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“Management fees”: The ugly

You know the cliché… there are always two sides to every story.  Well, the story painted in the recently released Tax Court of Canada case Mark A. Sochatsky v. Her Majesty the Queen 2011 TCC 41 is certainly an ugly story.

The case involves “management fees”.  The use of “management fees” continues to be a source of routine “planning” (said sarcastically) amongst many private corporations and their shareholders.  Those of you who know me know that I carry some strong opinions with respect to this type of planning given that much of it may involve significant tax risk for the corporations and their shareholders.  I have written many times on this matter including our blog of September 29, 2009. The case of Sochatsky appears to be a case which is typical of “plans” that carry such risk.

The facts of Sochatsky involve Mr. Mark A. Sochatsky (“Mr. Sochatsky”) who was a shareholder (although he disposed of his interest in the company later) of Northern Industrial Carriers Ltd.  In 2001, Mr. Sochatsky was paid $3,700,000 of employment earnings and received a T4 slip for such amount.  However, it appears that Mr. Sochatsky received advice from an accountant that a portion  of the amount could be diverted to two corporations in the form of “management fees” and thereby reduce the tax exposure on the $3,700,000 of employment earnings.  Accordingly, Mr. Sochatsky used his influence to have “management fees” paid to two newly incorporated companies 966772 Alberta Ltd. (“772”) (which had an April 30 fiscal taxation year end) and 966779 Alberta Ltd (“779”) (which had a January taxation year end).  Mr. Sochatsky appears to have caused $350,000 to have been paid to each of  772 and 779 and the T4 slip was therefore reduced by a collective $700,000 and reissued to Mr. Sochatsky.  772 included $350,000 of management fees in its income for its April 30, 2003 taxation year and 779 also included $350,000 in its income for the January 2003 taxation year.  Although it is not entirely clear, it would appear that 772 and 779 paid corporate income tax at the lower corporate tax rate (because of the use of the small business deduction) and desired to take advantage of certain income tax deferrals by virtue of their different fiscal taxation year ends.  However, this result is not entirely clear from the facts of the case.

The CRA was not amused and reassessed Mr. Sochatsky to include the $700,000 of diverted income in his personal hands pursuant to subsection 56(2) of the Income Tax Act (the “Act”).  It is important to note that the income inclusion by Mr. Sochatsky by the CRA did not include a corresponding adjustment to reduce the income from 772 and 779.  Accordingly, to the extent that the CRA would be successful, then double taxation would result on the $700,000 at issue.

The Court found that subsection 56(2) applied and therefore – pending a possible appeal to the Federal Court of Appeal – double taxation will result.

The Court reviewed the four elements required by subsection 56(2) for the provisions to apply:

(a)     that a payment or transfer of property be made by one person to a person other than the taxpayer;

(b)     that it be done at the direction of or with the concurrence of the taxpayer;

(c)     that the payment or transfer be for the benefit of either the taxpayer or some other person the taxpayer wished to have the benefit  conferred upon;

(d)     that the payment or transfer would have been included in the taxpayer’s income if he had received it.

The Court found that subsection 56(2) of the Act applied to  the facts at hand and therefore the $700,000 was taxable in Mr. Sochatsky’s hands.  With respect to the double taxation issue, the Court had the following to say:

“With respect to double taxation, there is no general rule against the taxation of the same amount in the hands of two different taxpayers. Perhaps the most common example of this is when profits of a corporation which are taxed in the hands of the corporation are taxed again in the hands of the shareholder when they are paid out as dividends.” [subject of course to the dividend tax credit]

This case is interesting since many “management fee” cases involve the non-deductibility of “management fees” due to the fees not being reasonable (pursuant to section 67 of the Act) or that the management fees have no business purpose (and therefore the fees are not deductible pursuant to paragraph 18(1)(a) of the Act).  This is one of the only cases in recent memory where the CRA used subsection 56(2) of the Act to reassess the taxpayer.

To be fair, I have not had the chance to undertake a detailed review of the other side of the story with Mr. Sochatsky’s counsel but certainly, as previously stated, the story painted in the Tax Court decision is ugly.  Taxpayers and their advisors should review this case and ensure that caution is exercised when attempting to “plan” using similar strategies.