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Good News for Farmers: Supreme Court of Canada Clarifies Proper Interpretation of Restricted Farm Loss Rules

This morning the Supreme Court of Canada released its decision in Canada v. Craig, 2012 SCC 43 (“Craig”). It’s good news for farmers, especially those farmers that need to work off the farm to make ends meet.

Mr. Craig’s horse racing business incurred losses of $222,642 in 2000 and $205,655 in 2001. Mr. Craig is also a lawyer. He reported the farm losses and used them to reduce his taxable income from his legal practice.

The Canada Revenue Agency reassessed Mr. Craig denying his claim of farm losses by applying the restricted farm loss rule contained in subsection 31(1) or the Income Tax Act which, when applicable, operates to restrict farm losses to a maximum of $8,750.

The restricted farm loss rules apply unless the taxpayer can show that:

1. farming is the taxpayer’s chief source of income; or

2. a combination of farming and some other source of income is the taxpayer’s chief source of income (the “combination test”).

The CRA relied on a 1978 Supreme Court of Canada decision Moldowan v. The Queen, [1978] 1 S.C.R. 480 (“Moldowan”) in applying the restricted farm loss rules to Mr. Craig’s horse racing business.

The Moldowan decision interpreted the combination test and found that the restricted farm loss rules applied because the taxpayer’s farming business was subordinate to the taxpayer’s other source of income. In other words, Moldowan found that if farming income is subordinate to the other source of income the restricted farm loss rules apply to limit the amount of loss that can be claimed. This left taxpayers in a situation where they had to demonstrate that farming was the predominant source of income in order to avoid the application of the restricted farm loss rules.

The Moldowan decision was widely criticized as reading language into the legislation that was not actually there.

Because of the Moldowan decision, the combination test was effectively read out of the legislation. If a taxpayer could show that farming was the predominant source of income, then that taxpayer would have to rely on the first exception to the restricted farm loss rules: the taxpayer would have to prove that farming was the taxpayer’s chief source of income.

The Supreme Court of Canada decision in Moldowan effectively ignored the combination test in subsection 31(1) and drew much criticism but stood as a precedent for over 30 years.

In 2006 the Federal Court of Appeal addressed similar facts in Gunn v. Canada, 2006 FCA 281 (“Gunn”) and decided not to follow and purported to overrule Moldowan because it considered Moldowan to be wrongly decided. However, the Federal Court of Appeal is not permitted to overrule binding precedent from the Supreme Court of Canada.

This created some uncertainty for taxpayers, tax professionals, the CRA and the Tax Court of Canada.

This uncertainty is now resolved by today’s decision of the Supreme Court of Canada in Craig. The Supreme Court of Canada decided that, although the Federal Court of Appeal should not have purported to overrule a Supreme Court of Canada decision, the Federal Court of Appeal’s reasoning in Gunn was correct.

In Craig the Supreme Court of Canada overruled Moldowan.

Accordingly, it is no longer necessary for a taxpayer to show that farming is the predominant source of income in order to avoid the application of the restricted farm loss rules.

The taxpayer must only show that the combination of farming and some other source of income are in aggregate the taxpayer’s chief source of income. The following excerpt from Craig at paragraph 41 provides some useful guidance:

“The provision still contemplates that the taxpayer will devote significant time and resources to the farming business, even if he or she will also devote significant time and possibly resources to another business or employment. It seems to me that, as long as the taxpayer devotes considerable time and resources to the farming business, the fact that another source of income produces greater income than the farm does not mean that such a combination is not a chief source of income for the taxpayer.”

Here is the full decision: http://scc.lexum.org/en/2012/2012scc43/2012scc43.html.

Applying for an Extension of Time to File a Notice of Objection

In my last post, I explained the deadline for Objecting to an Assessment/Reassessment and the process for applying for an extension of time to object if the initial 90 day deadline is missed. 

A taxpayer has a right to dispute an Assessment/Reassessment by filing a Notice of Objection.  That right must be exercised within the 90 days after the date the Assessment/Reassessment is sent to the taxpayer. 

If the taxpayer fails to object within that 90 deadline but would like to object after the deadline has passed, the taxpayer may file an Application for an Extension of Time to Object.  An Extension of Time to Object will only be granted where the following four requirements are satisfied:

  1. the application for an extension of time has been made within one year after the 90-day period for objecting has expired;
  2. the taxpayer was unable to act within the 90-day period for objecting or had a bona fide intention to object within the 90-day period for objecting;
  3. it is just and equitable to grant the application for an extension; and
  4. the application for an extension was made as soon as practicable.

Generally, if the taxpayer has not filed a Notice of Objection within the 90-day objection period and the taxpayer did not make an Application for an Extension of Time to Object within one year after the 90-day objection period has expired, the taxpayer does not have any further opportunity to dispute the Assessment/Reassessment. 

In such circumstances, the Assessment/Reassessment stands and the taxpayer has lost his or her right to dispute the assessment of tax.

There have been rare circumstances where the taxpayers have successfully advanced arguments after more than one year and 90-days have elapsed, which resulted in a Notice of Objection being accepted.  These two cases from 2011 illustrate arguments that can be raised by a taxpayer who failed to file a Notice of Objection within the 90-day deadline and failed to file an Application for an Extension of Time to Object within the one year and 90-day period.

Lambo v. R., 2011 TCC 293

In Lambo v. R., 2011 TCC 293, the taxpayer made an application for an extension of time to object.  The CRA denied the application for extension of time to object because the application was not made within one year after the expiration of the 90-day deadline for objecting.

The taxpayer filed a Notice of Objection after the 90-day deadline expired but before the one-year deadline to file an application for extension of time.  However, the taxpayer did not formally make an application to extend time to object.  

The Tax Court of Canada decided that, despite not make a formal application to extend time, the taxpayer had demonstrated an attempt to dispute the reassessments and had otherwise satisfied the four requirements for the granting of an extension of time to object.  

In Lambo, the Tax Court of Canada also confirmed that the CRA has the burden of proving the Notice of Assessment exists and its date of mailing.  The clock does not start ticking on the 90-day deadline to object or the subsequent one-year deadline to apply for an extension of time to object, until the Notice of Assessment or Reassessment has been issued and mailed. 

Melanson v. R., 2011 TCC 569

In Melanson, the taxpayer was assessed by two Notices of Assessment dated March 17, 2009.  The taxpayer did not file a formal Notice of Objection until January 27, 2011.  This Notice of Objection was filed well after the 90-day deadline for objecting and after the one-year and 90-day deadline for an application to extend time to object.

However, the Tax Court of Canada found that the taxpayer had sent a letter to the CRA on June 17, 2009.  The letter was virtually identical to the Notice of Objection which was later filed in January, 2011 except the letter did not formally meet the requirements to be a Notice of Objection because it was not addressed to the Chief of Appeals at the appropriate CRA office.  The letter was sent two days after the expiration of the 90-day deadline for objecting. 

The Tax Court of Canada stated that “there is going to be a reluctance to see a taxpayer’s entitlements derailed on the basis of some formality.”  The Tax Court of Canada further stated that the taxpayer “took reasonable steps to comply with the law and acted on incorrect written information given by the Agency when she was told how to file an objection without being warned that she was already past the 90-day limitation period.” 

The Tax Court of Canada sent the matter back to the CRA to reconsider stressing that the CRA could:

  1. treat the June 17, 2009 letter as an application for an extension of time to object and waive the formal requirements regarding how to make an application for an extension of time to object; or
  2. accept the June 17, 2009 letter as a valid objection by waiving either:
    • the requirement to file an application for an extension as a prerequisite to granting the extension; or
    • extending the deadline for filing the objection.

 The Tax Court of Canada stated that “under either of these approaches, the June 17, 2009 letter could be accepted by the Minister as an objection.”

Conclusion

In conclusion, the above two cases provide creative arguments that could be raised with the CRA or the Tax Court of Canada in some circumstances.  The two cases also suggest that the Tax Court is encouraging the CRA to exercise leniency with respect to whether taxpayers comply with the formal requirements of the Income Tax Act in this context

In both of the above cases, the situation would have been more easily resolved had the taxpayers had been mindful of the statutorily imposed deadlines and made objections or applications to extend time to object that met the formal requirements of the legislation within the statutorily imposed deadlines.

 

Deadline to Object

Deadline for Objecting to an Assessment/Reassessment

A taxpayer has the right to object to a Canada Revenue Agency assessment of tax.  Objecting is the first formal step a taxpayer takes in disputing the assessment.  The right to object must be exercised within 90 days of the date the Notice of Assessment or Reassessment was mailed to the taxpayer.  The right to object is exercised by filing a Notice of Objection with the Chief of Appeals of the CRA. 

The 90-day deadline to prepare a Notice of Objection requires prompt action by the taxpayer.  The taxpayer must gather its resources quickly in order to prepare a persuasive and comprehensive objection. 

 Extension of Time to Object

 If a taxpayer does not file a Notice of Objection within the 90-day deadline but wants to contest the assessment of tax, the taxpayer must file an application for an extension of time to object. 

 There are four requirements that must be met in order for a taxpayer to obtain an extension:

  1. the application for an extension of time must be made within one year after the 90-day period for objecting has expired;
  2. the taxpayer must demonstrate that it was unable to act within the 90-day period for objecting or had a bona fide intention to object within the 90-day period for objecting;
  3. the taxpayer must demonstrate that it is just and equitable to grant the application for an extension; and
  4. the taxpayer must demonstrate that the application for an extension was made as soon as practicable.

 A persuasive and effective application to extend time to object specifically addresses each of these four requirements and includes an explanation of how each requirement is satisfied.

If the CRA denies the extension the taxpayer can apply to the Tax Court of Canada.  The Tax Court of Canada will make a decision with reference to the same four requirements.  The deadline for applying to the Tax Court of Canada is 90 days after the CRA denies the application for an extension of time to object. 

If more than one year and 90-days has elapsed since the date the assessment or reassessment was mailed to the taxpayer, the taxpayer does not have a right to object to the reassessment and no extension of time to object can be granted by the CRA or the Tax Court of Canada. 

Typically, where a taxpayer has failed to file a Notice of Objection within the 90-day deadline and has also failed to file an application for an extension of time to object within one year of the expiration of that 90-day deadline, the taxpayer is out of luck.  Typically in such circumstances, the reassessment stands and the taxpayer has lost its opportunity to dispute the assessment of tax.  There have been some creative arguments advanced that have resulted in taxpayer success outside the one year and 90-day period.  My next post will review two of these decisions.

Supreme Court of Canada Releases GAAR Decision

On December 16, 2011 the Supreme Court of Canada (SCC) released its decision in Copthorne Holdings Ltd. v. Canada, 2011 SCC 63 (Copthorne).  The full decision can be viewed on the SCC Judgements website at http://scc.lexum.org/en/2011/2011scc63/2011scc63.html.

 Copthorne involved the application of the General Anti-Avoidance Rule, or as it is commonly referred to, GAAR. 

 GAAR applies to deny the tax benefit of a transaction or series of transactions despite the fact that the taxpayer seems entitled to the tax benefit on a technical reading of the relevant legislation. 

 In order for GAAR to apply three requirements must be met: 

  1. a tax benefit must arise from a transaction or series of transactions;
  2. the transaction or series of transactions must be an “avoidance transaction” as defined in subsection 245(3) of the Income Tax Act; and
  3. the tax benefit must be a misuse or abuse of the relevant provisions of the tax legislation.

In Copthorne the SCC applied tests enunciated in previous decisions applying GAAR.  The SCC found that all three elements required to apply GAAR had been satisfied and denied the tax benefit of the series of transactions.

Copthorne involved a horizontal amalgamation of two sister corporations and subsequent redemption of shares by the parent company.  The series of transactions was structured in such a way that the “paid up capital” of the redeemed shares exceeded the original investment with the result that the redemption of the shares did not trigger any tax. 

The SCC found that: (1) there was a tax benefit; (2) the series of transactions included a transaction that was an avoidance transaction; and (3) the tax benefit was a misuse or abuse of a provision of the Income Tax Act

Of particular note is that the SCC found that it is not enough that a transaction is a misuse or abuse of tax policy.  The misuse or abuse must be tied to a specific provision or provisions. 

If you are engaged in a transaction that provides you with a tax benefit you must not only analyze whether you are technically entitled to the tax benefit, but you must also be alive to whether GAAR could apply to deny the tax benefit. 

 

How Can I be Assessed for Someone Else’s Tax Debt? – Section 160(1) Assessments

Receiving a tax assessment or reassessment from the Canada Revenue Agency (CRA) is often alarming.

Imagine receiving a tax assessment that makes you liable to pay another person’s tax debt. Being assessed for someone else’s tax debt can be downright shocking.

The CRA has a collection tool at its disposal that allows it to assess a person for someone else’s tax debt and collect some or all of the tax debt from that other person.

Pursuant to subsection 160(1) of the Income Tax Act, where a tax debtor transfers property to a person with whom the tax debtor does not deal at arm’s length, and the tax debtor receives less than fair market consideration for that transferred property, the CRA can assess the recipient of the property for some or all of the tax debt of the transferor of the property.

The recipient of the property can be assessed the lesser of:

1. the tax debt owing by the transferor; and

2. the difference between the fair market value of the transferred property and the consideration received by the transferor.

Example

Perhaps it is easiest to understand Section 160 Assessments by way of an example.

Joe has a tax debt relating to his 2005 taxes. Joe owes $300,000 in taxes and interest from 2005.

Joe has a brother Alex. Joe and Alex purchased a vacation property together in Canmore, Alberta in the 1980s. They paid $40,000 for the vacation property ($20,000 each) but it is now worth $180,000.

Joe and Alex shared the use of the vacation property for many years. They never intended to sell it.

In 2006 Joe was transferred by his employer to Halifax, Nova Scotia. Joe hasn’t used the property since his move and decided that he has no use for the vacation property.

Joe sells Alex his interest in the vacation property for $20,000 cash (the amount Joe paid for his ½ interest) allowing Alex to become the sole owner of the vacation property.

In the above scenario it is possible for the CRA to assess Alex for $70,000 of Joe’s tax debt.

Joe has transferred his ½ interest in the vacation property to Alex. Joe and Alex do not deal at arm’s length. Joe has not received fair market consideration for his interest in the vacation property. Joe’s tax debt existed at the time of the transfer.

The CRA can only assess Alex for $70,000 (not the entire $300,000 tax debt owed by Joe) because a section 160 assessment is limited by the fair market value of the transferred property less any consideration received by the transferor. The vacation property was worth $180,000 so Joe’s ½ interest was worth $90,000 and he received $20,000 in consideration.

The Tax Court of Canada has indicated that knowledge of the tax debt and intent to evade collection action of the CRA can be relevant to deciding whether a section 160 assessment should stand, however, intention and knowledge are not key components of the legislation.

Alex can be assessed pursuant to section 160 even if he didn’t know about Joe’s tax debt and even if the transfer of the property had nothing to do with the tax debt or the collection action of the CRA.

How to dispute a Section 160 Assessment?

The key components of a section 160 assessment are:

1. a person has a tax debt (the tax debtor) that exists from the year of the transfer or a preceding year;

2. the tax debtor transfers property to a person (the recipient);

3. the tax debtor does not deal at arm’s length with the recipient; and

4. the tax debtor receives less than fair market consideration for the transferred property.

Each of the key components of section 160 presents a potential argument for disputing a section 160 assessment. If you are disputing a CRA section 160 assessment by filing a Notice of Objection to the CRA Appeals Division or filing a Notice of Appeal to the Tax Court of Canada consider whether any or all of the following arguments might be convincing in your circumstances:

1. the tax debt arose after the transfer that is being impugned in the section 160 assessment;

2. there was no transfer of property from the tax debtor to the person being assessed;

3. the tax debtor and the person being assessed deal at arm’s length;

4. the fair market value of the transferred property is an amount less than the CRA has assessed; and

5. the tax debtor received fair market consideration for the transferred property.

When considering the argument that the tax debtor received fair market consideration for the transferred property, it is important to think of various types of consideration. For instance labour that had been expended by the recipient could be consideration for the transferred property, or a prior debt owing to the recipient that is offset by the transfer of property could be consideration for the transferred property.

It is also possible for a person assessed pursuant to section 160 to argue that the underlying tax debt (the transferor’s tax debt), is not correct.

Last Thoughts

Typically the CRA does not resort to collection under a section 160 assessment until it has attempted and failed to collect the amount from the original tax debtor.

However I have recently seen situations where the CRA has issued section 160 assessments without attempting to collect from the original tax debtor and without any indication that the CRA would be unsuccessful in collecting from the original tax debtor.

How Far Back Can The CRA Go to Reassess Me?

Many clients ask me, “How long can the Canada Revenue Agency assess me for?”

Or put another way, “How long until I am safe from a CRA reassessment for any given year?”

In civil litigation the period of time that a person has to start an action is called the “limitation period”. In tax disputes, this is not referred to as a limitation period, but instead is referred to as the “normal reassessment period”.

For most Canadian taxpayers, the normal reassessment period for income tax is three years. This means that the CRA has three years from the date that your tax return for a particular year is initially assessed to reassess.

For example, if you are an individual and you filed your return for the 2008 taxation year on April 30, 2009 (i.e. on time), and the CRA issued a Notice of Assessment for that return on June 1, 2009, then the normal reassessment period for your 2008 taxation year will expire on June 1, 2012.

It is the initial assessment of a taxation year that starts the clock counting on the normal reassessment period. This means that if you do not file a return resulting in an assessment, then the clock does not begin to count and the normal reassessment period for that year will never expire.

Mutual fund trusts and corporations that are not Canadian-controlled private corporations have a four year normal reassessment period.

After that normal reassessment period has expired, you can argue that a reassessment is not valid and should be vacated.  After the normal reassessment period has expired for a given year, we refer to an assessment of that year as being "statute-barred".

However, there are circumstances in which the CRA can reassess a statute-barred year. Most commonly, the CRA can reassess after the expiration of the normal reassessment period where:

1. the taxpayer signed and filed a waiver within the normal reassessment period in respect of the year; or

2. the taxpayer made a misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing the return or supplying information.

If these circumstances apply, there is no time limit on a CRA reassessment for that year.

However the CRA must prove that these circumstances apply. In other words:

1. the CRA must produce a waiver signed by you for the relevant taxation year; or

2. the CRA must prove that you made a misrepresentation on your tax return for the relevant year and they must prove that the misrepresentation was attributable to neglect, carelessness, wilful default or that you have committed any fraud in filing the return or supplying information.

If you are reassessed more than three years after you filed a return for a taxation year it is worth investigating whether the expiration of the normal reassessment period could be a reason to have that reassessment set aside. You will have to determine when that return was initially assessed in order to figure out when the normal reassessment period expired.

If you want to rely on the expiration of the normal reassessment period you must raise that argument with the CRA Appeals Division or as a ground of appeal in your Notice of Appeal to the Tax Court of Canada.

Fixing a Mistake

One of the main jobs of the Canada Revenue Agency (Revenue Canada) is to ensure that the proper amount of tax is assessed on transactions such as a sale of property or a sale of shares. But what happens if Revenue Canada misinterprets the transaction and thinks that you have done something that triggers tax when it really doesn’t? What happens if you think you are doing a transaction which you think is tax free but in fact it triggers all kinds of unexpected taxes, interest and penalties? There are special tax rules which allow a person to transfer property or shares to a corporation without triggering any tax. But what if you make a mistake and you don’t qualify for the tax-free transfer?

In all of the foregoing situations, Revenue Canada can assess tax, interest and possibly penalties based on their assumptions about the transaction. But what if they are wrong? What if you disagree?

Can you tell Revenue Canada that they have misinterpreted the transaction or explain that it was a mistake and therefore they should them cancel the tax, interest and penalties? You can try but don’t be too optimistic. Don’t expect Revenue Canada to be too sympathetic. Revenue Canada auditors usually have accounting training. They are not experts on the laws governing contracts, corporations or transfers of property or shares.

Using the tax appeal system may not be the correct solution. Interpreting property laws and contracts and property and share transactions is not really within the jurisdiction of Revenue Canada or even the Tax Court. An appeal may result in the Tax Court saying that it does not have the jurisdiction to give you the relief you are asking for.

The tax appeal system is designed to deal with disputes about the application of tax law. But contract law, corporate law and the laws dealing with a transfer of property or shares is generally governed by Provincial/Territorial laws in Canada and not Revenue Canada or the Federal Courts. So it may be best to make an application to the Supreme Court or the Superior Court of the Province or Territory to interpret the contract or to determine whether a transfer did or didn’t actually occur at law.

If a Court of the Province or Territory makes a finding that a particular transaction is different than Revenue Canada thinks or is null and void, it will generally be binding on Revenue Canada and your tax assessment will be cancelled.

So not every dispute about tax is resolved within the tax appeal system. In some cases like mistake or a dispute about the terms of a contract or who owns a particular property or whether or not there actually was a transaction that triggered tax, you need to look at Provincial/Territorial property laws rather than tax laws.

Fighting the Imposition of Gross Negligence Penalties

The Canada Revenue Agency can impose gross negligence penalties in addition to the assessment of tax. Gross negligence penalties are imposed under subsection 163(2) of the Income Tax Act.

Under the Income Tax Act gross negligence penalties are determined with reference to the amount of tax owing: gross negligence penalties are 50% of the amount of the tax owing.

Accordingly, the amount of the penalty can be very significant.

It seems that CRA auditors often assess gross negligence penalties in inappropriate circumstances. It is often worth fighting the imposition of these penalties (even where you accept that the assessment of tax is correct).

Unlike most issues in tax disputes the CRA bears the burden of proving that gross negligence penalties should be imposed. Gross negligence penalties should only be imposed where the CRA can demonstrate that the taxpayer:

… knowingly, or under circumstances amounting to gross negligence, has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return.

Canadian courts have stated that the CRA should not be imposing gross negligence penalties unless the evidence clearly justifies it:

  • The onus is greater than on a balance of probabilities, and closer to the criminal onus under the Criminal Code than it is to a balance of probabilities.
  • Because subsection 163(2) is penal in nature, the provision merits a higher degree of culpability and must be imposed only where the evidence clearly justifies it. If the evidence creates any doubt, that it should be applied in the circumstances of the appeal, then the only fair conclusion is that the taxpayer must receive the benefit of the doubt in those circumstances.

So what is gross negligence? It is a difficult concept to articulate but Canadian courts have attempted to describe what is meant by gross negligence:

  • "very great negligence";
  • "flagrant or glaring negligence,";
  • "negligence of conspicuous magnitude";
  • "negligence in a pronounced, striking or aggravated form";
  • "a relatively odious act of negligence, which is difficult to explain and socially inadmissible";
  • "a much greater degree of negligence amounting to reprehensible recklessness"; and
  • "a punishment for reprehensible behaviour".

These descriptions offered by Canadian courts help to illustrate the circumstances in which gross negligence penalties should and should not be applied and what is really meant by gross negligence.

We hope this is helpful in deciding whether or not you should contest the imposition of gross negligence penalties in your circumstances.

Taxpayer Relief: CRA’s Discretion is Clarified

The Canada Revenue Agency has the discretion to cancel penalties and interest assessed to a taxpayer. Applications for relief from interest and penalties are made under the taxpayer relief provisions of the Income Tax Act.

Until recently, the CRA took the position that it could only exercise its discretion where the application for relief was made by a taxpayer within 10 years of the tax year that gave rise to the tax on which the penalty and interest assessed. For example, the CRA’s position was that if a taxpayer was assessed tax and penalties in 1998, an application for relief from the penalties and any interest accumulated must be made before December 31, 2008 in order to be considered by the CRA for relief.

The CRA felt that its position was supported by the language of subsection 220(3.1) of the Income Tax Act.

On June 2, 2011 the Federal Court of Appeal clarified the proper interpretation of that subsection and concluded that the CRA’s position was wrong. The Federal Court of Appeal decision in Bozzer v. Minister of National Revenue confirms that the CRA has the discretion to grant relief from interest accrued in the most recent ten years even if the tax year that initially gave rise to the tax was more than ten years prior to the application for relief.

The Federal Court of Appeal found that this interpretation is consistent with the purpose of the legislation as articulated by the CRA in its own Information Circular:

The legislation gives the CRA the ability to administer the income tax system fairly and reasonably by helping taxpayers to resolve issues that arise through no fault of their own, and to allow for a common-sense approach in dealing with taxpayers who, because of personal misfortune or circumstances beyond their control, could not comply with a statutory requirement for income tax purposes.

If you have been assessed penalties or interest and feel that a waiver of interest or penalties would be fair and reasonable in your circumstances it is worth exploring the option of an application for relief.