Unreported Income, Gross Negligence Penalty

Thursday, February 14, 2013

Case Citation

Murugesu v. The Queen (2013 TCC 21) [TCC] [CanLII]

Summary

A taxpayer and his corporation were engaged in placing workers with a farm in southern Ontario. As an immigrant with limited knowledge of language, laws etc. he relied on an accountant to prepare his personal tax return and those of his corporation. In doing so, the reported amounts did not reflect the facts. CRA sought to assess him and the corporation for unreported income as well as apply the gross negligence penalty under 163(2) of the Income Tax Act.

Part of the confusion lies with the fact the corporation paid some workers in cash and thus while the revenue of the corporation was understated, its cash payments for wages was also understated—a fact lost on the CRA and hence this appeal.

To the extent any funds paid from the corporation to the taxpayer were not included in income, the respondent (CRA) did not provided sufficient evidence to refute the testimony of the taxpayer.

Since the judge found no unreported income with his personal tax return, there could be no gross negligence penalty. That was not the case for the corporation, a portion of the assessed amount was unreported but did the penalty apply?

The burden is on the government to show the taxpayer acted in a way that warrants the gross negligence penalty. They could not. The judge found the taxpayer was a credible witness who unknowingly relied on an incompetent accountant. Further, the notion the penalty was assessed primarily based on the quantum of the unreported income was not relevant in determining if a person “knowingly, or under circumstances amounting to gross negligence” made a false statement in a return.

It seems to me a more thorough investigation by the CRA would have avoided this appeal. It appears they made assumptions instead of gathering facts about the taxpayer’s situation.

Issue

[14] I will first consider the Corporation’s appeal with respect to its 2002 fiscal year. The sole issue before the Court is whether the Corporation incurred an expense for wages in excess of the $301,305 reported on its 2002 income tax return.

[29] As I noted previously, the Minister assumed that Mr. Murugesu appropriated all of the unreported income of the Corporation. As a result, she included the amount of the unreported income in his income under subsection 15(1) of the Act on the basis that the Corporation had conferred a benefit on Mr. Murugesu.

ITA / ETA

| 15(1)—Benefit conferred on shareholder |
| 163(2)—False statements or omissions |

Cases Cited

| Venne v. Canada ([1984] C.T.C. 223) |

Analysis

[11] Mr. Murugesu does not know why his accountant understated the Corporation’s gross revenue. He accepts that the Corporation did understate its gross revenue by $171,142 on its income tax return; however, he argues that the First Accountant also substantially understated the Corporation’s wage expense. As a result, the unreported income is substantially less than $171,142. He also argues that the Corporation should not be subject to a gross negligence penalty.

[12] The Minister assessed Mr. Murugesu personally in respect of the $171,142 of purported unreported income. She included in his taxable income a $171,142 shareholder benefit pursuant to subsection 15(1) of the Income Tax Act (the “Act”) and imposed a $22,560 gross negligence penalty.

[23] I have reviewed the numerous time cards for the workers paid in cash that are included in Exhibit A-1. I agree with counsel for the Respondent that the hourly rates shown on the time cards are lower than the hourly rates used to calculate the Corporation’s fees. This is consistent with Mr. Murugesu’s testimony. Further, in my view, it shows that the Corporation has not attempted to overstate the cash wages it paid to certain of its workers.

[27] Exhibit R-12 provides a breakdown of the $301,305 that the First Accountant reported on the Corporation’s 2002 income tax return as wages. This breakdown shows that $59,917 of the $301,305 was for cash wages. As a result, I have concluded that the Corporation understated by $88,856 the wages reported on its 2002 income tax return. This represents the difference between the actual cash wages of $148,773 and the amount reported by the accountant, $59,917.

[28] In summary, the Corporation understated its 2002 income by $82,286, that is, the difference between its unreported gross revenue of $171,142 and the $88,856 understatement of its cash wages.

[38] I do not find the schedule particularly helpful. It certainly does not support a finding that Mr. Murugesu appropriated the $82,286 of income that the Corporation failed to report on its income tax return.

[39] The withdrawals identified by Ms. Moore [CRA Investigator] would appear to consist of the wages paid to Mr. Murugesu ($52,182), whatever wages the Corporation paid to Mr. Murugesu’s spouse and a portion of the $148,773 in cash payments that the corporation made to its workers.

[40] It is my view that the objective evidence before me supports Mr. Murugesu’s testimony that he did not appropriate any amounts from the Corporation.

[41] The Minister levied gross negligence penalties in respect of Mr. Murugesu’s 2000, 2001 and 2002 taxation years. The Minister also levied a gross negligence penalty of $11,227 in respect of the Corporation’s 2002 taxation year.

[42] Since I have found that Mr. Murugesu did not receive a shareholder’s benefit in 2002, the penalty in respect of his 2002 taxation year will be removed.

[44] Pursuant to subsection 163(3), the burden of establishing the facts justifying the assessment of the penalty is on the Minister.

[45] As Justice Strayer stated in Venne v. The Queen, [1984] C.T.C. 223 (FCTD) at 234:

. . . “Gross negligence" must be taken to involve greater neglect than simply a failure to use reasonable care. It must involve a high degree of negligence tantamount to intentional acting, an indifference as to whether the law is complied with or not . . . .

[46] Ms. Moore testified that she made the decision to levy the gross negligence penalties. She testified that she based her decision on the magnitude of the unreported amounts, the fact that Mr. Murugesu and the Corporation made cash withdrawals and the fact that Mr. Murugesu used some of the cash withdrawals to purchase a new condominium. She also referred to a “rough source and applications of funds” analysis. However, the Respondent did not provide the Court with the analysis.

[47] Ms. Moore testified that she never had a conversation with Mr. Murugesu or any employee of the Corporation. Notwithstanding the fact that Sargent Farms had provided her with the employees’ time sheets, she was not aware that the Corporation paid some of its employees in cash.

[48] After reviewing all of Ms Moore’s testimony, it appears to me that she based her decision to levy the gross negligence penalties primarily on the magnitude of the unreported income. This in my view is not a sufficient fact, in and of itself, to justify the imposition of the gross negligence penalties.

[49] Mr. Murugesu testified that, because of his very limited understanding of English and the Canadian taxation system, he relied on the First Accountant to properly prepare and file his tax returns. He had no idea that the tax returns filed by the First Accountant were incorrect.

[50] Once an official from the CRA came to his home to discuss the problems with regard to his tax returns he immediately fired the First Accountant and hired a new accountant.

[51] Counsel for the Respondent did not adduce any evidence either through Ms. Moore or through his cross-examination of Mr. Murugesu that would undermine Mr. Murugesu’s credibility. As I noted previously, I found Mr. Murugesu to be a credible witness.

Decision

[56] Accordingly, the Corporation’s appeal in respect of its 2002 taxation year is allowed with costs. The reassessments are referred back to the Minister for reconsideration and reassessment on the basis that the Corporation, when filing its income tax return, understated its income by $82,286. The subsection 163(2) gross negligence penalty will be vacated.

[57] Mr. Murugesu’s appeal in respect of his 2000, 2001 and 2002 taxation years is allowed with costs. The reassessments are referred back to the Minister for reconsideration and reassessment on the basis that no amount should be included in his income for the 2002 taxation year under subsection 15(1). All subsection 163(2) penalties will be vacated.

Note

A paragraph beginning with a number in square brackets is a direct quote from the case.

Another Case of Unreported Income

Saturday, February 2, 2013

Case Citation

Zhang v. The Queen (2013 TCC 19) [TCC] [CanLII]

Summary

Unreported income.

Issue

[1] Wen Zhang appeals assessments made under the Income Tax Act in which Mr. Zhang’s income was determined by what was referred to as an application of funds method. Under this method, the Minister assumed that Mr. Zhang’s personal expenditures were funded from unreported income to the extent that the expenditures exceeded other known sources of funds. Mr. Zhang submits that the assessed amounts were loans and not unreported income.

ITA / ETA

| 152(4)—Assessment and reassessment |
| 152(3.1)—Definition of “normal reassessment period” |

Cases Cited

None.

Analysis

[5] Mr. Zhang testified that when his brother and sister lost their jobs in China, he suggested that they start a business of selling crystal minerals on eBay.

[9] The eBay business earned annual revenues in the neighbourhood of $1,000,000 during the period at issue.

[11] The Canada Revenue Agency (CRA) became aware that Mr. Zhang had eBay accounts, and they contacted him for further information. In the initial call Mr. Zhang denied having eBay or PayPal accounts, but he acknowledged the accounts in a subsequent conversation. After further investigation, the CRA determined that Mr. Zhang had approximately 40 bank accounts associated with the eBay business to which significant deposits were made.

[12] The CRA was not provided with any business records to verify the reported income. Accordingly, income was determined using the “application of funds” method. The starting point was a determination of Mr. Zhang’s actual personal expenditures. These amounts were then reduced by known sources of funds, and the balance was assumed to be unreported income from the consulting business.

[16] The first issue is whether the assessed amounts are income or loans.

[17] One of the major difficulties that I have with Mr. Zhang’s position is that it depends largely on his own self-interested testimony. No business records were provided for either the eBay business or Mr. Zhang’s consulting business, and there was no contemporaneous supporting documentation regarding either the commissions or the loans.

[19] First, Mr. Zhang did not provide detailed testimony as to the assistance that he provided for the eBay business. For example, in the notice of appeal Mr. Zhang stated that he taught the brother and sister how to sell on eBay and that he opened eBay and PayPal accounts for them. However, it came out in cross-examination that Mr. Zhang opened a great many bank accounts for the business and managed the funds. This suggests that Mr. Zhang may have been quite involved in the day‑to-day business activity and may have earned more than the modest commission that was reported in the income tax returns.

[20] Second, there was no clear reconciliation between what Mr. Zhang said he earned as commission and what was reported in the income tax returns. Mr. Zhang provided some explanations but the explanations seem to raise more questions than answers.

[22] Further, if Mr. Zhang owed money to his sister and brother I find it implausible that he would not keep a record of these amounts.

[23] The lack of contemporaneous documentation is a serious problem in this case because there is nothing to corroborate Mr. Zhang’s self-interested testimony. Taxpayers are required to keep satisfactory records so that their income can be verified.

[26] A second issue concerns the assessment for the 2006 taxation year which was made beyond the normal reassessment period. The Crown submits that the assessment was properly made under s. 152(4) of the Act because the under‑reporting of income was willful.

[27] The Crown bears the burden to establish that the failure to report income was careless, negligent or willful. It has met this burden by establishing that Mr. Zhang withdrew more from the eBay business than what was reported, and that he attempted to hide this source of income from the CRA. A credible case has been made that Mr. Zhang knowingly under-reported the income, and Mr. Zhang has failed to provide reliable evidence to rebut this finding. I would conclude that the assessment for the 2006 taxation year is not statute barred.

Decision

[28] The appeal will be dismissed.

Note

A paragraph beginning with a number in square brackets is a direct quote from the case.

First Tax Case of 2013

Wednesday, January 16, 2013

The first Tax Court of Canada decision of 2013 is out: Jack v. The Queen (2013 TCC 1).

The case deals with the application of a penalty under subsection 163(1) of the Income Tax Act. The taxpayer failed to report income. The penalty is 10% of the unreported income and is on top of whatever taxes are owing on that income. Nothing the taxpayer presented in court swayed the judge to reverse the penalty and the assessment was allowed. Her defence seems to be ignorance with a touch of indifference plus putting blame on her tax return preparer.

The judge writes,

[19] Ms. Jack did not exercise a reasonable degree of due diligence in the filing of her 2009 tax return or of her 2008 tax return. The amount of income that Ms. Jack failed to report, $60,000, was not an insignificant amount that the failure of which, as in Symonds v. R., 2001 TCC 274 (sic), would be innocent.
[20] There is a difference between innocent and careless. I have no doubt Ms. Jack's failure to report $60,000 was not deliberate but it was due to her reckless or careless disregard of her obligation to report all of her income in a tax return for an appropriate year.

Note the case reference should be 2011 not 2001.

That’s One Large Tax Bill

Thursday, September 22, 2013

In Nowak v. The Queen (2011 TCC 3) [TCC] the Tax Court of Canada addressed the issue of the Canada Revenue Agency's reassessments of an individual with unreported income.

The facts of the case are cloudy for a number of reasons. The taxpayer's records of his income and expenses were incomplete and inconsistent. He was reluctant to answer questions posed by the auditor. And documents provided by the taxpayer raised more doubts and questions in the mind of the judge.

The CRA claimed the taxpayer had unreported income in excess of $290,000 during the two tax years in question. The auditor determined these amounts from an analysis of banking records. In essence, the records showed deposits that were clearly not reported as income.

As the judge notes, the burden is on the taxpayer to demonstrate the money received is not income subject to tax.

In this case the judge writes,

[25] The first issue is whether the Appellant failed to report income in his 2000 and 2001 taxation years. This issue turns mainly on the credibility of the Appellant and his spouse, and for the reasons that follow, I do not believe their testimony concerning the source of the unidentified bank deposits. I find their explanations unconvincing and implausible, and very little in the way of corroboration was presented to the Court. The few documents they did produce raise as many questions as they answer.

[42] I find therefore that the Appellant has not shown on a balance of probabilities that the unidentified bank deposits were not income to him in his 2000 and 2001 taxation years.

It would appear the taxpayer spun a story about where the money came from and it wasn't credible, hence he lost.

The second issue raised was the assessment of the gross negligence penalty under subsection 163(2) of the Income Tax Act. The provision can be summarized as: a 50% penalty of the tax owing where a taxpayer knowingly makes a false statement in a tax return. In this case, did the taxpayer knowingly understate his income?

In citing previous cases on this issue, the judge points out the burden of proof is on the government to show the taxpayer knowingly misrepresented his income.

Once the Ministère establishes on the basis of reliable information that there is a discrepancy, and a substantial one in the case at bar, between a taxpayer's assets and his expenses, and that discrepancy continues to be unexplained and inexplicable, the Ministère has discharged its burden of proof. It is then for the taxpayer to identify the source of his income and show that it is not taxable.

[49] These comments would appear equally applicable in a case such as this one where it has been shown that the taxpayer has had a substantial unexplained increase in his assets. I find that the Respondent has shown that there is a substantial discrepancy between Mr. Nowak’s income in the form of deposits to his bank account and his reported income, and that at the end of the day, this discrepancy remains unexplained.

In losing his appeal, the taxpayer faces a large tax bill. First, there is the tax owing on the unreported income for the 2000 and 2001 tax years. Second, there is arrears interest covering a period of a decade--that's a lot of interest. Finally, there is the 50% penalty. Add up these amounts and it's between two-thirds to 100% of the unreported income.

The lesson. First, don't understate your income. You'll get caught and be subject to a larger tax bill than if you had reported the income and paid tax on it.

Second, if in the past you have unreported income and the CRA hasn't started an investigation, it's time to consider the Voluntary Disclosure Program.