Expensive But Worth It

Recently, the Tax Court of Canada (TCC) levied interest and gross negligence penalties against five taxpayers who were shareholders and operators of a family restaurant.

Hot Spot Restaurant v. The Queen is a great example of a taxpayer defeat of a net worth assessment¹.  But what makes this case fascinating is the conduct and performance of the Canada Revenue Agency (CRA), who dragged the subject family through lengthy litigation and in general,  treated them poorly throughout.

When appealing net worth assessments, just like in other tax appeals, the taxpayer has the initial onus of demolishing the assumptions of the CRA. If the taxpayer establishes a prima facie case that the assumptions of the Crown are wrong, then the burden shifts to the Crown to prove its assumptions on a balance of probabilities.

The appellants in Hot Spot did so.  They were able to satisfy the Court that, after being closed for seven months due to a fire, the restaurant did not return to profitability until its 2000 taxation year. They argued that any increase in net worth that occurred prior to 2000 was a result of loans from family members and friends, distributions from an estate, and significant payments under two insurance claims.

The Court, meanwhile, noted a material error in the net worth evaluations.  The CRA performed a single net worth calculation for shareholders Peter and Voula and then attempted to allocate the result between the two taxpayers. At paragraph 33 the Court stated:

“I do not understand how the CRA, after conducting an extensive investigation of Hot Spot and its books and records over three years, could have allocated all of the unidentified appropriations to Voula. She simply did not have the means to effect such a large appropriation."

The enforcement officer for the CRA testified that he allocated the amount to Voula because she was “the shareholder of the company”. The Court noted however that she only held 30% of the shares of Hot Spot and further that she held them in trust for her disabled son. Moreover, the Court stated at paragraph 34 that the CRA “had to know, after conducting its extensive review of the Appellants’ affairs, that Voula had very little involvement with Hot Spot and that her late husband Peter was the controlling mind”.

The CRA did not take into account $218,631 of payments Peter and Voula received from third parties during their net worth assessments and instead attempted to persuade the Court that once the restaurant reopened after being closed for seven months due to a fire, it increased its annual sales by approximately 45%. The evidence simply did not support that however; the Court found an annual increase of 6% after reopening.

The conduct of the CRA got even worse.  During the trial Court heard and accepted as true that the CRA returned documents to the appellants in such a form that they could not use the documents at trial. The CRA officials left the boxes containing the documents on the street outside of the restaurant. Further, the CRA did not provide any form of index noting what was contained in specific boxes.

The Court also noted that the CRA made photocopies of the seized documents prior to returning the documents to the appellants. Various witnesses testified as to the authenticity of some of the purported copies, and many were illegible. The Court did not admit those documents into evidence. Even after reviewing the legible documents the Court noted that other important documents such as the daily sales reconciliation sheets were absent.

At paragraph 90 the Honourable Justice S. D’Arcy stated that it was not clear to him why the CRA did not provide all of the documents that made up the daily reconciliation.

The only aspect of the net worth assessments against the appellants that survived the appeal was $4,314 which one of the family members failed to report in 1998. All of the other assessments against all of the appellants for all three years under appeal were struck, as were all of the gross negligence penalties against all of the appellants for all of the taxation years.

It would appear that the CRA was relying on the fact that the onus would be on the appellants to demolish their assumptions. Fortunately the appellants had strong legal representation, but this would not have been inexpensive.  The Court awarded costs against the CRA, but costs do not cover all legal costs incurred, nor do them compensate for the time and stress involved in such litigation.

^1.  In a Net Worth assessment, the government (CRA) determines the changes in a client’s Net Worth (Assets – Liabilities) and imputes their income based on any increase in net worth.

Greer Jacks practices law in Victoria, BC. and researches significant cases for Knowledge Bureau for inclusion in EverGreen Explanatory Notes.