Draft CITA information circular on third-party civil penalties.
On March 15, 2001, Tax Executives Institute submitted the following comments to the Canada Customs and Revenue Agency on the tax agency's draft information circular on the administration and application of penalties under the Canadian Income Tax Act and Excise Act (ETA). The comments were prepared under the aegis of the Institute's Canadian Commodity Tax Committee, whose chair is David M. Penney of General Motors of Canada Limited.
In response to an invitation extended to J.A. (Drew) Glennie, Tax Executive Institute's 2000- 2001 Secretary, by William V. Baker, Assistant Commissioner, Compliance Programs Branch of Canada Customs and Revenue Agency (CCRA), I am pleased to provide TEI's comments and recommendations in respect of draft Information Circular 01-1. The circular outlines CCRA's guidelines for the administration and application of penalties under section 163.2 of the Income Tax Act (ITA) and section 285.1 of the Excise Act (ETA), the so-called third-party civil penalty regime.
Tax Executives Institute is the preeminent association of business tax executives. The Institute's 5,200 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 business tax laws. Canadians make up 10 percent of TEI's membership, with our Canadian members belonging to chapters in Calgary, Montreal, Toronto, and Vancouver, which together make up one of our eight geographic regions. Our non-Canadian members (including those in Europe) work for companies with substantial activities in Canada. In sum, TEI's membership includes representatives from most major industries including manufacturing, distributing, wholesaling, and retailing; real estate; transportation; financial services; telecommunications; and natural resources (including timber and integrated oil companies). 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 is concerned with issues of tax policy and administration and is dedicated to working with government agencies in Ottawa (and Washington), as well as in the provinces (and the states), to reduce the costs and burdens of tax compliance and administration to our common benefit. We are convinced that the administration of the tax laws in accordance with the highest standards of professional competence and integrity, as well as an atmosphere of mutual trust and confidence between business and government, will promote the efficient and equitable operation of the tax system. In furtherance of this principle, TEI supports efforts to improve the tax laws and their administration at all levels of government.
The draft circular provides a comprehensive review and interpretation of the third-party civil penalty legislation and outlines CCRA's proposed guidelines for its administration. TEI has a vital interest in ensuring that the guidelines are clear and workable. Indeed, during consultations on the draft legislation, TEI cautioned the Department of Finance that overbroad draft legislative language imposing penalties aimed at curbing tax-shelter promoters and their advisors would have harmful and counterproductive consequences for tax compliance and administration. Specifically, the legislation would likely prove unworkable unless the legislation was circumscribed to exclude corporate employees. TEI also testified before the House of Commons Standing Committee on Finance that exposing employees of large corporations to draconian penalties for the understatement of tax by their corporate employers would be counterproductive to the goal of ensuring corporate tax compliance. The government heeded TEI's concerns and added subsection 15 to the respective Income and Excise Tax Act provisions.(1)
Because of TEI's substantial and continuing concerns about the proper application of the these provisions, we offer the following comments on the draft Information Circular. Before the circular becomes operative and the administrative processes initiated, several statements and paragraphs in the guidelines should be revised or clarified.
A. Exemption for Employees. Other than certain "specified employees" (i.e., those owning directly or indirectly more than 10 percent of the corporation or a related corporation) or employees engaged in excluded activities, subsection 15 of the third-party civil penalty legislation is intended to exempt "employees" of a corporation from penalties where there is an understatement of a corporation's tax liability arising from a corporation's "culpable conduct." Paragraph 55 of draft Information Circular (IC) 01-1 confirms that subsection 15 exempts "employees" of a taxpayer from the penalty. Paragraph 57 of the IC also observes correctly that, in many large corporate groups, employees of one corporation maintain the accounting records, prepare tax returns, and undertake tax planning for the entire group. Regrettably, Paragraph 57 also asserts that "such employees are not technically covered by the exemption provided in subsection (15) for the work related to other members of the group."
After the draft legislation was revised, the Department of Finance provided assurances that, notwithstanding any technical deficiency in the legislative language, appropriate safeguards against the assertion of third-party civil penalties against employees of corporate taxpayers would be addressed administratively in CCRA's published guidelines. Hence, TEI is surprised that Paragraph 57 states "the CCRA would generally assess the preparer penalty against the employer and not the employee...." (Emphasis added.) The inclusion of the word "generally" in the foregoing sentence undermines the assurances and protection from penalties that employees of corporate groups expect and that the guidelines themselves otherwise provide. TEI recommends that the word "generally" be deleted from Paragraph 57 of the guidelines. Unless the guidelines recognize the reality that in-house tax advisors and return preparers perform tax work for a number of corporations in a group and afford such "employees" an exemption, the promise of relief in subsection 15 will be rendered hollow.
B. Attribution of Employee Conduct to the Company Taxpayer-Employer. For purposes of sections 163.2 and 285.1, Paragraph 57 of the draft circular states that "CCRA would generally assess the preparer penalty against the employer rather than the employee since the employee would be considered to have engaged in conduct that resulted in a penalty situation in the course of the employee's employment duties." In other words, where a false statement is made under circumstances involving culpable conduct by an employee that leads to a corporate tax understatement, the employee's culpable conduct will be attributed to his or her employer. While the draft legislation was beneficially amended to exempt "employees" from the application of the penalty, the guidelines should specifically state that penalties will be asserted against the company taxpayer employers only in strict adherence to the guidelines in the IC and the legislation. As important, procedural safeguards should be instituted to ensure that CCRA auditors do not threaten to improperly assert the penalties -- whether against the company or its employees -- as a lever for extracting settlements on underlying tax issues.
Persons Subject to Penalties
Paragraph 69 states "[a] corporation acts through its officers. Subject to the exception for employees.. ., if the officers knew of the false statement, ... both they and the corporation might be exposed to penalties." The Paragraph explains, by way of example, that a corporation may be engaged in planning, promoting, or selling a tax shelter and that such activities are likely conducted by the officers. In such a situation, the circular avers that the officers and the corporation would be exposed to the third-party penalty. In a second example, the Paragraph explains that an employee may be subject to a penalty if he or she engages in conduct "without the knowledge of the employer."
In the context of a closely held corporation where there are "specified employees" (i.e., those who are 10 percent or more shareholders) or in the context of an "employee" engaged in an "excluded activity" (i.e., the selling of tax shelters), the statements in Paragraph 69 are unremarkable. The commentary, however, is broader than necessary and, if applied erroneously in the context of large corporations or corporate groups, may lead to substantial confusion and possibly undermine the protection accorded to employees under subsection 15 of the legislation. TEI recommends that Paragraph 69 be deleted or substantially revised to clarify that the discussion is limited to "specified employees" or employees engaged in an "excluded activity." In addition, the circular should confirm that an officer of a corporation is considered an employee for purposes of sections 163.2 of the Income Tax Act and 285.1 of the Excise Tax Act.
Principle No. 5
The first sentence in Paragraph 10 states that the legislation is not intended to apply to honest mistakes, oversights, and errors in judgment. This statement of principle is beneficial and reflects a fair-minded and balanced approach to the administration of the penalty because penalties are generally appropriate only insofar as they deter wilful misconduct.
The second sentence of Paragraph 10 states that "evidence concerning a person's conduct will be gathered to determine whether the error was made honestly (with good faith) or dishonestly (with bad faith, or with a wilful, reckless or wanton disregard of the law)." This statement illustrates why, in the context of larger enterprises, "employees" should have a very clear exemption from personal liability. The practical challenges of the day-to-day administration of the tax function in a company of any magnitude will not afford in-house tax advisors an opportunity to scrutinize every written note (whether as a file note or note to others) or oral statement to other employees, customers, or vendors (if known) in light of whether CCRA might, with hindsight, assert that the advisor knew or "should have known" that the advisor was making a false statement that might lead to an understatement of the corporation's tax liability. Moreover, the preliminary investigative work by CCRA to determine whether a corporate employee's error is a result of "dishonesty" must be undertaken with exceptional sensitivity because the ramifications to the employee may extend far beyond the scope of CCRA's investigation.
Principle No. 6
Paragraph 11 states that the civil penalty provisions are "not intended to apply to differences of interpretation where a reasonable argument (an argument that is not obviously wrong) exists as to the application of the law." In addition, Paragraph 12 states that "the penalty would not be applied to honest differences of opinion on such issues as capital expenditures vs. repairs, capital gains vs. income, ... and the taxable status of a particular good for GST/HST purposes ..." where such issues have been "traditional sources of disagreement." Application of the penalty will be considered, however, where "a position is taken that is clearly contrary to the established industry practice, the Agency's public position, or the case law, and for which no reasonable argument can be made."
A. Analysis of Legal Authorities Supporting a Position or Interpretation. Paragraph 11 explains that the case law will often indicate whether uncertainty exists about the interpretation of the law. While true, the statement is potentially misleading. There are multiple levels of legal authorities, from the Constitution and statutes (and related regulations), to treaties, Supreme Court decisions, and lower court decisions. The guidelines thus provide incomplete guidance about how CCRA, taxpayers, tax preparers, or advisors should weigh various legal authorities in determining whether an area of law is considered well settled or subject to uncertainty and for which a reasonable argument may be made. Indeed, in its assessing positions CCRA itself frequently diminishes or disregards decisions of lower courts. Without substantially more explanation, the guidelines establish a highly subjective test for determining whether (i) the case law is well settled and its application indisputable and (ii) a taxpayer, tax preparer, or advisor has developed a reasonable interpretation of the law and, hence, exercised the due diligence necessary to avoid a penalty. Given the potential magnitude of the penalty, the assertion of a penalty under a standard based on case law interpretation should be limited to the most egregious circumstances, for example, for knowingly ignoring a Supreme Court decision directly on point.
In addition, as noted in several paragraphs throughout the guide lines, penalties should rarely be imposed under the third-party civil penalty provisions and the conduct giving rise to any penalty should be patently wrong. Hence, the Agency should be prepared to disclose the legal basis for the assertion of the penalty prior to its imposition. As a procedural matter, TEI recommends that the assertion of any penalty based on an interpretation of the case law be supported by an opinion from a Department of Justice lawyer and a copy of the opinion should be provided to the taxpayer, preparer, or advisor prior to assessment of the penalty.
B. Industry Practice. In the absence of clear statutes, regulations, or other guidance, "established industry practice" is frequently employed by taxpayers and CCRA in interpreting and applying Income and Excise Tax Act provisions to specific transactions or facts and circumstances. As useful as industry practice may be in interpreting the respective Acts, "established industry practice" is far too nebulous a standard to judge whether a taxpayer's, tax preparer's, or advisor's conduct establishes a proper threshold for avoiding the imposition of a penalty. Indeed, there can be wide variations among taxpayers in applying "established industry practices." Moreover, it is not uncommon for CCRA auditors to challenge whether "established industry practices" (or a taxpayer's specific application of those practices) is in accord with the Income or Excise Tax Acts. Hence, TEI recommends that the guidelines delete the reference to "established industry practice" as a standard by which to determine whether a penalty should be imposed.
C. Agency Position. CCRA provides public guidance on the application and interpretation of the Income and Excise Tax Acts and the positions it espouses are entitled to deference insofar as they are persuasive. Indeed, taxpayers, tax preparers, and advisors who rely upon and follow published Agency positions in interpreting the Income and Excise Tax Acts are traditionally shielded from penalties by following published guidance. Nonetheless, the assertion in the guidelines that a penalty will be considered for taking a position "clearly contrary to ... the Agency's public position ... and for which no reasonable argument can be made" could be viewed as bootstrapping of the Agency's authority. Courts frequently disagree with the Agency's public position and it is presumptuous for the Agency to propose that taxpayers and tax advisors must comply with CCRA's interpretative pronouncements in order to avoid the third-party civil penalty. In effect, the draft circular assigns CCRA's published guidance an importance equivalent to statutes, treaties, and Supreme Court decisions. We disagree and urge the Agency to reconsider this position.
Principle No. 7
Paragraph 13 and Paragraphs 35-37 address the relief for reliance in good faith under subsection 6 of the legislation. The draft circular seemingly omits discussion of how a corporate taxpayer avails itself of the reliance-in-good-faith defense. In order to comply with tremendously complex tax laws, companies hire competent well-trained professionals and invest substantial sums in information systems. Accordingly, we believe companies are entitled to a reliance-in-good-faith defense (for employee conduct attributed to the corporation) as much as the outside "planners" and "preparers" against whom the third-party civil penalty regime is primarily directed. Moreover, in making recommendations in respect of various transactions (engaging in tax planning activities) or preparing the corporate tax returns (tax preparer activities), tax executives, managers, and accountants of large enterprises are highly dependent on complex internal information systems as well as written and oral representations of other employees. As a result, the in-house tax advisor or return preparer (whose conduct might be attributed to the corporation) should also be entitled to rely in good faith on the statements made by other employees as well as the information produced by a well maintained and properly functioning accounting information system. TEI recommends that the circular be expanded to address how the reliance-in-good-faith defense applies to employees carrying out in-house tax responsibilities.
Principle No. 8
Paragraphs 14 and 15 provide general guidance about the scope of acceptable behaviour, including a taxpayer's ability to rely on CCRA's assessing practices where such practices afford taxpayers administrative tolerance or relief. The principle also addresses administratively acceptable reporting practices.
The relieving nature and tone of this principle are welcome, but the inclusion of the GST/HST example in Paragraph 14 is regrettable. The determination whether a particular adjustment warrants filing an amended GST/HST return is a difficult question that must be considered in light of all the taxpayer's facts and circumstances. Moreover, taxpayers should be encouraged to pay their proper tax liabilities as soon as practicable upon discovering errors in earlier filed returns. Hence, the use of this reporting practice should rarely if ever be considered evidence that the third-party civil penalty should be applied because the taxpayer is making a good-faith effort to pay the proper amount of tax -- albeit in a later period than it should be. As stated in Paragraph 15, the "penalties do not apply to those advisors and planners who act honestly in discharging their professional responsibility ... and it is expected that very few will ever be faced with a third-party penalty assessment." TEI recommends that the GST/HST example be deleted because (i) the administrative tolerance of accepting corrections in subsequently filed returns is an accepted reporting practice that encourages payment of GST/HST liabilities, (ii) the determination of "material" adjustments is a subjective taxpayer-by-taxpayer determination, and (iii) the implication that the third-party civil penalty might be applied to material adjustments will undermine other interest and penalty provisions in the Act that promote prompt, voluntary correction of GST/ HST payments.
Special Rules for Valuation Activities
Subsections 10 and 11 of the legislation provide the framework for applying a penalty where a valuation misstatement results in an understatement of tax liability. Under Paragraph 42 of the IC, a statement of value for a property or service is deemed a false statement made in circumstances amounting to culpable conduct if the "stated value" of a property or service is outside (either higher or lower than) a range of values. Under Paragraph 45, if a taxpayer employs a valuation for a property or service that falls within an as yet unprescribed range of values (but misses the fair market value of the property), CCRA can impose the third-party civil penalty and has the onus to prove that the false statement was made knowingly or under circumstances amounting to culpable conduct. Where the valuation employed by the taxpayer falls outside of the range, the taxpayer is deemed to have made a false statement under circumstances involving culpable conduct and must, under Paragraph 46, produce evidence under the reverse onus rule to establish that the valuation was reasonable in the circumstances, made in good faith, and not based on unreasonable or misleading assumptions.
Since the regulations prescribing the percentages that establish the valuation ranges are not yet issued, it is difficult to comment on the proposed administration of a statute setting forth a per se rule defining what constitutes a false statement made under circumstances involving culpable conduct. Valuations are very complex, fact-specific undertakings, and in many cases, highly skilled and reasonable professionals acting in good faith will arrive at vastly different results. Before it establishes valuation ranges on various types of property or services, CCRA should consult with valuation experts in a number of fields. What's more, where the property involved is a commodity, the range of values that CCRA will prescribe is likely to be narrow. Where the property involved is unique (such as real estate) or where the value depends on intellectual property content, the range of acceptable values must be expansive. Indeed, the challenge of valuing property escalates with the quantum of intellectual property or know-how incorporated, thereby requiring a substantial expansion in the range of values tolerated by CCRA. TEI foresees circumstances where a range from as low as 10 percent to as high as 200 percent (or more) of the fair market value of the property would properly apply. As a result, TEI reserves further comment on the special rules in Paragraphs 42-45 until valuation ranges are proposed.
Price Adjustment Clause
Paragraph 70 summarizes a series of conditions that Interpretation Bulletin IT-169, Price Adjustment Clauses, imposes in respect of price adjustment clauses employed in non-arm's length transfers. Paragraph 71 states that, if all the conditions in Paragraph 70 are met, "there would not be a false statement made with actual knowledge or in circumstances amounting to culpable conduct. Hence, the third-party civil penalties would not be applicable." The purpose of Paragraphs 70-71 is unclear. On one hand, it can be read as requiring taxpayers to comply with IT-169 in order to avoid civil penalties. That would seem an improper extension of the civil penalty legislation because the use of price adjustment clauses in non-arm's length transfers is not mandatory under the Income Tax Act. On the other hand, in recognition of the safeguards that IT-169 provides to the government, the provisions of the draft circular may represent an attempt to craft a safe harbour for taxpayers who comply with the terms and conditions of IT-169. If so, TEI commends CCRA for including the provision, but we believe clarification is in order. Specifically, taxpayers who fail to employ a price adjustment clause in non-arm's length transfers should not be presumed to have met the culpable conduct requirement for a civil penalty. In addition, the failure of a taxpayer to satisfy one of the conditions in IT-169 (e.g., failure to attach a disclosure letter to a relevant return) may be sufficient cause to deny the transferred properties the protection afforded by the price adjustment clause, but such failure should not make it more likely that the third-party civil penalty applies to the taxpayer. Thus, care must be taken that no inference is created that taxpayers who fail to employ price adjustment clauses or fail to satisfy all aspects of IT-169 are thereby subject to the civil penalty. TEI recommends that Paragraph 71 be revised to state: "In view of the administrative process set forth in IT-169, CCRA will not consider a civil penalty where a taxpayer complies with the above conditions. For purposes of the civil penalty, no inference will be drawn from a taxpayer's decision not to avail itself of a price adjustment clause or from the taxpayer's failure to comply with any of the conditions in IT-169."
The procedures employed by the government to determine whether a penalty should be applied to any particular facts and circumstances will be extremely important in preventing the assertion of an onerous penalty. In TEI's view, the process described in Paragraph 79 falls short of what is necessary to ensure that taxpayers, tax preparers, and advisors perceive the process as fair and impartial. Prior to assessing a third-party civil penalty, the field auditor should engage senior field office management in deliberations about the conduct of the affected taxpayer, tax preparer, or advisor. If senior field management determines that the matter should be referred to the Head Office, the taxpayer should be provided with the appropriate Head Office contact so that the taxpayer may make its representations concurrently with the field's referral. TEI believes that it is critical that the Head Office not form any preliminary impressions before the taxpayer (tax preparer or advisor) is afforded an opportunity to state its position.
In addition, the quality of the deliberations and credibility of the decisions of the Penalty Review Committee at CCRA Headquarters will be enhanced if at least one member is independent of the Agency and other government departments. An appropriate independent committee member might include a retired judge or a retired senior tax practitioner from industry or the accounting or legal professions.
Example Thirteen: Transfer Pricing
The last sentence of CCRA's comments in respect of this example should state that the subsection 163.2(15) exemption also applies to the non-resident entity's employees.
TEI's comments were prepared under the aegis of the Institute's Canadian Income Tax Committee, whose chair is David M. Penney. If you should have any questions about the submission, please do not hesitate to call Mr. Penney at 905.644.3122, or Sabatino Meffe, TEI's Vice President for Canadian Affairs, at 514.339.4446.
(1) The frameworks of section 163.2 of the ITA and section 285.1 of the ETA are very similar. For each subsection under section 163.2 of the ITA, there is a corresponding provision under section 285.1 of the ETA. Hence, TEI's comments will follow the convention set forth in Paragraph 16 of the draft circular. Unless otherwise necessary for clarification, references to the relevant subsection, paragraph, or other provision of the legislation will be by subsection or paragraph number only. References to the numbered paragraphs of the draft IC will be identified as "Paragraph #."
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|Title Annotation:||Canadian Income Tax Act|
|Date:||Mar 1, 2001|
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