The Memo points out, however, that some auditors feel a taxpayer should have to make an access request to get a copy of the audit report. It’s not just auditors who take that view. In the course of discoveries during one Tax Court appeal I was handling, a Department of Justice lawyer refused to provide a copy of the auditor’s report on the basis that I should make an access request instead!

In White Star, Justice Rossiter (as he then was), in refusing the application of a corporation to be represented by a non-lawyer, reviewed the “special circumstances” he felt should exist before the corporation could be represented by a non-lawyer. Interestingly, he included in his list the ability of the corporate appellant to pay a lawyer.

Justice Webb took a different approach in 1069616 Alberta Ltd. v R, 2011 TCC 431. Justice Webb first pointed out that the requirement for “special circumstances” in subsection 30(2) had been removed by an amendment to the Tax Court of Canada Rules (General Procedure) in 2007. As a result, according to Justice Webb, “the cases that should be reviewed are those from a jurisdiction which has a rule which is the same as the current version of subsection 30(2) of the Rules.” Justice Webb then reviewed a number of Ontario cases because the Ontario Rules contain similar wording. Based on those cases, Justice Webb specifically eschewed ability to pay as a relevant factor and concluded that the corporate appellant before him could be represented by one of its owners.

Justice Webb proceeded not to award costs on the motion because the Appellant did not ask for them—almost certainly because the non-lawyer representative of the Appellant didn’t know to do so!

Part of the fraud involved Mr Ruff having to deal with a “security company” that was supposed to be holding a valuable container to which Mr Ruff was attempting to gain access. The Court noted the following about the company:

[8] The Appellant also located the homepage for the security company (Optimum Security Service). In the joint book of documents there is a photocopy (in black and white) of the Internet homepage for Optimum Security Service. During the hearing the Appellant also introduced a copy of this page that was printed in colour. One obvious observation in looking at the page in colour is that of the five pictures at the top of the page, two of the pictures are clearly taken in an area where there is snow. One picture is of a house with snow in the driveway and snow on the roof and another is of a dog standing on a roadway which is snow covered. The security company was supposedly located in Abidjan, Côte d’Ivoire which is very close to the equator. Given the proximity of Abidjan, Côte d’Ivoire to the equator one would have expected that the climate would be a tropical climate and not one where one would find snow covered houses or roads. The Appellant stated that he had not noticed this until it was brought to his attention during argument following the hearing.

The Tax Court went on to consider Hammill v R, 2005 FCA 252 (which I discuss here). The Court distinguished Hammill with respect to whether Mr Ruff had a source of income on the basis that Mr Ruff did have such a source to which the fraud was reasonably related, namely his law practice. Mr Ruff seemed to indicate to the fraudsters that he would act as their lawyer and trustee. Mr Ruff apparently did act as a trustee in the course of his legal practice. The Court, then, was satisfied that the fraud reasonably related to a source of income (the taxpayer’s legal practice).

The Court, however, went on to hold that section 67 of the Income Tax Act (Canada) needed to be considered as well and that section 67 did not merely govern the proper quantum of an expenditure. The Court quoted Hammill, which in turn quoted ¶ 57 of the Supreme Court’s decision in Stewart v R, 2002 SCC 46:

.. If the deductibility of a particular expense is in question, then it is not the existence of a source of income which ought to be questioned, but the relationship between that expense and the source to which it is purported to relate. The fact that an expense is found to be a personal or living expense does not affect the characterization of the source of income to which the taxpayer attempts to allocate the expense, it simply means that the expense cannot be attributed to the source of income in question. As well, if, in the circumstances, the expense is unreasonable in relation to the source of income, then s.67 of the Act provides a mechanism to reduce or eliminate the amount of the expense. Again, however, excessive or unreasonable expenses have no bearing on the characterization of a particular activity as a source of income. [emphasis added]

Based on this approach, the Court then asked whether “it was reasonable for the Appellant to have believed that there was a container with $8.5 million U.S. in it” and then “whether the amounts incurred [to retrieve the container] were reasonable.” The Court held that Mr Ruff’s belief was not reasonable, then he was not entitled to deduct any amount in respect of the fraud.

Unfortunately for Mr Ruff, the Court concluded that his belief was not reasonable:

[28] It seems to me that there are simply too many inconsistencies and too many questions about the story for the Appellant to have a reasonable belief that the container existed. …

[29] … As a result of these inconsistencies and questions, it does not seem to me that it was reasonable for the Appellant to have believed that there was a container with $8.5 million U.S. in it that was being held by a security company in Abidjan, Côte d’Ivoire. As a result, it seems to me that none of the amounts expended by the Appellant are reasonable in relation to his law practice business and therefore no portion of these amounts is deductible in computing his income from his law practice business.

One of the letters relates to securities bought and sold outside an RSP; another letter relates to rental operations. The CRA letters note that the taxpayers have traded securities outside an RSP or claimed expenses relating to a rental operation for a particular taxation year. The letters invite the taxpayers to request an adjustment from the CRA within 30 days of the date of the letter if the taxpayers discover errors in the reported income for the trades/rental operations.

The CRA seems to be soliciting a species of voluntary disclosure with these letters, but the letters state that an adjustment made in response to them can be transmitted on a T1ADJ, which is not the form used for a voluntary disclosure. On the other hand, the letters do mention the voluntary disclosure program. Would adjustments made in response to the letters constitute voluntary disclosures of some sort? The CRA generally gives a taxpayer only one kick at the VD can, and the CRA generally also accepts that a disclosure is voluntary only if it is not triggered by a relevant inquiry from a tax authority. If a response to an inquiry letter is not a voluntary disclosure, will the CRA seek to impose penalties if a taxpayer responds to the letter with a significant amendment to his or her tax return? The letter provides no assurance in this regard. What if the taxpayer does not respond to the inquiry letter and then decides later to try to make a voluntary disclosure on an issue related to the subject of the letter? Will the CRA accept that the disclosure is voluntary given the existence of the inquiry letter?

Anyway, I suppose it’s woe to the taxpayer who does not review his or her return in response to an inquiry letter where the CRA discovers an error later during the course of an audit.

Is anyone else or their clients receiving letters like these?

In Orman v. Marnat Inc., 2012 ONSC 549, the Ontario Superior Court refused to rectify transactions entered into by the taxpayers over a eight-year period in connection with a Ponzi scheme of which they were victims because they “intended that the documents express the meaning that the payments from [the rogue] were income. There is no error in the expression of that intent in the corporate and tax documents, and, therefore, the equitable remedy of rectification is not available.”

The Court, however, agreed to issue a declaration to the effect that “income” received from the Ponzi scheme was in fact a return of capital. The Crown had argued that “in a Ponzi scheme, the investors do not receive a return of capital but rather investors receive funds from the contribution of new investors into the Ponzi scheme, which is a source of income for tax purposes”, which is interesting in light of Johnson v R, 2011 TCC 540. The Court was careful to emphasize its agnosticism on the effect of the declarations for tax purposes as follows:

[61] [I]n the case at bar, it would be wrong of me to declare how for tax purposes the monies received by D.S.D. Holdings and Marnat as investment income but now know in truth to be something other than genuine investment income should be treated for tax purposes. At this juncture, the determination of the legal effect of the nature of the payments received by D.S.D. Holdings and Marnat is for the Minister of National Revenue and the Minister of Finance subject to judicial review in the Federal Court with respect to the Income Tax Act or this court with respect to corporate tax under the Corporate Tax Act.

[62] Therefore, I do not have to agree or disagree with Simmonds v. R, [1997] 2 CTC 2293 (TCC), where the Tax Court held that money from a Ponzi scheme is a source of income for tax purposes or with Johnson v. R 2011 TCC 540, where the opposite decision was reached.

[...]

[65] For the above reasons, without prejudice to how as a matter of law the monies received by D.S.D. Holdings and Marnat from Downing & Associations and used by those corporations to provide bonuses and interest income to Messrs. Orman and Freed is treated for tax purposes, I declare the monies are not income but rather a return of principal or capital to D.S.D. Holdings and Marnat.

I’m not sure I understand the Court’s reasoning. The declaration seems to address an issue that is squarely within the jurisdiction of the Tax Court unless one accepts the idea that the declaration is without tax effect, in which case one might ask how it assists the taxpayers. With respect, I think the court has confused a question of pure fact (did the taxpayer receive certain payments in particular amounts from the rogue?) or a question of law that is not tax-related (eg is this person a director of X Corp, as in Danso-Coffey?) with a question of mixed tax law and fact (were the Ponzi payments “income” for the purposes of the Income Tax Act?).

In any case, the CRA is apparently not appealing this decision.

In McPeake v. Canada (Attorney General), 2012 BCSC 132, the taxpayer was before the Court asking for rectification a second time because apparently the first time around didn’t take:

[10] In 2003, the CCRA issued reassessments of both the trust and Mr. McPeake for the years 1997 to 2001. The reassessments were based on the ITA, s. 75(2)(a)(i). As I understand the evidence and counsels’ submissions, the Auditor concluded that Mr. McPeake’s contribution of property to the trust, combined with his inclusion as beneficiary and the possible reversion of trust property to Mr. McPeake, rendered the trust’s income effectively his own.

[11] The Trustees considered an action for rectification. They consulted with previous counsel for CCRA within the Department of Justice. That counsel, who retired in the summer of 2009, did not oppose rectification. The petitioners applied for rectification on notice to CCRA.

[12] The unopposed petition was heard by Josephson J. in May 2009. Mr. Justice Josephson made an order for rectification of the trust deed as requested with respect to the items found to be in conflict with ITA, s. 75(2)(a)(i).

[13] In November 2009, CCRA informed the petitioners that two other errors existed in the trust deed to support the reassessments, in spite of the deed’s recent rectification. In April 2010, the Minister of National Revenue confirmed the reassessments.

[14] The two other grounds cited by CCRA fall not within s. 75(2)(a)(i) but within s. 75(2)(a)(ii) and s. 75(2)(b). CCRA’s position centres on the aspects of the deed that possibly conflict with these provisions, namely that the trust decisions require unanimous consent, which implies that Mr. McPeake as a Trustee holds control over disposal of the trust property, and that Mr. McPeake could become sole Trustee, in which role he could determine beneficiaries of the trust after the trust’s creation and distribute property to them.

The Court’s description of the “retroactive” nature of rectification is interesting:

Rectification is restorative, not “retroactive”: “[Rectification] is to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgment by one party or the other” (Performance Industries, para. 31). Since rectification restores a truth to an instrument’s expression, it acts, in time, from the point of instrument formation forward.

In any case, the Court was not troubled by the fact that the trust was re-applying for rectification. It concluded that

As in Juliar, the desired tax consequences of the trust were not incidental to the trust’s formation but arguably the reason for its formation. This finding of a specific intention and the timing of its formation are sufficient to allow for rectification in this case.

I was helping a fellow tax professional with a situation like the following where I think I almost stumbled into a trap relating to the $750,000 capital gain exemption.

Assume that Mr X owns all of the issued shares in the capital of Holdco, which owns all of the issued shares of Opco. Holdco’s only asset is the shares of Opco, and Holdco owes Mr X $300. The gross value of Opco’s assets is $1,000, $700 of which is attributable to assets primarily used in an active business carried on principally in Canada. The other $300 is attributable to cash not needed in Opco’s business. Opco’s retained earnings are $100; it doesn’t have any debt.

Mr X wants to sell his shares in the capital of Holdco. Until now, the Holdco shares have met the asset tests applicable during the 24-month holding period. If Mr X wants to claim the exemption for his sale of the Holdco shares, however, he will need to remove the cash from Opco. Fortunately, Holdco owes him money, and so he need only move cash from Opco to Holdco and then cause Holdco to repay the debt it owes to him to “purify” the corporations to ensure he can claim the exemption.

So far, so good. The difficulty arises because of the negative retained earnings. Purchasers and their accountants tend not to like seeing deficits on balance sheets, and so it might be tempting to have Opco loan cash to Holdco rather than have Opco pay a dividend of the cash. The problem with the loan is that it likely throws the Holdco shares offside the 24-month asset test.

Paragraph (d) of the definition of a qualified small business corporation share (QSBCS) in subsection 110.6(1) provides that, if for any period of time during the 24-month holding period 90% or more of the gross value of Holdco’s assets is not attributable to active business assets or shares of a corporation that meets the 50% test, then Opco must meet a 90% asset test during that period. If Opco loans funds to Holdco, however, then neither corporation will meet these tests. Holdco will have cash such that it does not meet the 90% test; Opco will have a receivable from Holdco that likely is not an active business asset so that it doesn’t meet the 90% test either. The shares of Holdco, then, will not meet the 24-month holding period asset test. Mr X will not be able to claim the exemption unless he holds the shares of Holdco for another 24 months throughout which the asset test is met.

Paying a dividend from Opco does not cause this problem. When the cash is paid as a dividend paid from Opco to Holdco, Holdco no longer meets the 90% test, and so, while Holdco holds the cash, Opco must meet the 90% test instead, which it will because all of the excess cash has been paid to Holdco. Once Holdco repays the debt owing to Mr X, both corporations will meet the 90% asset test, which means that the Holdco shares will likely be QSBCSs at the time of the sale.

Can Opco pay a dividend that creates a deficit? The legal test in the Business Corporations Act (Ontario) for paying a dividend says nothing about retained earnings. Rather, the Act simply requires that the board of directors of the corporation have no reasonable grounds for believing that the corporation is, or after the payment of the dividend, would be, unable to pay its liabilities as they become due or that the realizable value of the Corporation’s assets would be, by the declaration or payment of the dividend, less than the aggregate of (1) the Corporation’s liabilities, and (2) the Corporation’s stated capital of all classes of shares of the Corporation.

The foregoing argues against being casual about moving funds from Opco to Holdco at any time because of the effect on the 24-month holding period asset test. Advisers would also do well to keep in mind the CRA’s rather strict notions about what is required to ensure that an amount paid is treated as a dividend. If cash is moved, but no proper dividend resolutions are prepared, then the CRA might argue that the movement of cash created an inter-company receivable with the adverse consequences noted above.