Accounting of Legal Services
During tax audits, inspectors draw attention to all non-gratuitous services, including consulting, marketing and legal services. Therefore, it is important to correctly conduct accounting of legal services. Moreover, in relation to this type of services, the problem of proving compliance with the legislation requirements may arise. This mainly concerns its inclusion in the structure of expenses for income tax and for VAT deduction.
Judicial practice on this issue is controversial, because the Presidium of the Supreme Court formulated a unified approach to assessing the eligibility of including the expenses of legal services provided by third parties. According to the Tax Code, taxpayers are entitled to
expenditure records of legal services as part of other expenses. However, the company entitled to take costs into account in calculation of income tax if they match the following requirement:
• economic feasibility and justifiability;
• documentary evidence – accounting of legal services;
• focus on generating income.
The economic feasibility of the costs means that the company’s expenses are economically justified, and this can be confirmed by financial calculations. Documentary evidence of the costs requires that all operations and understandings between the parties be formalized in accordance with Russian legislation and business customs. This requirement is also applicable for cases when the company’s activities are fully or partially carried out in the territory of another state. To confirm the expenses can be used the documents, which confirming the indirect costs. For example, it can be customs declarations, orders on a business trip, travel documents, reports on the work performed.
Expenses are any costs, which were directed to commercial activities and receiving profit in accordance with the established requirements.
So that the regulatory authorities don’t have any questions on the accounting of legal services in determining the tax base, the costs must comply with the following arguments:
• Detailed preparation of the documents on rendering services. When drawing up acts of services rendered, the parties should not be limited to the wording “under the contract legal services were provided in full and due quality”. When preparing documents, it should be detailed what services were provided and in what amount, how their cost was calculated.
• Positive economic result. Costs should lead to increasing of the enterprise’s income, they should be financially justified.
• Tax transparency. The legal assistance cannot be directed at unjustified tax benefits, for example, with the purpose of tax evasion. Your interests should not be contrary to law.
• There are no full-time lawyers. If the company have legal specialists, their duties and functions should not fully comply with the contract conditions of legal services with third-party lawyers. In this case, you can conclude the agreement with another company or an individual lawyer having specialization different from full-time employees in the company. However, this does not mean that the presence of a legal adviser on the staff does not allow a third party to be involved in resolving business issues. Just the reason for attraction should be justified. According to the Letter of the Ministry of Finance dated May 31, 2004, if there is a lawyer in the staff schedule, the issue of expenses on third-party lawyers should be considered in each individual situation. Moreover, should considered the Article 252 of the Tax Code regarding the re-inclusion of expenses in the tax base for income tax.
Accounting of legal services and litigation
After analyzing the current judicial practice of tax disputes, specialists of VALEN formulated the following conclusions. Firstly, the tax authorities cannot evaluate the costs of the enterprise from the point of view of their economic feasibility. Under the Russian legislation, the costs of company should be economically feasible. Judicial control should also not assess the appropriateness of business decisions who have independence and wide discretion in the business sector.
Secondly, during taxation, the contract price indicated by the parties to the transaction is taken into account. It is supposed that it corresponds to the level of market prices. The tax inspectorate not entitled to assess the correctness of the formation of contract values and to doubt in it, unless there are grounds for control under Article 40 of the Tax Code. For example, these are transactions between related parties, barter, foreign trade transactions, sharp changes in prices.
Thirdly, from the taxpayer, confirming the fact and the amounts of expenses incurred, the regulatory authorities cannot require additional evidence of the justification of these expenses. But in accordance with Article 65 of the Code of Arbitration Procedure (CAP), participants in the trial must prove the circumstances to which they refer in their claims. Moreover, regarding the acts of state bodies, the obligation to prove the circumstances on the basis of which the act was adopted is entrusted to the relevant official bodies.
Legal services, accounting and taxation
To correctly fill in tax documentation, all expenses concerning arbitration litigation should be accounted for with other costs of production and sale. But also these expenses, in conjunction with the payment of representation in court, can be realized as non-operating costs. Only the company or their executives decide which cost category they be included. This right is described in more detail in Article 252 of the Tax Code.
Accounting of legal services is also based on articles 264 and 265 of the Tax Code. One of them indicates the costs of legal services as production expenses. Moreover, the article does not determine what kind of services can be referred to the category of legal assistance, therefore, a broad interpretation of this article is possible. Another article indicates that legal costs and arbitration fees may be taken to non-operating expenses of the company. In other words, the accounting department can take them into account as expenses for the company’ activities that are not directly related to production or sale.
The list of legal costs can be found in article 106 of the Arbitration Procedure Code. In regards with the Commercial Arbitration court, this category includes:
• payment for the assistance of experts, translators and other specialists necessary to prove the company’s position in court;
• expenses for notification of a corporate dispute, if required by the situation;
• fees of attorneys and other lawyers involved in the process;
• cost of examining evidence on the spot;
• other expenses held by the participants in the case.
According to the above legal norms, all of the above costs can be attributed to legal costs only by parties to the process: the plaintiff and the defendant. In all other situations, such expenses cannot be related to legal costs, even if the company incurs such costs.
Recovery of legal costs from the losing participant
To take costs of proceeding into account as costs, it is necessary that the legal services be provided specifically to the enterprise, and not to its management, specialists or partners. It is impossible to take into account the expenses of attorney assistance if the subject of agreement concluded on behalf of the company was legal assistance to official of the company. Thus, the costs include only the services rendered for the company, and not for individual representatives, including the director.
Another important point: the costs recovered from the authorities as compensation for damages necessarily reduce the amount of VAT accepted for deduction. According to article 106 of the Arbitration Procedure Code the costs of the fees of attorney who provides assistance to a company is taken into account as legal costs. Article 110 indicates that the expenses incurred by the participants in the proceedings shall also be recovered if the court takes the side of that party.
If the court takes the decision in favor of the company, the amount of a judgement can be reflected as income. In accounting, these amounts shall be taken into account as other income for the reporting period, which the Court decision was made in. In terms of tax accounting it is unrealized income that is recorded on the effective date of the judicial act.
The set of documents for confirming expenses depends on the form of business entity that provides legal assistance. When concluding an agreement with a representative of the company, the payment should made out in accordance with the Law “On Accounting” and the Procedure for conducting cash transactions.
If the documents do not formally correspond to the regulations, this cannot be the basis for refusing to satisfy the claim to recover. Nevertheless, such situations should be avoided, since these violations, in conjunction with the mismatch of the details of payment order with information of the contract, may affect the court decision.
You can confirm the fact of payment for legal assistance using the following documents:
- payment order;
- expenditure cash order;
Despite this, a receipt confirming the transfer of funds can formally be recognized as proof of payment made under the agreement concluded with an individual, regardless of the presence or absence of a cash receipt order. However, it is important to take into account that the performance fee does not reduce the tax base for income tax. The size of this fee is 7% of the amount that is collected in court.
Legal services are provided on the basis of the contract. As a rule, 3 types of agreements are applied:
- non-gratuitous services agreement – suitable for advisory support or in cases where the company take a lawyer to draw up important documents;
- agency agreement – this type of agreement is chosen when representation of company’s interests in the court is required;
- a mixed contract – it combines the elements of two previous forms of documents, suitable for situations where a whole list of legal assistance is required. This can be consultations, preparation of documents, settlement of disputes in the pre-trial procedure and representation of client’s interests in court.
After the contract is executed, an act of rendered legal services is drawn up. This document contains the detailed information of the agreement’s parties, it is attached to the contract and accounting documents. There is no unified form for this act, but the law requires that it clearly indicates the parties to the agreement, details and cost of services.
All operations should be reflected using standard accounting entries. If the costs of the lawyer will be compensated by the other participant of the trial, the amount should be reasonable. It must be compared with similar offers on the market. In this case, the court will determine the period and procedure for payment of legal services rendered the losing participant. An important point of compensation: it occurs only if there is evidence of the cost of the rendered legal services.
VALEN has extensive experience in the field of legal services accounting. We cooperate with large and small businesses, advise international corporations and foreign companies operating in Russia. Our experts consult on accounting issues, prepare documentation, and represent interests in court.
To order a service or consult with specialists, please dial: +7 (495) 7-888-096! We are also waiting for you at our office in Moscow.