Canada: Legal Fees Deduction To Fight Tax Reassessments

Are Tax Lawyers' Fees Deductible?

As experienced Canadian tax lawyers, we are often asked the question by our clients and their accountants as to what, if any of the Canadian income tax services we provide can be validly deducted in the income tax returns of our Canadian income tax clients. In many circumstances, the answer to the question of whether our legal fees are deductible is complex, requiring research of its own to determine.

Generally speaking the Income Tax Act divides a taxpayer's income into "sources", such as employment, business or property, and each of these sources has its own type of deductions that are considered appropriate to apply and offset the net income from that particular source. For example, employment expenses are generally disallowed by the Tax Act unless a specifically enumerated deduction is contained within section 8. On the other hand, business income utilizes the generally accepted accounting principles to inform deductibility under section 9 of the Tax Act, and to the extent that a business expense is not specifically excluded by some other section, taxpayers may generally deduct the expense from their income if it is reasonable and for a valid business purpose.

But the one area of tax legal representation that we get the most questions about is the deductibility of Canadian tax lawyers' fees for representing a client with respect to appealing a CRA assessment by way of a Notice of Objection or appealing to the Tax Court of Canada. These are income tax services generally referred to as tax dispute resolution files.

If a client only earns employment income, does the general limitation on deductibility of expenses against employment income necessarily mean that they cannot deduct the fees for hiring a tax lawyer to represent them? The answer to this question can be found in the structure of the Tax Act itself, and in our opinion, as well as the CRA's, our fees for representing our clients in the Tax Court, at objection, or even at the audit phase with respect to income taxes are actually fully deductible for all of our clients, regardless of how they earn their income, and from what source that income flows.

The Structure of the Tax Act and How Tax Dispute Fees are Treated

A complete breakdown of the structure of the Income Tax Act is a complex analysis in itself, and so we will not attempt to break down the entire framework. Suffice it to say, the Tax Act as originally drafted was done so in a predictably rational way. Part I of the Tax Act contains virtually all of the various calculation provisions, and it is further broken down into Divisions and subdivisions. Division B, the portion that is relevant to this article, contains all of the rules for the basic calculation first of net income and then "taxable income" upon which the tax payable is itself separately calculated in later Divisions.

Division B is further subdivided into subdivisions a through k - subdivisions a through d deal with the specific sources of income, while subdivisions e through k create certain rules of either general application to all sources, or additional rules related to certain types of taxpayer, such as trusts, partnerships, individuals or corporations. Subdivision a, for example, encompasses sections 5 through 8 of the Tax Act, which are the sections related to the computation of employment income.

For the purposes of answering the question as to whether or not a tax lawyer's fees are deductible, we first turn to section 60 of the Act, which is located in subdivision e.

Subdivision e of the Tax Act and its Application

Subdivision e begins at Section 60 of the Act, which is titled "Other Deductions". Section 60 itself contains a number of deductions permissible against all of the other sources by virtue of its order in the Act. The order of application of the subdivisions in Division B is that the taxpayer first calculates the net income from the various sources, so employment expenses against employment income (subdivision a), and business expenses against business income (subdivision b) to arrive at their net income amount from that source. The sources are then "netted" together to create the total "net income" of the taxpayer for the year (this is done by virtue of section 3). Once the net income amount is determined, the taxpayer may then proceed to apply any of the available miscellaneous deductions specifically enumerated in section 60 against their total net income. The number arrived at once the specific deductions applicable to all sources have been taken is the "taxable income" that most are familiar with in their T1 income tax return.

Of paramount interest to us in this article however is subsection 60(o) of the Act which reads:

Legal Expenses

(o) amounts paid by the taxpayer in the year in respect of fees or expenses incurred in preparing, instituting or prosecuting an objection to, or an appeal in relation to,

(i) an assessment of tax, interest or penalties under this Act or an Act of a province that imposes a tax similar to the tax imposed under this Act,

Clearly this language is meant to encompass the work that a Canadian tax lawyer does for a client with respect to contesting an objection or appeal. The controversy related to this stems from the fact that legal expenses of this kind are normally deducted against business income under subsection 9(1) and the generally accepted accounting principles. Another further point of confusion is that tax professionals are taught very early that income from certain sources, such as employment is "quarantined" and that expenses are generally disallowed. While this is true from the perspective of calculating a taxpayer's income from a source of employment specifically, the confusion arises when determining the actual "taxable income" amount under the Tax Act, which as stated above is an expression of the net total of all sources, minus specific deductions.

The order of application of the subdivisions is what is key here - as described above, the specific deductions allowed by section 60 are computed against a taxpayer's total net income from all sources, after the specific deductions have been netted against their respective sources. Support for this is explicit in the Act itself in section 4.

Section 4 of the Act and the Concept of "Source"

Section 4 of the Act stipulates that a taxpayers "income" for the year in their income from a source or sources of income in that year. This general principle is what leads to the confusion about the deductibility of tax lawyer's fees regarding objections and appeals - subsection 4(2) states that "in applying subsection (1) for the purposes of this Part, no deductions permitted by sections 60 to 64 apply either wholly or in part to a particular source or to sources in a particular place." In other words, the deductions contained within section 60 are specifically designed not to be applicable only to a specific source of income, but rather should be applied once the taxpayer's total net income is calculated as an amalgam of the total income earned from all the various applicable sources. This "total net income" is prescribed in section 3 of the Act, which states that a taxpayer's income is the net of each source of income calculated first separately, and then netted against one another to come up with the actual total income.

Confused yet? Not surprising as this is a question that still leads to some controversy among tax professionals. This is where an examination of some of the other specific deductions under section 60 is helpful. The most well-known of these is found in subsection 60(b), which allows a taxpayer a specific deduction for periodic spousal support payments. Under subsection 60(b), the payer ex-spouse makes a support payment which is deducted from their net income and added to the ex-spouse's income, where ultimately the income is subjected to tax. This deductible amount reduces the payer's total net income, and its deduction (in the absence of any other specific deductions) results in the payer spouse's taxable income for the year. The payment of spousal support is not related or dependent upon the actual "source" from which the income was earned, as per section 4, but rather it demonstrates clearly that the deductions under section 60 in essence come "off the top" of a taxpayer's total net income to result in the total amount that is used to calculate the taxes owing, or the "taxable income" of the taxpayer.

The easiest way to illustrate this is by example; take a taxpayer who earns income from employment, but also has a small side business that from which he earns income on the weekends. He is reassessed and hires our firm to file an objection. In 2021, he earned $100,000 in income from employment, $100,000 in income from the business, but incurred $50,000 in expenses related to the business, and also paid our firm $5,000 to contest the reassessment. How are the legal fees expended applied and how is the net income calculated? We attempt to demonstrate this visually using the table below:

Applying the Concept to Tax Lawyers' Fees, the Courts' and the CRA's Position

If you've made it this far, you're probably wondering how all of this works in the real world. We've had senior respected CPA's ask us this question many times, and we believe that some of the confusion stems from the concept of "taxable income" versus net income. Luckily the Courts have provided us with guidance on this topic specifically.

In Flood v The Queen, an estates lawyer was working on settling an estate for the beneficiaries and obtained an outside valuation for a piece of vacant property at $71,000. He filed the estate's final tax return and requested that the CRA provide a clearance certificate. After more than two years of waiting, he contacted the CRA and was informed that the CRA had obtained an outside valuation of the property at $500,000 and that a referral had been made against him to the investigations division of the CRA for the levying of a criminal charge of tax evasion. To combat this, the lawyer hired outside counsel to represent the estate with respect to the civil side of the assessment against the estate. The outside tax counsel billed the lawyer directly, and on its invoices included the following statement:

In accordance with subsection 60(o) of the Income Tax Act, these fees are deducible in the year they are paid. These fees are deductible by whoever pays the fees, even if that is not the taxpayer whose taxes are under appeal.

As the lawyer paid the fees personally, he deducted the amount on his personal tax returns. Eventually, the criminal charges were dropped and the only issue left was the deductibility of the fees paid to outside counsel by the lawyer. No less an authority of Chief Justice Bowman of the Tax Court ruled on the case, and while accepting that in these circumstances the amount would have been deductible as a valid business expense under subsection 9(1) for the lawyer at any rate, he made it clear that the deduction under subsection 60(o) was meant to be read as broadly and all-encompassing as possible:

[5] The Crown's position is that the only person who can deduct the costs of objecting to an assessment under paragraph 60(o) is the person against whom the assessment was issued. I think this is an unnecessarily narrow view of the provision.

[6] For one thing, paragraph 60(o) contains no such restriction. I think it would be unreasonable to permit a stranger or volunteer who had no pecuniary interest to deduct the fees of contesting someone else's assessment. However, if someone has a pecuniary or other interest in the outcome that was not too remote, I see no reason for prohibiting such a person from deducting this expense insured by him or her. I note for example the comment in Sherman's edition of the Income Tax Act:

Note also that 60(o)(i) does not say "an assessment of the taxpayer". Therefore, amounts paid by a director or shareholder to contest a corporation's assessment should still be deductible. See Theodore Sherman (Walbi Trust), [1976] C.T.C. 2207 (TRB).

Legal fees may also be deductible from business or property income under generally accepted accounting principles. See Notes to 9(1). For other provisions allowing deduction of (or credit for) specific legal costs, see 8(1)(b), 89(1)(f), 20(1)(e), 20(1)(cc), 60(o.1), 62(3)(f), 118.2(2)(1.1)(i) and 152(1.2). See Interpretation Bulletin IT-99R5.

Clearly then, as per Justice Bowman, section 60(o) is meant to be applied with a broadness that does not preclude the deduction of the fees related to objection or appeal on the basis of "source" of income. Indeed, the case reference to Theodore Sherman (Walbi Trust) allowed a shareholder to deduct fees to contest a corporation's reassessment. It is a basic principle of income tax law that the business of a separate taxpayer, in that case a corporation, is not the business of another, so if the section 60 deductions were only available to offset specific sources, such a deduction would not have been allowed by the Court in that case.

The CRA's own administrative position mirrors this and offers the most explicit statement that any taxpayer may deduct the legal fees incurred to contest an income tax objection or appeal. Paragraph 7 of the CRA's Interpretation Bulletin IT-99R5 "Legal and Accounting Fees" makes this clear:

¶ 7. Under paragraph 60(o), all taxpayers, including those persons who report income from sources other than business or property (such as salary or capital gains), may deduct fees or expenses incurred and paid for advice or assistance in preparing, instituting or prosecuting an objection or appeal in respect of

(a) an assessment of tax, interest or penalties under the Income Tax Act or a similar provincial law,

(b) a decision of the Canada Employment and Immigration Commission, the Canada Employment and Insurance Commission, or a board of referees or an umpire under the Unemployment Insurance Act or the Employment Insurance Act,

(c) an assessment of income tax, interest or penalties levied by a foreign government or political subdivision thereof, if the tax is eligible for a foreign tax credit, or

(d) an assessment or decision under the Canada Pension Plan or a similar provincial plan.

A taxpayer may deduct amounts expended in connection with legal and accounting fees incurred for advice and assistance in making representations after having been informed that the taxpayer's income or tax for a taxation year is to be reviewed, whether or not a formal notice of objection or appeal is subsequently filed.

As per the last part of paragraph 7, the CRA's position is that these fees are deductible in all circumstances related to a reassessment or even a contingent risk of reassessment - the language of the paragraph clearly contemplates representation at audit prior to reassessment and allows for the deduction even if the taxpayer and their representatives are successful in the audit and no reassessment is issued.

More recently, the CRA chose to further clarify this position in a response to a taxpayer query made to the technical interpretations department. The response was to clarify the ability of taxpayers to carry-forward any tax losses generated by the deduction of legal fees. Per the CRA technical interpretation

Paragraph 3(a) of the. Tax Act requires a taxpayer to determine the amount of each (net) income for the year "from a source", including income from each office, employment, business and property. Legal fees deductible under paragraph 60(o) are not deductible in determining income or loss from a source, and therefore are included in this calculation in accordance with subsections 4(2) and (3). For the same reason, such legal fees are not included in the calculation of a non-capital loss, as described in subsection 111(8) of the Act.

As they are not covered by paragraph 3(a), legal fees deductible under paragraph 60(o) are considered in the calculation described in paragraph 3(c). The result of a paragraph 3(c) calculation cannot be negative. This is supported by the wording of paragraph 3(c): "the amount, if any, by which the total determined under paragraph (a).exceeds the total of deductions permitted."

Based on this calculation, and the calculation of non-capital loss described in subsection 111(8), no non-capital loss can be created by legal fees described in paragraph 60(o).

The CRA's position, which upon consideration we agree with, is that because the expense cannot result in a loss by virtue of being applied under section 4, it cannot generate a net loss and thus does not result in the creation of a non-capital loss under section 111(8). Accordingly, these expenses are "quarantined" and must be applied in the year they are actually paid by the taxpayer. Note that this rule may not apply if the legal fees are validly expensed under subsection 9(1) and offset against a source of business income.

Pro tax tips - Hiring a Canadian Tax Lawyer is More Affordable than it may Seem

As expert Canadian tax lawyers we specialize in contesting CRA reassessment actions, be it at the audit, objection or Tax Court appeal phase. Our position to our clients has always been that our fees are deductible in full on any dispute file related to an income tax reassessment or audit. This means that the real expense in hiring our firm to represent you is actually less than the cash value - the fees expended will be deducted on your income tax return, resulting in a recovery of taxes when you file. However, we should note that there are additional rules related to the deduction of these expenses under some of the other acts, such as GST/HST that may preclude the deduction of our fees. The best way to determine your chances of success, and your actual out of pocket amount for hiring the best Canadian tax lawyers to contest the CRA is by consulting with our certified tax specialist Canadian tax lawyer as soon as possible whenever CRA comes calling.

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.