Management fees

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Managing your management fees

By Robert Leombruno

Management fees are a powerful tax planning tool. However, case law has provided ammunition to the Canada Revenue Agency (CRA) in their review of  inter-corporate management fees. As such, proper execution is crucial when undertaking any tax planning using management fees.

Corporate groups commonly use management fees to shift income and expenses between companies. While such fees can help with risk management by keeping excess cash out of an operating company, corporate groups can also defer taxes by creating a company that earns management fees and accesses the small business deduction. However, if the rules surrounding management fees are not properly considered double taxation can occur; i.e., the company paying the management fee would not be allowed a tax deduction while the company providing the management service would still be required to include the management fee into income.

The CRA will generally allow management fees to be deductible to the extent that they are incurred for the purpose of gaining or producing income and provided they are “reasonable in the circumstances”. Even an expense that is specifically deductible under the Income Tax Act may be partially or fully disallowed if it is considered unreasonable.

While the CRA has a long-standing practice of not challenging the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation’s business, their position is that this practice would not extend to intercorporate management fees. To be fully deductible, any fees and/or bonuses paid to corporate shareholder-managers by an operating company (Opco) must be reasonable given the services actually rendered by the holding company (Holdco) through its employees. The resulting profits of Holdco may be distributed to the shareholder-employees of Holdco where the general practice of the corporation is to distribute profits of the company to shareholder-employees in the form of bonuses or additional salary. If the management fee from Opco to Holdco is not reasonable in the light of the services rendered, the unreasonable portion would not be deductible by Opco.

There have been significant court rulings surrounding the deductibility of management fees. The case law is clear that the deductibility of management fees should not be taken for granted. At a minimum, for the management fees to be deductible, bona fide management services are necessary for the payer in its income-earning activities. These services must actually be provided by the payee to the payer, should actually be paid, must be reasonable in amount, and should be documented pursuant to a written contract, the terms of which are adhered to.

Factors affecting the reasonableness of management fees include:

  1. The nature of the management services
  2. Whether the management services were performed on or off site
  3. A comparison to similar operations in similar markets in terms of efficiency, profits, etc.
  4. Effort applied and the responsibilities of the provider of the services
  5. Special expertise or know how held by the service provider
  6. The portion of the profit that reflects the expertise and quality of the management services performed
  7. Existence of a management-services contract

Documentation is key. We recommend that a formal management agreement be signed by the two parties and that this agreement include the nature of the services provided and the number of hours to be spent providing the services. Furthermore, this agreement should be supported by a corporate resolution authorizing the management services or payment for the services.

While management fees are a powerful tool to implement corporate strategy and tax planning, the mismanagement of intercorporate management fees could be costly and problematic.

Robert Leombruno is a tax senior manager in Burlington.

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