Are you using more than one corporation (or other entities such as trusts or partnerships) for business purposes? For example, do you use management fees to bill central management expenses to these entities? Or do you bill management fees to other entities for services performed? If you do, there are important considerations to ensure these fees are deductible for income tax purposes.
For management fees to be allowed as a deduction from taxable income, the following three criteria must be met:
- The amount of the fees charged must be reasonable
- The fees must have been incurred for the purpose of earning income
- There must be a legal obligation to pay the fees
The Canada Revenue Agency (CRA) knows that some entities have used management fees to eliminate or reduce taxes by shifting income to corporations with losses. In response, the CRA often reviews the deductibility of these fees, and they have been known to send management fee questionnaires to corporations that deduct these fees as part of their review. Where the CRA disallows the deduction of management fees in one entity, the law does not require any adjustment to fees in the receiving entity, effectively resulting in double taxation.
However, the CRA has a policy of not taxing the same amount twice. This means that if it disallows an intercompany management fee deduction in the payor company, it will allow for an offsetting adjustment in the recipient company. To achieve this, a request must be made in writing by the recipient corporation to the CRA, and the recipient corporation must refund an amount equal to the disallowed fees to the taxpayer. The CRA may also administratively allow an adjustment in other ways to avoid double taxation. However, in general, the CRA will look closely at transactions between related or associated businesses and will not adjust in the case of perceived abuse. Therefore, if the CRA asks for details, you will need to be ready to prove your fees are bona fide management fees with the proper documentation.
Let's look at the requirements for the deductibility of management fees in a little more detail.
Reasonability
Unless the CRA provides an exception through an administrative concession, expenses must be reasonable in the circumstances to be deductible for income tax purposes. Management fees are no exception to this rule. This means that the amount charged must be reasonable compared to the work performed. There have been several court cases specifically pertaining to charges for management fees between related organizations. Based on tests that set out those decisions, it is necessary to consider the nature of the services and the time expended in performing those services when determining the amount of the management fees. As well, consideration should be given to the amount of fees that would be paid to obtain similar services from third-party sources.
Purpose and legal obligation
Management fees must be paid for specific services performed and should not be based on the results of a business. The specific services should be identified in a management fee agreement between the parties involved. Remember that management fees must be incurred to earn or produce income. Where the CRA has challenged fees, the tax courts have required taxpayers to prove how the payment of a specific fee generated revenue for the entity. Management fees must also be paid during the year or be payable under an agreement. It is recommended that taxpayers have a written agreement that describes the management services to be provided, the fee to be charged, and the responsibilities of each party. It is best practice to have a written agreement that sets out the terms, and this could also be an oral understanding. If the management fees are paid to a related non-resident, the arrangements must be in writing and the requirement is to have supporting documentation when fees are paid under the transfer pricing rules. Lastly, there must be a legal obligation to pay the fees; the decision to pay management fees cannot be a discretionary one.
Documentation
Proper documentation is critical to substantiate any management fees you have paid (or that are payable) to support a full deduction based on the above requirements. If the CRA performs an audit or review of the fees, they will generally be looking for the following information for all management fees paid:
- Names of recipients and their business/social insurance numbers
- The amount paid and the date of payment
- Whether the amount was paid by cheque or journal entry
- The relationship between the corporation and the recipients
- Details of the services provided, including:
- A description of the work performed
- The amount of time spent
- Details on how often the services were provided
The CRA will also likely want to see a copy of the contract for services between the parties if there is a written agreement. Although you would generally have used the above information when you set the amount of management fees, you should keep the information available if the CRA requests it (rather than tracking it down later).
It is also important to resist the urge to charge a fee based on general information and estimates.
The CRA will be looking for specific proof of how your management fees were determined. Therefore, you should consider retaining backup copies of the employees' time records and a detailed description of the work performed for the other company. The critical point to keep in mind here is that otherwise, reasonable fees could be denied if there is insufficient documentation to back up the fee charged.
Indirect taxes
Management fees are considered taxable services for GST/HST and QST purposes. As such, unless the entity receiving the fees is a small supplier (generally meaning it must have revenues on an associated basis of less than or equal to $30,000) or is eligible to make and has made an election for closely related corporations and/or Canadian partnerships (election form RC4616 for the CRA and form FP-4616 for Revenue Québec), the fees may be subject to GST/HST and or QST.
Reporting of inter-corporate management fees
Unlike many corporate expenses, there is a requirement for corporations to report management fees paid on a schedule that forms part of their corporate income tax return (Form T2). Management fees paid to shareholders, other residents of Canada and non-residents, are all separately reportable on schedules that support Form T2. Management fees paid to non-residents are also subject to a non-resident reporting process separate from corporate tax return reporting.
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If you have questions concerning the use of management fees or documentation, contact your local BDO advisor. They can help you determine whether your management fees are properly documented to support their deduction for income tax purposes.
The information in this publication is current as of March 21, 2022
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.