Commission employees EXAMPLE

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1 BLAIN M. ARCHER, B.Sc., CA* PAUL M. FOURNIER, B.Sc., CA* RUSS J. WILSON, B.Sc., CA* KATRIN BRAUN, B.B.A., CA* MICHAEL MCISAAC B.Sc., CA* TAX LETTER For MARCH 2006 WHEN ARE LEGAL FEES DEDUCTIBLE? ANOTHER ART FLIP FLOPS HIGH TAXES ON MODEST EMPLOYMENT INCOME AROUND THE COURTS WHEN ARE LEGAL FEES DEDUCTIBLE? Legal fees that you pay may be deductible for income tax purposes. Listed below are the situations where you can deduct legal fees. This topic is relevant as it reviews the various expenses which can be contentious. Business expenses Legal fees of a business you carry on are deductible if they relate to earning income (or preventing a loss) from the business. However, legal fees that relate to capital assets are normally not deductible; they are instead included in your cost base of the capital asset, on which you can claim capital cost allowance (depreciation) if the asset is depreciable property. They will also reduce a future capital gain by being included in the cost. EXAMPLES You retain a lawyer to help you collect an overdue account for your business. The expense is deductible. You retain a lawyer to help you buy some machinery for your business. The legal fees are not deductible. Instead, they are included in the capital cost of the machinery, on which you can claim capital cost allowance. Thus, you can effectively deduct the fees over time. You retain a lawyer to help you buy land on which to build a factory. The legal fees are not deductible. Instead, they are included in the cost of the land. Thus, if you eventually sell the land for a capital gain, they will reduce that gain. Note that if you have a corporation that runs your business, you might not be able to deduct legal fees associated with the corporation, to the extent you pay them personally. Legally, it is the corporation that is carrying on business, not you. From a tax point of view, what you own is shares a capital asset and legal fees associated with the shares are not deductible unless they relate to earning income from the shares (dividends). Expenses of making representations to government, such as lobbying, are generally deductible even though they may relate to capital assets or goodwill. Property expenses Legal fees relating to property are generally deductible on the same basis as for a business. If the fees relate to income generated by the property (e.g., legal fees incurred to collect unpaid rent), they are Page 1 of 7

2 deductible. If they relate to the acquisition of capital property (e.g., legal fees incurred to buy a rental condominium), they are not, but instead form part of the cost of the property. Commission employees If you are an employee who sells on commission, and you are permitted to deduct expenses associated with your employment, then you may deduct legal fees as part of those expenses. The fees must be normally incidental to the income-earning activity. The deduction of legal fees (and certain other expenses) is limited to the commission income earned in the year. EXAMPLE An employed real estate agent, who works on commission, is sued for misrepresentation in connection with a sale of the property. The vendor is seeking to recover the commissions paid to the agent. The agent may deduct her legal expenses to defend the lawsuit. Collecting wages Legal expenses paid to collect (or to establish a right to) salary or wages are deductible. The same principle applies as above: the expenses relate to an amount that is taxable as income to you, and so they can be deducted. Legal expenses paid to protect your job (e.g., to keep yourself from being fired from a public service position) are generally not deductible, though there are some conflicting decisions from the Tax Court of Canada on this issue. Collecting severance pay or a wrongful dismissal award Severance or termination pay, and awards for wrongful dismissal, are called retiring allowances under the Income Tax Act, and are taxable. Legal expenses paid to collect such amounts are deductible, but only to the extent you have income in the year from the retiring allowance which is not transferred to your RRSP. If you do not have income from that source (because you are still trying to resolve the case), you can carry the expenses forward and claim them in a future year for up to 7 years. EXAMPLE You were fired from your job in You spend $3,000 in legal expenses in 2005 and a further $1,000 in In 2006 you receive a $20,000 settlement from your former employer, which under the Income Tax Act is classed as a retiring allowance. Your entire $4,000 of legal fees is deductible in 2006 against the $20,000 of income. Collecting a pension benefit Legal expenses paid to collect benefits from a registered pension plan are deductible against the income from the pension plan, with a 7-year carryforward, on the same basis as for retiring allowances discussed immediately above. Divorce and support proceedings Legal fees paid in divorce proceedings are not deductible where they relate to the divorce itself, or to property and custody disputes. Legal fees are deductible if you already have a right to support from your spouse or former spouse, and you incur expenses in enforcing payment. Thus, if you go to a lawyer because your former spouse is late in alimony or spousal support payments, your fees in obtaining such payments are deductible. Page 2 of 7

3 Since children have a pre-existing right under family law legislation to support, legal costs to obtain an order for child support are also deductible. Furthermore, legal costs incurred to obtain spousal support, or to make child support non-taxable, are now deductible (the CRA acknowledged this in Income Tax Technical News No. 24, based on a 2001 court case). However, the costs of defending a claim for support are non-deductible. Fighting the CRA Amounts paid to prepare, institute or prosecute an income tax objection or appeal are deductible, whether paid to a lawyer, an accountant or any other representative. This includes, for example, filing a Notice of Objection, negotiating with the CRA and taking an appeal to the Tax Court of Canada. Under the CRA s administrative policy (Interpretation Bulletin IT-99R5), it also includes expenses of dealing with an auditor who is reviewing or auditing your tax return, even if you never actually file a Notice of Objection. Expenses of objections or appeals of foreign income tax are also generally deductible. The Income Tax Act provision allowing this deduction (paragraph 60(o)) does not limit it to contesting an assessment of your own taxes. Therefore, if you pay legal fees to contest a corporation s income tax assessment which you might do to protect your shareholding in the corporation, or to protect yourself from being assessed later as a director of the corporation those fees are deductible. Similarly, if you contribute towards the legal costs of a tax shelter in which you have invested and which is being reassessed, then you can deduct your contribution even if it is another taxpayer who is going forward with the appeal while yours is put on hold awaiting the result. Expenses of defending against a prosecution for tax evasion have traditionally been considered non-deductible, but based on the case law, they might be deductible as ordinary business expenses if the evasion was related to ongoing business profits. Moving expenses If you move more than 40 km closer to your new place of employment or business than your old home was (to your new place of employment or business), you can deduct a wide range of moving expenses, using Form T1M, on your personal income tax return. Included in the allowable deductions are the legal costs associated with buying a new home. As well, if you do buy a new home, your legal fees on the sale of your old home are deductible. Organ or bone marrow transplant Where a person needs an organ transplant or bone marrow transplant and finds a suitable donor, the transplant recipient may reimburse the donor for a number of expenses including legal fees. The amount paid qualifies as a medical expense credit for tax purposes. Medical expenses are not deductible against income, but to the extent such expenses exceed a certain threshold, they generate a credit that is worth about 22% of the amount paid. Adoption expenses A credit is available for up to $10,000 of adoption expenses, in the year in which the adoption is finalized. These expenses can include legal fees. The federal credit is 15% or 16% of the expenses paid. This credit, which was announced in the February 2005 federal budget and has not yet been enacted by Parliament, will apply beginning The provinces are likely to copy it and provide a parallel provincial credit. Quebec has had such a provincial tax Page 3 of 7

4 credit for many years. The Quebec credit is a refundable tax credit of 20% of up to $15,000 of qualifying expenses. Note that when an adoption is arranged by a charity, the tax authorities will normally disallow claims for donations to the charity that are, in substance, fees for arranging the adoption. Legal fees that are reimbursed In general, whenever you can deduct an amount for legal fees, you must include in income any later award that repays you for all or part of those fees. If, for example, you win a court judgment for back wages and legal costs are awarded as part of the judgment, those costs will be taxable (unless you never paid your lawyer up front and the costs are paid by the other side directly to your lawyer). More information For more information on legal fees see CRA Interpretation Bulletin IT-99R5, Legal and Accounting Fees, available on cra.gc.ca. Note that fines and penalties are generally non-deductible. The principal exception is GST late-payment penalties. This rule, in section 67.6 of the Income Tax Act, was introduced in ANOTHER ART FLIP FLOPS A number of promoters in the years through 2003 pushed so-called charitable art flips as a tax shelter. Thousands of taxpayers got into these deals before they were shut down completely on December 5, The concept was simple: you buy a piece of artwork for, say, $200. The work comes with a professional appraiser s certificate valuing it at $1,000. (The valuation is based on the rule that fair market value is the highest price someone will pay for a particular item in an open, unrestricted market.) You donate the art to a charity, which gives you a receipt for $1,000. Since the credit for a donation is normally worth about 50% of the donation, the receipt is worth about $500 on your tax return. A quick $300 profit? That was the theory. The Canada Revenue Agency (CRA) is obviously not enamoured of these deals, and will challenge them by reassessing the taxpayer to disallow the donation credit. There are several lines of attack available to the CRA. The most obvious is that, if you were able to buy the art for $200, it wasn t really worth $1,000. Indeed, the new rules announced on December 5, 2003 (which have not yet been enacted by Parliament, but which will apply to donations made after the rules were announced) provide that property you donate to a charity will be valued for tax purposes at the amount you paid for it, if you bought it during the past three years or within the past 10 years for purposes of donating. Taxpayers have lost a number of these cases in the courts, on the basis that the real value of art was what the taxpayer paid for it. In a group of cases that we reported on in the March 2005 Tax Letter, Nash, Tolley and Quinn, the taxpayers succeeded at the Tax Court of Canada. The taxpayers paid $8,571, $8,025 and $8,648 for groups of prints which the Tax Court concluded were worth $29,400, $28,325 and $25,280 respectively. The Tax Court ruled that the amount paid by a taxpayer is not determinative of the value of the property. Unfortunately for these taxpayers, the Federal Court of Appeal has overturned this decision. In a ruling issued in November 2005, the Court of Appeal held that the value of the prints was what the taxpayers paid for them. The Court of Appeal concluded that this was the best price the taxpayers could have obtained had they sold the whole group of prints at the time of the donation. As the Court put it: Page 4 of 7

5 The groups of prints purchased by the taxpayers were donated to charities or universities within two to six months of their purchase. If any of the taxpayers had wished to sell the groups of prints within that time frame, what price could have been obtained? The inevitable answer is that the price would have been, at most, the price for which that group of prints was being sold by CVI [the promoter]. If a higher price was sought, a knowledgeable potential purchaser would buy from CVI. In other words, CVI s price was the highest price each of the groups of prints would bring at or near the relevant time. The Court noted that the fair market value of a group of items is not necessarily the total of the prices that could be obtained for individual items in the group. This case follows on the heels of the Klotz case, decided by the Federal Court of Appeal in May 2005, which reached essentially the same conclusion. Not good news for other taxpayers who took part in art flip schemes! Note that under draft legislation released on July 18, 2005 (proposed subsection 248(41) of the Income Tax Act), taxpayers will not be entitled to any charitable donation credit even for the value of what they donated if they make a donation and do not advise the charity of special circumstances (such as a recent purchase at low cost) which should reduce the amount of the receipt. These rules, which have not yet been enacted by Parliament, will apply to donations made since January 1, HIGH TAXES ON MODEST EMPLOYMENT INCOME Taxpayers with taxable income of up to about $30,000 pay only 15% or 16% federal tax on this level of income, and an additional provincial tax that brings the rate up to about 22%, though it varies by province. (The federal rate was 16% before It was lowered by the Liberals to 15% for 2005 in the dying days of their minority government, but this change has not yet been enacted. If Parliament under the minority Conservative government does enact it, the change may or may not continue to apply for 2006.) In addition, however, for employees there are substantial employment taxes that increase the tax rate significantly. Employment Insurance (EI) applies to annual employment income up to $39,000. Although EI rates have gone down in recent years, employees still pay 1.87% EI premiums on that amount of income (for 2006), and this is taken off their paycheque as source deductions. (The employer has to pay an additional 2.62% employer s premium on the same first $39,000 of each employee s income.) As well, Canada Pension Plan (CPP) mandatory contributions apply to employment income up to $42,100 (the first $3,500 is exempt). CPP rates have gone up in recent years; employees now pay 4.95% CPP contributions on that amount of income. Again, this is taken off their paycheque as source deductions. (The employer has to pay a matching amount as the employer s contribution.) For self-employed people, there are no EI premiums (since they are not eligible for EI benefits), but CPP contributions are double they have to pay both the employee s and the employer s portions for themselves so the rate is 9.9% on the first $42,100 (again, with an exemption for the first $3,500). For employees with modest incomes, the extra EI premiums and CPP contributions of Page 5 of 7

6 more than 6.8% add significantly to the 15% or 16% federal income tax rate! AROUND THE COURTS Computer can be a musical instrument Most employees cannot deduct the cost of tools or other equipment they need for their jobs. Musicians, however, are allowed to deduct the costs of a musical instrument required by their terms of employment. The deductible costs include capital cost allowance (CCA) if they purchase the instrument, rental costs if they rent it, and maintenance and insurance costs. The Tax Court of Canada recently heard an appeal by a music professor at the University of Montreal. Alan Belkin used a Macintosh computer for teaching and composing music. The CRA denied his claim for CCA on the cost of the computer, ruling that a general purpose computer is not a musical instrument. The Court sided with Professor Belkin, noting that music has evolved from where it was 20 years ago. A computer is now an essential tool for some musicians. As the judge put it, What is the musician s tool to teach music, to create musical works, to reproduce musical sounds and even to produce sounds that a traditional music instrument cannot produce? The Court thus ruled that a computer can be a musical instrument, and allowed the CCA deduction. Oral evidence may be enough in Tax Court The CRA often disallows expenses or deductions because the taxpayer does not have documentary evidence to support the claim. CRA auditors generally give little weight to the taxpayer s own statements. If you persevere, however, and you are credible, there is a good chance of having the claim allowed by the Tax Court of Canada. In the recent Benjamin case, decided in February 2006, Chief Justice Bowman of the Tax Court allowed a claim for an allowable business investment loss where the taxpayer had no written proof of making the $50,000 loan in question. The judge stated: Whatever may be the policy of the CRA to require documentation to support an expense, a payment or a deduction, it is not the policy of this court, unless the taxing statute specifically requires it (as for example, in the case of charitable donations). If a taxpayer in court can demonstrate through credible oral testimony that a payment was made or an expense incurred, the court must make a finding based on that evidence and give effect to it. The court cannot avoid its responsibility to base its conclusions on the evidence adduced by saying in effect It doesn t matter how credible your testimony is, if you don t have a piece of paper you must necessarily lose. This is encouraging news for taxpayers who have genuine expenses or deductions but who, for whatever reason, do not have sufficient documentation. Of course, it can be an uphill battle to convince the Tax Court that you actually incurred the expense or deduction! No B.C. sales tax on lawyers fees to low-income clients! The provinces that still impose their own retail sales tax (B.C., Saskatchewan, Manitoba, Ontario and PEI) have slowly been extending them into new areas, including various services. In Christie v. British Columbia, the B.C. Court of Appeal recently overturned an Page 6 of 7

7 amendment that imposed B.C. provincial sales tax on lawyers fees. The lawyer who applied to have the tax struck down had many clients with limited resources. Because of the tax, he had to lower his fees further and became insolvent. As a result, his clients lost legal representation. The Court agreed that access to legal services is a fundamental right under the Canadian Charter of Rights and Freedoms. As a result, the Court ruled, the tax is unconstitutional for all legal services relating to the determination of rights and obligations by courts of law or tribunals, not merely those provided to poor citizens. Although this case applies only to the B.C. tax, it is an interesting ruling that could affect the imposition of other taxes on lawyers fees, perhaps including the GST. It remains to be seen whether the decision will be appealed to the Supreme Court of Canada. uphold the [application of GAAR] would be to find that there is some overarching principle of Canadian tax law that requires that corporate distributions to shareholders must be taxed as dividends. There is no such principle. If taxpayers arrange their affairs to extract money from a corporation in some other way that fits within the rules of the Income Tax Act, that is not a violation of GAAR. This is good news for taxpayers. It appears that converting corporate cash into a tax-free capital gains exemption is now acceptable, provided all the technical rules of the Act are followed. * * * This letter summarizes recent tax developments and tax planning opportunities; however, we recommend that you consult with us before embarking on any of the suggestions contained in this letter, which are appropriate to your own specific requirements. Extracting money from corporation via the capital gains exemption As reported in our December 2005 letter, the Supreme Court of Canada recently issued two decisions on the General Anti- Avoidance Rule (GAAR) in the Income Tax Act. The Court limited the application of GAAR to cases where the scheme in question clearly defeats or frustrates the purpose of the provisions of the Income Tax Act. The Tax Court of Canada s decision in Evans is the first decision on GAAR since the Supreme Court decisions. In Evans, the taxpayer extracted funds from a corporation by selling the shares of the corporation and claiming the capital gains exemption. The Court ruled that this did not violate GAAR. As Chief Justice Bowman of the Tax Court put it, The only basis upon which I could Page 7 of 7