Introduction – Successful Law Suit for CRA Negligence
On July 31, 2018, the Honourable Stephen W. Hamilton of the Québec Superior Court issued what should be recognized as an historical legal decision on the question of whether or not the Canada Revenue Agency ("CRA") can be held liable for damages for a tort of negligence. Previous plaintiffs, such as Irving Léroux in Léroux v Canada Revenue Agency, had convinced the Courts that a duty of care existed between the CRA's tax audit division and the taxpayers whom it audits. In that case, the BC Supreme Court readily admitted that the potential power imbalance between most taxpayers and the CRA could result in a business going defunct due to aggressive CRA tax audit and enforcement action. However, until this point, no taxpayer had successfully sued the CRA for a negligence claim.
More recently in Samaroo v Canada Revenue Agency, two taxpayer spouses were successful in holding the CRA liable in damages under the seldom used tort of misfeasance of public office. However, it still remained a truth in the Canadian legal system that the CRA had avoided a judgment for damages for the normal common law tort of negligence.
This all changed on July 31, 2018 with what appears to be little fanfare in the mainstream media; on that date the Québec Superior Court's decision in Ludmer et al c. Attorney General of Canada made it clear that the CRA can and will be held liable for damages in negligence where its actions create a measurable harm to the taxpayers when it abuses its powerful tax audit mandate.
All in all, between the various taxpayers in Ludmer, the action was granted and the CRA was forced to pay approximately $4.8 million in damages for negligence exercised throughout the protracted and abusive tax audit. The facts and a detailed analysis by our skilled Canadian tax lawyers follows on this watershed case.
History of the Global Asset Management Business
In the mid-1980's, two friends and business partners who had spent several years investing in the new and chic USA based hedge funds met a European money manager who advised them to create a new offshore fund in the British Virgin Islands along with family, friends and other wealthy investors. The idea, known as a "fund of funds", was to group the investments and have them outsourced to various external business managers in order to diversify the risk. At the time, holding offshore assets through these types of investment vehicles such as corporations attracted no Canadian tax liabilities so long as the profits were not distributed to the Canadian resident individual taxpayers. For brevity's sake we refer to this concern and group of entities in this article as Global Asset Management ("GAM").
Over the next 15 or so years, GAM continued to gain investors, diversify and restructure, such that it had amassed a net asset value of close to $1 billion CAD. The fees charged to investors were paid to trusts owned by the original friends which was itself incorporated in the British Virgin Islands ("BVI"). BVI at the time (and to this day) has no income tax, and to sweeten the deal, there was no tax upon the Canadian owners provided that no dividends or other distributions made. The income was at that time capable of being reinvested indefinitely without the need for taxes being paid at all.
Massive Changes Proposed to Taxation of Offshore Income
In February of 1999 the federal government proposed a series of changes to how offshore income of Canadians was taxed, particularly when using offshore trusts. These proposed changes resulted in the current regime which essentially eliminates the ability of Canadian resident taxpayers to defer taxes on "passive" income earned through trusts and other entities in foreign jurisdictions. These rules are most often referred to by accountants and lawyers as the "FAPI" (Foreign Accrual Property Income) rules and the proposed 1999 legislation proposed to widen the scope of FAPI.
In anticipation of the changes to the new FAPI system, GAM undertook further restructuring:
- The non-Canadian shareholders and 45% of the assets of GAM were spun out into a new entity;
- The approximately 160 Canadian shareholders in GAM were then left with 55% of the assets;
- GAM then sold the remaining assets to two foreign subsidiaries of two of the major Canadian banks in Ireland and BVI;
- The proceeds of the sale of the assets was utilized by GAM to purchase two notes receivable, payable in fifteen years, and each issued by a further subsidiary of the aforementioned Canadian banks. The notes were guaranteed by the parent corporations of the foreign bank purchasers, and the value at maturity of the notes was tied to the pool of assets disposed of by GAM;
- GAM was given the right to terminate the notes with 367 days notice; and
- The GAM shareholders were given the right to put their shares to the subsidaries for a price equal to the assets at the time the put option would be exercised. The obligations were guaranteed and GAM proceeded to change its name to SLT.
The purpose of the restructuring was essentially to ensure that the Canadian resident shareholders recognized no income until the maturity of the notes some 15 years later in 2016. Additionally, the plan called for the shareholders of now SLT to sell their shares just prior to the maturation of the notes in order that their gains be characterized as capital as opposed to income.
It should also be noted that the management fee structure was "Canadianized" in 2007 with the original two investors opening Canadian resident trusts to accept payment of the management fees paid by the GAM/SLT investors. Taxes were reported and paid by the new trusts, but the CRA refused to pay back any refundable taxes as a result of the trusts distributing income to the individual taxpayers. The CRA had not, as of the date of the judgment, repaid those valid refundable taxes amounts due.
By the deadline in 2016 all of the Canadian investors in SLT had exercised their put options, and SLT had effectively ceased operations.
The CRA Takes Interest
In the 2005 taxation year, the CRA began what became known as the Related Party Initiative ("RPI"), which was colloqually known as the "billionaires' audit". The CRA set out to audit a number of high net-worth individuals who had a history of paying low income tax amounts. As a result, SLT was targeted sometime in 2006 for additional tax audit work after the CRA had discovered it in the course of an audit of one of its investors.
The main point of concern for CRA was the original investor friends and their failure to pay taxes on the several million dollars of income they had earned through GAM/SLT and not recognized in Canada as of yet.
The individual taxpayers, having received new advice that they had filed incorrect reporting forms (they had filed T1135s when they should have filed T1134a or T1134b) attempted to file voluntary disclosure requests to clear the penalties up. These requests were denied as having been submitted after tax audit action was already taken against a related party, that being SLT.
The Tax Audit Period
Between 2006 and 2012 the CRA engaged in a massive tax audit project of SLT, and due to the length of time requested waivers from some of the interested taxpayers, and for those who refused issued protective tax reassessments in order to draw the tax audit period out as far as possible.
Finally, after almost six years, the CRA issued final tax reassessments in May of 2012 against the investors totaling more than $25 million in taxes, interest and penalties. The tax audit report contained four different grounds to support the tax reassessments, which were promptly objected to by the plaintiffs and the tax amounts owing were paid off in protest in order to prevent additional interest accrual.
The Statutory Income Tax Appeals Process
The taxpayer Plaintiffs effectively ignored the appeals division and proceeded at first opportunity to the Tax Court of Canada. It was after the appeals were instituted that the CRA began attempting to gather evidence of gross-negligence on the part of the plaintiffs in order to substantiate gross-negligence penalties which they had levied under section 163(2) of the Tax Act. In order to do so, the CRA wrote to the Bermuda tax authorities with respect to gathering information related to a "criminal tax matter". The plaintiffs Canadian tax lawyer caught wind of the request and demanded that it be withdrawn, which CRA did in time, after apologizing to the taxpayers and tax counsel.
Eventually, the CRA realized that proposed changes to the FAPI regime from the 1999 budget would never be promulgated by parliament. On that basis they sent a settlement offer to the taxpayers allowing the old rules to apply and to eliminate the gross-negligence penalties assessed. The plaintiff rejected the settlement offer, resulting in the Department of Justice seeking to consent to the judgment sought by the plaintiffs in Tax Court.
The Civil Action & Trial
Based on the length of the tax audit and actions of the CRA during same (described in limited detail below), the Plaintiffs brought an action in negligence against the CRA. The action alleged all types of negligence and requested damages and punitive damages. The Court was reluctant to allow all of the plaintiff's arguments, however this case should be seen as a watershed in that it proved that the CRA does indeed have an obligation to the public when it exercises its tax audit powers and should it overextend its powers it will be forced to pay recompense.
The judgment itself is more than 150 pages and details each division of the CRA that was involved.. For example, the case provides a detailed factual analysis of the inner workings of CRA's Aggressive Tax Planning and Advance Rulings divisions, and also carefully details the history of the tax dispute itself, such as the Notice of Objection and Tax Court appeals stages. These details are beyond the scope of this article However, when boiled-down to the salient points on the negligence issue, the questions posited by the Court in its judgment give us a framework for understanding why the CRA was found to be negligent and forced to pay damages in this case. The Court asked the following questions in its judgment:
- What is the standard of conduct the CRA must meet in the course of a tax audit?
- Was the CRA negligent, and thus at
fault with respect to the following:
- Refusing the voluntary disclosure and threatening gross-negligence penalties?
- Failing to move the matter forward expeditiously?
- Taking and then clinging to unreasonable tax assessing positions and ultimately relying upon these in issuing tax reassessments?
- Failing to give the taxpayer prior notice before issuing tax reassessments contrary to a promise to allow for a period to consider and respond?
- Referring to the matter as a "criminal tax matter" to the Bermuda authorities?
- Issuing unreasonable draft tax reassessments?
- Making bad faith settlement offers which it knew were untenable in order to maximize the collection of tax?
- Providing incomplete responses to access to information requests?
- If the CRA did in fact commit negligence, was it liable for the
- Reimbursement of lost interest on amounts paid due to tax reassessment?
- Reimbursement of all professional fees to deal with the tax audit, Tax Court Appeals, the Privacy Commissioner and a related Federal Court Application?
- Damages for reputational loss, stress, trouble and inconvenience?
- Damages for lost income for SLT?
- A stay of the aforementioned draft tax reassessments? and
- Punitive damages.
The Court's Answers to the Questions
The Standard of Conduct
The Court held that although there was a long common law tradition of the CRA having been held to be immune from negligence claims during the performance of an audit, the plaintiffs had the advantage of having been residents of Québec. The Court in this case held that the common law concepts of duty of care, proximity etc. had no effect in that province and instead were governed by article 1376 of the Québec Civil Code.
The Civil Code, in conjunction with the Crown Liability and Proceedings Act and the Supreme Court of Canada's decision in the R v Imperial Tobacco case led the court to a finding that the CRA could only be immune from a negligence claim if it were taking action in accordance with its true core policy. The Court held that the true core policy of the CRA is limited to the calculation and collection of taxes, and that the CRA itself is not charged with exercising a legislative or regulatory power or setting tax policy - this is in fact the core policy only of the Department of Finance. On that basis the Court held that the CRA could not claim immunity from an action in negligence in Québec and that it is subject to the regular civil standard of fault in that province.
As such, the Court answered the first question as follows:
- The CRA must act reasonably when it performs an audit. The Taxpayer Bill of Rights is an important document that must speak to how an auditor comports themselves during the tax audit which is merely an administrative function;
- Negligence is sufficient to establish fault;
- It is not necessary to establish that the CRA acted maliciously. Intentional conduct is only necessary for a finding of punitive damages;
- The CRA can be wrong without being at fault - the CRA is not at fault if it takes a reasonable position which later turns out to be incorrect; and
- To the extent CRA has powers under the taxing statutes, it must exercise them reasonably and not in an abusive manner.
The Individual Heads of Negligence
With respect to the failure of the CRA to accept the voluntary disclosure application, the failure to move the tax audit forward expeditiously, issuing unreasonable draft tax reassessments, the Tax Court settlement offers and the access to information requests, the Court found that the CRA had not acted negligently and dismissed those portions of the claims.
However, it further found that the CRA was negligent and had improperly conducted its tax audit for the following issues:
- Creating and refusing to abandon clearly untenable tax reassessment positions;
- Failing to provide notice of forthcoming tax reassessments after promising to do so, which the Court characterized as akin to non-compliance with an undertaking;
- Making a request to the Bermuda authorities with reference to a "criminal tax matter";
- Acting improperly in attempting to railroad through a settlement on issues it had already decided to abandon during the Tax Court Appeals; and
- The failure to properly disclose information through the Access to Information Directorate, resulting in the delay of inevitable disclosure by years and creating considerable expense to the plaintiffs.
However, it should be noted that the Court found no intentional acting on behalf of the CRA, and thus precluded the awarding of any punitive damages in the case.
The final total of damages awarded by the Court to the various plaintiffs rested at $4,844,658.85 including solicitor's costs, but exclusive of pre and post judgment interest
Commentary – Damages in Negligence
As the jurisprudence in this area continues to develop, we continue to see creative judges who wish to hold the CRA accountable for its actions when those actions pass beyond the realm of reasonability and clearly into the realm of abuse. Years of precedents set by various courts that would absolve the CRA of any culpability seem to be continuously whittled away by creative Canadian tax lawyers and judges who are interested in holding parties, including government actors, accountable for abusive use of power.
We expect that more of these cases will be forthcoming, and that eventually a taxpayer resident outside of Québec will be able to hold CRA to account for the abuses incurred. We by no means wish to state that abuse of power is a normal state of affairs at the CRA, however, when it does happen taxpayers should have a legal remedy, such was the case here.
It must also be noted that as stated in the introduction, no taxpayer has yet been successful in a claim for negligence against the CRA in any of the common law jurisdictions in Canada. Essentially, outside of Québec, taxpayers are subject to the common law decisions of the various Superior Courts. There have been numerous cases of taxpayers attempting to hold the CRA liable for damages in negligence in those jurisdictions, however the caselaw still resoundingly supports the proposition that the CRA cannot be sued for negligence. The sole exception in the caselaw has been the Leroux case, which resulted in a finding of a duty of care by the CRA, but no actual negligence.
Taxpayers in Québec on the other hand have the advantage of the Civil Code, which enumerates much of the law in that province and supersedes the common law precedents. Based on our analysis of the Court's interpretation of the Civil Code and federal statute in Ludmer, we believe that the case represents a judicial "thawing" of the concept that CRA cannot be held liable for damages in negligence and that creative Canadian tax lawyers will be able to hold the CRA accountable in the common law courts in time given the correct factual circumstances.
Tax Tips to Sue CRA for Negligence
Ludmer seems to demonstrate that building a proper record by the taxpayer at the tax audit stage is key to success. Indeed, much of the fault that the Court found at the tax audit stage would never have been identified by the plaintiffs were it not for current and ongoing representation by a Canadian tax lawyer during the tax audit and at all other stages of the dispute.
Taxpayers who are facing an audit, be it offshore compliance or simple expenses should always do so with a knowledgeable Canadian tax lawyer involved in order that the CRA is kept in line and that a documentary record is created should an appeal to Tax Court or even an action in damages as in Ludmer be needed.