New rule introduced in the 2004 federal budget
by Jamie Golombek
Individuals or businesses are entitled to deduct from their income most expenses incurred for the purpose of earning that income. Some expenses, however, such as golf membership dues and green fees, for example, are disallowed completely. Other expenses are subject to limitations, such as the 50 per cent limitation on the deductibility of meals and entertainment expenses.
The law
The 2004 federal budget, which received royal assent this past May, included a measure prohibiting individuals and businesses from deducting fines or penalties from their income, even incurred solely for the purpose of earning income.
As is often the case, this new rule was introduced to overturn a case decided by the Supreme Court of Canada (SCC), specifically the decision in 65302 British Columbia Ltd. v. the Queen. In this case, the taxpayer was an egg-producer and was only able to produce and sell a certain number of eggs as designated by its quota from the egg marketing board in British Columbia. The company intentionally produced more eggs than it was allowed under its quota because it wanted to meet the demand of a significant customer. The B.C. marketing board imposed a fine of approximately $270,000, which the company paid and deducted as a cost of doing business - after all, the company had to pay tax on the additional profits from the sale of the "over-quota" eggs.
The Canada Revenue Agency (CRA) objected to the deduction of this penalty arguing that in order for a penalty or fine to be tax deductible, the jurisprudence to date indicated that the penalty or fine must have been unavoidable and must not be against "public policy". The SCC disagreed and allowed the deduction of the fine, as it saw nothing in the Income Tax Act that distinguished the deductibility of a fine or penalty incurred to earn income from any other otherwise deductible business expense.
Clearly the tax man, unhappy with this state of affairs, introduced this new measure to eliminate it. As the government stated, "it is generally recognized that to allow a deduction for a fine or penalty that has been imposed in respect of a particular act or omission by a taxpayer, diminishes the disincentive to engage in that activity. Generally, therefore, such a deduction is contrary to overall public policy objectives".
Interest and penalties
In my April 2003 FORUM column ("Penalties and Interest"), I discussed the interest and penalties exigible under the Income Tax Act for late-filing a tax return or late-payment of tax owing. As a recap, if your client files his or her return after April 30 (or June 15 for the self-employed), there is a five per cent penalty on the amount of tax that was unpaid at the time the return was due plus an additional one per cent per month penalty on the amount due for each month the return is late (up to a maximum of 12 per cent).
If this is the second time that your client has been late and he or she was previously charged a late-filing penalty in any of the prior three years, the late-filing penalties double to 10 per cent of the unpaid amount plus two per cent for each late month, to a maximum of 20 months. This higher penalty would only be charged if your client has also received a formal demand to file from the CRA.
If your client fails to pay the required amount of tax on time, even if his or her return was filed on time, he or she will be subject to arrears interest. The interest, which is not tax deductible, is compounded daily and charged at the CRA prescribed rate plus an additional four per cent (for July to September 2005, the rate is: 3% + 4% = 7%). The penalties for late-filed returns are also subject to arrears interest from the return due date onwards.
The technical interpretation
In a recent technical interpretation released earlier this year (2005-0119721E5), the CRA was asked to comment, in light of the new legislation, whether various penalties, fines and interest imposed by various taxing statutes are deductible.
Penalties: The CRA responded that, under the new legislation, no deduction is permitted for any fines and penalties other than those specifically prescribed by the tax regulations. Currently, only three penalties are prescribed: the penalty for late payment of GST, the penalty for late payment of duties and the penalty for the late remittance of the September 11 Air Travellers Security Charge.
Interest: The new non-deductibility rule does not, however, generally apply to the deductibility of interest. That being said, the Income Tax Act has its own specific rule introduced in 1989 that specifically prohibits interest on unpaid income taxes to be deductible. This may be contrasted with the Excise Tax Act (which imposes the GST), which does not contain a similar provision and thus interest owing on late GST remittance would be tax deductible.
With respect to interest on provincial taxes owing, the CRA stated that such interest would also not be deductible in computing income.
Finally, the CRA confirmed that any interest assessed under the Canada Pension Plan Act or Employment Insurance Act due to an untimely remittance of an employer source deduction would be deductible in computing business income.