Litigation – 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.

Advisor liable to client in donation scheme

Tax-motivated donation schemes have been in the public eye for decades now.

Such schemes have long been on the radar of the Canada Revenue Agency, since before it was CRA or even CCRA, back to when it was Revenue Canada. In progressively more formal pronouncements and definitive tones, the agency has warned about the tax exposure risks of engaging in such enterprise.

In recent years, CRA has actively – and very effectively through the tracking convenience of assigned tax registration numbers – pursued and reassessed participants. Purported tax benefits have been reversed, interest layered on, and penalties imposed.

A degree removed from the taxpayer-agency battles, it was inevitable that we would begin seeing civil cases before the courts. In particular, it is not at all surprising that affected investor-taxpayers would turn their attention toward those who assisted them in engaging in such programs.

The question remained whether and how liability might be determined. Some answers are now starting to emerge.

Wrangling with CRA

Just reported June 30, 2010 is an Ontario case in which an advisor was sued by his former client when CRA unwound claimed tax benefits.

For almost two decades, Accountant MP was a close advisor to client EL’s small business operations, and secondarily to EL himself and his wife VL. Mainly MP assisted with the business corporation’s financial and tax reporting, and also advised upon related personal tax matters, for example on decisions about dividend/salary mix. From time to time MP brought tax-related strategies to EL/VL, such as limited partnership units.

At issue in the case were artwork donation transactions MP recommended to EL in 1998, and to both EL/VL in 1999. A taxpayer could purchase prints in bulk for a little over $300 apiece, donate them to an American University at appraised values of 4-5 times the purchase price, and then submit the appraised value for calculating the charitable tax credit. In total over the two years, the couple ‘invested’ $78,500, claiming tax credits well in excess of that outlay, based on the later appraised values.

In 2001, EL/VL were reassessed, and initially faced both interest and penalties. When they consulted MP, he advised them not to pay the disputed amounts, and to await the outcome of a challenge the program sponsors intended to bring to court.

A test case did follow, spanning through to 2005 from the Tax Court to the Federal Court of Appeal and denial of leave to the Supreme Court of Canada. In the end, the tax credit was limited to the cost of the artwork, with no penalties due, but interest applied on the underpaid tax that was outstanding over the intervening years.

Client sues Advisor

Following this tax litigation, EL/VL, now into their retirement, became suspicious that MP may have been paid secret commissions on the artwork. A suit was launched against MP alleging breach of fiduciary duty, or in the alternative negligence.

While characterization of a “fiduciary” is most familiar in trustee-beneficiary and principal-agent relationships, it is not unknown to be impressed upon other relationships where there is a strong degree of reliance upon another person. In fact, in 1994 the Supreme Court of Canada found a tax accountant to be a fiduciary to a stockbroker.

In the present case, the judge had “no hesitation in concluding that, in relation to matters of tax planning, [MP] had undertaken to act solely on behalf of [EL/VL] and had relinquished his own self-interest in that regard, except for the normal fees he would charge for providing his advice.”

The judge’s factual determinations included:

Obtaining a secret commission, and worse that it was paid by the scheme’s promoters

Failure to point out the risks identified in the promoter’s own legal opinions, and worse still … failure to even disclose the existence of the legal opinions being in MP’s possession

Pressure tactics employed by MP, including tight time constraints and pre-completion of purchase orders by MP prior to arriving at meetings with EL

Quantifying the damages

The direct cost of the endeavour was the $78,500 outlay less $38,703 taxes avoided, netting to $39,797. In addition, EL/VL sought the $7,500 commission to MP, interest payable to CRA on the outstanding taxes, and interest on money borrowed to ultimately pay the bill – a total claim of $151,500.

While the two interest charges were not accepted as appropriate heads for compensation, the judge otherwise dispensed with any notion that the claim should be reduced because EL/VL could have acted differently. MP was held liable for the net taxes and also had to pay over the commission to EL/VL.

Perhaps the egregious elements of this case make the outcome easy to understand, but the finding should ring loudly for all advisors touched by such schemes.

It remains a fact-dependent determination whether advisors of other stripes and levels of interaction may be characterized as fiduciaries, and what quantum of liability may ensue. That’s a lot of grey area yet to be explored.

Keeping those tax deals confidential? Be wary

There was no mention of it in the Federal Budget Speech, but there is a very important proposal in the Budget Plan itself that could have serious implications for wealth advisors, particularly those involved in sophisticated tax planning.

It has to do with requiring the reporting of certain tax avoidance transactions that fall outside existing tax shelter registration requirements.

The trend toward information reporting

The Canadian government is following a path that a number of jurisdictions have taken of late — to require disclosure of certain transactions that may warrant greater scrutiny by tax authorities. This includes many major economies and some of our closest trading partners, including the U.S., U.K., Ireland, New Zealand and Australia.

Closer to home, in January last year provincial authorities in Quebec circulated a working paper titled “Aggressive Tax Planning” for public consultation. Following those discussions, Revenu Quebec announced in October that it would be intensifying its efforts in this area, including requiring the mandatory disclosure of confidential or conditional remuneration transactions. Penalties for non-compliance can be as much as $100,000, with no time limit for the agency to review undisclosed transactions.

The proposal

There are existing substantive rules in the Income Tax Act intended to counter aggressive tax planning, including information reporting to help identify certain transactions and participants.

Further, there are rules that may be applied to deny tax benefits, including the General Anti-Avoidance Rule (GAAR).

Still, we operate within a self-assessment system that relies on taxpayer disclosure to support the integrity of the system. The government sees these foregoing substantive rules as being more effectively applied if CRA is able to identify aggressive tax planning in a timelier manner.

The proposal uses the term “hallmark” to describe the characteristics of an avoidance transaction that will be deemed a reportable transaction. Transactions would have to be reported if they bear at least two of the following three hallmarks:

A promoter or tax advisor in respect of the transaction is entitled to fees that are to any extent:
1. attributable to the amount of the tax benefit from the transaction;
2. contingent upon the obtaining of a tax benefit from the transaction; or
3. attributable to the number of taxpayers who participate in the transaction or who have been given access to advice from the promoter or advisor regarding the tax consequences from the transaction.
A promoter or tax advisor in respect of the transaction requires “confidential protection” about the transaction.
The taxpayer or the person who entered into the transaction for the benefit of the taxpayer obtains “contractual protection” in respect of the transaction (other than as a result of a fee described in the first hallmark).

According to the proposal, the presence of these hallmarks doesn’t necessarily imply there is abuse, but rather indicates there is a higher risk of abuse which merits a closer look by the CRA.

It’s important to understand this is strictly a reporting exercise. Disclosure would have no bearing on whether the tax benefit is allowed, nor would it be considered an admission that the GAAR applies to the transaction.

Scope and timeframe of implementation

The focus is on whether the transaction itself may be reportable by the taxpayer, not whether other individuals must report or be registered in some manner.

Nonetheless, professionals of all stripes will want to be aware whether they are touched by a given transaction — even if only tangentially. They may not be required to take action, but it’s prudent to be aware.

The proposal language is a bit vague and references “promoter or tax advisor,” without any further details of how widely that net may be cast — at least not in the Budget Plan document. It will be interesting to see how this definition is fleshed out once all parties concerned have weighed in during the public consultation process.

As to timeline to implementation, the quick speed of the Quebec experience should be instructive. The Budget Plan purports the proposal (as modified through consultations) is intended to apply to transactions after 2010, and series of transactions completed after 2010.

CRA’s best tool?

On a personal note, I’m reminded of a conversation in an earlier business life a dozen or so years back.

During lunch at a wealth-planning conference I was running, a senior official in the International Tax Directorate was asked about recent legislative changes. He commented that it was certainly nice to have new tools, but that their best tool remained . . . divorce.

Apparently, at least at that time, acrimonious marriage breakdown was a catalyst to not-so-anonymous tips to their hotline.

And you thought disclosure was just an issue between you and the CRA.