Deductibility of Professional Fees for Income Tax Purposes by a CCAA Debtor Company

Inproceedings under the Companies’Creditors Arrangement Act (“CCAA”)insolvency practitioners may be asked for advice or assistance in preparing theincome tax returns for the debtor company (or companies). This article isintended to inform practitioners about the deductibility for income taxpurposes of professional fees that are associated with some of the commonactivities undertaken by a company within a CCAA proceeding; and to provide some“best practice” suggestions for practitioners to follow at the onset of afiling to make the tax return preparation more efficient for the company andits advisors. 

Background:

In verygeneral terms the Income Tax Act (Canada)(the “ITA”) works like this:businesses are taxed on their taxable income for which the starting point istheir income from business, being their profit from that business (subsection9(1) of the ITA).  Profit for thesepurposes is essentially net income for accounting purposes subject to a varietyof adjustments. The common adjustments critical to our analysis here are:

1. Section 18: this section excludes various categories of expenses from being deducted when determining the profit or loss from a business, including, in particular:

   1. Pursuant to paragraph 18(1)(a) – expenses which are not incurred for the purpose of gaining or producing income.

   2. Pursuant to paragraph 18(1)(b) – expenses which are capital in nature or allowances on account of depreciation, obsolescence or depletion, except as expressly permitted.

2. Section 20 – permits the deduction of certain specific expenses which would normally be subject to the above restrictions.

There is nosection of the ITA which specifically allows for the deduction of professionalfees when calculating taxable income.

Theposition of the Canada Revenue Agency (“CRA”)in respect of expense deductibility in the context of a CCAA process is[1]:

The purpose of the CCAA is to permit a corporation to remain in business notwithstanding that it is insolvent. It preserves the insolvent company as a viable operation and enables it to reorganize its affairs to the benefit of the debtor and the creditors. Accordingly, a company under CCAA protection is allowed to stay in business. Therefore, provided that the expenses are otherwise eligible for deduction and there is no court order to the contrary, deduction under the provisions of the Act will be allowed notwithstanding the fact that the corporation is under CCAA protection.

As in anyother context, the deductibility of an expense in a CCAA context will continueto be based on the nature of the expense and whether it is excluded pursuant tosection 18 of the ITA or specifically deductible pursuant to section 20 (oranother section of the ITA).

Set outbelow is an analysis of the nature of the professional fees associated withcertain common activities that occur within CCAA Proceedings and whether suchfees may be eligible for deduction under the ITA (or not otherwise excludedfrom deduction per subsection 18(1)).

Regular Operating Activities:

After aninitial order is granted and while the debtor entity may well be operating itsbusiness, professional fee expenses related to the proceedings may bedeductible under section 9(1) of the ITA to the extent that they are beingincurred for purpose of earning income (the “Purpose Test”). Certain of those professional fee expenses mayrelate to the restructuring of debt and in that respect may be capital innature, depending upon the nature of the debt, but may remain deductible underone of the exceptions in section 20 of the ITA.

Asset Sale Activities:

Professionalfees associated with the sale of non-capital assets (e.g., inventory) shouldnormally be deductible in the calculation of income under section 9(1) of theITA.

Professionalfees related directly to the sale of capital assets (e.g., drafting andnegotiation of a purchase and sale agreement) may be characterized as capitalexpenditures under section 18(1)(b) of the ITA, and therefore may not bedeductible in calculating income from a business. However, those expenses maybe taken into account in the calculation of any capital gain (loss) orrecapture of capital cost allowance (terminal loss). In the context of acapital gain (loss), the net impact of this treatment is that only 50% of theprofessional fees are deductible and if the sale results in a capital loss,such losses can only be used to offset capital gains (limited carry back toprior years or forward to future years).

During theperiod of the CCAA Proceedings when assets are being sold, professionals willalso likely be working on other aspects of the administration such as reportingto the Court, monitoring the cashflows and progress of the company orrepresenting it in Court. The fees associated with that work should likely beconsidered to be regular running expenses on the income account.  Accordingly, those fees should ideally besegregated such that they can be identified separately from those expenses thatare more likely to be viewed by the tax authorities being as capital in nature.

Post-Asset Sale Activities:

After sellingall of its assets, a debtor company’s activities will be limited to managing thecash proceeds and completing the administration of the CCAA Proceedings. Duringthis period the debtor will earn interest income on which the debtor will betaxable except to the extent the debtor has deductible expenses.

Professionalfee expenses during this period of the CCAA Proceedings may be significantlyhigher than interest income and therefore such expenses present an opportunityto recover taxes paid (if any) in prior taxation years by entities within thecorporate group. This situation sometimes arises when either: i) certainentities had not previously been allocated professional fee expenses (i.e.prior to an allocation order); or ii) had taxable income due to capital gainsor recapture of capital cost allowance if their assets were sold for more thantheir relevant tax cost. Accordingly, in the spirit of maximizing stakeholdervalue, it is imperative to ensure that the professional fees incurred by the debtorentity (or entities) remain deductible for tax purposes.

A problemcould arise if the professional fees are considered to be no longer deductible fortax purposes on the basis that they no longer meet the Purpose Test (i.e. arenot incurred for an eligible income earning purpose) as the company is nolonger operating a business and the professional fees are not necessarilyconnected to earning interest income. There are several important cases fromthe Courts that consider the Purpose Test to be satisfied as long as a link canbe established between the expense and a former income producing activity[2]. 

Linking theprofessional fees to a former income producing activity may be easy for sometypes of activities and harder for others and any such determination issubjective and may be open to interpretation by the tax authorities.

Practitionersmay want to consider tracking the professional fees at a more detailed level soas to better utilize some of the specifically deductible expense categoriesprovided for by the ITA. Some of the most relevant and important categoriesare:

• Expenses related to financing (ITA subparagraph 20(1)(e)(ii.2)):

  • Expenses related to the rescheduling or restructuring of debt are specifically deductible under the ITA. The restructuring of the debt must provide for a modification of the terms or conditions of the debt or substitution or conversion of the debt to another instrument. These expenses are deductible on a straight-line basis over a 5-year period, but this can be accelerated if the debt obligations are settled or extinguished during the year. Accordingly, this provision may potentially be applicable if the restructuring results in a Plan that contemplates the modification, substitution or conversion of a debt.

• Expenses of representation (ITA paragraph 20(1)(cc)):

  • The ITA allows for a specific deduction of amounts incurred by the taxpayer in connection with representations relating to the business made to the government or a public body, including for instance, the tax authorities.

• Legal Expenses Related to Tax Assessments et. al (paragraph 60(1)(o):

  • This section is more specific, and in certain respects more restrictive, than paragraph 20(1)(cc), as it allows for the deduction of legal expenses incurred by the taxpayer in connection with an objection to or an appeal in relation to an income tax assessment and certain employment insurance and pension plan matters.

Conclusion and Considerations:

Practitionersshould be cognizant of the Purpose Test requirement and potential benefits froma tax perspective of ensuring expenses remain deductible. By trackingprofessional fees and other expenses incurred in a restructuring proceeding bythe subject matter to which they relate, the debtor company will have the dataavailable to file an accurate tax return and respond to any queries withrespect to such expenses from the tax authorities should they arise.

At the veryleast, consideration should especially be given to tracking separatelyprofessional fees associated with capital transactions from those associatedwith the other administrative activities as they are treated very differentlyfor tax purposes. When share or asset sales are reported for tax purposes, thetax authorities may expect that at least some portion of the reporting period’sprofessional fees would be treated as costs of disposition of the shares orother assets.

Given thebenefits and expectations described above, practitioners should considerwhether they would prefer tracking professional fees in separate subject mattercategories at the onset of an engagement or would undertake the onerous task ofparsing through reams of invoices for professional fees at a later date (e.g.when the tax returns are prepared or are audited by the tax authorities). Thechoice is yours…

[1]2009‑0328671I7

[2] Raegele v. R., [2002] 2 CTC 2955 (TCC)[Informal Procedure], Langille v. R,2009 TCC 398 [General Procedure] (restated in Grenier v. R., 2010 TCC 641 [Informal Procedure]) and AG (Canada) v Poulin, 1996 DTC 6477(FCA)

Michael Basso, Senior Director, Corporate Finance/Restructuring FTI Consulting  T +1.416.649.8050 [email protected]

Derek Chiasson, Partner Norton Rose Fulbright Canada S.E.N.C.R.L., s.r.l. / LLP T: +1.514.847.6114 [email protected]

Adrienne Oliver, Partner Norton Rose Fulbright Canada S.E.N.C.R.L., s.r.l. / LLP T: +1.416.216.1854 [email protected]

Sylvain Rigaud, Partner Norton Rose Fulbright Canada S.E.N.C.R.L., s.r.l. / LLP T: [email protected]

[1]2009‑0328671I7

[2] Raegele v. R., [2002] 2 CTC 2955 (TCC)[Informal Procedure], Langille v. R,2009 TCC 398 [General Procedure] (restated in Grenier v. R., 2010 TCC 641 [Informal Procedure]) and AG (Canada) v Poulin, 1996 DTC 6477(FCA)