Tax court not easily swayed when it comes to deducting legal fees
If you incur legal fees, whether it be for updating your will, filing for divorce, or perhaps suing your neighbour over her unkempt begonias, in most cases those fees won’t be tax deductible. There are, however, at least a couple of situations where you may be able to get some tax relief for the cost of legal fees, either as an employee or business owner.
For employees, legal fees are deductible if they are paid “to collect or to establish a right to salary or wages owed by their employer” or “to collect or establish a right to a pension.” For business or property owners, the fees would only be deductible if they are incurred to gain or produce income from a business or investment.
Two interesting decisions of the Tax Court of Canada released last week dealt with the issue of legal fee deductibility, the first by an employee defending criminal charges and the second by a business owner suing his in-laws.
Legal fees as an employment expense
The first case involved a police officer, who was suspended, with pay, from active duty in 2006 when an investigation began into an alleged sexual assault after a Christmas party in 2004. The police officer was charged with various Criminal Code offenses. He retained legal counsel to defend the criminal charges and some of the charges were withdrawn. Ultimately, there was at least one conviction, which resulted in a conditional sentence involving a period of house arrest.
The taxpayer incurred nearly $116,000 in legal fees, which he attempted to deduct on his 2012 tax return. At trial, he submitted various legal invoices, dated from 2007 through mid-2011, which referenced specific criminal procedures and proceedings, such as bail hearings, bail review, preliminary inquiries, pre-trial conferences and motions, severance and charter applications and meetings with Crown attorneys. There were no references to other “non-criminal” legal services.
The taxpayer argued that the legal fees should be deductible because any criminal conviction, if proved against him, would have resulted in the loss of his employment income. He also argued that he incurred the fees to access his pension funds during “a long and arduous claim process” in which he ultimately received a commuted lump sum amount.
The key question before judge was whether an individual who pays legal fees for the “preservation” of their employment is sufficient to constitute an effort to “collect” or “establish” a right to collect an amount of employment income owed.
The judge found that since the officer was fully paid during the period in which he defended the criminal charges, there were no amounts owing or unpaid to him. When he retired from his police service in 2011, he received a monthly disability pension as a result of a prior, serious car accident. As the judge wrote, “there simply was no gap relating to unpaid, withheld or contested remuneration as employment income.”
Indeed, prior jurisprudence has found that unless legal fees are incurred to collect amounts “owed” from employment, they are simply not deductible as “the protection or preservation of a future source of income is not sufficient.”
As for the fees paid to collect his pension income, the Tax Act is clear that you’re only allowed to deduct legal expenses paid “to collect or establish a right to a pension.” The former officer only commenced the process to collect that pension in 2011 while most of the legal fees were incurred in prior years. In addition, “there were no entries in the legal accounts suggesting legal advice was sought or given concerning the collection, application or assertion of a right constituting a pension benefit.”
The judge disallowed all of the taxpayer’s legal expenses.
Legal fees as a business expense
The second, somewhat bizarre case which must have resulted in some serious family infighting, involved a taxpayer and his wife who sponsored the immigration of his in-laws to Canada. Prior to their arrival in Canada, the in-laws sold all their property in Russia and loaned approximately $260,000 to the taxpayer to be invested and used to “acquire a risk-free investment earning 10 per cent a year” which would generate “a lifetime income for the in-laws.”
The taxpayer decided to invest these borrowed funds in his software development sole proprietorship. The in-laws later requested the return of the funds, or, among other things, $3,000 per month in support.
The taxpayer and his wife ended up suing his in-laws “for breaking the sponsorship agreement and the loan agreement causing the (taxpayer) severe financial damages.” They also sued a third party and a local YMCA association “because they encouraged the in-laws to breach the sponsorship agreement and the loan agreement.”
The taxpayer incurred about $75,000 in legal fees that he attempted to deduct on his 2014 tax return arguing that “the money he borrowed was used by his business and therefore the legal expenses to prevent a return of those funds were properly deductible in computing his income because the business could not operate without the funds.”
Needless to say, the judge wasn’t buying this argument. As he wrote, “I failed to see any basis upon which one could say that the … lawsuit, which was started by the (taxpayer) and his spouse, against the in-laws is in any way ‘for the purpose of gaining or producing income from the’ (taxpayer’s) proprietorship. There is nothing in the evidence to suggest that there is any link between the sponsorship agreement and the business…
“The litigation as a whole is in relation to private family arrangements between the (taxpayer) and (his) spouse, on one hand, and his in-laws, on the other hand and (the tax rules) apply to prevent the deduction.”