Legal fees are only tax deductible in limited situations. For employees, they are deductible if they are paid “to collect or to establish a right to salary or wages owed by their employer.” For business or property owners, the fees would only be deductible if they are incurred to gain or produce income from a business or investment.
A recent Federal Court of Appeal case (Gouveia v The Queen, 2014 FCA 289) upheld the decision of the lower Tax Court. The verdict denied the tax deductibility of more than $2.2 million in legal fees paid from 2004 through 2007 by former Atlas Cold Storage Income Trust CEO Patrick Gouveia. He incurred the fees defending charges brought by the OSC and a class-action civil lawsuit.
Gouveia was a director, president and CEO of Atlas from August 2000 until his resignation in 2003. Since 2002, he has operated a management consultancy business as a sole proprietorship, Patrick Gouveia Consulting (PGC), soliciting business in the public refrigerated warehousing industry.
In 2004, the OSC brought charges against Gouveia and other senior employees of Atlas, saying they “engaged in a course of conduct that was intended to present an improperly improved picture of the financial performance of the Trust.”
In February 2007, however, the OSC determined that “the prosecution no longer has a reasonable prospect of conviction” and dismissed all charges against Gouveia.
THE CLASS ACTION
Around the same time, a class-action lawsuit was brought against Atlas, Gouveia, the auditors for Atlas and Atlas’s lead underwriter. The lawsuit sought damages in excess of $400 million. In 2008, the parties to the class action reached a settlement, and the suit was resolved without admission of liability.
Deductibility of the legal fees
Gouveia retained legal counsel to defend himself in both the OSC proceedings and the class-action lawsuit. All legal fees relate to a period after Gouveia left Atlas, and were not related to his employment income while he was CEO.
His position was that he should be entitled to deduct his legal fees since they were incurred to gain or produce income from his consulting business (PGC), and that the OSC proceedings and the class action “threatened his ability to generate income from his consulting business.”
CRA, however, said the legal fees should be denied since they were not incurred to gain or produce income from business. The agency’s position was that the legal fees related to the OSC proceedings and the class action would have been incurred regardless of whether he was running PGC.
Further, since the OSC proceedings and the class action arose directly as a result of his employment with Atlas, they could “only indirectly and potentially impact…[his] consulting activities.”
CRA also stated any connection between the legal fees incurred and Gouveia’s consulting activities was “too remote” to permit a deduction of his legal fees. The tax authority said the legal fees were incurred to protect his reputation, as well as his capacity to earn money in the future. Such expenditures are capital outlays and therefore not tax deductible.
The Tax Court judge agreed with CRA. He wrote, “The expenses were incurred to protect his reputation within the cold storage industry, where he focused his consulting business activities. As such, the legal expenses were personal in nature and were not incurred to protect the income earning potential associated with his consulting business.”
Ultimately, the judge concluded that preserving Gouveia’s reputation, as well his capacity to earn future consulting income, was “central to his decision to defend himself” before the OSC and in the class-action lawsuit, and that his “unblemished record of business experience, acumen and service was under attack by the OSC proceedings and the Class Action.”
The decision was that the “deduction of legal fees incurred to preserve the appellant’s reputation and capacity to earn future income is prohibited by [the Tax Act] and is considered to be capital in nature.”
As a result, the entirety of Gouveia’s deduction for legal fees was dismissed.