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.
Principal Issues: Whether Holdco has correctly reported management fees receivable.
Reasons: Holdco must report the management fees on a receivable basis pursuant to paragraph 12(1)(b) of the Act.
November 18, 2004
Doug Williams HEADQUARTERS
Team Leader A. Seidel, CMA
Verification and Enforcement Division (613) 957-2058
Toronto Centre Tax Services Office
Attention: Michael Schwantes
We are writing in response to your letter of June 24, 2004, in which you request our comments on the reasonableness of inter-corporate management fees, and, if it is determined that such management fees are reasonable, whether such management fees are a contingent liability, in the following fact situation.
(a) "Holdco" is XXXXXXXXXX;
(b) "Opco" is XXXXXXXXXX;
(c) "Mr. A" is XXXXXXXXXX;
(d) "Mrs. A" is XXXXXXXXXX;
(e) "Trust" is the XXXXXXXXXX.
1. Holdco owns all of the voting shares of Opco. The shareholders of Holdco are Mr. A, Mrs. A and the Trust.
2. On XXXXXXXXXX, Opco and Holdco entered into a written management services agreement (the "Original Agreement"), under which Holdco is to provide Opco with management services. Mr. A and Mrs. A mainly provide these management services to Opco on behalf of Holdco. Mr. A and Mrs. A are also directors of Opco.
3. The Original Agreement provided that, in consideration for the management services, Opco "shall pay to [Holdco] a management fee per annum equal to the total of (i) XXXXXXXXXX% of the net merchandise sales of [Opco], before taxes". The Original Agreement further provided that the management fee "shall be payable by [Opco] monthly or at such other time as may be agreed upon by the parties hereto".
4. On XXXXXXXXXX, a series of transactions was entered into whereby Opco recorded management fees payable to Holdco, Holdco reported this amount as income but offset the income with an expense for management wages, payable mainly to Mr. A and Mrs. A, the payment of this amount to Mr. A and Mrs. A, who then reported the management wages they received as employment income in their personal income tax returns.
5. A letter from XXXXXXXXXX, to XXXXXXXXXX, outlines the requested amendments to the Original Agreement. The letter requests that XXXXXXXXXX prepare the management services agreement "based on the aforementioned terms" (see paragraph 10 below) and to provide a copy once finalized. The reply from XXXXXXXXXX, states: "Further to our recent discussion, we enclose ... an Amended and Restated Management Agreement made as of XXXXXXXXXX" (the "Amended Agreement").
6. The Amended Agreement provides that "The fee for the aforementioned services is an amount equal to XXXXXXXXXX% of Newco's [Opco] net merchandise sales per month and is payable monthly or is to be credited in arrears from time to time throughout the year. In addition, XXXXXXXXXX [Holdco] is eligible to receive a performance bonus which may be declared at the sole discretion of Newco [Opco] and, if declared, it shall be determined as of and be payable or credited as of the fiscal year-end of Newco [Opco]".
7. Holdco and Opco have now filed their XXXXXXXXXX corporate tax returns. The reporting of the management fees in these tax returns is consistent with the terms of the Amended Agreement.
Rectification/Retroactive Tax Planning
The timing of Holdco's reporting of the management fees received/receivable from Opco will be determined by whether the management fees are paid/payable pursuant to the Original Agreement or the Amended Agreement.
Nothwithstanding the fact that the letter from XXXXXXXXXX bears a date of XXXXXXXXXX, the response letter from XXXXXXXXXX is dated XXXXXXXXXX and states that they are providing a copy of the Amended Agreement "Further to our recent discussion". It is our view that the real audit issue is whether or not the Amended Agreement is valid as of XXXXXXXXXX, in which case the taxpayer should be pursuing a rectification order through the applicable courts, or whether the Amended Agreement is, in reality, retroactive tax planning and was not put into place until early XXXXXXXXXX, as suggested by the XXXXXXXXXX letter, in which case the comments in our February 20, 2004 memorandum continue to reflect our views with respect to the application of section 67, subsection 9(1) and paragraph 12(1)(b) of the Act to the series of transactions described in paragraph 4 above.
The courts have generally accepted rectification of mistakes and have generally dismissed attempts at retroactive tax planning.
In William Lee v. The Minister of National Revenue, 90 DTC 1738 (TCC), Couture, C.J.T.C. stated that:
"The reason why the Appellant changed his mind as to the year in which his debt from the company became bad was clearly explained by the witness Waites and his explanation was reasonable and I accept it. Furthermore, I am not aware of any authority for the proposition that once a taxpayer has signed his tax return that he may not change his mind subsequently following the discovery of a mistake notwithstanding the certificate that he signed as part of his return. Certainly, when an honest mistake has been discovered by a taxpayer he must be permitted to correct it and the procedure to do so is provided in the Income Tax Act within certain prescribed requirements. The appeal process serves this purpose."
In Attorney General of Canada v. Paul Juliar, Karen Juliar and Juliar Holdings Ltd., 2000 DTC 6589 (Ontario Court of Appeal), Austin, J.A., quoted the general principle in regard to rectification, and indicated agreement with the propositions contained therein, as stated in Snell's Principles of Equity:
"If by mistake a written instrument does not accord with the true agreement between the parties, equity has power to reform, or rectify, that instrument so as to make it accord with the true agreement. What is rectified is not a mistake in the transaction itself but a mistake in the way in which the transaction has been expressed in writing. Courts of Equity do not rectify contracts; they may and do rectify instruments purporting to have been made in pursuance of the terms of the contract.
The true principles governing these matters I conceive to be as follows. (1) The court has a discretion to rectify where it is satisfied that the document does not carry out the intention of the parties. This is the basic principle. (2) Parties are entitled to enter into any transaction which is legal, and, in particular, are entitled to arrange their affairs to avoid payment of tax if they legitimately can. The Finance Acts 1969 and 1975 tell them explicitly how they can do so in the case of estate duty and capital transfer tax. (3) If a mistake is made in a document legitimately designed to avoid the payment of tax, there is no reason why it should not be corrected. The Crown is in no privileged position qua such a document. It would not be a correct exercise of the discretion in such circumstances to refuse rectification merely because the Crown would thereby be deprived of an accidental and unexpected windfall. (4) As counsel for the trustees submitted, neither Whiteside v. Whiteside [ 2 All E.R. 913] nor any other case contains anything which compels the court to the conclusion that rectification of a document should be refused where the sole purpose of seeking it is to enable the parties to obtain a legitimate fiscal advantage which it was their common intention to obtain at the time of the execution of the document."
The following cases considered the issue of retroactive tax planning. (See also: John A. Matheson v. Her Majesty The Queen, 74 DTC 6176 (FC-TD) and Réjean Lagacé v. The Minister of National Revenue, 93 DTC 1144 (TCC))
In Her Majesty The Queen v. Phyllis Barbara Bronfman Trust, 87 DTC 5059 (SCC), the Chief Justice, stated that "the courts must deal with what the taxpayer did, and not what he might have done".
In Steven Adam v. The Minister of National Revenue, 85 DTC 667 (TCC), Rip, T.C.J. concluded that "[A]n adjustment to the books of account of a taxpayer cannot render null that which has transpired. Past events cannot be ignored. ... no taxpayer has the right to retroactively alter events when it best suits his purposes".
In, Tetrad Resources Ltd., supra, the taxpayer tried to argue that amounts appropriated from a corporation were in fact management fees. Beaubier, T.C.C.J. concluded that the "story of management fees is a fiction" on the basis that the taxpayer "did not care how the accounting was done ... so long as it was to his advantage".
The letter from XXXXXXXXXX, to XXXXXXXXXX, bears a date of XXXXXXXXXX, but not the firm's letterhead, and outlines the request for the Amended Agreement. The reply from XXXXXXXXXX is dated XXXXXXXXXX and states that it is "Further to our recent discussion". It would appear that the Amended Agreement mirrors the fact situation in the Tetrad Resources Ltd. case, supra. The Original Agreement did not provide Holdco with the tax result that was anticipated. The Amended Agreement is an attempt to change the accounting for the management fees payable to Holdco with the sole intention of avoiding the income inclusion that arises under the Original Agreement. It is therefore our view that the Amended Agreement is nothing more than retroactive tax planning. Since "no taxpayer has the right to retroactively alter events when it best suits his purposes", Holdco, Opco, Mr. A, Mrs. A and the Trust are bound by the terms of the Original Agreement.
As stated in our February 20, 2004 memorandum, assuming Mr. A and Mrs. A are both active in the business operations of Holdco and are each resident in Canada, it is our view that the management wages paid to them by Holdco are within the scope of our policy on shareholder/manager remuneration, as contained in Income Tax Technical News No.22, and are, therefore, reasonable for purposes of section 67 of the Act. This would also be the case if the courts were to grant Opco and Holdco a rectification of the Original Agreement.
Pursuant to the terms of the Original Agreement, the management fees were determined by reference to the net merchandise sales of Opco and were payable to Holdco monthly or "at such other time as may be agreed upon by the parties". If the courts were to grant Opco and Holdco a rectification of the Original Agreement, then pursuant to the terms of the Amended Agreement, the monthly management fee is payable monthly or is to be credited in arrears from time to time. Unless there are no "net merchandise sales" in a given month, the liability for management fees payable to Holdco arises at the end of each month. The quantum of the amount becomes fixed and a liability exists at the end of each month. The uncertainty as to the timing of the payment of Opco's liability does not result in the liability being considered a contingent liability.
If the courts were to grant Opco and Holdco a rectification of the Original Agreement, then pursuant to the terms of the Amended Agreement, Holdco is eligible to receive a performance bonus "which may be declared at the sole discretion of [Opco] and, if declared, it shall be determined as of, and be payable or credited as of, the fiscal year-end of [Opco]". A performance bonus under this provision would be considered a contingent liability of Opco until such time as it is declared. At that point in time, the liability would be crystallized in Opco and it would no longer be a contingent liability. In this case, the provision even provides for the date upon which payment of the liability, once it exists, must be made, being the last day of the fiscal period to which the performance bonus relates.
It is therefore our view that paragraph 18(1)(e) of the Act would not apply to the monthly management fees payable by Opco, pursuant to the Original Agreement or the Amended Agreement, or the performance bonus payable under the Amended Agreement, once declared.
If we can be of further assistance, please contact the writer.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
John Oulton, CA
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch
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