If you’ve sat down with an accountant for a tax planning discussion, you may have come across the term management fees. While management fees can be a legitimate source of revenue, they can also be used in a variety of tax planning and minimizing techniques.
Management fees have come under the CRA spotlight in recent years so it’s a good idea to understand what they are and the risks involved before incorporating them into a tax planning strategy.
So just what is a management fee?
A true management fee is exactly as it sounds – a fee you’d get for the management of some type of asset. For example, brokers and investment advisors generally take a fee for the management of an investment portfolio. They follow market trends then buy and sell assets on your behalf to get you a solid return on your investment (or so you hope). It’s easy to understand what service they provide for the fee you pay.
However, sometimes the service provided is not so clear.
Consider a company whose head office is in Ontario. Head office controls the majority of the functions of the company from hiring, to marketing to strategic planning. The company has done well in the BC market so they decide to open a small office there. However, the small office is only responsible for BC sales – they only have a few sales personnel and all other corporate functions happen in the Ontario head office. The Ontario head office charges the BC corporation a management fee for basically managing all other facets of the company.
While it can certainly be argued that head office is providing some sort of management services, as the BC office grows, it will be more difficult to argue just what in fact they are managing.
So how are management fees used in tax planning?
Suppose our head office had significant tax losses and the majority of total revenues were recognized in the BC company. By charging a management fee to the BC company, head office can use up the tax losses that would otherwise be lost. Charging a management fee can then be a way to transfer a tax loss from one corporation to another.
While lawyers and accountants can incorporate in the majority of provinces, other professions are not allowed to incorporate. Consider a real estate agent who is not permitted to recognize income in a company and must therefore pay tax at the normal marginal rates. If the agent does well for the year, they could be taxed at over 46%. Compare that with a lawyer who would be taxed in a corporation at 15% and you’ve got a huge disparity.
One strategy would be to start a management company. That company would manage the marketing, hiring and strategic planning for the real estate agent just like in our example above. The company would then charge the real estate agent a management fee for that service – effectively transferring income that would otherwise be taxed at 46% into a company to be taxed at 15% and creating large tax savings.
Some shareholders will claim that they’re paid through their company as subcontractors. In a normal corporate structure, shareholders can take out money from the company in the form of salaries or dividends.
In a subcontracting arrangement, the shareholder may form another company operating as a management company. The shareholder’s personal management company will charge the main operating company a management fee for the shareholder’s services throughout the year.
The shareholder can then claim additional expenses in their personal management company and defer the tax they would otherwise have had to pay on a salary had they taken it out directly from the main operating company.
So what’s the risk?
Ensure you’re aware of the risks.
When it comes to taxes (and perhaps other things in life too) if something sounds too good to be true, it generally is. The risk in most of the tax planning techniques above lies in the actual value of the service provided.
In our head office example, there are truly management services being provided. However, the question is how much? Are those services worth 10K a month or 100K? The question is a complex one, however, it’s easy to look at it in terms of intent. Is head office charging a reasonable amount to account for their costs or are they simple trying to transfer tax losses?
If the CRA deems the latter to be true, the anti-avoidance rules can kick in and they can deny the fees along with the usual set of penalties and interest.
In our real estate agent example, the CRA may deem that your management company’s only purpose is to lower the tax on your real estate income. In our subcontracting example, they may claim that you’re not providing any real management services at all and are instead operating a personal service corporation. In that case you’ll be denied the majority of your expenses and the main operating company could face large penalties.
So how do you stay in the clear?
If you’re using a management fee strategy as part of your overall tax planning, you should make a good case as to the real value of the service you’re providing. Ultimately you want to show that you’re providing a real service and not only avoiding tax. As that’s not always easy, it’s a good idea to talk to a professional to ensure you’re taking the right steps to support your claim.