Left in the cold for legal fees

According to an agreed statement of facts, Gouveia became director, president and CEO of Atlas in August 2000. That firm operated a network of refrigerated warehouses and a transportation business. Through a numbered company, Gouveia held about 8% of the trust units in Atlas.

On Aug. 29, 2003, Atlas announced it would restate its earnings for 2001 and 2002. Three months later, Gouveia resigned and filed a wrongful dismissal action against the firm, which was settled in 2010 with no admission of liability.

The earnings restatement triggered OSC charges against Gouveia, alleging he and other Atlas senior executives engaged “in a course of conduct generally intended to present an improperly improved picture of the financial performance of Atlas for the period including the financial years 2001, 2002 and the first two reporting periods of 2003.”

However, the OSC discontinued those charges on Feb. 27, 2007, after reviewing new evidence and determining that “the prosecution no longer has a reasonable prospect of conviction.” More than $2 million of the legal fees Gouveia sought to deduct were related to his defence against the OSC charges.

The $400-million class action, launched on Feb. 4, 2004, against Atlas and certain of its officers, directors, its auditor and underwriter, was settled in 2008 for $50 million with no admission of liability. Insurers picked up $40 million of the tab and Atlas paid $10 million, according to court documents.

Gouveia sought to deduct the legal fees he incurred while fighting the actions from the management fees his consulting firm earned between 2002 and 2007. Those management fees amounted to more than $1.2 million. Evidence indicated that Gouveia was banned by a non-compete agreement from carrying on business in Canada, the U.S. or Western Europe, so he had focused his consulting activities on places such as Eastern Europe, Ukraine, Georgia and India, where he succeeded in making joint ventures.

Gouveia’s lawyers argued that Gouveia was entitled under s. 9 of the ITA to deduct legal fees incurred to earn income and that the OSC and class action “threatened his ability to generate income from his consulting business.” Gouveia’s lawyers also argued that the connection between the legal expense and earning consulting income was not too remote and that a conviction “would have destroyed [Gouveia’s] income.”

Revenue Canada argued that the legal fees did not constitute expenses that were “normally incurred by others” involved in similar business activity; the legal proceedings were not a “normal and ordinary risk”; the legal fees were “too remote from his consulting activity”; the expenses “far outweigh the average income” reported by the taxpayer; and that the fees were incurred to preserve Gouveia’s reputation and capacity to earn future earnings, which amounts to an outlay of capital (which, under the ITA, is treated differently than an expense).

Justice Réal Favreau, of the Tax Court of Canada (TCC), noted that he could appreciate it took Gouveia “years to reinstate his credibility with financiers around the world even after the charges were dropped.”

However, the decision cites Gordon Ironside v. The Queen, a recent case involving an accountant who paid legal fees to defend himself from charges brought by the Alberta Securities Commission. The court in Ironside found that the expenses were the result of Ironside’s position as an officer and director of a company: “The expenses were incurred to protect his reputation within the oil and gas industry, where he focused his business activities. As such, they were personal in nature and were not incurred to protect the income earning potential associated with his professional accounting business.”

Favreau ruled that the facts in Ironside were similar to Gouveia’s case and that “the legal fees were not incurred to gain or produce income from [Gouveia’s] consulting business, as they were a direct result of the position that he held as a director, president and executive officer of Atlas. 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.”

Further, the management fees Gouveia charged seemed to be “fixed and regular from year to year and he seems to have earned the same amount despite the various legal litigations.”

The TCC’s ruling concluded that an OSC conviction or class-action liability would affect more directly Gouveia’s future employment prospects than his current and future consulting income, and the connection between the legal expenses and consulting activity was “too remote” to justify a deduction.

Gouveia’s lawyer declines to comment, noting the case is under appeal.

Next: Implications of the decision
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Implications of the decision

Tax lawyer Monica Biringer of Osler Hoskin & Harcourt LLP in Toronto says the case has “limited application” because Gouveia was an employee at the time of the events that led to the litigation. In that case, earnings such as director fees are considered employment income, which limits expense deductions.

“Deductions for an employee are very limited. It’s only when you start a business that the ability to deduct expenses greatly enhances,” Biringer says. “If you are a business and you’re sued and pay lawyers to defend [against] litigation, those fees are generally going to be deductible.” She adds that the TCC “didn’t really buy the connection” between the litigation and Gouveia’s consulting business.

Tax litigator David Thompson in London, Ont., notes that the legal fees were “sizable sums” and the case highlights the unfairness that can arise in the tax system.

“It does seem to me,” he says, “that it’s inappropriate that an individual who’s an employee and gets in a bind isn’t allowed to deduct those costs. When you’re in business, you get to deduct any expense incurred for the purpose of earning income. But when you’re an employee, you only get to deduct those things listed in the ITA. Legal expenses are not one of them.”

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