Mutual fund advi-sors who channel their trailer fees through per-sonal corporations risk being reassessed by the taxman if they don’t set up and maintain the corporations properly.

This is the lesson an advisor in Nova Scotia learned from the Tax Court of Canada’s decision, Boutilier v. The Queen, released in February. The court upheld the Canada Revenue Agency’s reassessments of Robert Boutilier’s 1998, 1999 and 2000 tax filings. The CRA had said trailer fees were part of the certified financial planner’s income and should be taxed at his personal rate rather than at the lower corporate rate.

“The deficiency of documentation killed this case,” says Ed Harris, counsel at Halifax law firm McInnes Cooper and Boutilier’s lawyer before the TCC.

A carefully drafted corporate agreement establishing that trailer fees would be paid for his services would have supported Boutilier’s position, Harris says. But Boutilier’s case was heavily dependent on oral evidence, and the court did not accept that evidence. Harris has no instructions from his client to appeal.

This was the first TCC case in which trailer fees were examined in the context of the Income Tax Act’s anti-avoidance provision, Section 56(4). Harris adds there are “a lot of these cases waiting in the wings.”

Each case will be heard on its facts. And, like Boutilier’s, they will fail if their facts are not in order.

“The one-man corporation is always a tricky concept,” Harris warns. “Advisors had better dot their Is and cross their Ts — both ways.”

Many advisors have personal corporations and face a similar risk, says Jamie Golombek, vice president of taxation and estate planning at AIM Funds Management Inc. in Toronto. “Advisors can’t orally assign things to a personal corporation,” he says. “They have to get professional, legal advice, from the beginning, defining the corporation. It can’t just be a shell.”

The ability to utilize personal corporations varies within the financial services industry. While insurance advisors are permitted to set up corporations to run their businesses, provincial securities legislation prevents stockbrokers from doing so; investment advi-sors are employees of investment dealers.

The issue is more complex for mutual fund salespeople, many of whom are licensed to sell insurance as well as mutual funds. In Canada, the Mutual Fund Dealers Association prohibits payments to mutual fund corporations. The securities commissions of four provinces — Ontario, British Columbia, Saskatchewan and Nova Scotia — have extended an exemption to permit this practice until the end of 2008.

Boutilier was acting within the bounds of securities law in setting up his corporation. He lost the case before the TCC, however, because of how he ran his corporation.

Boutilier has been working since 1997 as an independent contractor, first with Kentville, N.S.-based mutual fund dealer Hicks Financial Solutions, then with its successor company, IPC Investment Corp.

Boutilier and Hicks shared commissions for the sale of mutual funds. The trailer fees earned for client retention of funds initially were paid directly to Boutilier but, in January 1997, Boutilier set up a personal corporation. Boutilier and Hicks Financial had an oral agreement directing Hicks to pay Boutilier’s trailer fees to this corporation. This was done throughout the 1998, 1999 and 2000 taxation years. The corporation declared these fees as income and paid taxes on them.

When Boutilier set up the corporation, he also set up a family trust. He was a trustee of the trust, and family members were beneficiaries. Funds received by the corporation were paid into the trust.

The CRA reassessed Boutilier for the 1998, 1999 and 2000 tax years under Sec. 56(4), the focus of which is the potential tax avoidance when a right to income is transferred between parties who are not dealing at arm’s length — in this case, between Boutilier’s corporation (Boutilier) and the family trust (Boutilier’s family).

The CRA determined the income paid to the corporation should have been included in Boutilier’s personal income and taxed accordingly. In its ruling, TCC uses the example of the 1998 tax year, when Boutilier’s corporation claimed revenue of $148,146. In the reassessment, this was added to his commission income of $338,177.91.

On the characterization of trailer fees, however, the TCC ruled against the CRA. “It is clear to me,” Justice Diane Campbell wrote in her decision, “that there is a distinct line between commissions earned on sales of mutual fund units and fees earned for services provided, which enable retention of the clients’ funds. While the right to trailer fees arises at the time of the sale of mutual fund units to a client, the broker will be eligible to receive these fees only if he provides some level of service so the client will not redeem or transfer those units after the sale.”

@page_break@Campbell added that trailer fees “have been criticized within the financial services industry because service may not be required for the fees to be paid, [but Boutilier] clearly demonstrated the provision of some service is required and was provided.” She noted the testimony of Henry Hicks, former president of Hicks Financial, supported Boutilier’s evidence. Hicks had testified that if service was not provided after a sale, a salesperson would not last long in the business.

However, the TCC’s decision did not turn on this issue. “My conclusion here does not determine the issue because [Boutilier] must satisfy the beneficial entitlement test under Sec. 56(4) to determine who earned the trailer fees. It is at this junction on the road that the appellant’s argument begins to falter,” Campbell ruled. “Based on my earlier conclusion that the nature of trailer fees involves provision of ongoing services, I believe it possible to transfer an ‘opportunity’ to serve clients and earn trailer fees, but that is not what happened here.”

The corporation incurred almost no expenses to earn trailer fees. Boutilier personally claimed the corporation’s expenses for rent, telephone, utilities and employment.

Another piece missing was remuneration for services Boutilier claimed on behalf of the corporation. Boutilier had no employment contract with the corporation.

Robin MacKnight, a partner with Wilson Vukelich LLP in Markham, Ont., who advises entrepreneurs on the set-up of their businesses, says: “This was a classic case of bad implementation. Boutilier transferred the right to earn trailer fees into the corporation, but not the opportunity to provide services. You have to transfer the whole business in.” IE