Khanna v. The Queen, 2022 FCA 84 is an important decision of the Federal Court of Appeal (the “FCA”) on the topic of gross-negligence penalties imposed under subsection 163(2) of the Income Tax Act (Canada) (the “Act”). The decision highlights two key points in relation to the burden of proof to be met by the Minister of National Revenue (the “Minister”) for the imposition of gross-negligence penalties: (1) the Minister must establish that a taxpayer was grossly negligent, even in cases involving indirect audit methods such as a net-worth analysis; and (2) the Minister must meet this burden with respect to each taxpayer under an audit project.
The genesis of this dispute was a net-worth audit of Mr. and Ms. Khanna, who both worked as mortgage brokers for a corporation they jointly owned. The Minister reassessed each of them with unreported income for the 2008 taxation year and imposed gross-negligence penalties under subsection 163(2) of the Act.
At trial, Mr. and Ms. Khanna each conceded that they had unreported income in the amounts reassessed by the Minister. Accordingly, the only issue was whether they were liable for gross-negligence penalties.
By way of oral reasons, the Tax Court of Canada (the “TCC”) upheld the imposition of gross-negligence penalties. Mr. and Ms. Khanna both appealed to the FCA. At the FCA, however, Mr. Khanna decided not to make any further arguments, and his appeal was dismissed. Thus, the only live issue before the FCA was whether Ms. Khanna was liable for gross-negligence penalties.
The FCA held that the Minister had not met her burden of proof in relation to the gross-negligence penalties imposed on Ms. Khanna and allowed her appeal.
As mentioned above, Ms. Khanna had conceded that she had unreported income and therefore that there was a misrepresentation on her tax return for 2008. What Ms. Khanna argued, however, was that the Minister had failed to adduce any evidence as to her knowledge of the unreported income, so there was no evidence that she acted knowingly or in circumstances amounting to gross negligence.
Importantly, throughout the audit and the TCC hearing, the focus was on Mr. Khanna—not Ms. Khanna. At the trial level, the Crown put forward, and the TCC accepted, several facts which referenced both Mr. and Ms. Khanna but were, in fact, solely related to Mr. Khanna.
For example, the TCC found that Mr. and Ms. Khanna were both uncooperative during the audit. But all the evidence related to the audit was in respect of Mr. Khanna’s actions. Moreover, the FCA noted that even if such evidence did relate to Ms. Khanna, actions during the audit had no bearing on the application of gross-negligence penalties.
The Crown chose not to call Ms. Khanna as a witness at trial. The FCA noted that it appeared from the record that Ms. Khanna had agreed to accept Mr. Khanna’s testimony. But even still, the Crown failed to ask Mr. Khanna any questions about several topics related to Ms. Khanna’s involvement. For example, the Crown had not asked questions about:
- the assumptions in the Reply related to Ms. Khanna;
- her involvement in the business;
- her knowledge of the unreported income;
- the process taken in filling out her return; or
- her knowledge of what was reported (or not reported) in her tax return.
The FCA also noted that the penalty recommendation report for Ms. Khanna largely parroted the language in the report for Mr. Khanna, other than certain sections which were marked as “unknown”.
Based on the foregoing, the FCA found that nothing on the record established what Ms. Khanna knew, believed, did, or did not do in connection with the filing of her tax return.
The Crown argued that the net-worth analysis itself was sufficient to justify the imposition of gross-negligence penalties given that Ms. Khanna had not provided a credible explanation for the increase in her net worth. In so doing, the Crown cited the FCA’s decision in Lacroix v. The Queen, 2008 FCA 241:
… Insofar as the Tax Court of Canada is satisfied that the taxpayer earned unreported income and did not provide a credible explanation for the discrepancy between his or her reported income and his or her net worth, the Minister has discharged the burden of proof on him within the meaning of subparagraph 152(4)(a)(i) and subsection [163(2)].
The FCA disagreed. The FCA cited its decision in Deyab v. The Queen, 2020 FCA 222, in which it also rejected a Lacroix argument, stating that “simply finding that an unreported amount is taxable does not inevitably lead to a conclusion that a gross negligence penalty is justified” and reiterating that even if there is unreported income, the circumstances relating to the failure to report must be examined in order to determine whether the imposition of the penalty is justified.
In this case, the FCA noted that Ms. Khanna did not testify and was not asked to explain why she did not report the unreported income. The FCA affirmed that “the failure to report the amount by itself does not demonstrate ‘an indifference as to whether the law is complied with’.”
The Crown also argued that the evidence was sufficient to show wilful blindness on the part of Ms. Khanna. In this regard, the Crown relied on:
- the materiality of the amount;
- Khanna’s education and position as a mortgage broker;
- the fact that she had appointed Mr. Khanna to represent her;
- the fact that Ms. Khanna only reported income from one property (when there were more properties);
- the fact that much of the income was deposited to an account she held jointly with her daughter; and
- the fact that the net-worth analysis led to a large amount of unreported income.
Again, the FCA disagreed. The FCA stated that none of the reasons relied on by the Crown demonstrated wilful blindness, writing: “Where is the evidence or finding about the appellant’s deliberate choice not to make inquiries or the finding of deliberate ignorance?”. In other words, the above factors—which are often cited by the CRA—are not stand-ins for evidence of negligence or wilful blindness.
There are two key takeaways from the FCA’s decision. First, it is important to bear in mind that certain legal issues, such as the imposition of gross-negligence penalties, must be examined on a taxpayer-by-taxpayer basis. All too often the inquiry will focus on one person—the principal of a group or the head of a family—but result in penalties being imposed on all taxpayers. Second, despite the FCA’s comments in Lacroix, the Minister must prove that a taxpayer was grossly negligent in order to justify penalties, even in cases involving indirect audit methods such as a net-worth analysis.