Introduction: The Problem of Deduction of Legal Fees in the Family Law Context
As Canadian tax lawyers, although we have a very distinct and specific tax law knowledge, developed over years of specialized income tax practice, clients are sometimes surprised to learn that we have at least a general knowledge of other areas of law. This is because the Income Tax Act is drafted in such a manner that almost all transactions, transfers, income, capital and windfalls are affected in some manner by income tax law. This means that while as Canadian tax lawyers we are tax specialists, we also must often act as the "jack of all trades" when it comes to other areas of the law.
One of the areas in which specialized tax knowledge can make a huge difference for client outcomes is family law; while most family lawyers are aware that income taxes can be effected by their work, their main focus the division of value, property and cash, that is under most circumstances already a part of the spouse's after-tax receipts. On the other hand, future amounts earned, and the maintenance of children do raise the issue of income taxes, though the rules are often generally misunderstood by both family lawyers and accountants to be less complex than they actually are. A simple example demonstrates why proper tax guidance can ultimately lead to large savings in the family law context - something that can help entire families by reducing the Canada Revenue Agency's share of the marital property, and income moving forward.
The Deduction of Legal Fees to Enforce a Support Obligation
One of the most recent queries we received from a family law colleague was a question regarding the deduction of legal fees in the family law context. His understanding of the applicable income tax law was fairly solid, but incomplete. This led to constant arguments with clients' accountants who refused to claim a deduction on those clients' tax returns for legal fees related to enforcing a spousal support obligation. Legal fees related to enforcing a child support obligation, or lump-sum payment, are commonly known as deductible, but the real uncertainty is with respect to spousal support amounts.
Under the Income Tax Act, spousal support amounts are normally deductible by the payor spouse and get brought into the income of the payee spouse. From a child-support perspective, it would normally make no sense that a source of income that is not subject to tax would be considered "income" to the payee and thus legal fees to secure it could be deductible. However, subsection 248(1) of the tax act saves this by classifying child support payments as a type of "exempt income", which has the effect of removing the income itself from a taxpayer's net income calculation, but still allows for a deduction in line with the rest of the provisions of the tax act.
On the other hand, confusion arises in the context of spousal support payments. Normally, lump sum payments to spouses are not deductible by the payor, as they are treated as a division of after-tax receipts upon breakdown of the union. Monthly spousal support payments come from ongoing and current income, and they are thus included in the payor spouse's tax return. There is no argument related to the deductibility of the legal fees expended to enforce the payment of these amounts, as it is a simple connection to make in the abstract.
How Tax Guidance Solves and Improves the Problem of Lump-Sum Spousal Support Amounts
The reason for the confusion, as we explained to our lawyer colleague, is that there is no specific statutory income tax act reference that deals with spousal support payments, their enforcement, and the deductibility of legal fees therefor.
The CRA's previous position has been that legal fees incurred for the securing of lump sum spousal support payments do not qualify for deduction under the tax act. However, over the last fifteen or so years, the Tax Court of Canada, the Federal Court of Appeal and the Supreme Court of Canada have clarified the law regarding these deductions.
In essence, the Courts have turned to a typical income tax technique to help solve the issue: characterization. In many cases, spouses become delinquent in their payments and the payee spouse is forced to bring the matter to Court to have an order issued for payment and possibly other sanctions. Once this is done, the result is normally an Order requiring a lump-sum payment in lieu of monthly support fees, whether retroactively or prospectively. In typical income tax fashion, in these cases the Courts have examined the underlying character of the lump-sum payment, and where it can be attributed to an enforcement of a previous or future periodic support obligation, the Courts have allowed the deduction of related enforcement costs based on the characterization as income to the payee in accordance with the general scheme described above.
Pro Tax Tips-Why Tax Guidance Can Help - Canadian Tax Lawyer's Analysis
As experienced Canadian tax lawyers, the question of characterization is where we often spend time and analysis. But what does this mean for those embroiled in a family law dispute?
A Canadian tax lawyer, such as the experienced tax counsel at our tax law office, can examine the facts of your situation, or that of your family law clients, and provide justification for the characterization of legal expenses as deductible. In tax law, form matters, meaning with specific legal advice from an expert Canadian tax lawyer, a family lawyer can negotiate lump-sum settlements with obvious and specific intent to characterize spousal support payments as nominally attributable to a periodic support obligation, or at the very minimum, demonstrate why they are distinguishable from a traditional lump-sum division of property type payment. The difference could mean savings in the thousands of dollars worth of income tax deductions on either spouses' tax returns.
If you are a taxpayer going through a divorce, or a family lawyer who would like to maximize value for your client in their ongoing dispute, give our top Canadian tax lawyers a call. We can work in a support role to ensure that you are maximizing savings during this most costly of times. Those that seek out tax guidance in advance will be surprised at the tax savings our office can facilitate in the short or long term.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.