When CRA auditors are wrong

We expect fair treatment in a dispute with CRA. But, proving CRA didn’t live up to its duties doesn’t guarantee success in court.

Irvin Leroux and the RV Park

In 1989, Irvin Leroux purchased forested land in B.C. to establish an RV park business. By 1993 he had begun clearing the land, selling the logs to a local sawmill.

In 1996, Leroux was the subject of a GST audit for the 1993, 1994 and 1995 tax years. CRA’s investigation led auditors to review his income tax returns. Leroux received a letter in Sept. 1997 proposing adjustments to his GST and income tax returns.

The dispute was partly about personal versus business expenses, but was mainly over whether the logging activity resulted in capital gains or business income. Leroux claimed the logging as capital gains in 1993, then later as business activity. CRA denied the capital gains characterization, alleging Leroux had mischaracterized his business expenses. As a result, Leroux was assessed more than $600,000 in taxes, interest and penalties.

Read: CRA gets ‘C’ grade from small business

After a series of collection procedures, including a Writ of Seizure and Sale on his property, Leroux successfully appealed to the Tax Court in 2005. But it took a fairness application in 2006 to waive his interest and penalties, which by then totaled more than $800,000. The application succeeded, in part, because of CRA delays during audit and objection. “In the meantime, Leroux had lost his business and most of his property,” according to Le-roux v. Canada Revenue Agency.

Suing CRA

Later in 2006, Leroux launched an action for negligence against CRA, focusing on the three auditors he dealt with. To succeed, he would have to prove: CRA owed him a duty of care; there was a breach of that care; a causal link between the breaches and a loss; and a quantification of those losses.

The judge held that CRA did have a duty to take reasonable care to avoid doing him harm. To assess CRA’s actions, the judge used, as a standard, what a reasonably competent tax auditor would do in the circumstances.

Read: 7 answers from CRA on insurance and tax

The judge found that, while CRA’s assessment of the logging activities was based on “erroneous and unsupported assumptions,” Leroux did not fulfil his own responsibility to clarify the record. So, even though CRA’s position was incorrect, it was “not a breach of the standard of care, given the information available to [the auditors] at the time.”

The judge saw the penalties, however, in a different light:

The assessment was based on the auditor’s belief that Leroux “ought to have known” that the proceeds of his business were business income, not capital gains. However, the Income Tax Act requires that the taxpayer “knowingly” mischaracterize income or be “grossly negligent” before imposing penalties.
The auditors assessed penalties on all Leroux’s income, rather than on each alleged tax offense. For 1995, he was penalized $51,682 on $5,787 in tax due—a 900% penalty.
Finally, the original auditor threatened Leroux with gross negligence penalties if he did not sign a waiver allowing for the audit of the statute-barred 1993 tax year. He did not sign the waiver, and the unjustified penalties were assessed.

Read: Avert—and fix—mistakes

And damages for the taxpayer?

Despite showing CRA breached the standard of care, Leroux couldn’t succeed without demonstrating that the breach was the cause of his losses.

The judge determined Leroux’s business was in difficult financial straits even before CRA registered any judgments. In addition, Leroux’s delays worked against him; in particular, he failed to file his income tax appeal on time. And, in the case of the GST, the issue would have been resolved sooner if he had kept better records and had disclosed them sooner.

So, despite proving CRA auditors breached their standard of care, Leroux couldn’t recover any damages.