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There's a difference between ordinary negligence and gross negligence when it comes to false reporting on tax returns.

Melissa King/iStockphoto

A number of years ago, Dorrell Mainer and her prospective groom, Kevin Rainey, needed money to pay for their wedding in New York. "Plan A" was to pay for it with an expected tax refund, but when the IRS denied that refund, it was time to move on to "Plan B." So they robbed a bank. Now that we're in tax season, here's a question for you: How badly do you want a tax refund? Some will take drastic measures to get money back from the taxman.

Canada Revenue Agency (CRA) knows this and is on the lookout. There's a plethora of court cases where the taxman has discovered a problem on a tax return, reassessed to levy more tax and has charged big penalties for gross negligence. I want to share two stories to shed light on the topic.

Story One

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This first story is about a court decision handed down on Feb. 12. In this case the taxpayer, who I'll call "Mr. D," is an auto mechanic by background. In 2009, he had a conversation with a friend who referred Mr. D to a new tax preparer – an organization that had managed to get his friend refunds. Mr. D engaged this firm to prepare his tax return for 2009.

That year, Mr. D's tax return showed fictitious business losses amounting to $243,097 and a request to carry those losses back to prior years. If these losses had been allowed, they would have resulted in a tax refund to Mr. D of all the taxes he had paid for the years 2006 through 2009 – about $51,700. How's that for a refund? His tax preparer was to receive a percentage of that refund. These losses were fabricated. Mr. D didn't have a business. In the end, the CRA disallowed the losses and imposed penalties for gross negligence.

Mr. D's mistake was that he signed his tax return for 2009 without so much as glancing at the numbers. He trusted his tax preparer. The court was satisfied that Mr. D was unaware of the losses being reported, and so did not knowingly make false statements in his return. But the judge said there's a difference between ordinary negligence and gross negligence. Negligence is the failure to use such care as a reasonably prudent and careful person would use under similar circumstances. Gross negligence involves greater neglect than simply a failure to use reasonable care. It involves a high degree of negligence tantamount to intentional acting or indifference as to whether the law is complied with or not. The judge used the term "willful blindness." Mr. D was accused of this, which equated to gross negligence and big penalties for Mr. D.

Story Two

And now, for Mr. H. In 2005, Mr. H embarked on a new business of buying, fixing up and flipping houses for profit. He was good at the fixing-up part. His wife, Mrs. H, did all the bookkeeping and prepared their tax returns each year. Although she's not an accountant, she had some experience and training in this area. When they started the business, she spent much time researching how to report the income and expenses from this type of business, including spending time on the phone with the CRA.

In 2006, Mrs. H had mistakenly failed to report income of $157,965 from the sale of one property. The couple didn't dispute this fact. Although Mrs. H is normally very thorough in her work, there was some confusion around the profits on the sale of the home in question. Mr. H had sold the property, but the funds received were net of the mortgage amount paid back to the bank. Further, the funds never did come to Mr. H's bank account, but rather, remained in the lawyer's trust account because the funds were immediately used to purchase another property.

The taxes owing in this case were $5,200. The CRA imposed penalties of $28,111. The court sided with Mr. H in this case. The reason? He concluded there was a simple mistake made by Mrs. H. Further, the judge found Mr. H's reliance on his spouse's preparation of his taxes to be reasonable based on her work in the past. There was no gross negligence in this case.

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The judge also concluded that the standard of proof required to conclude that there has been gross negligence should be higher in the case of these penalties, which are quasi-criminal penalties. The Crown needs better evidence to come within the scope of this penalty provision than it would to establish mere negligence.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotia Wealth Management, and founder of WaterStreet Family Offices.

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