Many incorporated businesses use more than one entity for business purposes. It is a common practice among small businesses to pay management fees within multiple entities. But some small business owners use the management fee between associated companies to avoid tax. Are you billing a management fee and showing it as a deduction from taxable income? The Canada Revenue Agency (CRA) is watching.
The CRA closely monitors the purpose of management fees and whether the deduction is genuine or a way around taxes. Based on its findings, the CRA may allow or disallow its deduction from taxable income. The management fee is a subjective deduction and differs on a case-to-case basis. Nevertheless, there are certain things small business owners should know about inter-corporate management fees to ensure their tax deduction is CRA-approved.
What Small Business Owners Should Know About Inter-Corporate Management Fees?
Many large and small businesses use multiple entities. For instance, Jack owns two companies; company A and company B. Company A raises a bill to Company B quarterly for business consultation and records it as inter-corporate management fees in its books. In this transaction, Company A is the receiver and pays tax on that fee; company B is the payor and deducts the management fee from its taxable income.
This form of income is eligible for deduction from taxable income. If Jack comes under CRA review, he has to prove the management fee is a qualified deduction by following the criteria set by the CRA.
This article will discuss some important things business owners should consider before deducting inter-corporate management fees from their business income.
Legitimate Purpose For Charging Management Fee
Management fees cannot be like dividends at the management’s discretion or paid based on the business outcome. There should be a legitimate purpose for charging a management fee for the specific service. It should have the qualities of a business expense – regular, obligatory, and undertaken to generate income. How do you determine that?
Firstly, you must provide regular invoices or bank transactions between the two entities to fulfil the first requirement. A lump sum payment doesn’t justify it as a tax-deductible expense. Secondly, you should have a legal agreement between the two parties, clearly defining the scope of work and the fees charged. A written agreement creates an obligation to pay, and the scope of work determines the intent of income generation, fulfilling the other two requirements.
Failing any one criterion is enough for the CRA to disallow you the deduction.
Is The Management Fee Reasonable?
A specialized skill deserves a reward, but it has to be reasonable, neither underpaid nor overpaid. Every lawyer, accountant, or business consultant charges differently for their work. Defining reasonable is the trickiest part of the inter-corporate management fee and has been the subject of argument in several court cases related to this specific fee.
Sometimes, business owners hire family members and pay them generous fees. Such transactions are bound to raise an eyebrow. You should ensure that the amount paid as a management fee justifies the work done. How to do that? Three aspects determine the reasonability of a service fee; difficulty, time spent, and competitiveness. Several third-party professionals provide similar offerings in the market. The CRA will look at the market rate for similar job work while considering the deduction. It would also look at the nature of work and the time spent completing it. Failing to prove the reasonability may lead to the disallowance of the deduction.
Small Business Owners Should Have Records and Documentary Proof of Every Tax Deduction
No matter how big or small a business expense, you need to save the documentary proof if you deduct it from your business income. In the case of a CRA audit, these documents and records can save you from a significant penalty and tax obligation. For inter-corporate management fees, you need
- Transaction details – the amount, date of transaction, mode of payment
- Service details – the scope of work, frequency of work, and time spent performing the work
- Details of parties involved – name and relationship between the parties involved
Make sure you prepare the written agreement at the time of execution of the work for which the management fees are being charged.
What Happens When the CRA Disallows the Management Fee Deduction?
Some business owners use their profitable entities to pay management fees to their loss-making entities to shift income and avoid taxes. Hence, the CRA pays special attention to this deduction during their review. Despite meeting all the above criteria, there is a possibility that the CRA might disallow the management fees. What happens next?
The CRA does not practice double taxation. If the agency does not find the intent of the management fee to be an abuse of the tax deduction, some administrative adjustments are required. For instance, Company B (payor) pays $10,000 in management fees to its associate entity, Company A (receiver). The CRA only allowed an $8,000 fee. Company A (receiver) has to file a request with the CRA and refund the disallowed fee ($2,000) to Company B. If the CRA deems the intent to be tax avoidance, you might face penalties.
It is always better to get professional help to avoid troubles with the CRA. An experienced tax advisor can help you with the subjectivity of the deduction.
Contact Glenn Graydon Wright LLP For Further Assistance on Tax Deductions and CRA Reviews
If you have queries regarding management fees, documentation, and other tax deductions, we are here to help you. At Glenn Graydon Wright LLP, our professional accountants can guide you on inter-corporate management fees and other tax deductions and CRA reviews. You may also contact us online or on 905-845-6633 for assistance with tax planning and accounting services.