The Inequity of the Income Tax Act
Advisors who are employees don't reap the tax benefits
by Jamie Golombek
On March 15, 2006, the Canada Revenue Agency (CRA) released a troubling technical interpretation (2004-0103391E5) dealing with a commissioned employee financial advisor. The technical interpretation is disconcerting not because it's wrong, but rather because it illustrates a potentially serious problem with the tax law that undoubtedly occurs on a regular basis in the financial services industry. It also, once again, highlights the significant advantages, from a tax point of view, of being self-employed as opposed to being an employee.
The case involved Larry (not his real name), a financial advisor who was licensed to sell a variety of financial products, including life insurance, mutual funds and marketable securities. In the year in question, Larry changed employers from Firm A to Firm B.
At both Firms A and B, Larry was considered to be a "commissioned employee" and, as a result, met all the conditions under the Income Tax Act to allow him to deduct commissioned employee expenses under paragraph 8(1)(f) of the Act.
Prior to leaving Firm A, Larry was required to pay Firm A $27,000 for a "commission chargeback" and $40,000 for an "error on trade". The commission chargeback was due to the premature collapse of a life insurance policy sold in a prior year and the error on trade resulted from Larry's incorrect processing of a client's mutual fund sale instructions.
Under his employment contract with his former employer, Firm A, Larry was legally required to repay Firm A for commission chargebacks and errors on trade. If he failed to make such a payment, he would have been fired.
During the year in question, Larry's income from Firm A was $4,000, on which he claimed $3,000 expenses for a net income of $1,000. He then sought to deduct an additional $67,000 in respect of the chargeback and trading error.
Under paragraph 8(1)(f) of the Act, a taxpayer who was "employed in the year in connection with the selling of property or negotiating of contracts for the taxpayer's employer" can deduct "amounts expended by the taxpayer in the year for the purpose of earning the income from the employment (not exceeding the commissions or other similar amounts) ... received by the taxpayer in the year".
The CRA stated that, in its opinion, the references to "the taxpayer's employer" and "the employment" means that expenses incurred to earn income from a specific employer are deductible only from income received from that particular employer. Accordingly, the CRA stated that the deduction that Larry could claim for amounts that he was required to repay Firm A under his employment contract would be limited to his net income from Firm A, or the $1,000.
This finding, while technically correct, is troublesome in that Larry likely included the amounts in income yet he is not entitled to relief when the amounts are repaid. If Larry was a self-employed financial advisor, earning business income as opposed to a commissioned employee earning employment income, he likely would have been able to deduct both his commission chargeback and his error on trade payments simply as a cost of doing business.
This is yet another example of the current inequity that exists between employees and the self-employed when it comes to writing off legitimate expenses. The current rules treat the self-employed or "independent contractor" much more favourably from a tax point of view, since a self-employed business person can take advantage of myriad tax deductions that are severely restricted for employees.
This issue came to the forefront in the 2004 Supreme Court of Canada decision in Gifford, a case that dealt with a broker who was unable to deduct the cost of buying another broker's client list. Thomas Gifford was denied any deduction for the $100,000 he paid to purchase the client list. The Supreme Court publicly highlighted this unfairness, saying: " ... that employees are treated differently than taxpayers earning income from business ... is not novel nor readily seen as fair ... This seemingly inequitable result for [Gifford] is the result of the structure of the [Income Tax] Act".
What if Larry had purchased a home computer, used exclusively in the evenings and on weekends to check his e-mail, conduct Internet research and complete investment policy statements? Because of his employee status, he would not be entitled to any deduction in respect of the capital cost of the computer since, under our outdated Income Tax Act, employees are only allowed to depreciate automobiles or airplanes. Certainly, one would think that many more employees today use personal computers in the performance of their employment duties than they do airplanes.
It's time for advisors who are considered employees to speak up against this inequity. It's time for them to write to their members of Parliament asking that the Act be modernized to deal with the seemingly unfair tax treatment afforded to employees as opposed to the self-employed.