Published: September 1, 2021
Last Updated: January 17, 2022
Impact of Contracts and Written Agreements on Tax Reporting
Your contract or written agreement may impact how you can report income or expenses on your taxes. This could be as simple as ensuring the contract or written agreement has the right parties so the correct parties are entitled to claim amounts related to the contract. In other cases, it may involve complex issues such as when income can be reported, whether an individual is an employee or independent contractor, or the value of the assets transferred.
Use of Contracts and Written Agreements for Tax Planning
Contracts and written agreements may be drafted with tax planning in mind. The exact nature of the tax planning involved depends on the type or subject matter of the contract or agreement. Tax planning opportunities may include holdbacks for construction contracts, payments to shareholders in shareholder agreements and asset transfers to defer taxes. Our experienced Canadian tax lawyers can review and draft contracts and written agreements to implement tax planning strategies.
Contracts and Written Agreements Impact on Disputes
In a tax dispute, contracts and written agreements will become key documentary evidence supporting or negating the taxpayer’s position against the Canada Revenue Agency (“CRA”). A taxpayer may use a contract or written agreement for a number of purposes such as demonstrating a source of income, legitimizing an expense claimed, or showing business activities. However, a poorly drafted contract or written agreement can work against the taxpayer’s position, as can the taxpayer not following the terms of an agreement. A poorly drafted contract or agreement, or one not adhered to, may lead to numerous possible interpretations, not all of which are advantageous to the taxpayer.
Renovation Corporation, a taxpayer, claims expenses related to purchasing supplies from supplier A to complete a renovation job for a client. Renovation Corporation’s contract with the client for the renovation job only allows the purchase of supplies from supplier B. The CRA may use that contract term to call into question the legitimacy of the claimed expenses.
Renovation Corporation files its income tax returns annually, but its GST/HST returns quarterly. It retains Accounting Corporation pursuant to a written agreement to “prepare and file tax returns for 2017, 2018 and 2019”. By 2020, Accounting Corporation has failed to file the GST/HST returns for Renovation Corporation. The CRA denies the expense Renovation Corporation claims for preparation and filing of the GST/HST returns for its quarterly filing periods in 2017, 2018 and 2019. In support of denying the expense, the CRA interprets the contract to only refer to income tax returns as it specifies years not quarterly periods. Renovation Corporation argues the clause refers to any type of tax return needing to be filed in those three years, GST/HST returns included.
Josh starts a renovation company. The initial start-up costs result in him reporting business losses in the first two years of his business. The CRA denies the business losses arguing no business exists. Josh is able to submit his contracts with his clients as part of his evidence of a business existing.
The contract or written agreement may also be used by the CRA to allege the taxpayer was engaging in a disallowed scheme to avoid tax rather than a legitimate transaction. For instance, the CRA may argue the taxpayer engaged in a sham – a transaction intended to create tax benefits but disguised to look like a legitimate business transaction. In Snook v. London & West Riding Investments, Ltd., the court defined sham to be acts or documents which “give to third parties or to the court the appearance of creating between the parties’ legal rights and obligations different than the actual legal rights and obligations”.
Not having a contract or written agreement can also injure the taxpayer’s position in a tax dispute as it limits the written evidence available in support of the taxpayer’s position.
The person who signs the contract may also be an important consideration with tax disputes. The CRA may request information from a party who signed a contract during a tax audit, or question them during a tax court proceeding. Further, in the case of dispute as to a person’s status as a corporate director, signing contracts or written agreements on behalf of the corporation may be used by the CRA to allege an individual was acting as director of the corporation. Being found to be a corporate director could give rise to director’s liability.
While issues with a written agreement or contract may negatively impact a taxpayer’s case against the CRA, depending on the factual circumstances, it is possible to work around these issues. Our experienced Canadian tax lawyers have assisted many clients in tax disputes with related contract issues.
Pro Tax Tips: Have a Canadian Tax Lawyer review your contract
Many individuals may choose to have a contract or written agreement drafted by another type of lawyer than a Canadian tax lawyer, or pull something off the internet for a do it yourself solution. They may also be asked to sign a contract drafted by the other party. Consulting one of our Canadian tax lawyers can assist in understanding the tax impact of a particular agreement or recommend amendments for a better tax outcome.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
Frequently Asked Questions
A sham in the tax law context refers to a situation where there is an element of deceit, documents or acts that “give to third parties or to the court the appearance of creating between the parties’ legal rights and obligations different than the actual legal rights and obligations” and gives rise to taxation benefit.
There are numerous ways in which a contract may impact on your tax reporting, such as who can declare income, when expenses or income can be claimed, the valuation of assets and numerous other issues. A contract may also be an opportunity to engage in tax planning.
Written contracts provide the ultimate understanding of the agreement between the owners of a company or its investors, about the services rendered by a third party, or payment obligations to your hired workers. All these things should be stated within the written contract as legal proof.
The purpose of a contractual agreement is to serve as a record of the agreement between the two parties. By entering into a contractual agreement, both parties are legally obligated to the terms of the contract.
Annual tax reports should include the sum of the previous year’s (January to December) taxable income, tax credits, and other information relating to those two items. The return is the method by which the Canadian government determines the appropriate amount of tax that should be paid by individuals and corporations.