Does going fee-based save clients tax?

There is a longstanding debate over whether an investor is better served by a fee-based investment advisor or one compensated through management expense ratios (MERs). Often, tax deductibility is used as an argument in support of fees.

In a series of four articles, we will outline the tax treatment of investment counsel fees, and then look at how this treatment may vary depending on how an investor pays for such charges.

Why investment counsel fees can be deducted

While a qualified professional may be providing valuable financial guidance, that in itself is not enough to result in tax deductibility. That’s because deductibility is based on whether a particular outlay is related to income generation. The further removed from that core purpose, the less likely the outlay is to qualify.

The main Income Tax Act provision is s.20(1)(bb), which allows an income deduction for:

• (bb) fees paid to investment counsel—an amount, other than a commission, that
  • (i) is paid by the taxpayer in the year to a person or partnership the principal business of which
    • (A) is advising others as to the advisability of purchasing or selling specific shares or securities, or
    • (B) includes the provision of services in respect of the administration or management of shares or securities, and
  • (ii) is paid for
    • (A) advice as to the advisability of purchasing or selling a specific share or security of the taxpayer, or
    • (B) services in respect of the administration or management of shares or securities of the taxpayer[.]

In 1983, CRA issued Interpretation Bulletin IT-238R2 Fees Paid to Investment Counsel. The bulletin was last updated in 2002, and has since been archived, but it still represents CRA’s administrative position.

Principal business

The first subsection deals with the party to whom a fee is paid, and the second with the nature of the fee itself.

Subsection (i) prescribes the required characteristics of the party to whom a fee is paid. In short, the principal business of the person (which includes a corporation) or partnership must be the provision of advice or administration of securities. So, if you give advice but it’s not your main business, then your fees are not deductible.

Financial counseling

Subsection (ii) requires that the fees are paid for provision of advice or administration of securities only.

IT-238R2 reinforces subsection (ii), stating explicitly that deductibility does not extend to general financial counseling or planning. So even if a payee fits the principal business rule under subsection (i) and may employ the same or similar skills in offering another type of financial service, such other advice or services are not deductible.

Commissions

The potential deduction excludes “a commission,” even though this term is sometimes the generic equivalent to fees or charges. Commissions (e.g., the classic brokerage fee for a trade) charged to carry out a transaction are not deductible under s.20(1)(bb). However, such transactional commissions are not unacknowledged for tax purposes.

Transactional commissions increase the adjusted cost base (ACB) of the security on purchase, and decrease the proceeds on sale. For instance, assume a $10 flat commission on share purchase or sale. A 50% marginal tax bracket (MTR) investor purchases $1,000 worth of shares, and later sells for $1,200. The original cost base is $1,010 ($1,000 + $10) and the net proceeds $1,190 ($1,200 – $10), leading to a $180 capital gain less $45 tax ($180 x 50% x 50%), arriving at net after-tax cash of $1,145 ($1,190 – $45).

By factoring the $20 commissions into the ACB, there is a $5 tax savings to the investor ($20 x MTR50% x CG50%), for a net commission cost of $15. In a sense, half of the commissions were deductible. This underlines the general need to keep track of all contributing components to an investment’s ACB (including automatically reinvested distributions). Periodic purchases and periodic sales are more likely.

As purchase price will have fluctuated over time, these must be averaged across the units/shares (factoring in transactional commissions as outlined) in order to arrive at the appropriate capital gain or loss on any disposition.

Reasonableness

As with all deductions, the amount claimed must be reasonable, pursuant to ITA s.67:

• In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

Per IT-238R2, this requirement is normally satisfied when the fees are paid to an unrelated person. Where the payment is to a related person, the potential for deductibility will depend on a closer review of the type of activity and time spent. Note, however, that paying fees to an unrelated person does not in itself meet the reasonableness requirement. The fee amount and surrounding circumstances must also be considered (e.g., pooling fees related to multiple family members and charging them to one taxpayer would be unreasonable).

Another instance where reasonableness could be an issue is if an advisor charges different fees for different types of accounts, even though the advice and/or service is otherwise indistinguishable. For example, using a higher fee on non-registered assets compared to registered assets, the investor could potentially claim a larger deduction; but this would be unreasonable.

Tax preparation

Tax return preparation fees are generally not deductible, regardless of who is preparing the return. But if part of the preparation fee relates to calculating and reporting the details of business income and/or investment income, that portion should be deductible. For those whose income is derived principally through business income and non-registered investments, this could arguably amount to almost the full preparation fee.

It’s helpful if the fee’s components are itemized—or better yet, if the preparer renders a separate invoice for the business and the investment-related fees.

Registered money

Expenses related to generating tax-exempt income are not deductible:

• 18 (1) general limitations — in computing the income of a taxpayer from a business or property no deduction shall be made in respect of […]
• (u) fees – individual saving plans — any amount paid or payable by the taxpayer for services in respect of a retirement savings plan, retirement income fund or TFSA under or of which the taxpayer is the annuitant or holder.

In 1998, CRA conceded that fees, including investment counsel fees, “can be paid by the trust without any income inclusion or paid by the annuitant with no deduction.”

By “trust,” CRA was referring to an RRSP or RRIF. In short, though an annuitant may pay investment counsel fees for an RRSP/RRIF or TFSA personally, no deduction is allowed.

Next time, we’ll examine the tax treatment of MERs versus direct fees.

Read Part 2 of this series here, read Part 3 here and read Part 4 here.