Reasonableness Test

Definition

ITA s.67 is a general anti-avoidance rule that limits the deductibility of any outlay or expense to the amount that is reasonable in the circumstances. It most often applies to compensation paid to shareholders, their family members, or related corporations, where the question is whether an arm's-length party would have paid the same amount for the same work. The leading test comes from Gabco Limited v. MNR: "would a reasonable businessman with business interests have paid that amount, keeping his business interests in mind". There is a long-standing CRA administrative position that owner-manager salaries to the principal shareholder are generally accepted as reasonable regardless of amount, because they reduce income otherwise taxed at the lower CCPC rate. This favourable position does not extend to family members.

Key rules

• Applies to deductible outlays and expenses. A dividend is not a deductible expense, so s.67 does not apply to dividends directly (TOSI applies instead).
• The principal shareholder of a CCPC is, as an administrative matter, treated as effectively self-chosen. Salary from corporate income that would otherwise be taxed at the small business rate is accepted regardless of the dollar amount, subject to integrity concerns.
• Salary paid to a shareholder's spouse, child, or other family member must reflect actual work performed at a rate comparable to an unrelated employee with the same duties.
• Management fees paid to a related company must reflect actual services, reasonable rates, and appropriate documentation (invoices, timesheets or deliverables, and a services agreement).
• CRA will recharacterize amounts in excess of reasonable as non-deductible to the payer. The recipient is usually still taxed on the full amount received. This produces effective double taxation on the excess, the classic penalty.
• Contemporaneous documentation (job descriptions, hours worked, market rate evidence, services rendered) is the taxpayer's best defence.

Example

A CCPC owner pays her university-age son $60,000 for summer customer-service work over 12 weeks. Market wage for comparable customer-service work is $22 per hour, and he actually worked 30 hours per week.

Actual hours worked         12 weeks x 30 hours = 360 hours
Market rate                 $22/hour
Reasonable amount           $7,920
Amount paid                 $60,000
Excess (non-deductible)     $52,080

Effect on the corporation:
  Deduction allowed        $7,920
  Deduction denied        $52,080  (added back under s.67)
  
Effect on the son:
  T4 income reported       $60,000 (full amount still taxable)
  Personal tax unchanged

The corporation loses the deduction on $52,080 while the son is fully taxed, creating effective double tax on the excess.

Common mistakes

• Paying a spouse a round salary (for example, $24,000) with no time records, no job description, and no evidence that the work occurred. CRA will reassess to zero in the absence of documentation.
• Treating the "owner-manager exception" as covering family members. It does not.
• Charging management fees between related corporations without a written services agreement, invoices, and GST/HST invoicing where required.
• Paying compensation "for past services" that were never billed. CRA may recharacterize as a shareholder benefit under s.15(1).
• Failing to issue a T4 for salary paid to a family member, which is a separate penalty regardless of the s.67 analysis.

Related concepts

Reasonableness is the constraint that sits on top of every owner-manager compensation decision. It governs the salary leg of salary versus dividends, bounds intra-group management fees, limits income splitting with family, and interacts with TOSI for dividend-based splits.