What is a Management Fee?
Often, businesses in Canada use multiple entities to run their operations or there are allocations of Management fees because of the centralization of management within a corporate group.
The management fee mentioned in this blog is not the one used in Investment management.
Charging management fees from one entity to another is perfectly legitimate as long as the requirements are met.
Misuse of Management Fee
Before we discuss the requirements of management fee deduction for income tax purposes in Canada. Let’s have a quick mention of how some entities try to misuse the management fee as a tool for income shifting:
- Income shifting from a profit-making business to a loss-making business to reduce the overall tax burden.
- Income shifting from a non-CCPC to a CCPC to claim the small business deduction. Canadian Controlled small business corporations (CCPC) are eligible for a small business deduction (SBD) on Active Business Income.
Do NOT use Management fee for any of the above since this is an area that is frequently reviewed by Canada Revenue Agency (CRA) and such a deduction is usually denied if it does not meet the requirements.
Requirements and Considerations for Management Fee Deduction
In order to deduct the management fee, there are four requirements:
- Reasonability of management fee
- Business purpose
- Legal obligation to pay
Four Key Requirements: Reasonability, business purpose, legal obligation and non-discretionary
Reasonability of Management Fee
How much management fee is reasonable?
As per subsection 67. Of Income Tax Act (ITA), any expense or outlay to be deductible must be reasonable and management fee deduction has no exception to this rule.
While considering the reasonability requirement of management fees have a look at both the circumstances and the amounts. Consider the nature of services resulting in the management fee to be charged and ensure they are reasonable. When establishing the amounts of the management fee, maintain enough documentation to substantiate the time spent on these services. Another way of understanding the reasonability of the amount is to look for costs that would be incurred using third-party to get the same services.
Business Purpose of Management Fee
A deduction of management fee can be denied based on the Income Tax Act subsection .18(1) which generally limit the deductions of expenses to business purpose only.
Whether you should claim management fee, simply check the answer if the management fee charged is in response to the services performed which resulted in generating the business income. If services performed do not have an effect on the business income, you should not claim a deduction. When CRA challenges management fee, courts usually ask the taxpayer to prove that management fee has generated income for the business. Always ask your corporate tax accountant or income tax service provider to look into this.
Legal Obligation to Pay
Any management fee deducted must be either paid in the current year or is payable as per an agreement. There must be a legal obligation to pay this fee and such a payable cannot be written off.
Another requirement is that the management fees cannot be discretionary!
The management fees cannot be calculated based on the results of business operations or be contingent upon the performance.
Documentation and Other Important Considerations
If you are deducting the management fee, keep always in mind that it is an area of interest by the CRA. Often, CRA challenges these deductions! It is very important to keep the necessary documentation handy, in case if you receive a questionnaire from the CRA. The below list is not conclusive but it can help to substantiate the claim.
- Maintain a management fee or an inter-company agreement identifying the parties involved and their relationship. This agreement may include the details about the nature of services to be performed and the basis for the pricing of these services.
- Invoices for the work performed resulting in the management fee. If possible, include the timecards and as many details as possible.
- Documentation for each management fee showing how the services performed contribute towards the business income.
- How the management fee paid and when? It’s better to pay this through cheque during the current year instead of an intercompany journal entry. If for any reason the management fee is not paid during the current tax year, a payment agreement should be there. Periodic invoicing and payment of the same is better than a single year-end charge.
- Documentation establishing the competency of the party performing these services and the reasonability of pricing by comparing it with services offered by third parties.
- Consider the applicability and implications of GST/HST since the management fee is a taxable transaction. A convenient way to handle this is to file RC4616 Election with CRA.
- If your deduction is denied for the business which is paying management fee, you may have to follow the additional procedure to remove the income recorded in the corporation receiving this management fee.
When it comes to a successful management fee claim, documentation is the Key!
The management fee is a very important area in Corporate Tax Accounting in Canada and requires careful tax planning. The above post is for a general-purpose and cannot be relied solely on in making any decision regarding the deduction of the management fee, it is always better to contact a reliable Corporate Tax Accountant in Canada to get precise and up-to-date advice.
Maroof HS CPA Professional Corporation provides both Corporate Tax Services and Individual Tax Preparation Services in Canada. It is an accounting firm registered with CPA Ontario providing accounting and tax services.