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Many taxpayers will be delighted to know that the Income Tax Act (Act) specifically permits the deduction of legal fees to institute or prosecute an objection or an appeal of a tax assessment. However the Act does not permit the deduction of legal fees in relation to a criminal charge of tax evasion. This presents an interesting question as to when legal fees are deductible.
The most important rule is that unless there is a specific provision in the Act allowing a deduction, legal fees are deductible only to the extent that they are incurred for the purpose of gaining or producing income from a business or property. According to Symes v Canada  S.C.J. No. 131 the purpose of a particular expenditure is ultimately a question of fact to be decided with due regard for all the circumstances. It follows that legal fees may be claimed in connection with a broad range of routine business functions such as preparing contracts, obtaining security for and collecting trade debts owing, preparing financial records and minutes of shareholders’ and directors’ meetings, and in respect of financing costs. Legal fees that meet the threshold requirement but are outlays of a capital nature, are generally not fully deductible in the year but rather over a period of years. Legal fees incurred on the acquisition of capital property for example, are added to the cost base of the property and can be expensed through the capital cost allowance rules. Legal fees considered to be an eligible capital expenditure may also be claimed over several years. Such is the case for legal fees incurred on the purchase of goodwill or, according to the Canada Revenue Agency (CRA), by a proprietor in the cattle hauling business to defend against the loss of his driver’s licence.
The second rule is that personal and living expenses are generally not deductible. That is the reason that legal fees incurred, for example, for a division of matrimonial property, to get a separation or divorce, establish custody or visitation arrangements of a child, or to get a discharge from bankruptcy, are not deductible. The same logic applies if a small business corporation became bankrupt and the sole shareholder is sued by the bank for the corporation’s debts. The legal fees incurred by the shareholder to defend are not deductible unless the shareholder was, for example, defending a personal guarantee and the legal fees were incurred to protect the shareholder’s income earning assets.
Once one progresses past these general rules, exactly which amounts are deductible under the Act? The following provides some specific and perhaps surprising examples.
Employees may deduct legal fees incurred to collect or establish a right to salary or wages, or to a retirement allowance. The test to be met for an employee seeking to deduct legal fees in respect of salary or wages is whether, if received by the employee, the amount would be included in his or her employment income. The amount need not come directly from the employer, for example, legal expenses incurred by an employee to collect insurance benefits under a sickness or accident insurance policy provided through an employer are deductible. However, legal fees incurred to save a job after an employer advises that employment is to be terminated may not be deductible, particularly if a settlement is reached and the employee retains his or her employment.
Legal expenses paid to collect or establish a right to a retiring allowance are deductible and may include a right to damages for wrongful dismissal. The deductibility of legal fees in this situation is limited to the amount of the retiring allowance. A taxpayer may also deduct eligible legal expenses paid to collect or establish a right to a pension benefit.
In a well received about-face in 2001 the CRA now permits the deduction of legal costs incurred to obtain spousal support under the Divorce Act, or under the applicable provincial legislation in a separation agreement, as well as legal costs to obtain an increase in support or to make child support non-taxable under the federal child support guidelines. Legal fees incurred to collect late support payments, to establish the amount of support payments from a current or former spouse or common-law partner, and to establish the amount of support payments from the legal parent of a child where the support is payable under the terms of an order are also deductible, at least while the person paying child support is alive. According to the CRA legal fees incurred to secure payment from the estate of the person previously paying child support, (dependant’s relief) are not.
Legal fees may also be deducted from the proceeds of disposition when capital assets are disposed of. Specifically, outlays and expenses including finder’s fees, commissions, broker’s fees, legal fees, and advertising costs may be deducted in calculating the capital gain or loss. According to the CRA, this may include legal fees incurred to litigate a right to amounts in respect of the share proceeds under an oppression remedy. The reasoning is that the amount awarded constitutes proceeds of disposition of a capital property and the legal fees were incurred to establish the right to compensation. Further, as there is often the expectation of an interest award in litigation, the legal fees can be prorated between the amount awarded in respect of the shares and the amount awarded for interest related to that award.
Other deductible legal fees
A number of other useful deductions are sprinkled throughout the Act. For example, deductible medical expenses include an amount paid on behalf of the patient who requires a bone marrow or organ transplant, for reasonable expenses including legal fees, to locate a compatible donor and to arrange for the transplant. Deductible moving expenses include selling costs relating to the sale of the taxpayer’s old residence, including advertising, legal fees, real estate commissions, and legal fees relating to the purchase of the taxpayer’s new residence. A new adoption expense credit allows a parent to claim a credit up to $10,220 for eligible adoption expenses related to the adoption of a child who is under 18, and can include related legal fees.
In a recent request to the CRA, a taxpayer asked whether legal fees incurred to defend against his involuntary commitment were deductible. The answer: no. Perhaps if he had advised that he was trying to stay out of an institution to preserve his income earning, he would have received a more favourable response.
Catherine Brown has been teaching tax at the Faculty of Law, University of Calgary since 1981.