Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: Are certain legal fees incurred as a result of a dispute regarding the payment of proceeds of disposition deductible?
Position: No.
Reasons: The legal fees where not incurred to the earn income from a business or property. Furthermore, the legal fees were not directly incurred for the purpose of making the disposition of the Property but rather were incurred as a result of a dispute regarding the payment of proceeds of disposition with respect to the sale and consequently may not be considered in calculating the amount of a taxpayer's loss under subparagraph 40(1)(b)(i) of the Act.
June 9, 2003
Mark Feduck HEADQUARTERS
Verification and Enforcement Division Karen Power, CA
Hamilton Tax Services Office (613) 957-8953
2003-001330
Deductibility of Legal Fees
We are writing in reply to your letter of April 9, 2003 regarding the above-noted subject matter. You enquire whether a partnership would be entitled to deduct legal expenses incurred regarding a dispute on the payment conditions of proceeds of disposition related to the sale of a building and land.
The facts as we understand them are as follows:
1. The partnership ("Partnership") consisting of a husband and wife, XXXXXXXXXX ("Mr. X and Mrs. X"), operated two separate businesses. XXXXXXXXXX.
2. The Partnership purchased a building and land (the "Property") in XXXXXXXXXX for use in the XXXXXXXXXX business. This business operated from XXXXXXXXXX until XXXXXXXXXX.
3. On XXXXXXXXXX, Mr. X and Mrs. X entered into an agreement to sell the Property to an arm's length third party. The agreement indicated that the purchaser was to pay the vendor the sum of $XXXXXXXXXX. The purchase price was to be paid as follows:
a. On XXXXXXXXXX the purchaser was to pay $XXXXXXXXXX.
b. Commencing on XXXXXXXXXX the purchaser was to pay, on behalf of the vendors, the monthly mortgage payments, principal and interest owing by the vendors to the XXXXXXXXXX. These mortgage payments would continue until XXXXXXXXXX.
c. Finally, the purchaser had the right to pay the balance of the purchase price ($XXXXXXXXXX) at any time upon XXXXXXXXXX days written notice prior to XXXXXXXXXX.
4. The purchaser made the initial payment and all necessary mortgage payments. In XXXXXXXXXX, the purchaser made a final payment of $XXXXXXXXXX. The final payment was computed by the purchaser as $XXXXXXXXXX less the principal portion of the mortgage payments made from XXXXXXXXXX to XXXXXXXXXX.
5. Mr. X and Mrs. X believed that the final payment should have been $XXXXXXXXXX and it appears that the Partnership had reported the monthly mortgage payments as income from XXXXXXXXXX to XXXXXXXXXX. They took the purchaser to court to recover the remaining proceeds of disposition. The lower court ruled in favour of Mr. X and Mrs. X. The purchaser appealed the decision and the Court of Appeal for Ontario ruled in favour of the purchaser. The Court of Appeal ruled that the agreement clearly provides for a purchase price of $XXXXXXXXXX with a down payment of $XXXXXXXXXX. In addition, the agreement describes the monthly mortgage payments as part payment of the purchase price. Nowhere in the agreement is there any reference to rent or lease. The court stated as follows:
"XXXXXXXXXX".
Mr. X and Mrs. X were ordered to pay the purchasers legal costs.
6. Both the legal and beneficial ownership of the Property were transferred in XXXXXXXXXX, such that the disposition of the Property by the vendors occurred at that time.
7. The Partnership claimed legal expenses in the amount of $XXXXXXXXXX and $XXXXXXXXXX in taxation years XXXXXXXXXX and XXXXXXXXXX respectively. The XXXXXXXXXX legal expenses consisted of $XXXXXXXXXX paid to settle the purchaser's legal costs and the remaining portion related to legal fees incurred to sue the lawyer who had drafted the original XXXXXXXXXX purchase and sale agreement.
8. You have advised us during a recent telephone conversation (Power/Feduck) that you have not yet proposed any adjustments with respect to the legal expenses discussed in paragraph 7 above, but are of the view that they are not deductible in computing business or property income.
In order for an outlay or expense incurred to be deductible in computing business income, it must be incurred for the purpose of gaining or producing income from the business in accordance with paragraph 18(1)(a) of the Income Tax Act (the "Act"), not be capital in nature, except as expressly provided in the Act, (paragraph 18(1)(b)) and not otherwise prohibited by a specific provision in the Act. As stated in paragraph 2 of Interpretation Bulletin IT-99R5, generally legal fees are allowable deductions where they are incurred in connection with normal activities, transactions or contracts incidental or necessary to the earning of income from a business or property.
The purpose test discussed above will be met where the taxpayer is carrying on a business and the legal fees can be considered as being incurred for the purpose of gaining or producing income from that business. This does not appear to be the case in the above situation. Based on the information provided, the XXXXXXXXXX business ceased operations in XXXXXXXXXX and the legal fees paid in XXXXXXXXXX and XXXXXXXXXX were incurred as a result of a dispute regarding the payment of the proceeds of disposition with respect to the sale of a capital asset.
Alternatively, you enquire whether the legal fees may be considered in calculating the amount of a taxpayer's loss under subparagraph 40(1)(b)(i) of the Act or in calculating the amount of a taxpayer's terminal loss under subsection 20(16) of the Act on the sale of the Property. Pursuant to subparagraph 40(1)(b)(i) a taxpayer is able to effectively add to the adjusted cost base of a property any outlays and expenses to the extent that they were made or incurred for the purpose of making the disposition of the property. As you note, paragraph 14 of Interpretation Bulletin IT-99R5, acknowledges that legal and accounting fees may constitute expenses of disposition for the purposes of subsection 40(1) of the Act.
In the case of Avis Immobilien G.M.B.H. v. Her Majesty The Queen 94 DTC 1039 (T.C.C.), affirmed in 97 DTC 5002, F.C.A., the court was requested to determine whether a foreign exchange loss that arose on the repayment of a bank loan was incurred for the purpose of making a disposition of certain property which had been acquired with the proceeds of the loan. Since the bank did not agree to deal with the purchaser, it became necessary for the taxpayer to repay the bank loan in advance of the disposition of the property. In concluding that the foreign exchange loss was not an outlay or expense enumerated in subparagraph 40(1)(a)(i), the court stated the following:
At pages 1045-1046. "The words 'for the purpose of' are susceptible of different meanings depending on whether the purpose is immediate or ultimate, direct or indirect or initial or final. Subparagraph 40(1)(a)(i) provides a rule for determining what outlays and expenses may be deducted in calculating a taxpayer's capital gain. The words 'for the purpose of' in subparagraph 40(1)(a)(i) are directed to the action of making a particular disposition. The outlays and expenses in that provision are directed to a particular disposition and no other."
At page 1046. "The words 'for the purpose of' in subparagraph 40(1)(a)(i) mean 'for the immediate or initial purpose of' and not the eventual or final goal which the taxpayer may have in mind. To give the words the latter meaning would permit the most indirect or most distantly related outlay or expense to reduce the amount of the gain. This could not have been Parliament's intent. We are not dealing in subparagraph 40(1)(a)(i) with the computation of income from a business, which is of an ongoing nature, but, rather, expenses or outlays made or incurred to dispose solely of capital properties. The statutory provision under consideration sets out a rule to determine a taxpayer's capital gain from the disposition of property and only expenses or outlays to be applied in reducing the gain are those incurred or made directly for the purposes of making the disposition. Subparagraph 40(1)(a)(i) does not contemplate expenses or outlays which may have merely facilitated the making of the disposition or which were entered into on the occasion of the disposition."
The same wording is used in variable F in the definition of "undepreciated capital cost" in subsection 13(21) of the Act, consequently a similar interpretation may be made. Variable F in the definition of "undepreciated capital cost" is required to determine a taxpayer's terminal loss under subsection 20(16) of the Act. In the above situation, the legal fees were not directly incurred for the purpose of making the disposition of the Property but rather were incurred as a result of a dispute regarding the payment of proceeds of disposition with respect to the sale. In our view, the legal fees incurred in XXXXXXXXXX and XXXXXXXXXX do not affect the calculation of the capital loss in respect of the disposition of the Property as determined under paragraph 40(1)(b) of the Act (in respect of the land) nor would they affect the determination of variable F in the definition of "undepreciated capital cost" in subsection 13(21) of the Act.
Similarly, any legal fees incurred to sue the lawyer who had drafted the original purchase and sale agreement will not be incurred for the purpose of gaining or producing income from a business, nor will they be incurred for the purpose of making the disposition of the Property.
In conclusion, it is our opinion that none of the legal fees in question would be deductible to the Partnership.
We are unable, at this time, to determine the taxation of moneys received from future lawsuits. The taxation of such amount may only be established after a review of the particular statement of claims and court findings or settlement.
Based on the information provided, it would appear that the Partnership reported some type of "rental" income throughout the period of XXXXXXXXXX. This income was effectively equal to the principal portion of the monthly mortgage payments. You may wish to consider the appropriate tax treatment of such payments, as the Court of Appeal for Ontario concluded that the monthly mortgage payments formed part of the purchase price of the Property.
We trust our comments will be of assistance.
Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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