Tax Avoidance Vs. Tax Evasion

It is a principle of tax law that taxpayers are entitled to arrange their affairs to minimize the amount of taxes they are required to pay. On this basis, the law differentiates between tax “evasion” and tax “avoidance.”

For a taxpayer’s actions to be considered tax “evasion,” the conduct must involve a deliberate violation of the tax laws. For example, a taxpayer commits tax evasion if they deliberately fail to report all taxable income or deduct made-up expenses on their tax returns. Tax evasion is illegal and is subject to prosecution under Canadian criminal laws. If you are interested in learning more about tax evasion, check out our blog post on tax evasion here.

Tax “avoidance” differs from tax evasion in that it does not involve the deliberate violation of the tax laws. Tax avoidance is essentially the ordering of one’s affairs (in accordance with the tax laws) in a way that minimizes the taxes that would otherwise be owed. Tax avoidance is merely concerned with minimizing tax, while tax evasion is about evading one’s legal liabilities. Tax avoidance will only be unlawful if it offends established judicial doctrines and statutory provisions such as the anti-avoidance rules.

Anti-Avoidance Rules

The Income Tax Act (“ITA”) contains provisions that disallow certain tax results sought by taxpayers through tax planning. These anti-avoidance rules are the “Specific Anti-Avoidance Rules” (“SAAR”) and the “General Anti-Avoidance Rule” (“GAAR“).

Specific Anti-Avoidance Rules (“SAAR”) 

The SAARs counter specific types of avoidance transactions, such as stop-loss rules, anti-income shifting rules, capital gains and surplus stripping rules. The SAARs are intended to combat particular types of avoidance transactions. They, therefore, contain very technical and detailed language detailing the scope of the transactions that offend the ITA.

General Anti-Avoidance Rule (“GAAR”)

The GAAR is set out in section 245 of the ITA and was introduced into the ITA in 1988 and amended in 2005. The GAAR gives the Minister of National Revenue (“Minister”) statutory powers to combat abusive tax avoidance transactions.

Unlike the SAARs, the GAAR is intended to cover a broad range of tax avoidance transactions. The GAAR is a measure of last resort that the Minister can invoke in denying otherwise successful avoidance transactions which SAARs and other ITA provisions fail to catch.

So, for example, if a taxpayer arranges an avoidance transaction that works to avoid the application of the SAARs, the Minister may invoke the GAAR in order to deny the avoidance transaction. Therefore, the GAAR is only applicable to an avoidance transaction after all of the other provisions of the ITA, including SAARs, have been exhausted. Therefore,while the SAARs are drafted in a very technical and specific language, the GAAR is drafted broadly in order to be able to cover offensive tax avoidance transactions that would otherwise be permissible under a literal interpretation of the provisions of the ITA.

Minister’s Ability to Invoke the GAAR

In the case of Lipson v. Canada, the Supreme Court of Canada stated that:

The GAAR is neither a penal provision nor a hammer to pound taxpayers into submission. It is designed, in the complex context of the ITA, to restrain abusive tax avoidance and to make sure that the fairness of the tax system is preserved. 

In the case of Canada Trustco Mortgage Co. v Canada, the Supreme Court of Canada set out a three-part test for invoking the GAAR. The three-part test is as follows:

    1. Is there a tax benefit arising from the transaction or series of transactions?

     (The burden is on the taxpayer to refute this part of the test)

    2. Is the transaction an avoidance transaction in the sense of not being arranged primarily for bona fide purposes other than to obtain the tax benefit?

     (The burden is on the taxpayer to refute this part of the test)

    3.  Is the avoidance transaction that gives rise to the tax benefit abusive?

(“Abusive” in the sense that it cannot reasonably be concluded that the transaction resulting in the tax benefit is consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer)

     (The burden is on the Minister to establish this part of the test)

Tax Consequences of the GAAR

The application of the GAAR to a tax planning transaction works to deny the tax benefit of the transaction. The consequence to the taxpayer is simply the loss of the tax benefit being sought. The application of the GAAR does not empower the Minister to impose any penalties (only interest on the taxes owing) and gives the Minister the power to assess the tax consequences to the taxpayer that are reasonable in the circumstances.

If the Canada Revenue Agency has assessed you under the GAAR, or if you want to know how the GAAR may impact your tax planning, contact our law firm today.

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By Kaveh Rezaei – Attorney at KR Law Firm

**Disclaimer 

This article contains information of a general nature only and does not constitute legal advice. All legal matters have their own specific and unique facts and will differ from each other. If you have a specific legal question, it may be appropriate to seek the services of a lawyer.

What is the “Sham Transaction” Doctrine 

The “sham transaction” doctrine is a legal concept that has been created by the courts to apply to circumstances where a taxpayer attempts to disguise a transaction to make it appear to be something that, in reality, it is not. As a result, the doctrine is an anti-avoidance doctrine that the Canada Revenue Agency (“CRA”) may rely on to attack a transaction they suspect lacks legitimacy.  

Historical Development of the Doctrine

The modern doctrine of sham in Canada originates from the English case of Snook v. London & West Riding Investments Ltd., where the English Court of Appeal defined the legal concept as: 

“… acts done or documents executed by the parties to the “sham” which are intended by them to give to third parties or to the Court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.” 

In order to meet the requirements of this definition, all parties involved in the transaction must have a common intention that the acts or documents do not create the legal rights and obligations which they give the appearance of creating. In other words, the elements of a sham require that the parties to a transaction together deliberately set out to misrepresent the actual reality of the transaction to a third party (i.e., the Minister of National Revenue).

In the Supreme Court of Canada case of Stubart Investment Ltd. v. R., the Supreme Court of Canada held that a “sham transaction” is 

“a transaction conducted with an element of deceit so as to create an illusion calculated to lead the tax collector away from the taxpayer or the true nature of the transaction.”

Therefore, for the sham doctrine to apply, there must be an element of deceit in the way that the transaction was constructed or conducted.

Sham Transactions vs. Tax Avoidance 

A sham transaction is different and distinct from transactions that can be labelled as tax avoidance transactions. Subject to the application of the General Anti-Avoidance Rule (“GAAR”) in appropriate cases, taxpayers are entitled to arrange their affairs in ways to minimize their tax burden, even if in doing so, they resort to detailed and elaborate plans that give rise to tax consequences that Parliament did not intend. Therefore, the tax avoidance transaction is lawful if the arrangement is not a sham and does not offend the GAAR. 

However, unlike tax avoidance, a sham transaction is a fraudulent transaction empowering court intervention. Courts will intervene in situations where a transaction can adequately be labelled a “sham.”

Court Interference in Sham Transactions 

The determination of whether a transaction is a sham is distinct from the correct legal characterization of a transaction. If a transaction is determined to be a sham, the Court will determine the true nature of the transaction from the extrinsic evidence (i.e., evidence other than the document(s) setting out the transaction). If the transaction is not a sham, the correct legal characterization of the transaction will be determined from the document(s) papering the transaction.

In cases where the Court finds that a transaction is a sham, it will consider the tax consequences of the actual transaction and disregard the one represented as the real transaction. This means that the Court will ignore the legal form of the sham transaction, declare the transaction a sham, and then ascertain the tax consequences of the real transaction.

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By Kaveh Rezaei – Attorney at KR Law Firm

**Disclaimer 

This article contains information of a general nature only and does not constitute legal advice. All legal matters have their own specific and unique facts and will differ from each other. If you have a specific legal question, it may be appropriate to seek the services of a lawyer.

The CRA is auditing taxpayers for “advantages” received from a “registered plan strip” relating to investments made with John Scholz, Northland Capital Inc., and Red Hill Capital Inc. 

Investment Restrictions on Registered Plans

The Income Tax Act (“ITA”) imposes certain investment restrictions on registered plans. Registered plans include retirement savings plans (RRSPs), registered education savings plans (RESPs), registered retirement income funds (RRIFs), registered disability savings plans (RDSPs), and tax-free savings accounts (TFSAs). 

These registered plans are only allowed to invest in property that is considered a “qualified investment.” These registered plans are also not allowed toinvest in property considered a “prohibited investment.” In addition, these registered plans must avoid any investments or structured transactions that aim to shift value into or out of the registered plans artificially or result in certain other supplementary advantages. 

These investment limitations are intended to safeguard against abusive tax planning and help ensure that registered plans do not provide tax advantages unrelated to their fundamental objectives. 

“Advantages” in Respect of Registered Plans and “Registered Plan Strips” 

A special tax is imposed under subsection 207.05(1) of the ITA if certain supplementary advantages are received in relation to a registered plan. An “advantage”in relation to a registered plan includes any benefit, loan or indebtedness that is conditional in any way on the existence of the registered plan. An “advantage” also includes a “registered plan strip” in respect of the plan. 

A “registered plan strip” is defined in subsection 207.01(1) of the ITA as: 

“the amount of a reduction in the fair market value of property held in connection with the registered plan, if the value is reduced as part of a transaction or event or a series of transactions or events one of the main purposes of which is to enable the controlling individual of the registered plan, or a person who does not deal at arm’s length with the controlling individual, to obtain a benefit in respect of property held in connection with the registered plan or to obtain a benefit as a result of the reduction….”

For the special tax to apply, the advantage must be extended to, or be received or receivable by, the “controlling individual” of a registered plan, the plan itself, or any other person not dealing at arm’s length with the controlling individual. Typically, the taxes are imposed on the controlling individual of the registered plan. The “controlling individual” is the annuitant, subscriber or holder of the plan. However, if the advantage is extended by the issuer, carrier or promoter of the registered plan, the issuer, carrier or promoter is liable to pay the tax. 

With regards to responsibility for the tax, the CRA has stated that: 

Responsibility for compliance with the advantage rules depends on the circumstances. Although financial institutions generally have no obligation under the Act to identify investments or transactions that may result in the annuitant being liable for the advantage tax, we would expect that financial institutions would not knowingly facilitate the holding of, orparticipate in, such investments or transactions in light of the serious tax consequences for the annuitant. 

Under subsection207.06(2) of the ITA, the CRA has the authority to cancel or waive all or part of the tax on advantages in certain circumstances. In determining whether to exercise its discretion, the CRA will take into account various factors. These factors include reasonable error, the extent to which the particular transactions that gave rise to the tax also gave rise to another tax payable, and the extent to which the payments were made from the taxpayer’s registered plan.

RRSP Strip Schemes

In RRSP strip schemes, promoters will typically promise clients that they can get them immediate access to their “locked-in” RRSP funds without incurring any taxes. In general, taxes must be paid upon withdrawals or received payments from an RRSP. The CRA will generally assess those it claims to have participated in these schemes with taxes upon withdrawing funds from the RRSP, as well as interest and penalties. 

John Scholz Found Guilty of Tax Evasion

On July 13, 2021, Joern Scholz (also known as John Scholz) was sentenced to three years imprisonment after being found guilty on April 13, 2019, of fraud over $5,000 under the Criminal Code of Canada for the evasion of federal income tax and goods and services tax/harmonized sales tax (GST/HST). John Scholz was initially sentenced to a conditional jail sentence, which the CRA appealed to the Court of Appeal for Ontario. The Court of Appeal determined that the situation warranted a three-year prison sentence as John Scholz’s tax evasion was a large-scale fraud on Canadian taxpayers.

With advice from the Ontario Securities Commission, the CRA investigated John Scholz. The investigation revealed that John Scholz operated an investment counselling business and did not report any of the commission fees he had received from his clients on his tax returns from 2011 to 2013. Specifically, John Scholz did not report taxable income totalling $2,149,730 for 2011, 2012, and 2013 tax years and therefore evaded a total of $605,355 in federal income tax. John Scholz also did not file GST/HST returns for the 2011 to 2015 taxation years, which resulted in him evading remittance of GST/HST totalling $445,789. 

Contact our firm today if the CRA has contacted you regarding a registered plan strip resulting in an advantage or if you have invested with John Scholz and are worried that the CRA may audit you in the future. Our firm can represent you against the CRA and advise you on how to tackle your tax situation.

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By Kaveh Rezaei – Attorney at KR Law Firm

**Disclaimer 

This article contains information of a general nature only and does not constitute legal advice. All legal matters have their own specific and unique facts and will differ from each other. If you have a specific legal question, it may be appropriate to seek the services of a lawyer.

Situations where the CRA Performs a Net Worth Audit  

In situations where the Canada Revenue Agency (“CRA“) suspects that a taxpayer has earned more income than they reported on their tax returns, the CRA can perform what is known as a “net worth audit” or “net worth assessment”. A net worth audit examines a taxpayer’s lifestyle to determine whether the taxpayer’s lifestyle is more expensive than he or she would be able to afford based on the amounts declared on his or her tax returns. 

Generally, the CRA uses net worth audits when it sees that a taxpayer has significant assets, cash or property that it suspects the taxpayer could not have purchased based on their reported income. If the taxpayer’s income is insufficient to justify his or her lifestyle, the CRA will assess the taxpayer for unpaid taxes on undeclared income and charge the taxpayer interest and penalties. Generally, those at most risk of being subjected to a net worth audit are those operating cash businesses, those who report low income or consistent losses, and those who do not keep good records.

Burden of Proof and Onus

According to subsection 152(7) of the Income Tax Act and subsection 299(1) of the Excise Tax Act, the CRA is not bound by the information provided by a taxpayer. Once a taxpayer reports his or her income by filing a tax return, the CRA has the power to assess the taxpayer. In assessing a taxpayer, the CRA can make assumptions about a taxpayer’s income and expenses, and the taxpayer has the onus to prove that these assumptions are wrong. In other words, the onus is on the taxpayer to show that the factual findings upon which the CRA based the assessment are false. This gives the CRA the power to perform a net worth audit when it determines that the taxpayer’s books and records are unreliable. 

In addition, when a CRA auditor performs a net worth audit of the taxpayer under these provisions, there is a presumption in law that the CRA’s assessment is valid. In other words, a net worth audit is presumed to be valid under the law unless the taxpayer can prove that the CRA’s assessment is incorrect. 

How a Net Worth Audit Works

When the CRA conducts a net worth audit of a taxpayer, it creates what is known as the “net worth statement.” A net worth statement is a running balance of the taxpayer’s assets, equity and liabilities. 

In calculating a taxpayer’s net worth, the CRA auditor will add up all the taxpayer’s assets (e.g. cash, property, vehicles etc.). The CRA auditor will also add to this figure all of the taxpayer’s living expenses. In situations where the taxpayer cannot provide figures for his or her living expenses, the CRA auditor will use figures from Statistics Canada. The CRA auditor will then add up all of the taxpayer’s liabilities (e.g. credit card debt, loans etc.) and subtract this amount from the taxpayer’s assets and living expenses. This amount becomes the taxpayer’s net worth. 

Once the CRA auditor has determined the taxpayer’s net worth, it will look at the taxpayer’s tax returns for those years under audit. If the taxpayer’s net worth for any of the years under audit is greater than the income declared on his or her tax returns, the difference is presumed to be undeclared income. Unless the taxpayer can prove that the difference in the figures is incorrect or from another source, the CRA will assess the taxpayer for unpaid taxes, interest and possible penalties. 

Professional Legal Help With Your Net Worth Audit

The best way to defend against a net worth audit is to reconstruct your income for the years under audit completely and challenge the CRA’s determinations of your assets, liabilities and expenses. If you have been subjected to a net worth audit, contact our firm today to receive professional legal help against the CRA.  

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By Kaveh Rezaei – Attorney at KR Law Firm

**Disclaimer 

This article contains information of a general nature only and does not constitute legal advice. All legal matters have their own specific and unique facts and will differ from each other. If you have a specific legal question, it may be appropriate to seek the services of a lawyer.

Gross Negligence Penalties

Once the Canada Revenue Agency (“CRA“) audits a taxpayer and comes to the conclusion that the taxpayer made false claims or under-reported their taxes, the CRA can apply additional penalties known as “gross negligence” penalties. The CRA imposes these penalties under subsection 163(2) of the Income Tax Act(“ITA”) and section 285 of the Excise Tax Act (“ETA”). 

These penalties are the most severe penalties that the CRA can assess a taxpayer. For income tax, the gross negligence penalty will be 50% of the income tax that the CRA reassesses. For example, if the CRA reassesses a $40,000 tax owing, the gross negligence penalties will be $20,000. For GST/HST, the penalty will be 25%. For example, if the CRA reassesses a $40,000 GST/HST owing, the penalty will be $10,000. In addition, the CRA imposes interest on the gross negligence penalties and the amount of tax it reassesses. 

What is “Gross Negligence”?

For the CRA to assess a gross negligence penalty to a taxpayer, they must establish 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 an omission” on their tax return. 

The term “gross negligence” is not defined in the Canadian tax statutes. The meaning of gross negligence has, however, been considered by the courts in various cases. In the case of Laplante v. R, the Tax Court of Canada provided a summary of principles regarding the meaning of “gross negligence.” The Court stated: 

“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.”

In determining whether the taxpayer’s conduct amounts to gross negligence, the CRA must contextually assess the taxpayer’s situation. While no one single factor will be determinative, the following are some of the factors that must be assessed in determining whether the taxpayer was grossly negligent: 

1. The magnitude of the omission in relation to the income declared
2. The opportunity the taxpayer had to detect the error
3. The taxpayer’s involvement in preparing the tax returns
4. The taxpayer’s education and apparent intelligence 
5. The taxpayer’s genuine effort to comply with tax laws

Each factor must be assigned its proper weight in the context of the overall picture that emerges from the evidence.  

Reliance on Accountants and Advisers

In some instances, the courts have held that the gross negligence penalties assessed by the CRA were not applicable as the taxpayer in question sought professional assistance. For example, in the case of MNR v. Donald Weeks, the taxpayer’s accountant prepared the taxpayer’s income tax return. The accountant claimed a $2,000 deduction for the support of the taxpayer’s wife even though the taxpayer’s wife was gainfully employed. The Federal Court held that the taxpayer was not subject to a gross negligence penalty as he was not privy to any gross negligence on the part of his accountant. 

With that said, there have also been several cases where the courts have upheld the CRA’s imposition of gross negligence penalties despite taxpayers designating the responsibility for the mistake on their professional advisers who prepared the returns for them. However, most of these cases involved taxpayers who were “wilfully blind” to the actions of a tax preparer or tax advisor or cases where the taxpayers were very sophisticated in matters of business and tax. Wilful blindness is when a taxpayer has suspicions or reason to suspect wrongdoing but chooses to make further inquiries or ask further questions from the accountant or professional advisor. 

Burden of Proof

Generally, in tax disputes with the CRA, the burden of proof is on the taxpayer to prove that their tax return is correct. As gross negligence penalties are very severe, the burden of proof for gross negligence penalties shifts to the CRA. This means that for gross negligence penalties, it is the CRA, and not the taxpayer, who must prove that the penalty is justified and appropriately applied. This onus is a heavy burden and is greater than the civil onus of balance of probabilities and closer to the criminal onus under the Criminal Code. This means that even if the CRA has any evidence to prove that the taxpayer was grossly negligent, if the evidence is not determinative, the taxpayer will be given the benefit of the doubt. 

Professional Legal Help With the CRA

If the CRA has assessed you for gross negligence penalties, contact our lawyers immediately. Our lawyers have the skills and experience necessary to give you the best chance of defending against gross negligence penalties and resolving your tax dispute. 

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By Kaveh Rezaei – Attorney at KR Law Firm

**Disclaimer 

This article contains information of a general nature only and does not constitute legal advice. All legal matters have their own specific and unique facts and will differ from each other. If you have a specific legal question, it may be appropriate to seek the services of a lawyer.