Federal Court of Appeal finds inadequate record-keeping does not justify gross negligence penalties

Published by Morgan Watchorn & Leonard Gilbert

On December 21, 2020, the Federal Court of Appeal (“FCA”) released its decision in Deyab v Canada, 2020 FCA 222 (“Deyab”), partly overturning the decision of the Tax Court of Canada (“TCC”). The FCA’s decision clarified that failing to document corporate withdrawals may justify the reassessment of a statute-barred taxation year but does not alone warrant the imposition of gross negligence penalties.

In Deyab, the taxpayer was reassessed for approximately $2.4 million of shareholder benefits received from M.D. Consulting 2005 Inc. (“M.D. Consulting”) over the 2007 to 2011 years.  The reassessments for 2007 to 2010 were statute-barred, having been issued outside the “normal reassessment period” (as defined in the Income Tax Act (Canada) (the “Act”)). The taxpayer was also assessed gross negligence penalties for each of the 2007 to 2011 years.

The taxpayer did not dispute that he and other family members received amounts from M.D. Consulting, but argued that he was simply withdrawing money he had previously loaned to the company. However, the taxpayer failed to produce sufficient evidence documenting his advances of funds to the company and admitted that M.D. Consulting did not keep records of its shareholders’ loan accounts.

The FCA did not accept that the withdrawals were loan repayments to the taxpayer. Thus, the FCA upheld the reassessment of the taxpayer’s 2007 to 2010 years outside the normal reassessment period on the basis that the taxpayer made a misrepresentation attributable to neglect or carelessness in his tax returns by not reporting amounts appropriated from M.D. Consulting.

However, the assessment of gross negligence penalties for each of the 2007 to 2011 years was overturned. The FCA reiterated the well-established principle that the statutory requirements for reassessing statute-barred years and assessing gross negligence penalties are distinct, and clarified that the decision in Lacroix v. R. (2008 FCA 241) should not be interpreted to mean that a taxpayer’s failure to provide a credible explanation of unreported income will always justify the imposition of gross negligence penalties.

The requirements for reassessing a statute-barred year are met if the taxpayer’s misrepresentation is due to neglect or carelessness. However, the requirements for assessing gross negligence penalties are only met if the conduct of the taxpayer amounts to gross negligence tantamount to intentional acting or indifference. Since the taxpayer maintained throughout the appeal that the company was simply repaying funds he had previously transferred to M.D. Consulting, there was no basis to conclude he knowingly failed to report the amounts as income from the company. Therefore, the taxpayer’s insufficient recordkeeping justified reassessing otherwise statute-barred years but did not amount to gross negligence.

This case reinforces the heavy burden on the Minister to justify the imposition of gross negligence penalties. The FCA was clear that while insufficient record keeping may be evidence of carelessness that would permit reassessment of statute-barred years, that fact alone does not justify the imposition of gross negligence penalties.