6 April 2009 Internal T.I. 2009-0310391I7 - Deduction of Legal Fees

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: Are the legal fees incurred by the taxpayer deductible under paragraph 8(1)(b)?

Position: Question of fact.

Reasons: It depends on whether the taxpayer was attempting to establish that salary or wages were owed for services performed.

								April 6, 2009

St. John's Taxation Centre  			HEADQUARTERS
								Income Tax Rulings
			   					Directorate
		Attention : Mr. Bill Meadus		Michael Cooke, CA
(613) 446-0484

								2009-031039

Deduction of Legal Fees

We are writing in response to your email correspondence dated February 16, 2009 wherein you requested our comments on the deductibility of certain legal expenses incurred by a taxpayer under paragraph 8(1)(b) of the Income Tax Act (the "Act") in the following circumstances.

Our understanding of the facts is as follows:

The taxpayer is an employee of XXXXXXXXXX . The taxpayer was demoted in XXXXXXXXXX , apparently due to some accusations that were made by another member of the XXXXXXXXXX . In addition to the demotion the taxpayer was also prevented from applying for any other positions. The taxpayer filed a lawsuit for slander against the person who made the false accusations.

Additionally, some sort of action was commenced against the employer. Although we have no details regarding what the claim entailed, this lawsuit was ultimately settled in XXXXXXXXXX and pursuant to a settlement agreement the taxpayer was reinstated to his former XXXXXXXXXX and pay by the employer. No amount was paid by the employer in respect of any damages or wages that may have been lost as a result of the taxpayer's demotion between the time the taxpayer was demoted in XXXXXXXXXX and ultimately reinstated to his former XXXXXXXXXX and pay in XXXXXXXXXX (referred to hereinafter as the "disputed period").

The taxpayer has incurred legal fees of $XXXXXXXXXX for the XXXXXXXXXX to XXXXXXXXXX taxation years.

The taxpayer's lawyer maintains that XXXXXXXXXX % of the legal fees incurred by the taxpayer ($XXXXXXXXXX ) were in respect of the taxpayer's attempt to establish his right to be reinstated to his former position and as such, should be deductible under paragraph 8(1)(b) of the Act.

Our Comments:

For the 2001 and subsequent taxation years, paragraph 8(1)(b) of the Act permits a deduction in computing income from an office or employment for amounts paid by the taxpayer in the year as or on account of legal expenses incurred by the taxpayer to collect, or to establish a right to, an amount owed to the taxpayer that, if received by the taxpayer, would be required by subdivision a to be included in computing the taxpayer's income ("income from employment"). Paragraphs 22 to 24 of IT-99R5 (Consolidated) - Legal and Accounting Fees, provides some guidance on the deductibility of legal fees that were incurred to collect amounts owing as salary and wages.

In particular, paragraph 23 of IT-99R5 states, inter alia:

"A deduction under paragraph 8(1)(b) is allowed only in respect of an amount "owed" by an employer or a former employer. If the taxpayer is not successful in court or otherwise fails to establish that some amount is owed, no deduction for expenses is allowed. However, failure to collect an amount established as owed to the taxpayer does not preclude a deduction under this paragraph."

However, as a result of the FCA's decision in John Loo v. The Queen, 2004 DTC 6540 (see discussion below) the CRA has accepted that this paragraph will have to be revised to provide for a deduction of legal expenses that were incurred by a taxpayer in a failed attempt to establish that a right to an amount was owed to the taxpayer that would, if received, be included in the taxpayer's income from employment. However, if the legal fees were incurred by a taxpayer to establish a right to a promotion or a raise, or to seek financial compensation in connection with allegations of unlawful or wrongful acts by an employer, such amounts would not be deductible under paragraph 8(1)(b) of the Act.

The basic facts in Loo were as follows:

Mr. Loo was one of approximately fifty lawyers employed with the federal Department of Justice in Vancouver. Mr. Loo sued the Treasury Board, alleging that he was entitled to be paid the same salary as legal counsel doing the exact same job in the Toronto and who were at the same job classification level. Mr. Loo was successful in his lawsuit and deducted the legal expenses that were incurred by him in respect of this action pursuant to paragraph 8(1)(b) of the Act. The Minister argued that nothing was "owed" to Mr. Loo as salary or wages since he already received his normal salary.

The FCA allowed the taxpayer's deduction under paragraph 8(1)(b) of the Act noting that even though Mr. Loo had received his "normal" salary, his legal expenses were incurred in an attempt to establish that additional amounts were owed to him in respect of the services he had already rendered to his employer. Essentially, the FCA found that the legal expenses fell squarely within the words of paragraph 8(1)(b) of the Act because Mr. Loo was trying to establish, by litigation, that in respect of the services he already rendered to his employer, the law may require that he be paid more than he was already paid.

The FCA also distinguished the facts in Loo from several other cases, such as, Jazairi v. Canada, 2001 DTC 5163 (F.C.A.), Turner-Lienaux v. Canada, 1997 DTC 5294 (F.C.A.), Blagdon v. Attorney General of Canada, 2003 DTC 5491 (F.C.A.), Guenette v. Canada, 2004 DTC 2276, and Fortin v. Canada, [2002] 4 CTC 2245. The FCA noted in Loo that in none of those other cases could it be said that the claimant was alleging that he/she was being underpaid for work done. The FCA also noted that paragraph 8(1)(b) of the Act has two branches. The first branch permits a deduction for legal expenses incurred in an action to collect salary or wages owed (i.e. it contemplates litigation resulting from the failure of an employer to pay the salary or wages due to an employee). In these circumstances, there may be no dispute as to the amount of salary or wages that the employee is entitled to be paid for the services the employee has performed, but there may be a factual dispute as to how much of the salary or wages remains unpaid.

In your fact situation, the first branch does not appear to be particularly relevant since the taxpayer was presumably paid for the XXXXXXXXXX services he actually performed between XXXXXXXXXX and XXXXXXXXXX .

The second branch contemplates a situation in which the matter in controversy is the legal entitlement to the salary claimed and applies if, for example, an individual incurs legal expenses in litigating a factual dispute as to whether he or she has actually performed the services required by the contract of employment, or a dispute as to the rate of salary payable for services performed (i.e. this would include, for example, a dispute as to the terms and conditions of employment).

In your fact situation, the second branch might apply if the taxpayer was trying to establish, by litigation, that in respect of the XXXXXXXXXX services he actually performed for the disputed period he was entitled to be paid at the rate applicable to his former higher XXXXXXXXXX . Based on the limited facts that we have, it is not clear to us if this is the case. While we understand that the taxpayer was ultimately reinstated to his former position, it does not appear that such reinstatement was retroactive nor was any amount paid by the employer in respect of such reinstatement.

As noted above, the legal expenses appear to have been incurred for the purpose of suing the particular member of XXXXXXXXXX for damages as a result of the slanderous allegations made by that member (which apparently resulted in the taxpayer's demotion) as well as for the purpose of establishing the taxpayer's right to be reinstated to his former position.

Paragraph 2 of IT-365R2, Damages, Settlements and Similar Receipts, indicates that amounts received by a taxpayer as special or general damages for personal injury or death will generally be non-taxable; however, an amount which can reasonably be considered as income from employment rather than an award of damages will not be excluded from income. Generally, it is our view that an award of damages for "libel" (i.e. defamation of character, slander, etc.) would be considered for personal injury and would not be taxable, and as such legal fees incurred to obtain a non-taxable award would not be deductible.

While no amount appears to have been awarded as general or specific damages in your situation, the taxpayer's lawyer maintains that approximately XXXXXXXXXX % of the legal fees incurred relates directly to establishing the taxpayer's right to be reinstated to his former XXXXXXXXXX and pay. We have no basis to conclude whether this statement is true or whether such allocation is reasonable.

Notwithstanding the above, if the legal expenses were not incurred to establish a right to an amount that was owed to the taxpayer as income from employment in respect of service already performed by the taxpayer during the disputed period then no amount of legal fees would be deductible. This would be the case where the taxpayer was only attempting, via the legal action, to be reinstated to his former XXXXXXXXXX and pay on a go-forward basis. However, if credible evidence exists to support the proposition that the taxpayer was attempting to collect an additional amount of pay for services already rendered by him for the disputed period based on the pay rate for his former higher XXXXXXXXXX then some reasonable portion of the legal fees might be deductible.

In respect of the above, if there is a significant difference in the duties and responsibilities of employment actually performed by the taxpayer during the disputed period at the lower XXXXXXXXXX when compared to the duties and responsibilities of employment at the taxpayer's former higher XXXXXXXXXX then it might not be reasonable to conclude that a right to an amount was owed to the taxpayer as income from employment in respect of services already performed by the taxpayer. In these circumstances, and assuming the suit claimed some sort of monetary compensation attributable to the disputed period, it would be more proper to conclude that the legal fees were incurred by a taxpayer to establish a right to seek financial compensation in connection with allegations of unlawful or wrongful acts by an employer, which as noted above, would not be deductible.

A detailed breakdown of the legal fees incurred by the taxpayer and a review of the actual pleadings made by the taxpayer's lawyer in respect of this matter would have to be examined by you to arrive at any definitive conclusion.

We trust that these comments will be of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada 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 severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Renée Shields
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch