Damages – Doug Carroll

CRA auditors fail in their duty to taxpayer – But do damages follow?

It can be a scary proposition to face-off with the Canada Revenue Agency. With the size and power of such a large agency, the consequences of failing to make your case can be financially debilitating.

At the very least a taxpayer should be able to expect fair treatment. Indeed, the Taxpayer Bill of Rights, as published on the CRA website, expresses the duties incumbent on the CRA.

However, as a taxpayer learned in a recent case from the BC Supreme Court, proving that the CRA did not live up to those duties does not guarantee ultimate success in court.

Mr. L and the RV Park

In 1989 Mr. L purchased forested land in the British Columbia interior that he felt would be suitable for establishing an RV Park business. By 1993 he had begun clearing the land for the intended use, selling the logs to a local sawmill. The following year he cleared more land that he eventually subdivided and sold, in part to finance the business.

In 1996, Mr. L was the subject of a GST audit for his 1993, 1994 and 1995 tax years. The investigation of the business records led to a review of his income tax returns as well. Eventually Mr. L received a letter in September 1997 proposing adjustments to both the GST and income tax returns.

Some of the dispute was about personal versus business expenses, but a large part dealt with whether the logging activity was capital or business income.

After a series of CRA collections procedures, liens and sale of the property under receivership, Mr. L succeeded on appeal to the Tax Court in 2005. However, it took a “fairness” application in 2006 to obtain a waiver of the remaining interest and penalties, resting in part on CRA delays during audit and objection.

Suing the CRA

Later in 2006 Mr. L launched an action for negligence against the CRA, focused on the three auditors he had dealt with over the years. In order to succeed, he would have to prove:

a duty of care was owed to him from CRA,
breach of the standard of care,
a causal link between the breaches and a loss, and
a quantification of those losses, or ’damages’.

Given the clear and potentially devastating consequences for Mr. L, the judge held there was a duty to take reasonable care to avoid doing him harm. The appropriate standard to measure against was that of “a reasonably competent tax auditor in the circumstances.”

While the judge found that the assessment of the logging activities was based on “erroneous and unsupported assumptions”, Mr. L did not fulfil his own onus to clarify the record. And though that characterization turned out to be wrong, it was “not a breach of the standard of care, given the information available to [the auditors] at the time.”

However, the judge saw the penalties in a different light:

The assessment was based on what Mr. L “ought to have known”, whereas the relevant section of the Income Tax Act uses the words “knowingly” or “grossly negligent”.
Penalties were assessed on the whole of the income rather than on each alleged offending issue. For 1995, it was $51,682 on $5,787 tax due — a 900% penalty.
Finally (or firstly?), the original auditor threatened Mr. L with gross negligence penalties if he did not sign a waiver allowing for the audit of the (otherwise statute-barred)1993 tax year.

And damages for the taxpayer?

Despite showing breach of the standard of care, Mr. L could not succeed unless he could show a causal connection between that and his losses. Much of that rested on the registration of income tax and GST judgments against the property.

On the evidence, the judge determined that the business was in difficult financial straits even before any judgments were registered. On top of that, Mr. L’s own delays worked against him, in particular failing to file his income tax appeal on time. And in the case of the GST, matters would have been resolved sooner if he had better records and disclosed them sooner.

Thus, though able to prove the CRA auditors breached the standard of care, Mr. L was not able to recover any damages.

Adding insight to injury – Payment options for personal injury awards

We all hope to live healthy and productive lives, but sometimes fate can intervene in unexpected and unwelcome ways. When a person suffers a personal injury, the impact will often be both a shortened expected lifespan, and adversity in coping with new physical, mental and emotional challenges.

The premise underlying a personal injury legal claim is to make the injured individual whole again, understanding that money is at best a proxy for intact health. In large part this involves calculating the cost of future accommodations and rehabilitation, and rendering that back to a present value.

Having determined an appropriate figure, attention then turns to the form of payment, a decision very much guided by tax considerations.

Taxation of damage awards

Depending on the type of claim, damage payments may be taxable, non-taxable or a combination of the two. For example, commonly in employment disputes the bulk of the claim will relate to lost wages. As this would be compensation for loss of an otherwise taxable receipt, the substituted payment would itself be taxable.

A variety of types or ‘heads’ of damages may be claimed in a personal injury matter, with the key one generally being for loss of future earning capacity. On the face of it, that would seem to look a lot like that lost wages claim, but in fact — or rather, in law — there is a critical tax distinction between the two. Loss of earning capacity is considered the loss of a capital asset capable of producing income, not income itself.

Accordingly in our legal system, personal injury damages are generally non-taxable capital payments.

Origin of structured settlements

Structured settlements, or ‘structures’ as they are often called, extend the logic of a single damage payment to making a series of payments. If the purpose of the payment remains the same, the non-taxation should apply to either a lump sum or a series.

The basis for this tax treatment does not appear in the Income Tax Act directly, but is instead expressed through the Canada Revenue Agency’s administrative practice. Interpretation Bulletin 365R2 “Damages, Settlements and Similar Receipts” restricts the treatment to physical injuries. It applies where the damaging party acquires an annuity that is non-assignable, non-commutable, and non-transferrable to make payments for the agreed upon amount.

A key benefit of this approach is that it encourages the alleged offending party toward settlement. Commonly a lump sum award goes through a gross-up calculation to account for future taxes on investment growth. No such calculation (nor increased cost to the payor) would be required under a structure.

Court-ordered ‘structures’

A structure is an option available for a damage award, not necessarily a mandatory procedure. Still, when the claimant is under a disability a judge may be able to make such an order even if the claimant opposes, if the judge determines that it is nonetheless in the person’s best interests.

In a 2013 judgment, Melvin v. Ontario (Correctional Services), a judge considered whether to order a structured settlement. Thomas Melvin suffered brain injuries at the hands of two other inmates while incarcerated at an Ontario correctional facility in 1997. After four mediation attempts, the matter was eventually settled in 2012. As his litigation guardian, his mother had agreed to the amount of compensation, but subsequently opposed having it paid as a structured settlement.

In addition to submissions from the parties, a report was receive from the Public Guardian and Trustee. The judge allowed a small lump sum amount, but otherwise ordered a structure would be most appropriate for a number of reasons:

Little or no prospects for Mr. Melvin’s future employment
Predictable monthly income flows (with some indexing) without need for investment decision-making
The guardian Mrs. Melvin had no specific investment expertise to counter the guarantee and predictability of a structured settlement
Preservation of Ontario Disability Support Plan(ODSP) payments that would otherwise be at risk if the lump sum was owned, and/or when taxable income was earned
Associated benefits from being a continuing ODSP recipient, including better health care coverage

Investing a lump sum payment

Not all injured persons will be so affected that a full structured settlement is necessary. In such cases, some or all of the funds will be paid in the form of a lump sum.

This is a classic situation where a comprehensive financial plan is called for, before making any commitments. The tough balancing act will be to preserve current and future supports, while producing sustainable income.

Initial investment inclination may be toward guaranteed income options such as annuities. Again though, tax considerations should be carefully factored-in, perhaps a combination of annuity income and drawdown of capital from an investment portfolio.

Above and beyond – Is a broker liable to a beneficiary?

The mere fact an issue is raised before a court can be enough reason to pay it attention. Win or lose, someone was willing to undertake the costly and taxing journey through the legal system, and the court’s findings frequently provide clarity as to where the boundaries of liability lie.

This was my reaction to the Gish v. Hooper Insurance and Financial Services Inc. case recently decided by the British Columbia Court of Appeal. The key issues on the appeal were whether a life insurance policy was actually cancelled, and whether there was a duty of care owed to a beneficiary to allow for the policy to continue.

Be careful what you ask for

Robert and Margaret Gish ran a jewelry business for over 20 years, winding it up in 2004. On October 7 of that year, they met with their insurance broker, Bernard Hooper, to discuss their five-policy insurance portfolio with Transamerica, which included two life insurance policies on Mr. Gish. Hooper suggested they maintain the coverage, and the couple directed him to pull together more policy details for a follow-up discussion.

On October 22, Mr. Gish called Transamerica directly to cancel his two life insurance policies, but was advised that written notice of cancellation was required. Shortly after this phone call Mr. Gish faxed Transamerica a handwritten cancellation notice. Transamerica followed up with letters dated October 23, 2004, confirming the two policies had been cancelled as requested. On becoming aware of her husband’s actions, Mrs. Gish called Transamerica and learned the policies had been cancelled — much to her displeasure.

Unaware the two policies had been cancelled, on October 28 Hooper faxed a request to Transamerica for information concerning the premiums on all policies held by Mr. and Mrs. Gish. It was in a November 3, 2004 email response to this inquiry that Hooper learned the two life insurance policies on Mr. Gish had been cancelled on October 22. The email also noted the cancellations were effective November 15 and 22, respectively — the paid-to dates of the policies.

In subsequent consultations with the Gishs, Hooper did not discuss the cancellation of the two life insurance policies, nor note the effective date of the cancellations. The Gishs discussed their other insurance policies with Hooper during these meetings, but didn’t raise the issue of the two cancelled policies, let alone express concern over their cancellation.

Robert Gish died in the spring of 2005.

Beneficiary claims against broker

After her husband’s death, Mrs. Gish commenced a lawsuit against Hooper, his brokerage and Transamerica, claiming there had been a breach of duty to her as beneficiary.

Under the Insurance Act, certain parties, including a beneficiary, may pay premiums when the insured fails to do so — provided the payments are made within a specified late-payment grace period — to avoid the policy lapsing and being terminated for the non-payment of a premium. In this case, the assumption is the policy has not been intentionally cancelled by the policyholder, but rather is terminated or at risk of being terminated due to non-payment.

Mrs. Gish claimed there was a duty to inform her, as the beneficiary, of this aspect of the governing legislation, which she thought she could use to keep the policies in force.

The trial judge rejected Mrs. Gish’s argument, stating that the policies were not terminated because of the non-payment of a premium; rather, Mr. Gish cancelled the policies, which was his right as their owner. The appeals court confirmed this finding.

Should brokers be concerned?

This seems like an easy case for the judge to decide, as the facts show Mr. Gish cancelled the coverage. But what if the facts lined up differently?

As the appeals court judge commented, an insurer’s relationship with an insured is generally constrained to the terms of the policy and the governing legislation. The position of an insurance agent or broker is not so clearly delineated.

There is case law under which lawyers have been found liable to disappointed beneficiaries due to an error or omission in drafting wills or some other aspect of estate planning. Similarly, financial advisors have been found liable to disappointed beneficiaries where there was a failure to properly complete a registered plan beneficiary designation. In both cases, the professional was engaged in providing a service to a client, and the beneficiary’s claim would have required the services of that professional.

But would the law go so far as to impose an obligation on an advisor to seek out and advise a beneficiary of a right to pay a premium on a lapsed policy? I don’t know the answer, but if I am an advisor with knowledge of a potential lapse situation, I’d have the compliance department on speed dial.