Misrepresentation of a tax matter by a third party.

May 3, 2000

Th following letter to the Canadian Department of Finance was prepared under the aegis of the Canadian Income Tax Committee, whose chair is John M. Allinotte of Dofasco, Inc. The comments were prepared following a meeting in Ottawa on March 9, 2000, between representatives from TEI and the Department of Finance. The purpose of the meeting was to discuss TEI's January 14, 2000, submission relating to draft legislation that would impose a civil penalty in certain circumstances on corporate employees for understatements of corporate tax liability. (The previous submission is reprinted in the January-February 2000 issue of The Tax Executive, beginning at page 64). Representing TEI at the March 9 meeting with the Department of Finance and contributing to the development of TEI's comments were, in addition to Mr. Allinotte, David V. Daubaras of GE Capital Canada Inc., J.A. (Drew) Glennie of Shell Canada Limited, David M. Penney of General Motors of Canada Limited, Gary G. Penrose of TransCanada Pipelines Limited, and Alan Wheable of Toronto-Dominion Bank.

On January 14, 2000, Tax Executives Institute submitted comments to the Minister of Finance expressing serious objections about draft legislative provisions captioned Misrepresentation of a Tax Matter by a Third Party. Specifically, draft section 163.2 of the Income Tax Act and draft section 285.1 of the Excise Tax would add parallel penalty provisions that would expose corporate employees to a risk of enormous personal penalties for corporate tax understatements. In response to an invitation from the Department, members of TEI's Canadian Income Tax Committee met with representatives from your office on March 9, 2000, to discuss TEI's concerns. This letter summarizes various issues that were discussed at the meeting and elaborates on TEI's continuing concerns about the draft provisions, especially the onerous penalty amount and the potential for improper administration of the penalty -- whether through widespread assertion to unintended targets or as a potential lever for improperly extracting company tax settlements.

Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,000 professionals manage the tax affairs of the leading 2,800 companies in Canada, the United States, and Europe and must contend daily with the planning and compliance aspects of Canada's complicated business tax laws. The comments set forth in this letter reflect the views of the Institute as a whole, but more particularly those of our Canadian constituency.

TEI recognizes that the Department faces considerable pressure from many sources to prescribe legislation to curb tax shelter -- and especially tax shelter promoter -- activity. Even though we agree with the Department's goals of enhancing the fairness of the tax system and curbing activities that challenge the efficacy of its administration, TEI stands by its previous comments. The aim and scope of the draft provisions are overbroad and will have unintended consequences that will undermine compliance with, and administration of, both the Income and Excise Tax Acts. Under the draft provisions, all corporate employees whose job duties affect financial and tax reporting could be liable to Draconian penalties as a result of acts or omissions involving "indifference" -- whether collectively or individually -- that are beyond the volition of the penalized individuals. We continue to recommend that draft section 163.2 of the Income Tax Act and draft section 285.1 of the Excise Tax Act be revised to clarify that they will not apply to corporate employees acting within the scope of their employment at the direction of the employer. The current civil and criminal penalty regimes provide adequate safeguards to deter misconduct by company employees. At a minimum, TEI strongly urges the Department to ensure that the penalty will only apply to wilful misconduct of employees and not to acts or omissions involving "indifference."

At the conclusion of the March 9 meeting, the Department and TEI representatives agreed that TEI would consider, and provide additional comment on, three specific issues. Our comments on those matters follow.

TEI Representation on Penalty Guideline Committee

The Department stated that Canada Customs and Revenue Agency (CCRA) will establish an advisory committee to assist in developing guidelines governing the assertion of the proposed penalty. TEI's representatives noted that our members work with CCRA on a daily basis and requested that TEI members be included among the practitioners invited to work with CCRA in developing the guidelines. The Department acknowledged that CCRA would benefit from TEI's input and said that it would encourage CCRA to solicit the Insitute's participation. Subject to an invitation from CCRA, TEI is pleased to confirm that it will put forward members to serve on the penalty guideline drafting committee. We would appreciate any assistance the Department can lend to effect this salutary result.

Recommended Cap for the Proposed Penalties

During the meeting, TEI emphasized that, merely by performing their day-to-day duties, many employees could be subject to personal liability for enormous penalties in the range of millions of dollars for understatement of tax on a corporate return. Even though the Department disagrees with our analysis of the flaws in the proposed "indifference" standard (especially in a corporate context where the actions or omissions of multiple individuals can lead to a "false statement" contributing to a corporate tax understatement), the Department conceded that subjecting individual employees to a penalty of 50 percent of a large corporation's tax liability could be excessive. In nearly all cases, such a penalty would exceed an employee's net worth. Hence, the Department invited TEI to recommend an alternative "cap" on the penalty for company employees.

The Department demurred in respect of TEI's previous recommendation of a $1,000 cap, expressing the view that consistent standards and penalty sanctions should be applied to both internal and external advisers. With that in mind, TEI believes that the legislation will be more equitable if the penalty applicable to internal tax advisers (indeed, all corporate employees) is limited to (or capped by) the amount of the individual's "gross entitlement" directly related to or arising from the transaction giving rise to the penalty. In other words, just as penalties on external advisers under draft subsection 163.2(2) are the greater of "gross entitlements" or $1,000, the penalty for misrepresentation of a tax matter applicable to internal tax advisers be the greater of $1,000 or the "gross entitlements" directly related to the activity.

Expand Examples in Explanatory Notes to Illustrate Application of the Penalty to Employees

TEI believes that the "indifference" prong of the "culpable conduct" standard is extremely vague and that, because of the complexity of the tax acts and the difficulty inherent in achieving even substantial compliance with the Acts' requirements, the nebulous language of the penalty standard will likely lead to frequent and inappropriate assertions of the penalty. Indeed, we argued that the penalty could be asserted in many circumstances that are likely beyond the Department's or, ultimately, Parliament's intent. In response, the Department said that the penalty will not be administered at the audit level; CCRA's Head Office will closely scrutinize and approve the assertion of the penalty in every case. The Department emphasized that it has a stake in ensuring that the provision is workable and that TEI should be assured that CCRA will administer the proposed legislation in a reasonable manner, thereby limiting assertion of the penalty to rare and unusual situations "where all would agree that the penalty should be asserted."

In response, TEI noted that the government's assurances in this case are strikingly similar to the assurances that taxpayers received when the General Anti-Avoidance Rule (GAAR) was introduced, i.e., that the provision would be asserted "only in rare, unusual or extraordinary circumstances." Regrettably, the application of GAAR to transactions in large-case audit files has expanded dramatically -- so much so that it is a rare and unusual audit where GAAR is not invoked. More important, taxpayers should not have to rely on the government's oral assurances about the interpretation and application of tax legislation, especially the application of substantial penalties. TEI believes that legislation should be clear and unambiguous on its face.

The Department acknowledged that, while it believes the provisions should apply to company employees in the same manner and fashion as they apply to self-employed individuals and to external tax advisers and promoters, the Explanatory Notes to the legislation omit examples illustrating the application of the rules to company employees. To address TEI's concerns, the Department offered to consider adding examples to the Explanatory Notes and invited TEI to submit examples.

Upon further reflection, we have concluded that the legislation is so broad that the inclusion of additional examples would, by itself, be an insufficient remedy for its flaws. That is to say, no matter how many examples are included in the Notes, there will be many situations where the penalties should not apply but the literal language of the legislation will permit or require the imposition of the penalty. Hence, it would be better for the Department to clarify the legislation itself rather than add examples to the Explanatory Notes.

Should the Department decide against revising the legislation, TEI recommends that the Department consider the examples presented in our January 14, 2000, submission and discuss in the Explanatory Notes how the rules apply to each situation. To assist the Department in that endeavor, we attach Appendix 1, which sets forth those examples together with a proposed conclusion that will permit the Department to more easily incorporate them in the Explanatory Notes. The examples are hardly an exhaustive compilation of the manifold situations that can arise in corporate tax planning and compliance, but they represent a start.

Clarification of Penalties for Internal and External Advisers and "Reliance in Good Faith" Defense

In the previous submission and during the course of the March 9 meeting, TEI questioned (1) whether the penalties apply evenly to internal and external tax advisers and (2) whether the "reliance in good faith" defense is available for company employees. The Department confirmed that the same penalty standards and amounts are intended to apply to corporate employees (whether large or small companies), self-employed persons, and internal and external advisers. The goal of applying equivalent sanctions in a neutral fashion to similar misconduct is not in question. We do, however, question whether the draft legislative language advances the goal since self-employed individuals (and corporate employees, absent changes to the draft legislation) will, in most cases, seemingly be subject to a "50 percent of tax understatement" penalty under draft subsection 163.2(4), whereas the penalty for external advisers will, in most cases, seemingly be limited under draft subsection 163.2(2) to the "gross entitlements" received for a planning activity.

The Department also expressed the view that the current draft of the statutory language affords a "reliance in good faith" defense for all corporate employees. TEI continues to believe that the current draft of the legislation does not clearly establish that the "reliance in good faith" defense is available to company employees generally and inside tax advisers specifically. We recommend that the legislation be clarified to state explicitly that the reliance in good faith defense is available to employees of large companies and that the Explanatory Notes confirm its availability with examples that illustrate the issues.

Conclusion

TEI appreciates the invitation from the Department to meet to discuss our views in respect of how the legislation should be clarified. We also appreciate the opportunity to provide input into implementation process to ensure the legislation is applied in a reasonable and fair manner to all tax advisers. TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is John M. Allinotte. If you should have any questions about the submission, please do not hesitate to call Mr. Allinotte at [phone] (ext. 6821), or Marlie R.M. Burtt, TEI's Vice President for Canadian Affairs, at [phone].

Appendix 1 Examples Where Third Party Penalties Would not Apply to Employees of Corporate Employers

Example 1A. A member of the corporate tax department provides correct tax advice to a field engineer (or other employee) who misunderstands the information and incorrectly documents an SR&ED project expenditure. The tax return is filed on the basis of the directions provided by the tax department, but the paper trail of documentary evidence created by the engineer (or other employee) is at variance with the directions and, hence, indicates that the tax return includes a "false statement."

The penalty provision does not apply to this situation. The penalty does not apply to false statements on a return that result from errors or omissions in the preparation of a return. There is no intentional, wilful, or reckless disregard of the Act. Even assuming the misunderstanding is attributable to the negligence of one or more company employees, the "indifference" standard of "culpable conduct" is not met.

Example 1B. In response to information supplied by a field engineer, a member of the corporate tax department provides advice to the field engineer (or other employee) who then documents an SR&ED project expenditure in accord with the instructions and advice rendered. The tax return is also filed on the basis of the directions provided by the tax department. The tax department's advice, however, is erroneous because it is not based on all the pertinent facts. (The field engineer who supplied the information to the tax department was either unaware of the relevance and significance of certain information for the tax determination or misunderstood the request for information.) As a result, the tax treatment of the expenditure is incorrect and, hence, the tax return includes a "false statement."

The penalty provision does not apply to this situation. The penalty does not apply to false statements on a return that result from errors or omissions in the preparation of a return. There is no intentional, wilful, or reckless disregard of the Act. Even assuming the misunderstanding is attributable to the negligence of one or more company employees, the "indifference" standard of "culpable conduct" is not met.

Example 2. An employee -- a highly trained tax professional -- undertakes to prepare and file the company's corporate income tax return for the most recently completed fiscal year. During the course of preparing that return, the employee discovers a technical issue that he believes should be investigated and makes notes of it. Because of the time constraint of the filing deadline, however, the employee is unable to fully investigate the matter and resolve it prior to filing the return. The tax professional subsequently resigns his employment with the company under circumstances involving considerable rancor and animosity toward the company and the other members of the corporate tax department. During the course of the audit of the return, other members of the tax department discover the notes and conclude that the previously filed return includes a material error. The remaining employees attribute the error to the "indifference" of the former employee.

The penalty provision does not apply to this situation. (Note: If the Department concludes otherwise, we invite the Department to explain in the Notes (1) who is liable to the penalty and (2) how either the former or current employees are to defend against the assertion of the penalty.)

Example 3. Assume that errors are discovered on previously filed GST returns. Owing to the large volume of transactions and frequency of filing GST returns, the company pays the additional taxes due on a subsequent period GST return rather than file amended returns for the earlier tax periods. Voluntary correction of GST payments in subsequently filed returns is a common practice among large companies.

Even though the practice of voluntarily overreporting a tax liability and submitting a correspondingly higher tax remittance to offset liabilities that were underreported in earlier filed GST returns is not technically correct under the Excise Tax Act, the practice does not amount to intentional, reckless, or wilful conduct or "indifference as to whether the Act is complied with" within the meaning of "culpable conduct" as contemplated by the legislation. This is true in respect of both the previously filed tax returns showing the underreported liability and returns reflecting voluntary overpayments. Hence, the penalty provision does not apply.

Example 4. Assume an intercompany asset sale of a business division between related, taxable members of a corporate group. The sale is effected by using book value as a proxy for the fair market value of the assets. A standard "price adjustment" clause is included in the purchase and sale agreement to account for changes in valuation between the contract and closing date as well as for valuation challenges from the tax authorities. A full-blown appraisal of the assets is not undertaken because the risk of a significant adjustment to the assets' individual or aggregate value is considered immaterial or offsetting in effect between the two companies in the affiliated group. In other words, the corporate group is prepared to accept the risk of additional interest and penalty cost should the price be successfully challenged on audit. An adjustment is proposed to the valuation of the assets leading to an underpayment of corporate tax by one or more members of the group.

The penalty provision does not apply in this situation. Employees are not guarantors of the accuracy of the corporate group's tax liabilities. The corporate group made a good faith judgment that the group's tax liabilities would not be materially affected by the failure to undertake a valuation on the sale of the assets. To the extent that the understated tax liability is attributable to a "false statement" on any group member's corporate tax return, there is no intentional, wilful, or reckless conduct or "indifference as to whether the Act is complied with" within the meaning of the legislation because the tax liability of the group as a whole is not understated.

Example 5. Assume that an employee in the corporate accounting group who is unfamiliar with tax rules inadvertently deletes certain critical general ledger files before a tax audit is completed. The deletion of the files prevents the company from documenting the information shown on the return. The company is likely subject to penalty for failing to exercise adequate controls over its records.

Even though the company is subject to other penalty provisions, the penalty contemplated by the legislation does not apply because the individual who deleted the files did not act knowingly or with "indifference as to whether the Act is complied with."

Example 6. Assume that a telephone help-line employee of Canada Customs and Revenue Agency (CCRA) provides incorrect advice to a company employee about the treatment of certain items. The CCRA employee provides the incorrect advice because he fails to consult the legislative material routinely available to all CCRA employees. The company employee subsequently prepares the company's tax return on the basis of the statements made by the CCRA employee.

The penalty provision does not apply to the corporate employee because he did not "act with indifference." (Query whether the CCRA employee is subject to a penalty based on 50 percent of the amount of the understated corporate tax liability?)

Example 7. Assume that a company determines that the costs (in terms of time and money) of documenting its transfer-pricing policy for certain intercompany transactions is prohibitive. The number of such transactions is large but the dollar amount of each transaction is de minimis and the company has some evidence, but less than the quantum required by the transfer- pricing legislation or CCRA's information circular, indicating that the price reasonably approximates an arm's-length price. Assume that CCRA determines that the transfer price should be adjusted and the company is re-assessed on the basis of the adjusted transfer price. The assessment is settled (or affirmed) at Appeals or in litigation.

Regardless of whether transfer pricing, documentation, or other penalties may be asserted against the company, the misrepresentation penalty provision does not apply to any company employee. A reasonable business judgment is not an act of "indifference" that meets the definition of "culpable conduct" under the legislation. Hence, the misrepresentation penalty does not apply to the senior tax executive, the tax professional providing transfer-pricing advice, the return signer (if different from the others), or even the business unit decision-maker who may have had a difference of opinion with the tax department and decided to eschew the full documentation required by the transfer-pricing legislation or CCRA's information circular. The employees are entitled to rely in good faith on the corporate decision-making process.