Over a year after it was originally heard, the Tax Court of Canada released a long-awaited case, Labow et al v. The Queen[1], in which the CRA successfully attacked deductions claimed for contributions to an “offshore health and welfare trust”.  But in addition, the case, along with a number of other recent cases (discussed below), continues the trend of the CRA’s successes in being able to reassess beyond the normal reassessment period. 

 The offshore structure - and the CRA dispute that resulted in the case itself – has become well known to many tax practitioners, especially around Ontario: as the case says, the taxpayers are among 75 files involving these trusts implemented by one Ottawa lawyer alone.  Actually, the Labow case involved three of the lawyer’s clients.  But I will largely confine my comments to one of them, especially since the fact situations are fairly similar.

 Dr. Labow, an Ottawa-area physician, started an offshore trust for his wife - essentially a part-time employee making $20,000 a year.  The plan involved disability and health benefits, but as the latter was funded on a pay-as-you-go basis, it is the disability benefits that ostensibly enabled large contributions.  The plan specified that a participating employee (i.e., Mrs. Labow exclusively) who is unable to work because of sickness or accidental injury is entitled to income replacement benefits equal to 75% of weekly earnings to age 70.[2]  Generally for these plans, the contributions were payable in two annual installments; the actuarial calculations were made on the assumption that the participating employee would be totally disabled at the end of the second year of the plan and would remain so until age 70.  Needless to say, these assumptions would generate very large contribution limits.  In fact, nearly $400,000 was contributed to the trust over the two-year period.[3]

 The CRA attacked the contributions as non-deductible expenses on a number of alternative grounds, including that the plan was a “sham” and the contributions were not made for the purpose of gaining or producing income.[4]

 The court ended up holding that, although the plan was not a sham, the contributions to the trust were not made for the purposes of gaining or producing income, so as to deny the deduction under paragraph 18(1)(a) of the Act (in view of this, the court declined to deal with the other grounds advanced by the CRA).  The court’s rationale is routed in common sense: notably, there was no commercial reason for Dr. Labow to spend $400,000 for such a plan (especially since Mrs. Labow already had a disability plan), nor did he attempt to compare the cost of the plan with the cost of purchasing similar coverage from an insurance company.

 The court also held that the income from the trust was taxable under the reversionary trust rules in subsection 75(2) because the particular plan provided that the residual amounts in the plan reverted to the employer.[5]  

Limitation Period Breached

 But the more interesting part of the case is the fact that the court upheld the CRA’s attempt to reassess beyond the normal reassessment limitation period. 

Generally, in order to do this, there must be a “misrepresentation” that is attributable to neglect, carelessness, willful default, or fraud.[6]  In the case of Dr. Labow’s contributions to the trust, the misrepresentation was that the deductions for the contributions were buried in salary expense on the financial statements[7].

In addition, the normal reassessment period can be extended (for three years) if the reassessment is made as a consequence of a transaction involving the taxpayer and a non-arm’s-length non-resident person.  The court held that, because the trust gave the employer the power to replace the trustee, Dr. Labow had “control” of the trust with the result that “he and the trust were clearly not operating at arm’s-length.”[8]

Not Just Unreported Income

As I said earlier, Labow is just the latest in a growing number of cases in which the CRA has successfully breached the limitation period.  Not just in respect of unreported income, other recent cases have shown that the normal reassessment period can be abrogated in respect of “technical issues” as well, where the taxpayer has not exercised reasonable care – basically, that of a “wise and prudent person”.  In one recent case[9], the assessment limitation period was breached because the taxpayer, part of an associated group of corporations, did not pay or report federal capital tax (which would have also reduced the company’s small business deduction).[10]  Another recent case[11] involved claiming the capital gains exemption where a corporation lost its CCPC status because of a merger.  These cases are discussed in a recent article by my tax partner at Minden Gross, Joan Jung[12].  This is not to say that a technical mistake, per se, will allow the CRA to open up the assessment limitation period.  In the well-known recent case involving Toronto Sun cartoonist Andy Donato[13], the court held that the taxpayer’s mistaken belief that the capital gains on donations of his cartoons were subject to the “personal-use property” rules did not constitute neglect, carelessness or willful default[14]. 

Another recent case[15] in which the CRA successfully breached the assessment limitation period and imposed the 50% gross negligence penalty (under subsection 163(2)) involved taxpayers who tried to redo corporate resolutions in order to fix a situation where Part IV tax would otherwise apply.  The CRA refused to admit the validity of the resolutions, characterizing them as retroactive tax planning that were never intended to be part of the original corporate reorganization plan in question. 

As pointed out in Joan’s article, the CRA’s Audit Manual suggests that tax auditors should look to the number of transactions for which income has been understated, or a single improperly recorded or omitted transaction involving a material amount of income[16].

In view of the emerging cases, heeding these (perhaps “inelegant”) guidelines may be prudent.  In addition to the ability to breach the assessment limitation period, one should also be aware of the 50% gross negligence penalty mentioned earlier which, although perhaps requiring somewhat more egregious conduct, nonetheless may often go hand-in-hand with extending the assessment limitation period. 

What bothers me about the CRA’s policy is that, in the real world, due diligence on a tax filing item can be a sliding scale ranging from a completely innocent mistake all the way to “taking a shot” at a dubious tax filing position in the hopes that it isn’t caught.  As the tax involved gets bigger, do we move closer to serious consequences for nothing much more than a simple mistake?  This is a chilling thought for tax preparers who don’t have the luxury of an in-house tax practitioner. 

The Labow case raises a number of other interesting issues which, though beyond the scope of this article[17], will no doubt be dealt with at greater length by other commentators. 

—        David Louis, tax partner, Minden Gross LLP, a member of MERITAS law firms worldwide. David's practice focuses on tax and estate planning for entrepreneurs and their corporations (dlouis@mindengross.com).