Introduction: CRA has the power to conduct investigation on account of misrepresentations
The plaintiffs, Allan Jay Gordon, James A. Deacur and Associates Ltd. [JAD] and James Allan Deacur sought damages from the government of Canada alleging that the Canada Revenue Agency [CRA] conducted tortious act in its criminal investigation. The plaintiffs developed a strategy to maximize some of their clients' SR&ED claims which involved backdating records to support transactions that did not happen at the time. The CRA indicted and prosecuted the plaintiffs on account of fraud, attempted fraud and possession of the proceeds of crime. However, after a lengthy preliminary hearing, the Crown ended the prosecution and stayed the charges. The plaintiffs then asserted several causes of action against the CRA which were all dismissed by the Court on the basis that the CRA had reasonable and probable grounds for recommending a prosecution and there was no evidence to prove CRA officials acted unlawfully, maliciously or negligently in conducting the investigation. This case underlines the importance of understanding the standard of care the CRA is subject to while conducting an investigation and the importance of discussion and understanding of the merits of a potential claim with your Canadian tax lawyer before taking any legal action against CRA.
JAD's Method of Backdating Records is inconsistent with generally accepted accounting principles
The plaintiffs adopted a method to overcome the absence of documentation by creating the appearance of a sub-contracting relationship and using ostensible invoices. However, there had never been an actual intention by the clients at the time to create that kind of relationship and the problems with JAD's methods were identified by both their clients and a number of CRA auditors. The Court did acknowledge that the approach to enhancing an SR&ER claim could remain a legitimate accounting strategy, but ruled that the reasoning given by the plaintiffs cannot "justify documenting corporate relationships and transactions that did not exist at the relevant time". The Court cited Justice Bowman's decision in Dale v R,  1 CTC 2303, 94 DTC 1100 that it is not acceptable to "create a state of affairs that did not, in fact, exist." In R v Cancor Software Corp, 6 OR (3d) 577, 14 WCB 2d 562, the Court also ruled "the behavior by the taxpayer that bears considerable similarity to the methods employed" by the plaintiffs were unacceptable. The Court ultimately found that the plaintiffs' methods of backdating were "indefensible and inconsistent with generally accepted and well-known accounting methods" as there was no justifiable evidence to support their methods. The Court also found that the JAD methods were never validated by the CRA and the plaintiffs never made a full disclosure of their methods to the CRA either.
The Plaintiffs Had a Cause of Action in Negligence against the CRA
After deciding that JAD's methods constituted misrepresentations which were "at least prima facie fraudulent", the Court ruled that CRA Special Investigators conducting a criminal investigation on the JAD methods were subject to a duty of care founded in negligence. The Court took into consideration the decision in Hill v Hamilton Wentworth (Regional Municipality Police Services Board), 2007 SCC 41,  3 SCR 129 where a negligence standard was imposed on the police who conducted a criminal investigation. In the Court's view, a duty of investigation pursuant to the law would not conflict with a duty to act reasonably toward the suspect and it would not result in any negative policy consequences. Since the kind of investigation that was carried out in this case more closely resembled a police investigation than an income tax audit holding CRA investigators to the same standard of reasonableness would be consistent with the legal duties imposed on other professionals such as the police in similar situations.
The Court then went on to address the plaintiffs' concerns regarding the process:
i. TOM II Manual's Legal Significance
The Plaintiffs contended that the CRA investigators didn't comply with some of the procedures set out in the TOM II Manuals which contains a set of procedural guidelines for the conduct of CRA Special Investigations and this constituted malice and negligence. In the Court's view, the standard for investigative conduct is reasonableness and some mistakes are to be expected in a complex criminal investigation. Moreover, just because the CRA stayed the charges doesn't necessarily mean a negative inference can be drawn.
ii. Failure to Interview the Plaintiffs
It was factually correct that the CRA investigators failed to interview plaintiffs before laying charges. However, the Court rejected the plaintiffs' contention that they had no knowledge about the nature of the CRA's concerns regarding JAD's methods. A letter was sent to JAD where Mr. Deacur was a part owner who ought to be aware of the charge. As for Mr. Gordon, the reason he was not interviewed was that the decision to charge him was not made until after the investigation was over and it was mainly recommended by the Department of Justice.
iii. Failure to Reassess
Mr. Deacur complained that the CRA should have reassessed the impugned SR&ED claims before criminal charges were laid and the failure was in breach of the TOM II Manual. The Court found that the provision had no connection to the investigation of a tax payer as it is related to the need to assess penalties against a taxpayer. The CRA investigator also testified that the Ministry can reassess at any time under the Income Tax Act (ITA).
iv. Failure to Turn Over the Investigation to RCMP
Although the plaintiffs complained the TOM II Manual required the CRA to transfer the investigation to RCMP, their complaint had no merits as it was not required by the relevant provision that and it was the CRA's general practice to "keep technical tax investigations in-house".
v. CRA's Improper Mischaracterization of Mr. Deacur
Mr. Deacur was labelled as "volatile" by a CRA investigator so that the CRA could justify their request for RCMP to be involved. Although the investigator had no basis and it was inappropriate to label Mr. Deacur that way, the Court found that this had nothing to do with the reliability of the evidence the investigators obtained.
Mr. Deacur was also referred to a "troublemaker" in government reporting, but the Court found this type of "heads up" reference was not infrequent and his reputation was not disparaged
vi. Mixing of CRA Audit Work and Investigations
There was no evidence to support the claim that CRA investigators tried to exploit the auditors to obtain evidence. Although there was one case that Special Investigators directed a CRA auditor to deny a JAD claim in full, the Court found that it was ultimately the auditor in that particular case who decided how to proceed.
vii. Investigative Records Were Stolen
Ms. Northey, the CRA lead investigator, left some investigative records in her vehicle which was stolen overnight at her home. The Court ruled that this event had no relevance to any issue as Ms. Northey testified that almost all of the stolen records were recovered.
viii. Unsupervised Investigator
The Court found the plaintiffs' allegation that Ms. Northey was unsupervised unfounded as the CRA investigators' work was constantly "vetted and approved by senior CRA officials". This was supported by the fact that when Ms. Northey prepared the draft information for search warrants and prosecution report, both documents were reviewed by CRA's senior investigators.
ix. ITA Section 239 Violation
The plaintiffs contended that Ms. Northey maliciously alleged violations of s.239 of the ITA when she knew that filing of SR&ED claims could never constitute an offense under the ITA. In the Court's view, the plaintiffs' allegation was not supported by the language of the provision as it created an offense for making "false or deceptive entries in records or books of account of a taxpayer". Therefore, it was reasonable for Ms. Northey to hold the view that s.239(1) of the ITA did apply to the plaintiffs' case.
x. Ms. Northey was Qualified to Lead the Investigation
The plaintiffs alleged that Ms. Northey was underqualified and it was improper for the CRA to assign her as the lead investigator. The Court ruled that the relevance was "whether there were serious mistakes or errors of judgement made by Ms. Northey and others" and there were none in this case.
There was No Viable Cause of Action for Malicious Prosecution
In response to the plaintiffs' allegation that Ms. Northey intentionally pursued what she knew to be a legally untenable case for additional salary, the Court examined the 4 elements that must be established by a plaintiff;
- The prosecution was initialled by the defendant. Since CRA officials were actively instrumental in setting the prosecution in motion, the Court was satisfied that this requirement was met.
- It was obvious the prosecution was terminated in favor of the plaintiffs, the Court then continued to examine the 2 other factors.
- Whether the prosecution was undertaken without reasonable and probable cause. The Court found that the CRA had met the standard by relying on substantial evidentiary support to initiate a prosecution.
- Whether the prosecution was motivated by malice or a primary purpose other than that of carrying the law into effect. Since the Court found that the JAD methods were "wholly indefensible and at least prima facie dishonest", it would be reasonable for Ms. Northey and other CRA investigators to lay charges against the plaintiffs. Therefore, the Court ruled there was malice.
Tax Tip – The Importance of Understanding the Standard of Care to which CRA Investigations are Subject
While none of the plaintiffs' actions was successful, this case demonstrates the importance of understanding the standard of care to which CRA investigations are subject when a taxpayer decides to litigate for any misconduct out of the CRA activities. Our top Canadian tax lawyers can help you evaluate the merits of a potential claim against CRA.
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