Tag: Tax audit

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.

Have your cake and write it off – A Pink Elephant in the room

During the early years of my career, I worked in the educational conference field — initially in not-for-profit academia, and later in the very competitive one-day commercial conference segment — delivering tax, insurance and investment content to professionals.

Despite largely successful conferences, for every star session there was at least a dog or two that drained the coffers. Accordingly, pricing strategy, provision of sustenance, and inclusion of swag were recurring themes at management meetings.

Much of this came back to me while reading a recent tax appeal of a CRA reassessment denying deductibility of certain catering expenses.

Ordinary course of business

The idiom of there being an elephant in the room is a reference to an obvious truth not acknowledged by those who can plainly see it is there. This apparently was the CRA’s perspective in denying half the catering expense deductions claimed by Pink Elephant, a provider of information technology training seminars.

Pink Elephant charged an all-inclusive fee to attendees — ranging from $2,000 to $10,000 — for courses that ran from two to 13 days. These public educational courses were provided in hotels, with breakfast and lunch served.

Under the Income Tax Act, a taxpayer is entitled to deduct reasonable expenses in arriving at taxable income. In the case of food, beverage and entertainment expenses, the general rule is: half of the outlay is deductible. Pink Elephant claimed entitlement to the exception to this limitation, seeking full deduction of these types of expenses when incurred within its ordinary course of business.

In interpreting the term “ordinary course of business,” the Judge considered the positions of a hotel and restaurant operation as compared to a restaurant operation alone. In the Judge’s opinion — the only one that counts in court — it would not make sense to apply the limitation to the former, and yet allow the exception for the latter. Furthermore, this treatment applies, “whether the provision of food or beverages is a minor or significant part of the ordinary course of business” of the taxpayer.

Pink Elephant got its full deduction.

Half measures

From the conference attendee perspective, in the absence of a detailed cost breakdown, there is a deemed $50 per day for food and beverages, to which the 50% limitation would apply.

Interestingly (and this received brief mention in the case), a later section of the Act treats amounts paid for travel on an airplane as not being in the same class as expenses incurred on food, beverages or entertainment. Given the now-standard practice of unbundling meals from airfares (at least for the class of cabin that I frequent), it would appear the 50% limitation might again apply to the in-flight sandwich purchased using my credit card — though I didn’t find any cases or rulings that either confirm or refute that treatment.