Eyes half open

  • May 20, 2021
  • Stuart Clark and Robert G. Kreklewetz

It is no secret that Canada’s complex value-added tax system and reporting regime are a headache for most small business owners who, rightly, want to focus on running their businesses. To do that, many businesses hire accounting and invoicing firms to handle their tax compliance. An interesting point of law arises in this situation when tax compliance mistakes are made by the tax professional—who has been downloaded the total responsibility of ensuring the business is compliant.

Such was the case in Frank-Fort Construction Inc. v. The Queen, 2020 TCC 6 (CanLII), which dealt with whether the taxpayer had been “wilfully blind” or “grossly negligent” for making an omission on its GST return per section 285 of the Excise Tax Act (“ETA”). Here, the Tax Court of Canada (the “Court”) found that the taxpayer business could not have known there were any omissions because of the unique circumstances in which the taxpayer had downloaded responsibility for tax compliance to the point that it could not have known that any omissions had been made.

Facts

In 2006, at the age of 25 and armed with only a high school diploma, Mr. Fernandes (as he is simply referred to in the case) incorporated Frank-Fort Construction Inc. (“Frank-Fort”) as its sole director/shareholder/employee. Mr. Fernandes had no accounting or tax compliance experience; he simply wanted to use Frank-Fort to develop vacant land into buildings for sale. He appeared to be fairly successful, selling over 80 buildings between 2008 and 2014. To handle this aspect of his business, he hired an invoicing company, which would handle payment of the various trades and manage Frank-Fort’s bank account, and an accounting firm, with a mandate to complete Frank-Fort’s bookkeeping, accounting, GST/QST and income tax returns, and financial statements, all while ensuring total tax compliance. He put his “full trust” in these firms so he could “focus on his field of expertise: overseeing construction sites.”

After an audit in 2011, which found that Frank-Fort had omitted certain sales from its QST returns, Mr. Fernandes dismissed his accountants and moved to another firm. However, he was soon convinced to return, as they were “very reassuring with regard to [the] audit” and assured him that they would pay “special attention” to his business.

Things came to a head in 2015, after Frank-Fort was audited again, this time for the August 2011 to May 2014 reporting period, which discovered that there were omissions to Frank-Fort’s (late-filed) June 2012 GST return for the sales of two buildings from the previous year, totalling around $21,000 in unreported/unremitted tax. The resulting notice of assessment also levied a penalty under section 285 for the omissions on account of Frank-Fort’s “gross negligence” or “wilful blindness.”

With respect to these two omitted sales, Mr. Fernandes testified that he had provided his accountants with all of the relevant information in order to file complete returns for that period. Furthermore, records from Frank-Fort’s invoicing company – which were regularly provided to the accountants for the making of returns – clearly indicated that the two sales had taken place.

Frank-Fort objected to the levying of the section 285 penalties, taking the position that it was not grossly negligent or wilfully blind. The objection was denied, and Frank-Fort appealed.

TCC appeal

On appeal, the issue was whether Frank-Fort was “grossly negligent” or “wilfully blind” in light of the omissions made on its GST return. Frank-Fort did not dispute the omissions, merely that the levying of the penalties under section 285 were inappropriate. Its position was that it had utterly and totally depended on its accountants to ensure that it met its tax compliance obligations.

Section 285 provides, among other things, that every person who “knowingly” or under circumstances amounting to “gross negligence,” makes an omission on a return is liable for a penalty equal to the greater of $250 or 25% of the unremitted/unreported amounts. The case law makes a fine distinction between whether an omission is done “knowingly” or under “gross negligence.” The first is a subjective test, which requires the court to examine whether specific taxpayer actually knew they were making the omission or false statement. The doctrine of “wilful blindness” arises when the issue is whether the taxpayer acted “knowingly.” It allows a court to impute “knowledge” of the omission to the taxpayer when they become aware of a need for further inquiry but decline to learn more because they do not want to know the truth, or they want to avoid the truth. The standard for “gross negligence” is, by contrast, an objective one. In applying this test, the court considers whether a reasonable person in those circumstances acted with “a high degree of negligence tantamount to intentional acting, an indifference as to whether the law is complied with or not.”

The Court focused deeply on the question of whether Frank-Fort (through Mr. Fernandes) was wilfully blind because of the degree to which Mr. Fernandes had delegated all of Frank-Fort’s tax compliance responsibilities to his accountants. The CRA was of the view that this was a deliberate attempt by Mr. Fernandes to prevent himself from learning the truth about Frank-Fort’s omissions, which, in their mind, constituted wilful blindness.

Drilling down on the facts, the Court found that the testimony of Mr. Fernandes conflicted with that of his accountant, who also testified at trial. The Court found that, contrary to the accountant’s claim that they had never been provided with the information on the omitted sales, the sales information was readily available to them. It was bookkeeping errors on their part that resulted in the omission on Frank-Fort’s GST return. The Court did not mince words on this point, stating that it was “difficult to understand why” the bookkeeping errors were made (paragraph 29). Further complicating the matter was the revelation from the accountant’s testimony that he had noticed the omission in 2013 (years before the audit) but did not inform Mr. Fernandes and took no steps to correct the returns! The Court notes that there was no adequate explanation as to why no corrections were made, the accountant merely providing that “I’m not saying it was done correctly. We should have accounted for the sale” (paragraph 31).

Turning to whether the penalties were warranted, the Court found that there was a line of case law that stood for the “proposition that an accountant’s error will not automatically clear a taxpayer of any imposition of penalties under section 285 of the ETA” (paragraph 35). Instead, “each case must be analyzed based on its own factual background” (ibid.). Applying the law to the facts, the Court found that Frank-Fort simply could not have known there were omissions on its GST return. Mr. Fernandes did everything he could to ensure his GST returns were complete by giving all required information and documents to the accountants. The accountant even admitted that there was nothing Mr. Fernandes could have done to avoid the omissions because he was never told of them. The Court noted, crucially, that Mr. Fernandes knew his limitations, and staked everything on the ability of hired professionals to navigate Frank-Fort’s tax compliance obligations on its behalf. Mr. Fernandes’ total reliance on his accountants who were not forthright with him, placed him in a position in which he could not have been wilfully blind.

Ultimately, the Court allowed the appeal with costs in favour of Frank-Fort, finding that it was neither wilfully blind nor grossly negligent, since it could not have known any omissions were made, and its conduct was “reasonable” given the circumstances. This vacated the penalties under section 285.

Commentary

Frank-Fort Construction Inc. v. The Queen is an interesting case. Too often, gross negligence and wilful blindness penalties seem to be “tacked on” by CRA auditors as a matter of course during the assessment process. CRA ought to be very reluctant to add 25% penalties where taxpayers have relied on third-party professional advice in preparing their tax returns or tax positions. It seems proper that Mr. Fernandes prevailed in this case.

That said, and on first blush, the difficulty that cases like these pose for the CRA might also be understandable. The CRA is not very well equipped to assess credibility in these situations, and often kicks these types of cases into the Court system, where the CRA seems to feel judges are better equipped to adjudge credibility issues. (We have actually been told this by the CRA.) Unfortunately, that type of approach just creates a recipe for more litigation, and a very costly option for taxpayers trying to vindicate their due diligence.

It seems that CRA auditors ought to be able to distinguish between cases where these penalties are appropriate and cases where they are not, and CRA needs to help its auditors evaluate those situations.


Stuart Clark and Robert G. Kreklewetz, Millar Kreklewetz LLP, Toronto