What is a Management Fee?
The Management Fee Expense
The payment of management fees for services rendered is an issue commonly under scrutiny by the Canada Revenue Agency (“CRA”). This is because a management fee can represent multiple services and the amount can be deducted from taxable income, leading to random application or abuse. However, if a management fee deduction is reviewed by CRA they may allow it if they are convinced that (1) there was a valid management agreement, (2) for a bona fide business purpose and (3) the amount was reasonable.
Is there a Management Agreement?
When determining whether there is an actual valid management agreement, various factors are considered such as the existence of a written agreement, services performed, and cost and benefits gained by both the service provider and payor.
A formalized management contract between a company and its managing contractor, particularly when the parties are not at arm’s length, strengthens the argument that a management agreement does exist, and the fee shall be deductible as an expense. In Pazner Scrap Metals Co. v. Minister of National Revenue, 1991 CarswellNat 592,  2 C.T.C. 2295, the Court required the parties to adhere to all the terms of the management contract for deductibility.
However, the lack of a formalized management contract does not always preclude the deduction of management fees from income. In 6051944 Canada Inc. v. The Queen, 2015 TCC 180 (CanLII), the Tax Court of Canada (“TCC”) allowed the taxpayer’s management fee deduction, without a written management contract. The main factors considered when rendering the decision was whether there was supporting evidence of an agreement such as a corporate resolution and actual services performed.
Is the Management Fee Reasonable?
While a bright-line test as to what amount of management fee is reasonable does not exist, the general test is that the payment for the services provided is equal to the amount that a third-party would charge for a service. Factors such as fair market value (“FMV”) of the services provided, the market rate of services provided, the time and cost incurred in performance of management services, all play a role in the analysis of whether an amount is reasonable.
Furthermore, section 67 of the Income Tax Act, RSC 1985, c 1 (5th Supp) limits deduction to the extent that the expense is reasonable in the circumstances:
General limitation re expenses
67 In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.
Petro-Canada v. Canada, 2004 FCA 158 (CanLII)
A leading case on the reasonableness of expense deductions is Petro-Canada v. Canada, 2004 FCA 158 (CanLII). In Petro-Canada, the Federal Court of Appeal reaffirmed the test set out from Gabco Ltd. v. Minister of National Revenue, 1968 CarswellNat 285,  C.T.C. 31, which stated:
It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind…
The CRA lists “the fees which would be paid to obtain similar services from other sources” as a factor to determine reasonability (CRA views, 9203575 – Deductibility of management fee). In other words, if a management fee is close to the market rate of services contracted for similar businesses, it will be likely to be found reasonable. Similarly, in CRA Views, Conference, 2010-0373441C6, it was reiterated that management services expenses are generally reasonable when the amount does not exceed the FMV of the services provided.
However, based on existing case law, a management fee that exceeds FMV does not necessarily preclude it from deduction. In Petro-Canada, the Federal Court of Appeal reaffirmed that paying more than FMV does not default to a determination of unreasonable.
Furthermore, in Bertomeu v. The Queen, 2006 TCC 85 (CanLII), the Tax Court of Canada entertained the idea that the management fee amount might be considered reasonable if it stemmed from the profit made, by virtue of the work and skill of persons who manage the company.
In Safety Boss Ltd. v. The Queen, 2000 CanLII 216 (TCC), the TCC allowed millions in management fees. A key factor was that the service provider, the sole shareholder, was essentially “a one-man operation”. Also, his skills were unique. He was in the business of oilfield firefighting and the capping of blow-out oil and gas wells in Kuwait. This following the Iraq military lighting the wells on fire as they fled the country.
Was there a Bona Fide Business Purpose?
CRA will also consider whether the transaction would be undertaken without regard to its tax consequences. Was there an independent and bona fide business purpose for the transaction? Examples of bona fide business purposes include personnel management, finance management, contract negotiation, business know-how and connections, and loan guarantee.
Furthermore, paragraph 18(1)(a) of the Income Tax Act imposes a general limitation of income deductions, to the extent that it was incurred for the purpose of gaining income from the business or property:
18 (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property…
When there is no evidence of management services performed, the CRA will deny the management fee deduction. The TCC will likely find the management transaction to be a sham, when there is no “bona fide business purpose”, and the only purpose is to reduce tax liabilities.
Management Fees and CRA Penalties
In general, CRA will apply a gross negligence penalty in cases where they consider a management fee to have been improperly deducted and in a negligent manner. For example, if it is alleged the management fee expense was not actually incurred.
In Longo v. The Queen, 2013 TCC 213 (CanLII), gross negligence penalties were applied for the deduction of expenses that CRA alleged did not occur, including management fees. In deciding against the taxpayer and upholding the gross negligence penalties, the Tax Court of Canada remarked that it believed the appellant knew the expenses claimed were false.
In contrast, in Murugesu v. The Queen, 2013 TCC 21 (CanLII), gross negligence penalties were applied because non-existent management fees were deducted by the taxpayer’s accountant. He claimed he was unaware of the claimed expense and agreed that the fees did not occur. He argued against the penalties on the basis that the fees were deducted without his knowledge. In finding for the appellant, the TCC took into account that he was an immigrant with a 7th grade education and moderate English language skills and unaware of the workings of his accountant.
In general, a review of the case law indicates that if a management fee is deducted in the ordinary course of business, with the appropriate consent and documentation, the determination merely comes down to reasonableness. However, if the CRA suspects that the fee was not incurred then gross negligence penalties are applied and the expense is disallowed. If CRA suspects the fee is merely too high, then the expense is disallowed but penalties are not applied.
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