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Taxes and Tax Penalties
CAVEAT
None of what appears here is meant to be a complete discussion of the subject. If something twigs an interest, talk to someone who does tax work as a specialty. The rules change frequently and seldom in the taxpayer’s favour.
Most people see income taxes to be enough of a penalty that they don’t look much farther. They should. There are a wide range of ways the tax authorities can extract more.
There are several categories and there are cases aplenty to discover. The taxpayer does not always lose, but that’s the way to bet.
Fraud and misrepresentation
The act presents degrees of error. The range from fraudulent misrepresentation to gross misrepresentation to innocents misrepresentation. The dividing lines are unclear and prior behaviour can shift you from one to another. Always upwards though. This is tax evasion.
Fraudulent misrepresentation is pretty easy. You have a job somewhere and have a business on the side. The business earns significant amount, but you don’t report any income from it. The penalty will be 50% of the income not reported. Given that your normal taxes apply in addition to that penalty, the total can be close to all the income you earned. Plus interest of course.
Gross misrepresentation involves things that are an interpretation of events that has no sound basis in fact. For example, you have a business you run out of your home. You claim 50% of allt he housing costs as expenses of the business. While generally a reassessment, if you have been reassessed before, perhaps lost in tax court before on the same facts, a penalty of 25% of the income avoided. If it goes too far it could become evasion.
The most common is someone who fails to report income where tax slips are presented. Let’s say you take money out of an RRSP and don’t report it. If you have done it before, they will penalize the second and subsequent events.
Innocent misrepresentation is the first time you miss a slip and don’t correct it. While the penalty in theory would apply, the authorities will usually not apply it.
Misusing structures and special provisions built into the tax act.
The act is essentially a book of rules and exceptions. The general case of who is taxable and on how much comprise about 1/600th of the act. When you are doing something that changes the nature of income or deductions, changes the owner of the income, or alters the residence of the recipient, you are getting into the technical area. Intuition will not be your friend. Seek professional help.
- The most common are of mistake is in corporate reorganizations. The incorporation of a previously unincorporated business, or freezing an existing corporation and transferring the rights to future income to new shareholders. Both look pretty easy, but in fact are not. The key is the value of what you received for what you “sold” must be equal. If you take “consideration” that is worth more or less than fair value of the assets transferred, there can be problems and penalties can apply. Many people balk at the fees to do a sound business valuation and risk serious consequences later. Value is a slippery subject.
- Income splitting is a common failing too. Opening an investment account in the name of the low rate paying spouse is quite easy. Having the income earned be taxable to them is is not. There are provisions in the act that attributes income to the person who supplied the capital. Income splitting has many rules and not so obvious exceptions you should know about before going far. Ask about or search “Kiddie-Tax” for a sense of the lengths they will go to in preventing split income.
At one time people set up trusts in their will so income could be earned and taxed in the trust and then paid to the beneficiary tax free. In some cases the saving was significant. Over $15,000 per year. The legislation changed as this became more common.
It is possible to split investment income with a spouse using Interspousal loans at prescribed rates of interest. Not hard to see the value. Spouse1 borrows at 1%, (The prescribed rate for Q3 2021) from spouse2. There is formal documentation. They then invest at 4% and pay tax on the 3% profit at their lower rate. What if they don’t pay the interest and spouse2 doesn’t include that interest in their own return. A problem, and all of the income earned will likely be deemed to belong to spouse2. Taxes and interest and possibly penalties due. If you are going to use particular rules they provide, you must do so with great care and precision. - Specific structures for particular purposes exist throughout the act. There are many from Registered Retirement Savings Plans (RRSP) to pension plans, to registered education savings plans, to registered disability savings plans, to tax free savings accounts. All of them involve at least four conditions
a) Who can have one?
b) How much can they put in?
c) How may they invest it once in the plan?
d) What happens when they take it out?
The rules on each factor are specified in the act and in the regulations. You should not assume a common sense or intuitive definition. For example Crypto currencies are not a permitted investment. A crypto ETF might might be. Emphasis MIGHT BE. There are penalties for overcontributing, usually 1% per month, and for holding ineligible investments. At least 1% a month and with TFSAs more. If you have any potential investment more exotic than stocks, bonds, and bank accounts you should get a list of eligible investments, then see if yours is specifically permitted. If not, have a good reason to run the risk.In these cases, it is not prohibited is not a good defence. - Administrative rules. There are penalties for filing your return late and for failing to file some elective things late. There are significant penalties for late payment of payroll deductions. Not only penalties but the directors of the company can become personally liable for the amounts. You need not have any knowledge of the defect. If you are a director of a non-business entity, like a community service organization, you should ask the question periodically.
Loophole seeking
Everyone loves a good loophole. There once was a Wizard of Id cartoon where a peasant is on the gallows and explains to the king that his lawyer said there was a loophole.The king replies, “You’re wearing it.”
For a long time the tax authorities were held to the specific wording of the act and if someone arranged their affairs in a way to minimize their tax, it was generally accepted, albeit promptly repaired by legislation. For the past couple of decades there has been GAAR, The General Anti-Avoidance Rules. The idea behind these rules is that if a taxpayer organizes their affairs to minimize tax, and there is no other reason for the structure used, the tax authorities can and arguably should ignore it. If you want to try something, be sure there is a non-tax reason for doing it.
There is little limit to the creativity of tax advisors and there are many examples of what has been deemed offensive. They range from offshore trusts, to exotic methods of moving accumulated earning out off a corporation, to income splitting in ways that are not the normal spousal split idea.
The authorities have some latitude in attacking it. As anyone who has spent time in tax court knows, the process is the punishment. From assessing to appeals, to court, to an appeal court is a tedious, stressful and expensive process. You don’t go there without the opportunity for a meaningful gain.
The takeaway
Never, as in not ever, rely on intuition in tax matters.
The Canadian tax act is self reporting and you are assumed to know the details. You don’t. In fact no one knows all of them and the interpretations. If there is only tax to pay that you would have owed anyway, you can take some risks. If there are potential penalties, seek advice and err on the side of caution.
Tax avoidance is not anything like tax evasion. Evasion tends to have taxpayers coming out of court with blood all over them. Sometimes on their way to jail.
I help people have more retirement income and larger, more liquid estates.
Call in Canada 705-927-4770, or email don@moneyfyi.com
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