For financial advisors keen on expanding their client base by purchasing a
client list from another advisor who may be leaving the business, last
Thursday's decision by the Supreme Court will prove to be a setback and make
such a purchase a more costly affair.
The Court handed down its decision in the case involving Mr. Gifford, an
employee and advisor at Midland Walwyn, who paid $100,000 to buy a client list
from a fellow advisor.
The other advisor agreed not to provide any further investment advice to his
clients or to provide the client list to anyone else and agreed to promote Mr.
Gifford as the new advisor of choice to his clients.
When the case was first heard in 2001 by the lowest court, the Tax Court
Judge ruled that the $100,000 payment was fully tax deductible as a marketing
expense because "clients are fleeting and evanescent."
The judge noted that you cannot "buy" clients. What you are really purchasing
is the right to market to those clients, he said.
Since, in the judge's opinion, there was no obligation that the clients would
continue with Mr. Gifford, there was no enduring benefit to the payment and he
therefore found it was fully deductible in the year of payment.
This ruling was overturned by the Federal Court of Appeal and confirmed last
week by the Supreme Court. The Court concluded the payment was not deductible
since it was on account of capital. In the words of the Appeal Judge, "surely
(Mr. Gifford) did not pay $100,000 for something he thought would be fleeting
... the purpose of the ... payment is to get access to a book of clients by
getting (the) client list."
The problem with the Court's finding lays with the fact that Gifford was an
employee and not self-employed. As a result, he was limited in his ability to
capitalize and depreciate business assets since, under the tax law, employees
are only allowed to depreciate automobiles or airplanes. This differs from
self-employed advisors who are free to capitalize and depreciate any business
asset purchased for the purpose of earning income, including a client list.
The Supreme Court publicly highlighted this unfairness: "that employees are
treated differently than taxpayers earning income from business ... is not novel
nor readily seen as fair... This seemingly inequitable result for (Gifford) is
the result of the structure of the (Income Tax) Act."
For advisors who are considered employees, the result of the decision is that
any amounts paid to purchase a client list are simply not deductible,
significantly increasing the true cost of purchasing a client base.
To achieve a better tax result, brokerage firms may need to facilitate such
purchase transactions, perhaps by paying the departing broker upfront and
recouping the funds from the purchasing broker by reducing her commissions going
forward.