Tax

Experienced tax lawyer integral at outset of audit process

By AdvocateDaily.com Staff

A recent Federal Court of Appeal (FCA) decision and the subsequent Canada Revenue Agency (CRA) response illustrates why an experienced tax lawyer should be retained early in the audit process, says Canadian tax lawyer David J. Rotfleisch.

The FCA decision held that s. 231.1 of Canada’s Income Tax Act did not permit the CRA to compel a taxpayer or its employees to give oral answers during an audit, he tells AdvocateDaily.com.

“The Federal Court of Appeal clarified that its decision concerned not only a CRA tax auditor’s request for an interview but any question from them about a taxpayer’s tax liability — regardless of whether they required them to answer orally or in writing. The court wrote: ‘Independent verification through an audit is different than compelling answers to questions,’” says Rotfleisch, founding tax lawyer with Rotfleisch & Samulovitch Professional Corporation.

An extended court process that resulted in the FCA ruling has its origins in a CRA audit of one of the world’s largest uranium producers. It concluded in 2008 and led to a Tax Court of Canada litigation involving the producer and CRA for the 2003-2007 taxation years.

While that litigation was still ongoing, the CRA audited the company again in 2013 for the tax years 2010-2012 for the same concerns that triggered the earlier audit, Rotfleisch says.

“The Canada Revenue Agency demanded that the company arrange interviews between a CRA auditor and 24 of its employees. The company refused. It did, however, offer to reply to written questions,” he says.

“In response, the CRA applied to the Federal Court of Canada for a compliance order under s. 231.7 of the Income Tax Act. In particular, it sought an order forcing the company to arrange interviews whereby the CRA auditor could question the 24 employees,” Rotfleish says.

The Federal Court denied the request for the compliance order citing the ongoing tax court litigation and the possibility the order might prejudice the company in those proceedings.

This prompted a CRA appeal to the FCA, which not only upheld the lower court ruling but expanded on it.

“The appellate court drew a distinction between an obligation to facilitate the auditor’s access to documents, records, books, and information, on the one hand, and responding to general questions with respect to tax liability or issues arising from the audit, on the other,” says Rotfleisch. “That is, the requirements in paragraph 231.1(1)(d) don’t require a taxpayer to answer general questions about tax liability. They require a taxpayer to answer questions that would aid the auditor in obtaining records and documents.”

While the ruling backs a taxpayer’s right to decline to answer an auditor’s general questions about tax liability, there are drawbacks to “completely ignoring” their inquiries, he says, noting CRA retains the power to reassess taxation on the basis of various assumptions.

“If the CRA issues a reassessment in accordance with an assumption, the resulting tax liability is valid and binding unless the taxpayer files a notice of objection to CRA’s Appeals Division or appeals to the Tax Court,” says Rotfleisch, who was not involved in the case and comments generally.

“Further, the initial onus rests with the taxpayer to destroy the CRA’s factual assumptions. In addition, even if the amount owing is in dispute, the CRA may still attempt to collect amounts concerning GST/HST and source deductions.”

He adds that the revenue agency can also insist that a large corporation pay 50 per cent of the assessed corporate income tax immediately.

“So, by entirely ignoring a tax auditor’s questions, you may disadvantage yourself later when you need to rebut the assumptions that the auditor made in response to your silence,” Rotfleisch says. “And you might attract CRA collections action — garnishment, liens, seizure — that you could have otherwise avoided.”

In response to the appellate court’s decision, the CRA issued a guidance communiqué to its tax auditors in June of 2019.

“Unsurprisingly,” Rotfleisch says, the communiqué urged CRA tax auditors to “continue to request oral discussions and interviews with taxpayers.”

Further, it reminded auditors that, should a taxpayer decline an interview, “the CRA is free to make inferences and assumptions and to assess on that basis.” The communiqué “notably, prompted tax auditors to consult the Department of Justice in ‘these types of situations,’” he says.

In a concluding section of the document — entitled Jurisprudence — the taxation agency compiled quotes from judicial decisions describing its Income Tax Act powers under 231.1 (basic audit power), 231.2 (power to demand information), and 231.6 (power to demand foreign-based information), Rotfleisch says.

“This collection of quotes apparently serves to give CRA tax auditors some material that they could copy and paste into a letter — namely, an auditor’s letter in response to a taxpayer’s attempt to refuse an interview on the basis of the recent FCA decision,” he says.

“But many of the quotes given are either taken out of context or nothing more than obiter dictum — that is, a court’s incidental remarks, which do not establish precedent because they aren’t essential to the issue before the court.”

Rotfleisch says it’s imperative to remember that the Act gives the CRA “expansive” audit power and that courts respect its authority to seek and receive documents and records.

While the appellate court ruling makes it clear that a tax auditor’s powers come with limits and that you need not answer their questions, that decision could give rise to repercussions, he says.

“This is because you might subsequently need to rebut an auditor’s outlandish assumptions while bearing the onus of proof. You must pick your battles,” Rotfleisch says.

“The Canada Revenue Agency’s communiqué underscores the importance of consulting with a knowledgeable Canadian tax lawyer when facing questions from a CRA tax auditor. In response to your refusal to answer a question, a tax auditor — finding justification in the communiqué — may be more willing to pursue a compliance order. Or they may simply quote a Supreme Court decision out of context under the guise of a legitimate legal argument.”

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