There are a couple of reasons for moving profits from one corporation to another:
the operating corporation is usually exposed to risks such as lawsuits as a consequence of services/products it supplies. Moving the cash to the non operating corporation helps protect that asset. There may be an opportunity to generate a loss in one corporation to carry back and apply against past profits to obtain a refund. This is especially beneficial if the past profits were in the top tax bracket.
The biggest error we see with respect to management fees is the lack of supporting documentation. Often the only support is a journal entry in the accounting records. Simply recording an entry in the corporation’s general ledger is not sufficient. A journal entry is just a record of a transaction it is not proof that the transaction actually took place. Evidence of management fees will include the following:
• There needs to be a reason for one corporation charging the other corporation management fees. This can often be achieved by having management’s payroll in the holding corporation and then charging the operating corporation for their time.
• A contract needs to be in place laying out what services are being provided in exchange for the management fee.
• In most cases GST must be charged on the management fees.
• An invoice must be issued and dated correctly to recognize that a sale has occurred or service provided.
• The money should be paid rather than allowing an intercompany balance to accumulate.
• The fees should be reasonable. There is no definition of reasonableness but the management fee contract should include a profit distribution clause to recognize that if the corporation’s earnings exceed expectations then management should be rewarded accordingly.
If any of the above elements are missing it opens up the door for a denial of the transaction by Canada Revenue Agency which in turn can lead to penalties on taxes owing and a lot of accounting fees to tidy up the mess.
If you are concerned about management fees then contact Gilmour Knotts Chartered Accountants for assistance.
OUR FAQ ISSUE NEXT WEEK
What are the most common corporate income tax issues our clients face? Next week the last of our six part series will focus on general tardiness of tax filings.