Introduction - The Canada Revenue Agency Reveals Internal Tax-Audit Policy on Loss Carryovers
In R v Posteraro and Dyck, 2014 BCPC 31, a voir dire about the admissibility of evidence in criminal proceedings for tax evasion, the Canada Revenue Agency revealed that it had an internal policy to audit any loss carryover claim exceeding $200,000. Indeed, a $700,000 non-capital loss carryover triggered the additional CRA scrutiny that ultimately led to criminal charges at issue in Posteraro and Dyck.
While most Canadian taxpayers need not worry about criminal liability for tax evasion, Posteraro and Dyck illustrates that even relatively mundane tax deductions may give rise to a tax audit. After discussing loss carryovers and the Posteraro case, this article concludes by offering pro tax tips.
Loss Carryovers: Non-Capital Losses & Net Capital Losses
A non-capital loss carryover arises when a taxpayer's current-year losses exceed the taxpayer's current-year income. Canada's Income Tax Act precludes a taxpayer from reporting a negative figure as income for the year. So, if, in a taxation year, a taxpayer's aggregate losses (from a non-capital source) exceeded the taxpayer's total income and taxable capital gains, the taxpayer reports nil income for that year and may deduct the excess loss from another year's income in the form of a non-capital loss carryover.
A net capital loss carryover arises when a taxpayer's current-year allowable capital losses exceed the taxpayer's current-year taxable capital gains. Capital losses can generally only offset capital gains. So, if, in a taxation year, a taxpayer disposed of several capital properties and thereby realized allowable capital losses that exceeded the amount of any taxable capital gains, the taxpayer reports a nil gain for that year and may deduct the excess loss from another year's income in the form of a net capital loss carryover.
Paragraphs 111(1)(a) and 111(1)(b) of Canada's Income Tax Act govern these two sorts of loss carryovers. (Subsection 111(1) also governs loss carryovers relating to farm losses, restricted farm losses, and limited-partnership losses. But this article will focus on non-capital loss carryovers and net capital loss carryovers.) The following two sections will discuss the mechanics of non-capital loss carryovers and net capital loss carryovers in more detail.
Non-Capital Loss Carryovers
A non-capital loss carryover relates to losses from a non-capital source-e.g., a loss resulting from business expenses or employment expenses.
You may deduct a non-capital loss from your taxable income in any of the 3 tax years preceding the loss-generation year or any of the 20 tax years following the loss-generation year.
For example, in 2020, a taxpayer earned $50,000 in employment income and sustained a business loss of $80,000. Hence, for 2020, the taxpayer's non-capital loss is $30,000 (i.e., $50,000 - $80,000 = ($30,000)).
The taxpayer may therefore claim the $30,000 non-capital loss as a deduction against taxable income in any of the 3 preceding tax years (i.e., 2017 - 2019) or in any of the 20 following tax years (i.e., 2021 - 2040). The taxpayer has discretion over the specific years for which to claim the non-capital loss carryover, and the taxpayer has discretion over how to allocate the $30,000 across the available tax years.
Net Capital Loss Carryovers
A net capital loss carryover relates to losses from a capital-source-i.e., allowable capital losses that exceed your taxable capital gains for that year. (The distinction between a capital transaction and a business transaction turns on whether you intended to invest or to trade when acquiring the subject property. To assess your intention, courts evaluate a number of factors, including the nature of the property that you sold, the frequency of any similar transactions, the amount of time that you owned the property, and the circumstances surrounding the sale. As a result, you might find it difficult to determine whether you should report a sale on capital account or income account. If you find yourself in this position, please seek tax guidance from one of our experienced Canadian tax lawyers.)
You may deduct a net capital loss from a taxable capital gain that you realize in any of the 3 tax years preceding the loss-generation year or any tax years following the loss-generation year. That is, you may carry forward a net capital loss indefinitely over your lifetime.
Like an allowable capital loss, a net capital loss is generally only deductible against a taxable capital gain, but this restriction doesn't apply to the taxpayer's year of death and the immediately preceding year. For those two years, a net capital loss may be deducted against any source of income.
For example, in 2020, a taxpayer earned $50,000 in employment income, realized a $9,000 taxable capital gain, and incurred an allowable capital loss of $80,000. Hence, for 2020, the taxpayer's net capital loss is $71,000 (i.e., $80,000 - $9,000 = ($71,000)).
The taxpayer may therefore claim the $71,000 net capital loss as a deduction against any taxable capital gain in any of the 3 preceding tax years (i.e., 2017 - 2019) or in any tax year from 2021 onward. The taxpayer has discretion over the specific years for which to claim the net capital loss carryover, and the taxpayer has discretion over how to allocate the $71,000 across the available tax years.
Suppose that, in 2040, the taxpayer died without claiming the $71,000 net capital loss. The taxpayer's estate may claim the $71,000 carryover against any source of income that the taxpayer earned in 2040 or in 2039.
Taxpayer's $700,000 Loss Carryover Triggers a CRA Tax Audit-and a Criminal Investigation for Tax Evasion
In R v Posteraro and Dyck, 2014 BCPC 31, the Canada Revenue Agency revealed that its internal policies meant that any taxpayer who claimed a loss carryover exceeding $200,000 would thereby increase the odds of triggering a CRA tax audit.
Two taxpayers owned and operated an incorporated railway-maintenance business. In 2006, the taxpayers and their corporation underwent a CRA income-tax audit. The CRA tax auditor discovered that the taxpayers had claimed about $160,000 in personal expenses as business expenses. The Canada Revenue Agency adjusted the income and reassessed for additional tax owing. Yet, in an unusual display of restraint, the CRA tax auditor decided against applying gross-negligence penalties. (The Canada Revenue Agency's tax auditors have historically been overzealous in doling out gross-negligence penalties.)
After the first tax audit, neither the taxpayers nor the corporation had any further run-ins with the CRA-that is, until 2010, when their corporation requested a $750,000 non-capital loss carryover. "All loss carry-backs in excess of $200,000 are internally referred by the CRA for audit consideration," explained Judge Marchand. Hence, the taxpayers and their corporation had yet again found themselves on the CRA's radar.
Not only did the second tax audit uncover non-compliance surpassing that discovered during the first tax audit, but it ultimately put the taxpayers in the crosshairs the CRA's Criminal Investigations Division. The CRA denied over $1.3 million in improperly claimed business expenses. And the taxpayers' accountant confessed that the corporation had underreported its GST by approximately $165,000. The Canada Revenue Agency tax auditor applied gross-negligence penalties and referred the file to the CRA's Criminal Investigations Division, who soon thereafter executed a search warrant and eventually laid criminal charges for tax evasion. During trial, when the CRA tax auditor was asked why he referred the file to the Criminal Investigations Division, the auditor replied that his office promoted its own internal policy of making such a reference for any file "involving adjustments over $10,000 and gross-negligence penalties."
The Posteraro decision itself focused on whether the Canadian Charter of Rights and Freedoms had barred certain evidence from the taxpayers' pending criminal trial. Yet, for our purposes, the case's true value is that it illustrates some of the inner workings of the Canada Revenue Agency's Audit Division and its Criminal Investigations Division. In particular, the Canada Revenue Agency observes a number of criteria when selecting taxpayers for a tax audit or a criminal tax investigation. These criteria reflect policies that the CRA promotes both across the entire agency and within its many local offices. So, depending on a taxpayer's industry, territory, and past tax filings, a fairly routine tax filing may provoke not only a CRA tax audit but also a criminal tax investigation.
Pro Tax Tips - Projecting Your Rights During a CRA Tax Audit
The CRA's tax auditors enjoy significant information-gathering powers. And courts respect these powers. As a result, if you're the subject of a CRA tax audit, you won't find much legal support for simply ignoring an auditor's requests for information.
That said, you need not answer every question posed by a CRA tax auditor. The Federal Court of Appeal confirms that the Canada Revenue Agency "does not have the power to compel a taxpayer to answer questions at the audit stage" (MNR v Cameco Corporation, 2019 FCA 67, at para 28).
You should understand, however, that a CRA tax auditor may draw an unfavourable inference when you refuse to answer questions, and that the CRA is free to make assumptions and to assess tax on the basis of those assumptions. Moreover, during a Tax Court appeal, the taxpayer bears the onus of rebutting any assumptions made by the CRA tax auditor. In other words, during a tax audit, you must pick your battles. Otherwise, you may find yourself facing a slew of outlandish assumptions.
You're better off seeking the advice of an experienced Canadian tax lawyer, who can advise you of your rights, determine when it may actually help your case to answer a tax auditor's questions, and ensure that the information you submit to CRA is both accurate and relevant.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.