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Reasonableness of Management Fees

The Tax Court of Canada recently considered a claim for input tax credits in relation to management fees paid by a construction company to various holding companies owned by the principals of the company.

The operating company was a very successful construction company.  Its shares were held by two management companies owned by the company’s founder and his son (“the “Principals”).

The Principals were paid by means of management fees and each of those recipient holding companies had no other employees except their own primary shareholders, namely the Principals.

At the end of each fiscal year, the operating company paid, through accounting entries, management fee expenses of over $1,000,000.00 in each year.  These fees were split, roughly equally, between each of the management companies owned by the Principals.  Indeed, the amount of the management fees paid was not determined until after the end of each fiscal year.

However, once determined, an invoice was prepared and the amounts were paid, inclusive of HST. 

In years prior to the tax years under review, the operating company had paid the Principals by means of salary and bonus.  However, this practice changed upon the incorporation of the management companies with the subsequent payment of management fees to each of those companies.

The Minister denied the ITC’s claimed in connection with the management fees paid to the holding companies on the basis that they were unreasonable. 

The Minister’s complaints included the following:

  1. The management fee expenses were recorded through journal entries following the completion of the fiscal years to which they related. 
  2. The payment of the management fees represented 65% of the operating company’s expenses.
  3. Billing for the management fees was made after each fiscal year end in question.
  4. There was no written management services contract.
  5. The management fees were not calculated based upon the actual services provided, even on an hourly or weekly rate.
  6. The management fee payment was so high that the operating company reported business losses (for tax purposes).
  7. No reasonable businessman with only his company’s commercial interests in mind would conclude a management agreement with an arm’s length person with whom no service delivery agreement was clearly pre-established setting out the payment of the company’s entire profits as management fees.

The Court’s analysis of this issue was focused on determining whether the services and the cost thereof were reasonable in the circumstances, having regard to the nature of the commercial activities of the appellant construction company.

The Court disposed of the Minister’s complaints quickly in concluding that the operating company could not carry on business on a day-to-day basis without the services provided by the management companies.  The management companies not only provided personnel to make business decisions but also provided funding to fund the operations of the operating company.  The Court found that the structure chosen was specifically chosen for the purpose of protecting assets of the operating company against risks associated with operating the construction business.  Furthermore, the Court found that there was no intent to defer taxation of income or transfer it to an entity with a lower tax rate.

In all of the circumstances, the appeals were allowed.

Although not a particularly compelling analysis, from a case law perspective, the case is a good demonstration of the benefits of transparent appropriate asset protection planning. 

Do not hesitate to contact myself or my colleagues, Linda Smits and Ainsley Furlonger, in regards to this case or any tax questions you might have.