain taxable income to the parent or management company.

Potential pitfalls

The CRA may challenge the deductibility of management fees paid from an operating company to its parent or management company using paragraph 18(1)(a) and/or subsection 67(1) of the Canadian Income Tax Act (Act). Under paragraph 18(1)(a), the Act states: “... no deduction shall be made in respect of... an outlay or expense except to the extent it was made or incurred by the taxpayer for the purpose of gaining or producing income from business or property.” Under subsection 67(1), it states: “... no deduction shall be made in respect of an outlay or expense... except to the extent that the outlay or expense was reasonable in the circumstances.” (Management fees paid to a non-associated management company may also face a challenge under subsection 256(2.1) of the Act, if it appears that one of the main reasons for the non-associated company’s existence is to multiply the small business deduction; however, that is beyond the scope of this article.)

The CRA has long maintained the administrative policy of not challenging the deductibility of salaries or bonuses paid by a Canadian-controlled private corporation to individuals who are shareholders of a company and actively involved in its operations. However, the CRA has always been careful to point out that this administrative policy does not apply to intercorporate management fees. In short, if an operating company is paying management fees to its parent company or management company, these fees must constitute an expense incurred to earn income from business or property, and must be “reasonable” in the circumstances.

Two court cases point to trouble

The tax deductibility of intercorporate management fees is not a new consideration. However, as two recent Tax Court of Canada (TCC) cases clearly illustrate, practitioners should not be complacent about the potential non-deductibility of these fees. 

Nielsen Development Company Ltd. v. Her Majesty the Queen

In Nielsen Development Company Ltd. v. Her Majesty the Queen (2009 TCC 160), the taxpayer owned and operated a hotel. Nielsen Development Company Ltd. (Nielsen Development) was 100% owned, via a holding company, by a Mr. Jason Lo. Nielsen Development had entered into an agreement with Mountain Tai Investments Company Limited (Mountain Tai) whereby the latter company provided hotel management services for the former. Mountain Tai was 100% owned by Mr. Lo’s spouse, a Ms. Phoebe Lo, who personally performed the management services.

During the 2003 and 2004 tax years, Nielsen Development paid management fees of $275,000 and $246,749, respectively, to Mountain Tai. These fees were based on the management services Ms. Lo had provided, and on a percentage of the profits from the hotel operations. The CRA disallowed the expenses to the taxpayer on the basis that they were unreasonable pursuant to section 67 of the Act.

The taxpayer appealed the CRA’s decision. In determining the reasonableness of the management fees, the Tax Court judge stated that the following factors should be considered:

• What were the management services provided?
• Were management services provided on site?
• How did the operations compare to similar operations in similar markets in terms of efficiency and profitability, etc?
• What level of effort was applied, and what were the responsibilities of the person who provided the management services?
• Does the person who provided the management services have a special expertise?
• Was the profitability of the taxpayer the result of, or a reflection of, the expertise and quality of the management services provided?
• Was a management services contract in place?

The court found in favour of the taxpayer, stating that the entire sum of the management fees was deductible because: a management agreement was in place; Mr. Lo had little or no involvement in the management of the hotel; Ms. Lo had considerable expertise in managing hotels; and Ms. Lo was in the hotel daily, providing management services. Finally, and perhaps most importantly, Ms. Lo impressed the judge with her management abilities and experience. It was clear to the judge that the hotel’s profitability resulted from Ms. Lo’s daily involvement and management skills.

Les Entreprises Réjean Goyette Inc. v. Her Majesty the Queen

In the case of Les Entreprises Réjean Goyette Inc. v. Her Majesty the Queen (2009 TCC 351), the taxpayer, Les Entreprises Réjean Goyette (Les Entreprises Goyette), and 2744-2870 Québec Inc. (Québec Co.) were wholly owned subsidiaries of 124660 Canada Ltd. (Canada Co.), which was 100% owned by a Mr. Réjean Goyette. Les
Entreprises Goyette paid Québec Co. a management fee of $80,000 in each of the 2002 and 2003 taxation years. The CRA disallowed the deduction, asserting that paragraph 18(1)(a) of the Act applied.

Once again, the taxpayer appealed the CRA’s decision. In this case, however, the Tax Court did not decide in the taxpayer’s favour.

It was evident to the judge that the management fees had been paid to Québec Co. to offset its operating losses. Moreover, no management agreement existed, nor were there any corporate resolutions authorizing provision of management services or payment of the management fees. In fact, the only evidence Les Entreprises Goyette could provide to support the management fees was a set of invoices from Québec Co. that contained no details as to the services provided. Mr. Goyette testified that he’d provided services to Les Entreprises Goyette for Québec Co., but was not paid a salary or fees from Québec Co. Further, the statement of earnings for Québec Co. reported no expenses that could be connected with providing management services to Les Entreprises Goyette. In short, there was no evidence that Québec Co. had provided any management services to Les Entreprises Goyette.

The judge ultimately dismissed the appeal, deciding that the $160,000 in management fees was not deductible. (Presumably, the management fees were still taxable income to Québec Co., but this issue was not discussed in the case.)

What these cases reveal

Both of these TCC cases show us that the CRA is paying close attention to intercorporate management fees, and that it will take steps to deny deductions if it thinks real management services have not been provided or management fees exceed the fair value of management services provided. The Nielsen Development case is a good example of how to structure intercorporate management services properly, while the Les Entreprises Goyette case exemplifies the opposite.

As with all tax planning, documentation is key to avoiding potential pitfalls. And, in the case of intercorporate management fees, practitioners must ensure that the company paying these fees is getting fair value management services.

David Badalucco, CA, is a tax manager with Smythe Ratcliffe LLP in Vancouver.