It is not uncommon for companies in a related group (or non-arm’s length companies) to incur intercompany charges for items such as management services, head office overhead and reallocation of expenses. In some cases, these charges are accrued but not paid at the paying company’s year end.
If any portion of these non-arm’s length charges remains unpaid at the end of the second taxation year after the end of the fiscal year during which the expense was incurred, the unpaid amount must be added back to the payor’s income in the third successive taxation year. This provision (subsection 78(1) of the Income Tax Act (Canada)), effectively disallows the deduction of the expense by the payor. However, the amount is still included in the income of the company that charged the fee. The result is double tax.
The double tax can be avoided if the payor files an agreement in prescribed form (Form T2047) by the filing deadline for that third year. If the form is filed on time, the unpaid amount will be deemed, for income tax purposes, to be paid to the recipient and loaned back to the payor on the first day of the third taxation year. The form can be filed late, but if it is, 25% of the expense will still be disallowed to the payor and there will be no reduction to the amount included in the recipient’s income. This reduces the double tax but does not eliminate it.
It is important to identify non-arm’s length charges and ensure that they are either paid within two taxation years of being incurred or that a Form T2047 is filed on time. Even though late filing of the form is allowed, it comes with a tax cost.
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