October 2005
The Payment of Director’s Fees to Children –
A Precautionary Reminder
It is often said that bad facts make bad law and this is
clearly evident in a recently released Tax Court of Canada
case (Manchester Chivers & Associates Insurance Brokers
Inc. - 2005 TC 402). The case involved the payment of
directors’ fees by an insurance broker to four adult children of
the shareholders. Mr. and Mrs. Manchester and Mr. Chivers
were the only shareholders of the company. The directors of
the company were these three individuals, three adult children
of Mr. and Mrs. Manchester and one adult child of Mr.
Chivers. The Canada Revenue Agency (“CRA”) disallowed
all of the directors’ fees paid to the four adult children for the
three taxation years in question.
None of the children were employed by Manchester Chivers
other than in their capacity as directors of the company. For
the most part, the children did not live at home during the
period under consideration. One of the children was employed
in the insurance industry by a different firm in a different city.
The court agreed that child is currently a realistic candidate to
take over the affairs of the corporation. Mr. Manchester
admitted in his testimony that the children did little as
directors of the company other than sign the necessary
corporate documents as required of directors. The children
were made aware of the liabilities, particularly the statutory
liabilities, to which they were exposed as directors of the
company.
Two arguments were put forth by the CRA in support of the
disallowance of the directors’ fees. The first was that the
directors’ fees were not incurred for the purpose of earning
income. The court quickly dismissed this argument. The
second position was that the fees were not reasonable in
amount. The court agreed with this argument and, in the end,
disallowed all but a small portion of the directors’ fees
actually paid (the decision of the court was to allow a
deduction of $ 11,800 in respect of one child (for only two of
the three years) and $ 1,500 in respect of each of the other
children for any year in which compensation was paid).
These cases are all factually driven and, in this case, the facts
were almost as bad as they can get. The children performed
minimal duties, they attended no directors’ meetings, they had
no experience and no apparent interest in the business and
there was no evidence that they could make a worthwhile
contribution to the board. There was nothing in their
remuneration on a current basis that could properly relate in a
reasonable way to some future goal of succession. Lastly, they
received widely differing amounts of annual compensation as
directors despite the fact that they all made approximately the
same minimal contribution to the business. At the end of the
day, it is perhaps not surprising that the Court concluded as it
did.
This is not the only case dealing with the deductibility of
payments to family members. In some cases, the outcome
from the taxpayer’s perspective is more favourable. However,
there are some lessons to be learned from all of these cases
and it certainly doesn’t hurt to be reminded from time to time
of the risks involved. When it comes to compensating children
of shareholders, particularly when the children are
compensated as directors, the lessons to be learned from this
case include the following:
- Don’t assume that the CRA will ignore any compensation
below any specific dollar amount. In this case, the
children were paid varying amounts ranging from a low
of $ 1,500 to a high of $ 40,000 and the CRA disallowed
all such payments.
- Some differential in compensation is reasonable as
among directors where any reasonable distinction can be
drawn.
- Barring a business explanation (such as a deficiency in a
prior years' compensation, years of service, a regulatory
requirement, etc.) it is not reasonable that a corporation
expense more for fees in respect of one director than for
another where the other made, objectively and
subjectively, the same or a greater contribution.
- If the children are to be compensated as directors, hold
periodic directors’ meetings, document the meetings and
otherwise involve the children in the board’s business to
the greatest extent possible.
One last comment is worth noting. The denial of the expense
in this case amounted to double taxation because the expenses
were disallowed to the company notwithstanding the fact that
the children included the fees in income (and were not
reassessed to remove this income). This is not the normal
consequence in cases of this nature. The Tax Court had some
advice in this regard. It offered the following suggestions:
"In cases like this it is possible to consider that the
parents were the constructive recipients of the fees
paid. If such an approach had been taken, the deduction
might have been allowed as bonuses paid to the parents
whose services would typically warrant the expense.
Such an approach would frustrate the tax planning
aspect of this case but avoid the double tax. This is not
to suggest one way or the other as to which approach
the [CRA] should take in cases such as this. It simply
recognizes an approach often taken by the [CRA]."
In the past, the CRA has often been willing to resolve cases on
this basis. Hopefully, they will continue to do so in the future
but only time will tell.
George F. Johnson, C.A.
Senior Tax Partner, Crawford, Smith & Swallow, Chartered Accountants, LLP
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