20 minute read 3 Jun. 2021
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TaxMatters@EY – June 2021

By EY Canada

Multidisciplinary professional services organization

20 minute read 3 Jun. 2021
TaxMatters@EY is a monthly Canadian summary to help you get up to date on recent tax news, case developments, publications and more. From personal and corporate tax issues to topical developments in legislation and jurisprudence, we bring you timely information to help you stay in the know.

Is your greatest tax obligation one you can’t see?

Tax issues affect everybody. We’ve compiled news and information on timely tax topics to help you stay in the know.  In this issue, we look at:

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Chapter 1

Understanding the CRA’s audit tools: indirect and alternative methods of verification

 

Lucie Champagne, Toronto, and Marie-Claude Marcil, Montréal

In any audit, regardless of the size or complexity of the taxpayer, the auditor must obtain complete and accurate information to conduct their examination. The audit risk associated with individuals and small businesses differs significantly from that of larger business operations.

The Income Tax Act (the Act) gives the Canada Revenue Agency (CRA) several tools to administer and enforce the Act, and auditors generally select their methodology to address the audit risk of a class of taxpayers.1

A roundtable question posed at the 2020 APFF2 conference last fall raised concerns with respect to certain requests received by taxpayers under indirect and alternative methods of verification. Just recently, the CRA published its response in a technical interpretation,3 clarifying its views on the use of such methods in the context of audits of individuals and small businesses. The CRA also took the opportunity to outline its obligations to taxpayers in the course of an audit.

Subsection 152(7) of the Act

As outlined in the question, it has been observed that CRA auditors sometimes request bank and credit card statements in the course of their audits of individuals or corporations. Taxpayers who refuse to provide the requested information, as well as their financial institution, may subsequently receive a requirement for information from the CRA, and any lack of cooperation could potentially be noted in their audit file.

Broadly speaking, subsection 152(7) of the Act clarifies that the minister is not bound by a taxpayer’s return or by information supplied by or on behalf of the taxpayer. As such, in making an assessment, the minister may assess tax payable notwithstanding a return filed or information provided by the taxpayer, or even if no return has been filed. The onus is on the taxpayer to disprove an assessment.

Thus, subsection 152(7) effectively allows the CRA to seek alternative methods to ensure a taxpayer has complied with their obligations under the Act. In the context of a self-employed individual or the shareholder of a small business, CRA auditors may use indirect or alternative methods of verification to seek assurance that all income derived from the business has indeed been reported in the tax return. Although not specifically stated in the question posed, such methods could also be used to identify unreported shareholder benefits.

The CRA’s ability to obtain information

The Act gives the CRA, as an authorized representative of the minister, the power to request access to and the production of any information or document related to the administration and enforcement of the Act. In instances where a taxpayer does not comply with the requests for information, the requests for information or documents may be escalated to take the form of a requirement or a demand from the CRA.

Generally, as a starting point under subsection 231.1(1) of the Act, CRA auditors have broad rights to access and obtain the information needed to conduct an audit. This provision provides, among other things, that a CRA auditor may, at all reasonable times, for any purpose related to the administration or enforcement of the Act:

  • Inspect, audit or examine a taxpayer's books and records
  • Examine a taxpayer's inventory
  • Inspect, audit or examine any document of the taxpayer or any other person that relates (or may relate) to the information that is (or should be) in the taxpayer's books or records or to any amount payable by the taxpayer
  • Require the taxpayer to give all reasonable assistance and answer all proper questions relating to the administration or enforcement of the Act

Specific rules apply with respect to the CRA’s ability to enter into any premises or place where a business is carried on or where any books and records are stored.4

If a person fails to comply with a request for inspection under section 231.1 of the Act, it will typically be followed by a formal requirement or demand for information under section 231.2, which provides authority to the minister to compel any person, including a third party, to produce information and documents that are within the person’s knowledge or possession.

In particular, subsection 231.2(1) provides that the minister may give notice to require any person to provide information or any document relating to the administration or enforcement of the Act, subject to certain restrictions relating to solicitor-client privilege and with respect to requests made to third parties.5 The minister is not obligated to first make a request for inspection under section 231.1 before making a formal demand for information under section 231.2; however, this is often the case in practice. Similarly, the minister is not obligated to make a formal demand under section 231.2 if a taxpayer fails to comply with a request for inspection under section 231.1 before taking judicial measures.

A taxpayer who fails to comply with a request or demand for information may be found guilty of an offence punishable by both a fine and imprisonment.6 In particular, section 231.7 of the Act allows the minister to seek a compliance order from the court for the failure to comply with a request or demand for information under sections 231.1 and 231.2. If the Court order is granted, a taxpayer who fails to comply is considered in contempt of court. For a taxpayer to be found in contempt, it must be proven beyond a reasonable doubt that a taxpayer willfully disobeyed the order.

Understanding the CRA’s powers and taxpayers’ rights in the context of an audit can be complex. General information is available in Guide RC4188, What you should know about audits, and in communiqué AD-19-02R, Obtaining Information for Audit Purposes.

Speak to your tax advisor if you have questions about your particular situation.

Questions to the CRA

The CRA was asked to comment on its approach to auditing individuals and shareholders, specifying when and for what reason bank and credit card information may be required. In addition, the CRA was asked to identify possible resources in situations where an individual would like to contest a request for information in the context of an indirect audit.

The first question posed also highlights the fact that the Act does not specifically require taxpayers to maintain separate accounting records of their personal accounts in relation to their bank and credit card statements, and that going through the process of reconciling every personal deposit and transfer between accounts may cause an undue burden to taxpayers. Often, there are significant discrepancies in reconciling these accounts since certain deposits may result from transfers between various family members’ accounts, or originate from non-taxable sources.

CRA’s comments

The CRA confirmed that indirect or alternative methods of verification are permitted under the Act and that such methods are effective in certain circumstances.

Indirect reviews include a review of bank statements, the computation of the approximate net worth, and an examination of the sources and uses of funds. This methodology is used when small businesses, which may be operating as sole proprietorships or corporations, are selected for audit, and assurance is sought with respect to the completeness and accuracy of the income reported in the tax return. The risk of under-reported income is greater with these taxpayers since small businesses are inherently more susceptible to weaker internal controls and a lack of segregation of duties.

Also, in some situations, there may be a pooling or co-mingling of personal and business accounts by the proprietor or shareholder(s). For this reason, the auditor may request personal financial information from the spouse or common-law partner of the proprietor or shareholder(s), and from any person who either contributes to the income or expenses of the household or lives in the same residence.

The CRA cites subsection 231.1(1) of the Act to support its authority to request personal bank statements of a shareholder and any person listed above. As explained previously, the CRA may inspect, audit or examine the books and records of other persons to the extent that these documents may relate to the information that is, or should be, contained in the books and records of the taxpayer who is subject to the audit.

The CRA further noted that the personal information of the taxpayer, and any other identified individual, will be requested at the beginning of the audit to allow the auditor to ensure that any income from business operations conducted through the bank account of the proprietor, shareholder(s) or any family member is properly reported in the tax return.

In response to the second question, the CRA stated that this practice (regarding how the taxpayer may contest a request for information) is based on the reasonableness of the request for information rather than clear indicators of unreported income. In the CRA’s view, the wording of subsections 231.1(1) and 231.2(1) and the use of the word “may” suggest that the minister has discretionary power with respect to the application of the Act. A taxpayer has the right to request a formal review of the CRA’s discretionary decisions made under these provisions pursuant to the fourth right of the Taxpayer Bill of Rights.7 If the taxpayer disagrees with the formal review, an application for judicial review at the appropriate court may be filed.

In its response, the CRA reminds taxpayers that information gathered in the course of an audit is protected and administered under strict confidentiality pursuant to section 241 of the Act.

While these provisions are not specifically discussed in the technical interpretation, it is important to note that this section sets out specific rules relating to the disclosure of taxpayer information. The minister has an obligation to protect taxpayer confidentiality. Broadly speaking, subsection 241(1) prohibits CRA officials (and other representatives of government entities) from knowingly using or communicating taxpayer information obtained under the Act except as specifically authorized in section 241. Taxpayer information includes information of any kind and in any form relating to one or more taxpayers that is obtained by or on behalf of the minister for purposes of the Act or prepared from information obtained by or on behalf of the minister.8

Specific rules and exceptions to the general prohibition may apply in certain cases. For example, an exception applies to communications where proceedings pursuant to certain legislation have begun, such as criminal proceedings and legal proceedings relating to the administration of the Act, the Canada Pension Plan, employment insurance legislation, or any other legislation of Parliament or of a province that provides for the imposition or collection of tax or a duty.9

Conclusion

The CRA’s powers under the Act are broad, but not unlimited. Understanding the tools available to CRA auditors in the course of an audit, and your obligations as a taxpayer, can help minimize confusion and potential conflicts. Having clear and frequent communication with the auditor will not only expedite the audit, but will also make the rights and obligations clear on both sides. Not surprisingly, maintaining detailed books and records that are separate from the personal accounts of the shareholders and their family members will also reduce the risk of unreported income.

Speak to your professional advisor if you are unsure about your rights and obligations during an audit. Seeking advice at the outset of the audit could help you achieve a positive outcome.

  

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Chapter 2

Settlement bound the taxpayer to include both partnership gains and losses in income

Savics v The Queen, 2021 FCA 56

Gael Melville, Vancouver, and Winnie Szeto, Toronto

This case concerns a taxpayer who entered into a settlement agreement with the Canada Revenue Agency (CRA) but was unhappy with the resulting reassessment, which he claimed was not in line with the agreement he had signed. Both the Tax Court of Canada (TCC) and the Federal Court of Appeal (FCA) sided with the CRA in the matter and found that the reassessment was consistent with the terms of the settlement.

Facts

The taxpayer was a limited partner in three limited partnerships that operated in the film distribution sector. He was one of approximately 1,200 partners who had invested in these or related entities and who were subsequently reassessed when the CRA determined, in 2002, that the partnerships did not carry on business with a view to profit and that the entities were not actually partnerships in a legal sense.

For the 1998 taxation year, the taxpayer reported income from the partnerships, and also claimed partnership losses, interest expenses and carrying charges. The net result was a reduction in income of approximately $41,000. Following an initial assessment, the CRA audited the taxpayer’s 1999 to 2002 taxation years and reassessed him on July 5, 2002. The result was in an increase in his income for the 1998 year of $41,000.

The taxpayer objected to the reassessment and a settlement was subsequently negotiated between the CRA and all the limited partners, including the taxpayer, whose objections and appeals were outstanding.

As part of the process, the taxpayer signed waivers accepting the settlement offer and waiving his right to object or appeal in relation to the partnerships for the years covered by the settlement.

The waivers specifically allowed the CRA to reassess the taxpayer to allow him to claim the losses allocated to him and the amounts he had claimed as interest and carrying charges. The waivers also contained a provision preventing the CRA from making other adjustments to the taxpayer’s tax liability in connection with his investment in the partnerships “other than consequential adjustments,” unless the taxpayer agreed to them.

In October 2014, the taxpayer was reassessed for the 1998 taxation year, restoring him to his original filing position, a reduction of income of approximately $41,000. The taxpayer appealed to the TCC, arguing that the settlement agreement allowed him to be reassessed only to allow losses and carrying charges, but not to include income from the partnerships. If he’d been reassessed as he suggested, it would have resulted in a reduction of income of approximately $177,000 for the 1998 year.

TCC judgment

The TCC dismissed the taxpayer’s appeal and found the waiver of his rights of appeal was operative and prevented him from pursuing an appeal of his 1998 assessment. The basis for this finding was that the CRA’s inclusion of the partnership gains allocated to the taxpayer in his income for 1998 was a consequential adjustment and was not inconsistent with the minutes and waivers that had been executed.

In particular, the settlement was based on the valid existence of the partnerships (a change from the CRA’s original position) and it followed that both losses and gains deriving from the partnerships must be recognized, since it would be inconsistent to recognize only the losses and not the gains.

The taxpayer filed an appeal of the TCC’s judgment with the FCA.

FCA judgment

The main issue the FCA had to consider was whether the TCC had erred in finding that the reassessment was consistent with the settlement agreement. The FCA found that the TCC had not made an error.

Even though the minutes of settlement stated that consequential adjustments would include certain amounts, and gains from the partnerships were not specifically listed, the FCA noted that this was likely due to the background against which the settlement was drafted. The taxpayer had objected to the denial of partnership losses and carrying charges, and so it was these amounts rather than the partnership gains that were the focus of the minutes of settlement.

The FCA stated that in allowing partnership losses and carrying charges under the settlement, the CRA was effectively recognizing that the partnerships were valid partnerships. That also meant that the amount of partnership gains that had been removed from the taxpayer’s income should be reinstated.

Interpretation of subsection 152(5)

The other significant issue the FCA considered was the application of subsection 152(5) of the Income Tax Act (the Act), which places limits on what can be included in an assessment issued outside the normal reassessment period. Specifically, the subsection prevents an amount that was not included in the taxpayer’s income for an assessment of Part I tax made within the normal reassessment period from being included in an assessment issued after that period.

While the parties in Savics agreed subsection 152(5) was applicable, they disagreed on how it should be interpreted.

The difference of opinion amounted to whether it was only the last assessment issued within the normal reassessment that mattered, or whether the contents of any assessment issued during the normal reassessment period could be caught by the provision.

In the taxpayer’s view, subsection 152(5) referred only to the assessment, reassessment or additional assessment that was valid and existing at the end of the normal reassessment period. If his view was correct, the reassessment issued on July 5, 2002, which did not include any income amounts from the partnerships, nullified the initial assessment that had included such amounts.

However, the FCA referred to previous case law in holding that a subsequent reassessment does not nullify prior assessments. Therefore, the initial assessment was an assessment made before the end of the normal reassessment period. The partnership income included in the taxpayer’s income for 1998 under that initial assessment could therefore be included in a reassessment issued after the normal reassessment period without contravening subsection 152(5).

Lessons learned

The main takeaway from this case for taxpayers is to ensure they understand the scope and application of any settlement agreement before they sign it. Seeking advice from an advisor is recommended. In this case, the difference between the taxpayer’s interpretation of the agreement and the CRA’s interpretation was significant and, as with many tax cases, the issue took several years to resolve. The FCA’s clarification of the limitation imposed by subsection 152(5) is also welcome.

  

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Chapter 3

Recent Tax Alerts – Canada

Tax Alerts cover significant tax news, developments and changes in legislation that affect Canadian businesses. They act as technical summaries to keep you on top of the latest tax issues.

Summary

For more information on EY’s tax services, visit us at https://www.ey.com/en_ca/tax. For questions or comments about this newsletter, email Tax.Matters@ca.ey.com.  And follow us on Twitter @EYCanada.

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By EY Canada

Multidisciplinary professional services organization