Case Dismissed: Due Diligence in Failure to Report Income

Tax and financial advisors take note: Within its reasons for judgment in a recent case, the Tax Court of Canada (TCC) has made some interesting comments about the due diligence defence as it pertains to subsection 163(1) of the Income Tax Act, and about how this defence can be successfully used in the context of a penalty under subsection 163(1).

The TCC dismissed the appeal of a taxpayer who was reassessed $51,727 and penalized $5,172.70 for failing to report income for the 2012 taxation year. The comments made in this judgment are important because this issue has not yet been decided by a higher court (the Federal Court of Appeal) and, therefore, the TCC’s comments are currently the latest guiding precedent on the issue.

Subsection 163(1) imposes a penalty of 10% of the amount of income not reported, if a taxpayer fails to report a taxable amount for two taxation years within a four-year period. However, a defence of due diligence is available to the taxpayer charged under subsection 163(1). The taxpayer in Dhanoa v. The Queen (2015) TCC 164 failed to report certain amounts of income in 2011 and 2012, thus invoking subsection 163(1).

The Honourable Justice Valerie Miller stated that she did not agree with the reasoning of at least four other judges of the TCC, who have held that a taxpayer can avoid a penalty under subsection 163(1) if they can establish a due diligence defence for either of the two years within the four-year period.

A defendant may rely on a due diligence defence if they made a reasonable mistake of fact or took reasonable precautions to avoid the event leading to the imposition of the penalty. Since the Federal Court of Appeal has yet to decide the issue, Justice Miller gave the taxpayer the benefit of the doubt by considering the due diligence argument for both 2011 and 2012. However, the TCC decided that the taxpayer in Dhanoa did not satisfy the conditions for a successful due diligence defence.

Of more interest to advisors are the specific results of this decision, and the implications they may have for future cases regarding subsection 163(1). Prior to Dhanoa there was a general consensus that if a due diligence defence was successfully argued for one of the two years at issue then the taxpayer could potentially avoid all of the penalties.

Dhanoa calls this interpretation of the Act into question and, although it is unlikely that another judge from the TCC would hold otherwise until a higher court considers the issue, it will be very interesting to see how, going forward, the Federal Court of Appeal interprets the due diligence defence as it pertains to subsection 163(1).

Greer Jacks practices law in Victoria and is a regular contributor to Knowledge Bureau Report. He has recently updated the certificate course, Use of Trusts in Tax and Estate Planning, for Knowledge Bureau.

ADDITIONAL EDUCATIONAL RESOURCES: MFA-Succession and Estate Planning Services Designation Program.