Canada: Galachiuk: TCC Clarifies Due Diligence Defence Under 163(1)

Subsection 163(1) of the Income Tax Act (the "Act") imposes a penalty of 10% on an amount that a taxpayer fails to report in his/her return where there has been a previous failure to report income in any of the three preceding taxation years.

The penalty under subsection 163(1) has been described as "harsh" due to the 10% federal penalty, a potential 10% provincial penalty, and the fact that the penalty may apply even where minimal or no additional tax is owing by the taxpayer (i.e., the tax relating to the unreported amount was withheld at source and remitted to the CRA).

In several cases, the courts have held that a taxpayer that is the subject of a penalty under subsection 163(1) has a due diligence defence. A taxpayer can satisfy the due diligence test in one of two ways: (i) By establishing that he/she made a reasonable mistake of fact (i.e., the taxpayer was mistaken as to a factual situation and the mistake was reasonable), or (ii) by establishing that he/she took reasonable precautions to avoid the event leading to the imposition of the penalty (see Les Résidences Majeau Inc v The Queen (2010 FCA 28)).

Some court decisions on the due diligence defence under subsection 163(1) appear to have reached inconsistent conclusions on the issue of whether the taxpayer's due diligence must exist in respect of (i) either of the two years in which the failure occurred (see, for example, Franck v. The Queen (2011 TCC 179),Symonds v. The Queen (2011 TCC 274), Chan v. The Queen (2012 TCC 168), and Norlock v. The Queen (2012 TCC 121)) or (ii) only the year upon which the penalty is imposed (i.e., the second failure) (see, for example, Chendrean v. The Queen (2012 TCC 205), and Chiasson v. The Queen (2014 TCC 158)).

This was the question considered by the Tax Court in Galachiuk v. The Queen (2014 TCC 188). In Galachiuk, the taxpayer failed to report portions of income in two consecutive taxation years: $683 in his 2008 tax return and $436,890 in his 2009 tax return. Given Mr. Galachiuk's failure to report income on two separate occasions, the Minister imposed a penalty under subsection 163(1).

The taxpayer argued that he had been duly diligent in 2008 because he had taken steps to inform his investment broker and advisors of a change of residence, and had also arranged with Canada Post to have his mail forwarded to his new address. Despite these efforts, one T3 slip had not been forward to or received by the taxpayer. The Crown argued that the fact that some T-slips had the incorrect information should have alerted the taxpayer to the need to take additional steps to ensure he had all of his T-slips for the year.

For 2009, the taxpayer argued that he had received a T4 slip and a T4A slip from his former employer, and had concluded that no additional slips were forthcoming from the former employer and that the two slips he received had included all of the income he had received from the former employer in 2009. The Crown argued that a reasonable person would not have made this mistake in the circumstances.

In respect of the legal test, the Tax Court stated that subsection 163(1) is a harsh provision and the absence of language that would limit the due diligence defence made it clear that Parliament had intended that the defence was available to explain the omission in either year. The Court noted that there was no requirement in the provision that the penalty could only be imposed if the taxpayer had first been reassessed in respect of his/her first failure to report (see such a precondition exists in the language of subsections 162(1) and (2) regarding repeated failures to file returns). Accordingly, the defence can be made out where the taxpayer was duly diligent in respect of either of the failures to report income.

In the present case, the Court stated that the taxpayer had been duly diligent in 2008 because he had taken steps to ensure he received his T-slips, he carefully prepared his 2008 tax return, and the unreported amount was a "tiny portion" of his income for the year. Accordingly, the taxpayer was duly diligent in reporting his income in 2008, and the Court allowed the taxpayer's appeal and ordered that the CRA reassess to delete the penalty imposed in 2009.

Additionally, the Court went on to consider whether the taxpayer had been duly diligent in 2009. On this issue, the Court concluded that it was not reasonable for the taxpayer to believe that his former employer would issue only one T4A in respect of the various amounts paid to him in the year. Further, there was a material difference between the amounts the taxpayer knew his former employer had paid to him in 2009 and the amount that had appeared on the single T4A slip he received. Accordingly, the taxpayer was not duly diligent in preparing and filing his 2009 return.

Interestingly, the Tax Court noted in a brief comment that it expected that there was a reasonable chance the Crown may appeal the decision to the Federal Court of Appeal in order to obtain clarity on the interpretation of subsection 163(1). As of the publication of this article, no appeal had yet been filed with the Court of Appeal.

For more information, visit our Canadian Tax Litigation blog at www.canadiantaxlitigation.com

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