This issue of the Legal Business Report provides current information to the clients of Alpert Law Firm on penalties under the Income Tax Act (Canada) and the possible challenges to such assessments. Alpert Law Firm is experienced in providing legal services to its clients in tax and estate planning matters, tax dispute resolution, tax litigation, corporate-commercial transactions and estate administration. Howard Alpert, C.S. is certified by the Law Society as a specialist in Corporate and Commercial Law and as a specialist in Estates and Trusts Law.
C. ADDITIONAL DEFENCES AGAINST IMPOSITION OF PENALTIES
Where penalties under subsection 163(2) of the Act have been assessed, the Minister has the burden of justifying their imposition. The Minister must prove, on a balance of probabilities, that the taxpayer had knowledge of, or exhibited gross negligence in the making of, the false statement or omission. An attack upon any of these constituent elements amounts to a defence against the imposition of penalties.
(i) MAINTAINING ADEQUATE BOOKS AND RECORDS
Penalties under subsection 163(2) of the Act can be imposed if the taxpayer had knowledge of, or was grossly negligent in the making of, a false statement or omission. One way in which the Minister can establish that a taxpayer was grossly negligent is if he proves, on a balance of probabilities, the taxpayer failed to keep proper and accurate records. On the other hand, where such a justification for penalties is raised by the Minister, a taxpayer can successfully challenge the penalties by providing evidence that proves that the taxpayer did indeed keep adequate records and as such was not grossly negligent in the making errors in the tax return.
(ii) COOPERATION WITH THE MINISTER
Where the Minister assesses penalties on the grounds that the taxpayer's actions or omissions constituted gross negligence, a taxpayer can challenge such an assessment on the basis that the taxpayer was not grossly negligent as the taxpayer had supplied the Minister with all the necessary and relevant information during the course of Minister's investigation. Conversely, the Courts have justified the imposition of penalties on the grounds that a taxpayer has exhibited a notable lack of cooperation with the Minister.
(iii) THE TAXPAYER LACKED THE REQUISITE MENTAL STATE
Recent case law has demonstrated that in order for penalties to be imposed against the taxpayer, it is essential that the taxpayer possess the requisite mental state to be penalized. Thus, where the Minister assesses penalties, if the taxpayer can prove that he does not possess the requisite mental state to be penalized, then the Courts will not impose penalties against him.
1. Cox v. The Queen,  TCJ No 139
In this case, the taxpayer, who was represented by Alpert Law Firm, was assessed for a total of seven years. In three of these years, the taxpayer had amassed a substantial fortune in mutual funds, but had altogether failed to file tax returns. In the remaining four years, the taxpayer, upon request from the Minister, had filed tax returns that were prepared by "volunteers" for Revenue Canada.
The Minister assessed the taxpayer and imposed penalties. The taxpayer appealed to the Tax Court of Canada, challenging the Minister's net worth assessment and the penalties imposed. The taxpayer challenged the imposition of penalties on the basis that his mental condition, paranoid schizophrenia, denied him of the requisite mental state required for the imposition of penalties. Evidence was provided by the taxpayer's brother, a psychologist, who testified that the taxpayer had for many years displayed all the classic signs traditionally associated with schizophrenia including: learning disability, anxiety disorder, inability to retain information, hallucinations and delusions, and being very disorganized and very forgetful.
The Court stated that in order for a penalty to be imposed under subsection 163(2) of the Act, two elements must be present: (i) a misstatement or omission in a tax return; and (ii) the requisite mental state. The Court found that the first element was evident, as the taxpayer clearly omitted to file his tax returns for three consecutive years. However, the second element was not present: as a result of his psychological illness, which divorced him from reality, the taxpayer lacked the requisite mental state to be penalized. Consequently, the Court disallowed the imposition of penalties on the taxpayer. As such, this case has opened the doors to the defence of lack of requisite mental state.
3. Pontarini v. Canada, 2009 TCC 395
In this Tax Court of Canada case, the taxpayer, who was a physician, was assessed for the 1997, 1998, 1999, 2000 and 2001 taxation years for significant underreporting of income and overstating of expenses. By the time the trial commenced, the substantive issues were resolved and the taxpayer was appealing the penalties for gross negligence. The taxpayer challenged the penalties on the basis that his mental health issues and the stressors in his life made it reasonable for him to think he filed his return correctly.
The taxpayer was negatively affected by the new OHIP changes that reduced his revenue by approximately 25%. His medical license was also suspended for a criminal conviction for trafficking in narcotics. He had additional financial difficulties due to some reassessed tax shelters, legal proceedings and the loss of his home. The taxpayer had also pled guilty to tax evasion and was fined a significant amount. He was asked by his hospital to resign for having an extra-marital affair with another colleague; he also separated from his wife for a period of half a year.
Evidence was provided by the taxpayer's own psychiatrist. The psychiatrist stated that the taxpayer was not clinically ill and his mental health was not significantly impaired aside from having reactive depression to stressful events. The only medication used by the taxpayer was a small dose of a tranquilizer. The psychiatrist also testified that the taxpayer had an odd and troubled personality with difficulty in making good judgments.
The Tax Court referred to Cox v. The Queen in its analysis, finding that unlike in Cox, the taxpayer in this case did not suffer from a mental health illness in such a way that interfered with his ability to comprehend his actions or to form the requisite intention as required by subsection 163(2). The Court found that the stressors in the taxpayer's life were not debilitating and incapacitating. He was able to continue his medical practice and salvage his family relationships. The Court concluded that the taxpayer chose not to focus any effort on tax compliance and intentionally filed an incorrect return.
(iv) TAXPAYER LACKED SOPHISTICATION
Where the Minister assesses penalties on the grounds that a taxpayer's actions or omissions constituted gross negligence, the taxpayer can challenge such an assessment on the basis that the taxpayer was inexperienced in tax matters and as such was not grossly negligent in failing to detect the errors or omissions. Recent case law has demonstrated that if a taxpayer is able to prove that he lacked sophistication in tax matters, the Court may hold that penalties are unjustified.
(v) STATISTICS CANADA AVERAGE EXPENSES
Where a taxpayer has failed to file an income tax return or has kept inadequate records, the Minister can assess the tax using the net worth method. This method involves subtracting the taxpayer's net worth at the beginning of the year from the worth at the end and also taking into account personal expenditures on an annual basis. The difference, less any amount declared by the taxpayer, is attributed to unreported income earned in the year unless it is demonstrated otherwise. Personal expenses are often based upon Statistics Canada's ("StatsCan") estimates of how much it costs for the average, normal Canadian to live. This method has been described as a last resort method that can produce inaccurate results.
The taxpayer may be able to challenge the estimates and the method of assessment if they can show their own lifestyle differed from the assumptions made based upon the StatsCan figures. By challenging the estimates, the taxpayer may be able to decrease the amount of unreported income, reduce the penalty or have the penalty deleted completely because the difference between the unreported income and the reported income was insubstantial.
1. Cox v. The Queen,  TCJ No 139
In this Tax Court of Canada case, the taxpayer, who was represented by Alpert Law Firm, was assessed for a total of seven taxation years. The taxpayer appealed to the Tax Court of Canada, challenging the Minister's expense estimates based upon StatsCan norms. He suffered from paranoid schizophrenia and his lifestyle was meagre and did not conform to that of the average Canadian.
The Tax Court of Canada allowed the appeal in part. The Court reduced the total annual personal expenses, based upon the judge's own observations of the taxpayer and the taxpayer's known mental health condition. For example, the judge noted that the taxpayer appeared in court on both days in the same dirty outfit and thus reduced the amount spent on clothing and dry cleaning significantly. The judge also noted that the taxpayer appeared unkempt and reduced the amount allotted for personal care. The judge also reduced the amount spent on recreation as he noted it was unlikely that a person with severe psychiatric problem would participate in these activities. The taxpayer did not fit into the StatsCan norms.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.