The TCC recently summarized gross negligence penalties in the “sad and sorry tale” of a group of taxpayers “who were led down a garden path, with the carrot at the end of the garden being significant tax refunds”. Torres (2013 TCC 380, which includes seven appeals heard consecutively) reaffirmed that gross negligence is supportable when taxpayers are willfully blind to the need to make necessary enquiries when reasonable suspicions are raised.Torres follows a series of 2013 cases in which gross negligence penalties were upheld against taxpayers who participated in tax scams, despite pleading that they were unwitting dupes of unscrupulous advisors. Torres summarizes the warning signs that should make a taxpayer suspicious and motivate him to make further enquiries into the legitimacy of his filing positions.

The taxpayers in Torres claimed fictitious business losses in returns prepared by Fiscal Arbitrators (FA), which the TCC described as “nefarious” and their tax advice as “nonsense”. The taxpayers were mostly well-educated individuals who signed off on their returns prepared by FA without knowing the source of their reported business losses, the nature of their reported businesses, and the basis of FA’s advice.

The sole issue before the TCC was whether the taxpayers were liable for gross negligence penalties under subsection 163(2), which provides for a penalty against each person who knowingly, or in circumstances amounting to gross negligence, assents or acquiesces in the making of a false statement or omission in a return filed under the Act. In order to support the penalty, there must be a false statement in a return and there must have been culpable intention (knowledge or gross negligence) in the making of that false statement.

The TCC summarized the gross negligence case law. Gross negligence is more than a failure to use reasonable care and involves a high degree of negligence tantamount to intentional acting or indifference to complying with the law. Ordinary negligence is distinguished from gross negligence by the presence of factors that include: a certain magnitude of the omission in relation to the income declared; the opportunity the taxpayer had to detect the error; and the taxpayer’s education and intelligence. Well-established principles provide that no single factor dominates and that each factor must be assigned its proper weight in the circumstances. The TCC confirmed that gross negligence includes willful blindness, a type of wrongful intent that deems the taxpayer to have had actual knowledge of the wrongful act. Thus a false statement may be imputed to a taxpayer who is willfully blind. 

Willful blindness is well understood in the criminal law and applies to subsection 163(2) penalties. If a person has suspicions that he deliberately refuses to engage, it may be concluded that he was avoiding actual knowledge of whether his conduct was right or wrong. Willful blindness differs from recklessness: recklessness involves persistence in the face of known risk and willful blindness involves awareness of a need to make enquiries but a refusal to do so. Willful blindness is a preference for ignorance. 

In upholding the penalties against the appellants, the TCC listed circumstances that should arouse suspicion or suggest a need for further enquiries, including: the magnitude of the advantage or omission; the blatantness of the false statement and how readily detectible it is; the fact that the preparation of the return by a third party was not acknowledged in the return; unusual requests from the tax preparer; whether the tax preparer was previously unknown to the taxpayer; incomprehensible explanations from the tax preparer; that others engaged or warned against engaging the tax preparer; and the fact that the tax preparer was not engaged by others or others warned against the tax preparer, or the taxpayer expressed concern about telling others about the tax preparer. A further criterion for willful blindness may be present if a taxpayer omits to inquire with the tax preparer to understand the return and also omits to make inquiries with third parties or the CRA. Presumably, the TCC did not mean that as a general rule a taxpayer must always seek a third party or CRA opinion to confirm that a filing position is appropriate. The TCC’s guidance should be limited to situations where the taxpayer is provided with what seems to be unusual or surprising tax advice.

Applying those guidelines to the taxpayers who relied on FA, the TCC concluded that their education and understanding of basic business concepts did not support a claim of ignorance. In the TCC’s view, numerous warning signs should have raised suspicions and caused the taxpayers to inquire further, such as the fact that they claimed substantial losses and obtained complete tax refunds even though there was no basis for the claims; FA did not identify itself as tax preparers on the returns; FA made unusual requests (the taxpayers were advised to sign their returns using the word “per” before their names); FA was previously unknown to the taxpayers; despite claiming to have the utmost confidence in FA, none of the taxpayers could explain the basis for FA’s filing positions; and some of the taxpayers used FA for only one year or declined to tell family about the firm. The TCC concluded that sufficient warning signs should have caused the taxpayers to inquire further of FA or seek advice from other advisors and/or the CRA.

It should be noted that in Longo (2013 TCC 213), another fictitious deduction case, the TCC concluded that the Crown’s burden of proof is not met by making factual assumptions in its reply pleading that are assumed to be correct unless demolished by the taxpayer.  However, it is presumably not difficult for the Crown to meet its burden in cases that are factually similar toTorres, which provides the Crown with helpful guidelines for establishing willful blindness as a justification for gross negligence penalties. 

The TCC also rejected the taxpayers’ argument that they should not be penalized because the CRA failed in its duty to warn taxpayers against tax preparers such as FA.  In the TCC’s view, the warning signs were sufficiently strong that the taxpayers should have inquired further regardless of whether the CRA published any warning concerning FA.

Crown evidence included excerpts from the CRA’s website that warned taxpayers that a tax strategy that sounds too good to be true, probably is too good to be true. To the CRA’s credit, this is good advice. A taxpayer who participates in untenable tax schemes not only risks reassessment with accrued interest, but he is more likely than ever to be subject to gross negligence penalties that will be upheld in court.

This article originally appeared in the Canadian Tax Foundation’s Highlights newsletter.