Introduction – Deductibility of Employee Expenses
Generally, employees are limited in deducting the expenses they incur in earning their employment income. Only employee expenses set out in section 8 of the Income Tax Act are deductible, meaning that if an expenditure is not listed in this section, an employee cannot deduct the amount from his or her gross income.
Commission employees, a specific category of taxpayers under the Income Tax Act, have the option of deducting a broader range of expenditures from their gross income. Generally, the sales expenses incurred by a commission employee are only deductible against the commission portion of the employment income, and the amount cannot exceed the commission that is received by the taxpayer during the year. Simply meeting the definition of commission employee is insufficient in triggering the deductibility of employee expenses incurred by a commission employee.
Who is a Commission Employee?
The term "commission employee" is defined in paragraph 8(1)(f) of the Income Tax Act. A taxpayer falls into this category when he or she is employed in the year in connection with selling property or negotiating contracts for the taxpayer's employer.
Generally, commission employees, as the name implies, earn commission income or a combination of salary and commission. Auto salesmen and financial advisors are two types of professionals who typically fall into the category of commission employees.
What Expenses are Deductible?
Generally, expenses incurred by a commission employee in the course of earning his or her commission income are deductible. Such expenditures are referred to as "sales expenses" in paragraph 8(1)(f), and may include the cost of entertaining clients, promotional and advertising expenses, motor vehicle expenses, salary of an assistant, and home office expenses.
It is important to note that under paragraph 8(1)(f), sales expenses are deductible only against the commission portion of the employee's income. However, certain expenses, such as motor vehicle expenses, which are further discussed in paragraph 8(1)(h.1), may be deductible against the salary portion of the employee's income.
Deductibility of certain expenses is explicitly excluded. For example, a commission employee cannot deduct expenses that may be categorized as capital expenditures.
An employee cannot deduct sales expenses by simply meeting the definition of a "commission employee" as set out in paragraph 8(1)(f). As the taxpayer is also required to meet the following four criteria:
- Under his or her employment contract, the taxpayer was required to pay for his or her own expenses;
- The taxpayer was ordinarily required to carry out the duties of the employment away from the employer's place of business;
- The taxpayer was paid in whole or in part by commission. This commission was paid in reference to sales made, or the contracts negotiated by the taxpayer; and
- The taxpayer did not receive a non-taxable allowance for travelling expenses.
The employment contract of a commission employee must be examined in order to determine whether these criteria are met. In making this determination, the employment contract must be interpreted objectively and not from the personal perspective of the employer.
Requirements, terms, and conditions of an employment contract may be explicitly stated or implied. For example, an employer may require a commission employee to pay for the promotional and advertising costs associated with generating sales even though this requirement is not explicitly stated in the employment contract. Generally, implied terms of the contract are evidenced by the conduct of the parties to the contract, the description of the employee's role, and a host of other factors.
Interpreting an employment contract from the perspective of the CRA is not an easy task. Our experienced Canadian Business and Tax Dispute lawyers have extensive experience in both drafting and interpreting employment agreements and they are avid advocates for Canadian taxpayers whose deductibility of employment expenses is challenged by the CRA.
Sales Expenses Incurred Must be Reasonable
Generally, under the Income Tax Act, the amount of any expense that is deductible must be reasonable. This means that only the portion of an expense that is reasonable in the circumstances of a particular case can be deducted. This general principle of deductibility applies to expenses incurred from any source, including employment and commission income.
Under section 8(1) of the Income Tax Act, one of the primary factors considered in determining whether an expense is reasonable is the volume of the goods sold or contracts closed by the commission employee. For instance, it is reasonable to expect an auto salesman with a high sales volume to incur greater expenses in advertising compared to a more average commission employee in the same role.
T2200: The Declaration of Conditions of Employment
The Canada Revenue Agency (CRA) requires a T2200 form as proof that the employer required the commission employee to pay for his or her sales expenses. Under the Income Tax Act, the commission employee is not required to file a T2200 form; however, he or she is required to submit the form if the CRA asks for it.
It is important to note that an employer does not have a statutory obligation to prepare a T2200 form, nor does the employer have an obligation to provide an exhaustive list of all the expenses that a commission employee is required to incur per his or her contract of employment. The CRA simply "expects" the employers of commission employees to issue a T2200.
The Tax Court of Canada has accepted the position that a T2200 form may be deficient. Generally, the Tax Court of Canada's position has been that a T2200 form is prima facie evidence, but not conclusive that the commission employee has met the deductibility conditions in paragraph 8(1)(f) and 8(10) of the Income Tax Act. For example, in Leith v R, the court found that failure to file a T2200 was not fatal to a taxpayer's ability to deduct employment expenses so long as the taxpayer provided the T2200 to the Minister upon request.
The Tax Court of Canada has recognized that the T2200 form may be erroneous and unreliable and may not include all the expenses that an employee is required to incur per his or her employment contract. In such instances, the Court has disregarded the T2200 provided by the employer and has instead relied on the documentary evidence presented by the taxpayer.
In Fitzgerald v R, the Tax Court of Canada found the T2200 forms to be unreliable and inconsistent evidence of the terms and conditions of the taxpayer's employment contract. Instead, the Court relied on the documentation advanced by the taxpayer in setting out the conditions of his employment, including the sales expenses that the taxpayer was required to pay.
The Tax Court of Canada has shown a willingness to accept an amended T2200 when the form is prepared and signed by the taxpayer's employer.
Tax Tips: Keeping Proper Documentation is Critical in Case of a Tax Audit
It is not unusual for the CRA to select commission employees for an audit of their sales expenses. Often, such a tax audit requires that the taxpayer provide the CRA with receipts and supporting documentation for the claimed expenses. For example, the CRA may require a logbook for the motor vehicle expenses claimed, a list of clients for whom the meals and entertainment expenses were incurred, or proof of salary paid to an assistant. The T2200 form is another important document that a CRA auditor is likely to ask for.
Often, however, a tax audit of a taxpayer's employee expenses may extend to other sources of income, or even other family members. This is common in instances where a commission employee has business income, or pays a salary to a family member without proof of the salaries paid. In such circumstances, it is important to seek professional tax advice in responding to the CRA in a cogent and complete fashion. Contact one of our experienced Toronto tax lawyers if you find yourself in this situation.