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FCA: Trial court cannot ignore taxpayer’s evidence without good reason

The decision of the Federal Court of Appeal in Newmont Canada Corporation v. Canada delivered July 27, 2012 was primarily concerned with an unsuccessful attempt by the taxpayer to write off the principal amount of a large loan.  What makes the case quite interesting, however, is a side issue concerning the taxpayer’s claim to write off accrued interest on the loan.  That is where the Federal Court of Appeal parted company with the Tax Court of Canada and provided a useful reminder about the importance of evidence in tax appeals.

The interest in question arose in the 1988, 1989 and 1990 taxation years.  The CRA auditor allowed a portion of the interest expense:

[173]  During the course of the CRA audit, [the taxpayer] provided the CRA auditor, Mr. MacGibbon, with the details of the entries recorded in its general ledger account 2101 between August 1, 1989 and the end of May 1990. [The taxpayer] used this general ledger account to record amounts due from Windarra, including accrued interest on the Windarra Loan.

[174]  Mr. MacGibbon testified that [the taxpayer] did not provide him with any books or records for periods prior to August 1, 1989.

[175]  Based upon his review of the general ledger for account 2101, Mr. MacGibbon was able to identify entries totalling $183,336 that recorded interest income in respect of the interest accrued on the Windarra Loan. As a result, he allowed a deduction under subparagraph 20(1)(p)(i) in respect of the accrued interest.

While it is not clear why the earlier records were not produced, it is a reasonable inference that they were simply misplaced; they related to periods 20 or more years prior to the trial, which was held in 2009.

The taxpayer’s evidence was simple and direct:

[176]  The Appellant argued that the Minister understated the subparagraph 20(1)(p)(i) deduction by $156,888. It arrived at this number by performing the following calculation:

First, it determined the amount of accrued interest as at December 31, 1989 as follows:

a. The amount shown on the balance sheet at December 31, 1989 in respect of the Windarra Loan: $8.513 million

b. Less: the principal amount of the loan at December 31, 1989: $8.25 million

c. Equals the amount of accrued interest as at December 31, 1989: $263,000.

The Appellant then compared the $263,000 with the amount of interest income Mr. MacGibbon had calculated for the periods prior to 1989, namely $106,112.

[177]  It is the Appellant’s position that the difference between $263,000 and $106,112, which is $156,888, represents additional accrued interest income that was included in the income reported in [the taxpayer’s] 1988 and 1989 income tax returns.

[178]  During his testimony, Mr. Proctor summarized the Appellant’s argument as follows: “Because we have it on the balance sheet and, since debits must equal credits, it must have been on the Income Statement and we did not adjust it in arriving at net income for income tax purposes. For financial statement purposes it must be in the net income for income tax purposes.”

The Tax Court Judge rejected the taxpayer’s evidence:

[181]  I cannot accept the Appellant’s argument. [The taxpayer] could have recorded the offsetting amount as interest income. Alternatively, it could have recorded the offsetting amount on a balance sheet account such as a deferred revenue account or a reserve account. The only way to determine how the offsetting amounts were recorded in 1988 and the first half of 1989 would be to review the relevant books and records. Unfortunately, the relevant books were not provided to either the Minister or the Court.

[182]  The only evidence before the Court of accrued interest being included in [the taxpayer’s] income was in the working papers of Mr. MacGibbon. I agree with counsel for the Respondent that in order for the Appellant to obtain a deduction in excess of the amount allowed by the Minister “the Court should be presented with something more reliable than a conclusion based on unsubstantiated assumptions.”

Fortunately for the taxpayer, the Federal Court of Appeal held that there was no basis for the Tax Court Judge to reject the taxpayer’s evidence on the point:

[65]  Notwithstanding the auditor’s admission that it was likely that interest accrued in 1988 and the first part of 1989 in the Windarra Loan, the Judge rejected Mr. Proctor’s evidence that additional interest was included in [the taxpayer’s] income on the basis that [the taxpayer] “could have recorded the offsetting amount on a balance sheet account such as a deferred revenue account or a reserve account.” However, for the reasons that follow, there was, in my view, no evidence before the Court to support such a conclusion.

[66]  The Judge found Mr. Proctor to be a credible witness. Mr. Proctor testified that [the taxpayer] would have included the sum of $263,000 in its retained earnings. He reviewed the Reconciliation of Net Income for Tax Purposes form (i.e. the T2S(1) form) provided by [the taxpayer] for each of the 1988 and 1989 taxation years as part of its income tax returns (Appeal Book volume 2, pages 81 and 109) and identified no adjustments “in moving from financial statement income to net income for tax purposes relating to Windarra” (Appeal Book volume 7, page 1699).

[67]  With respect to the Judge’s reference to deferred revenue and reserve accounts, while [the taxpayer’s] 1988 and 1989 balance sheets did show a deferred revenue liability (Appeal Book volume 5, pages 1176 and 1181), the notes to its financial statements specified that the deferred revenue liability related solely to [the taxpayer’s] gold loan owed to a consortium of Canadian banks (Appeal Book volume 5, pages 1178 and 1188). The 1988 and 1989 balance sheets did not record any reserve accounts.

[68]  In this circumstance there was, in my respectful view, no evidence on which to impugn Mr. Proctor’s evidence, so that the Judge committed a reviewable error in rejecting the evidence for the reasons that he gave. Mr. Proctor’s evidence, together with the auditor’s concession established that [the taxpayer] had included the additional sum of $156,888 in interest income in its income tax returns.

[69]  It remained for [the taxpayer] to establish that the interest income was or became a bad debt. This required consideration of whether any monies paid to it pursuant to the Settlement Agreement were allocated to monies owing on account of interest. If so, that portion of the interest income would not be a bad debt.

[70]  Article 1(3) of the Settlement Agreement evidenced the parties’ agreement that the settlement proceeds were to be “applied on account of the principal amount of the [Windarra] Loan.” This established on a prima facie basis that all of the interest owing to [the taxpayer] pursuant to the Windarra Loans was a bad debt.

[71]  To conclude on this point, in my view, this Settlement Agreement combined with the evidence of Mr. Proctor and the auditor’s concession was sufficient to demolish the Minister’s assumption. Further, counsel for the Minister did not point to any evidence which rebutted [the taxpayer’s] prima facie case.

[72]  It follows that [the taxpayer] established its entitlement to deduct $156,888 under subparagraph 20(1)(p)(i) of the Act in 1992.

The case serves as a useful reminder about two important points.  First, the rules of onus are alive and well (as also discussed in my recent blog post on McMillan v. Canada).  Once a taxpayer has raised a prima facie case rebutting the Minister’s assumptions, the Minister cannot succeed unless Crown counsel can adduce additional evidence or otherwise undermine that prima facie case.

Second, and perhaps more important, the case demonstrates that solid evidentiary preparation and strong witnesses are critical if a taxpayer hopes succeed in the courts.  As it is exceedingly rare for the Federal Court of Appeal to overturn findings of fact made by a Tax Court Judge, every effort must be made to adduce evidence, both documentary and viva voce, in the Tax Court of Canada in order to maximize the likelihood of success both at trial and on appeal.

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FCA: Trial court cannot ignore taxpayer’s evidence without good reason

Federal Court of Appeal Reaffirms the Onus of Proof Rules in Tax Appeals

In the recent case of McMillan v. Canada, the Federal Court of Appeal has reaffirmed the onus of proof rules in tax appeals. While the rules were never particularly unsettled at the federal level, the somewhat anomalous decision of the British Columbia Court of Appeal in Northland Properties v. The Queen in Right of the Province of British Columbia, appeared to cast doubt on prior Federal Court of Appeal pronouncements as well as the decision of Justice L’Heureux-Dubé in Hickman Motors Ltd. v. Canada. In Northland, the B.C. Court of Appeal took issue with the concept, articulated by Justice L’Heureux-Dubé in Hickman, that the onus was on the taxpayer to “demolish” the assumptions pleaded by the Minister by means of raising a prima facie case at which point the burden shifts to the Minister to prove the assumptions on the balance of probabilities:

[29] Before us, counsel for the Crown made persuasive submissions on the issue of the so-called “prima facie” standard: L’Heureux-Dubé J.’s use of “prima facie” was made in the context of a case in which the Crown had not called any evidence whatsoever; it was relying solely on its assumptions. It is certainly possible in such circumstances that a prima facie case, or even one with “gaps”, would be sufficient to displace the Crown’s assumptions, but the prima facie standard described by Justice L’Heureux-Dubé should not be interpreted as having altered the usual standard of proof in tax cases: see the comments in Sekhon v. Canada, [1997] T.C.J. No. 1145 at para. 37; and Hallat v. The Queen (2000), [2001] 1 C.T.C. 2626 (F.C.A.).

The facts in McMillan are uncomplicated and not particularly interesting. The taxpayer had a business in the Dominican Republic and claimed a number of expenses in connection with that business. The Tax Court denied most of the expenses claimed on the basis that they were not proven by the taxpayer. The taxpayer appealed to the Federal Court of Appeal and her appeal was dismissed on the basis that she did not demonstrate any material error on the part of the Tax Court judge.

The interesting part of the decision is the Federal Court of Appeal’s articulation of the rules relating to onus of proof in tax appeals:

[7] Before concluding these reasons, we note that the appellant did not raise in her memorandum of fact and law any issue with respect to the Judge’s statement at paragraph 19 of the reasons, and repeated at paragraph 21, that the appellant “has the initial onus of proving on a balance of probabilities (i.e. that it is more likely than not), that any of the assumptions that were made by the Minister in assessing (or reassessing) the Appellant with which the Appellant does not agree, are not correct.” In our respectful view, it is settled law that the initial onus on an appellant taxpayer is to “demolish” the Minister’s assumptions in the assessment. This initial onus of “demolishing” the Minister’s assumptions is met where the taxpayer makes out at least a prima facie case. Once the taxpayer shows a prima facie case, the burden is on the Minister to prove, on a balance of probabilities, that the assumptions were correct (Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336 at paragraphs 92 to 94; House v. Canada, 2011 FCA 234, 422 N.R. 144 at paragraph 30).

Thus, the Federal Court of Appeal has once again embraced the prima facie standard as the test that must be met by a taxpayer to displace or demolish assumptions pleaded by the Minister. While there may be a different standard applicable in provincial tax appeals in British Columbia, the reaffirmation of the prima facie standard by the Federal Court of Appeal is welcome news in federal tax appeals.

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Federal Court of Appeal Reaffirms the Onus of Proof Rules in Tax Appeals