Can You Deduct the Cost of Fighting the CRA?
A tax dispute can be expensive. Accountants must reconstruct records, lawyers prepare objections and appeals, experts provide reports, and years may pass before the matter is resolved. Fortunately, Canadian tax law generally permits taxpayers to deduct many of the professional fees incurred in challenging a tax assessment. The rules, however, are broader in some places and narrower in others than many taxpayers assume.
The Specific Deduction for Tax Dispute Expenses
Paragraph 60(o) of the Income Tax Act permits a taxpayer to deduct amounts paid for advice or assistance in preparing, instituting or prosecuting an objection or appeal concerning:
- an assessment of income tax, interest or penalties under the Income Tax Act;
- an assessment under a provincial statute imposing a similar tax;
- certain foreign income taxes eligible for a foreign tax credit; and
- decisions under the Canada Pension Plan, Quebec Pension Plan and Employment Insurance legislation.
Importantly, this deduction is available to all taxpayers. It is not confined to corporations, business owners or disputes involving business income. An employee challenging denied employment expenses, an investor disputing a capital gain, a shareholder contesting a benefit assessment, a trust challenging an allocation and a corporation appealing denied expenses may all potentially claim the deduction.
The CRA also recognizes that the rule can apply before a formal notice of objection is filed. Fees paid for professional assistance in responding to a CRA review, audit proposal or proposed reassessment may qualify where they relate sufficiently to the determination or contesting of the taxpayer’s liability. The deduction is not limited to courtroom advocacy. It can encompass legal fees, accounting fees and other professional expenses reasonably connected to the tax dispute. The CRA summarizes this treatment for individuals under line 23200 of the personal income tax return. CRA, Line 23200: Other Deductions
Individuals Do Not Need a Business
This is where paragraph 60(o) matters quite a bit.
Under the ordinary rules, an individual generally cannot deduct personal legal or accounting expenses. A salaried employee also has only narrowly defined employment deductions. Paragraph 60(o), however, supplies a separate statutory deduction for qualifying tax dispute expenses.
Suppose CRA reassesses an individual for an alleged shareholder benefit, unreported foreign income, a denied principal residence exemption or a taxable real estate sale. The individual may generally deduct the professional fees paid to respond to the audit, prepare the objection and pursue the appeal, even though the underlying dispute does not arise from a business carried on personally by that individual.
The deduction is generally claimed in the year the expense is paid, not merely when it is invoiced. Taxpayers should therefore retain invoices, payment records and a description of the work performed.
Corporations and Business Taxpayers
Corporations can also rely on paragraph 60(o). In addition, a corporation or other business taxpayer may be able to deduct tax dispute expenses under the ordinary income-computation rules in section 9, provided the expenses are incurred for the purpose of earning income and are not capital, personal or otherwise prohibited expenses.
The distinction can have practical consequences. A paragraph 60(o) deduction is a deduction in computing taxable income rather than an expense attributable to a particular source. It generally cannot create or enlarge a non-capital loss in the same manner as an ordinary business expense. A properly characterized business expense under section 9 may receive different treatment.
This is not simply a matter of choosing the most advantageous provision. The nature of the expense and its relationship to the business must support the treatment claimed. Invoices containing both dispute work and unrelated corporate, transactional or personal advice should be divided accordingly.
What About GST/HST Disputes?
Paragraph 60(o) is principally directed at income tax and the other legislation specifically identified in that provision. It does not expressly provide the same general deduction for an assessment under the Excise Tax Act.
For most GST/HST registrants, however, legal and accounting fees incurred in disputing a GST/HST assessment will arise directly from the operation of the business. Those fees will commonly be deductible as ordinary business expenses under section 9 of the Income Tax Act, subject to the usual restrictions.
The position can be less straightforward where the GST/HST dispute concerns a purely personal transaction, a non-business activity or an individual assessed in a capacity unrelated to an income-earning source. The existence of a CRA dispute does not, by itself, make every professional expense deductible.
The Deduction Is Not Unlimited
Several important limitations remain.
First, the expense must relate to determining or contesting an assessment, proposed assessment or qualifying government decision. Fees for general tax planning, preparing an ordinary annual return, reorganizing ownership or implementing a transaction are not converted into dispute expenses merely because tax considerations are involved.
Second, fees incurred in defending a tax-evasion prosecution are generally not deductible under paragraph 60(o). A criminal charge is not an assessment. A business deduction may be available in exceptional circumstances, but the connection to the taxpayer’s income-earning operations must be established independently.
Third, the tax, interest and penalties being disputed are separate from the professional fees. Income tax itself is not deductible. Interest and penalties imposed under the Income Tax Act are generally denied as deductions by paragraph 18(1)(t). Statutory fines and penalties may also be prohibited under section 67.6. Winning the right to deduct the lawyer’s bill does not make the underlying tax debt deductible.
Fourth, the amount claimed must be reasonable. Section 67 prevents a taxpayer from deducting an expense to the extent that it is unreasonable in the circumstances.
Finally, any costs award or reimbursement must be taken into account. Where a taxpayer deducted qualifying expenses and later receives costs from the Crown, paragraph 56(1)(l) generally requires the recovery to be included in income. The CRA expressly confirms that treatment in its guidance on legal and accounting fees. CRA, Archived Interpretation Bulletin IT-99R5
The Practical Lesson
The broad answer is that the cost of disputing a Canadian income tax assessment is usually deductible, whether the taxpayer is an individual, corporation, trust or partnership. But the statutory route, timing and tax consequences can differ.
The safest practice is to separate tax dispute work from tax planning, transactional work, bookkeeping and personal advice. Professional invoices should identify the assessment, taxation years, issues and stage of the dispute. Where income tax, GST/HST, criminal and non-tax matters overlap, the fees should be reasonably allocated.
The tax system may not reimburse a taxpayer for the cost of proving CRA wrong. It does, however, generally recognize that the reasonable cost of challenging an assessment should not itself be borne entirely with after-tax dollars.
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