Challenging Gross Negligence Penalties: Canadian Tax Lawyer Guide

Challenging Gross Negligence Penalties: Canadian Tax Lawyer Guide

Challenging Gross Negligence Penalties: Canadian Tax Lawyer Guide

Money transferred from a corporation to its shareholder was reassessed as shareholder benefits

This case was a split decision with the taxpayer’s Canadian tax lawyer winning the argument against gross negligence penalties but losing with respect to statute barred years.

Mr. Deyab and his spouse carried out engineering consulting work through a corporation (MDC). From 2007 to 2011 various amounts of money were transferred from MDC to Mr. Deyab and his immediate family members. Apart from the transfer of money, MDC also paid certain personal expenses of Mr. Deyab. The Canada Revenue Agency (CRA) reassessed Mr. Deyab by including the amount of transfers from the corporation in his income as shareholder benefits under s.15(1) of the Income Tax Act. A shareholder benefit arises where a corporation confers a benefit on a shareholder, a contemplated shareholder or an individual who does not deal at arm’s length or is affiliated with a shareholder such as a spouse or child, otherwise than by way of a dividend or other taxable payment. The notices of reassessment for the year of 2007 through 2010 were issued after the expiration of the normal reassessment period which is three years for individuals under s.152(3.1) of the Income Tax Act. In addition, the CRA assessed gross negligence penalties for each year under s.163(2) of the Income Tax Act. After the Tax Court dismissed Mr. Deyab’s appeal from reassessments that included substantial sums as shareholder benefits for the 2007 to 2011 taxation years, he appealed to the Federal Court of Appeal (FCA) which allowed his appeal in part. The FCA found Mr. Deyab did make a misrepresentation in his tax returns by not reporting the amounts transferred to him from MDC, therefore the tax court was justified to reassess the taxation years that were statute-barred. However, Mr. Deyab’s failure to maintain proper records and accounts didn’t demonstrate a high degree of negligence tantamount to intentional acting, the FCA then allowed the appeal in relation to the assessment of gross negligence penalties.

Mr. Deyab raised three issues in his submission that the Tax Court Judge erred in:

  • Shifting the burden of proof from the CRA to him in relation to reassessing the years that were statute-barred and assessing gross negligence penalties;
  • Relying on adverse inferences that the judge drew against him before the CRA had established a prima facie case;
  • Misapplying the evidence to the legal test raised in Lacroix v Canada, 2008 FCA 241.

CRA Met the Burden of proof to Reassess Mr. Deyab for the Statute-barred Years

Since there was no allegation of fraud in the appeal, the FCA found that the CRA must prove on a balance of probability that Mr. Deyab had made a misrepresentation that was attributable to neglect, carelessness or wilful default. Although Mr. Deyab argued that the money withdrawal from the corporation was to repay a loan made by him to MDC previously, the court found that it was clear Mr. Deyab did not maintain a shareholder loan account for the corporation. Based on the evidence, the FCA ruled there was sufficient evidence for the tax court judge to conclude the CRA had satisfied the onus to establish the facts that would justify the reassessments issued for the statute-barred years.

The Tax Court Judge was Correct to Draw Adverse inference against Mr. Deyab with respect to Misrepresentation

Mr. Deyab objected to the drawing of an adverse inference by the Tax Court Judge on the ground that the CRA failed to establish a prima facie case that that he made a misrepresentation that was attributable to neglect or carelessness.  The FCA found that Mr. Deyab did not call his accountant or bookkeeper as a witness when various banking statements were available. Therefore, since substantial sums were transferred from MDC to Mr. Deyab and his family member, the court held there was no basis to interfere with drawing of an adverse inference against Mr. Deyab because the CRA did establish a prima facie case against him for misrepresentation.

The application of Lacroix case

The federal court examined the facts of the case and agreed with litigation Canadian tax lawyer for Mr. Deyab that the Tax Court Judge erred in applying the Lacroix decision. The Court in Lacroix simply confirmed that the facts in that particular case supported both a finding that statute-barred years may be reassessed and that gross negligence penalties could be assessed. However, the Court never stated that this was always the case. The facts of each case must be examined to decide whether the requirements for reassessing statute-barred years and separately assessing gross negligence penalties are satisfied. Although the CRA met the burden to reassess Mr. Deyab for statute-barred years, there was no evidence that the documents provided by Mr. Deyab to support a shareholder loan were a sham.

Mr. Deyab was Successful in Challenging the Gross negligence penalties

The Federal Court reviewed the relevant provisions of the Income Tax Act and case law, and pointed out the different statutory requirements between reassessing a statute-barred year and assessing a gross negligence penalty:

  • Reassessing a statute-barred year: Under paragraph 152(4)(a) of the Income Tax Act, unless a taxpayer has filed a waiver within the prescribed period of time, the CRA may only reassess the taxpayer regarding statute-barred year if the taxpayer or the person filing the return has made any misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing the return or in supplying any information under this the Income Tax Act
  • Assessing a gross negligence penalty: By contrast under subsection 163(2) of the Income Tax Act, every person who knowingly or under circumstances amounting to gross negligence, has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return … is liable to the penalty imposed under this section.

The federal court also cited the Supreme Court of Canada’s decision in Guindon v Canada, 2015 SCC 41 that expressions that showed an indifference as to whether the Income Tax Act is complied with and tantamount to intentional conduct should constitute gross negligence. The Federal Court also referred to the tax court decision in Sidhu v R, 2004 TCC 174 that the burden to prove an indifference as to whether the law is complied with or not is on a balance of probability instead of beyond a reasonable doubt. However, in Mr. Deyab’s view, he was simply withdrawing funds from MDC to repay himself the loan he made to the corporation. Therefore, the FCA found there was no basis to conclude that he admitted knew he was receiving shareholder benefits and the Tax Court Judge made an error in reaching this conclusion. Therefore, his Canadian tax lawyer succeeded in overturning the gross negligence penalties.

Pro tax tips – shareholder should maintain a loan account to avoid shareholder benefits

One critical fact in the case of which the Tax Court failed to take notice is that the corporation suffered early losses up to 1 million but was still able to transfer funds to Mr. Deyab and his family. A reasonable explanation is that Mr. Deyab made a loan to the corporation because the transfer of money could not be from profits. Unfortunately, Mr. Deyab failed to maintain proper records or a shareholder loan account that could prove the corporation was repaying to him money from a loan. It is important to maintain proper corporate books and records. In similar circumstances our experienced Canadian tax lawyers have retained an accountant during the tax audit to re-create the corporate books and records to prevent any shareholder benefits penalty.

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