In recent years, the CRA has taken a more aggressive and proactive approach in auditing transactions in the real estate sector, especially house flipping. If you have investments in real estate you should pay attention to a recent decision issued by the Tax Court of Canada, Hansen v. The Queen on September 14th 2020. Many of these types of cases get settled before getting to court so when such a case actually gets to trial it is worth investigating further.
Overview
The CRA issued a reassessment on Mr. Hansen’s return around 2013-2014 for taxation years, 2007, 2008, 2009, 2011, and 2012. The CRA alleges that Mr. Hansen was involved in house flipping and that the numerous properties sold did not fall under the principal residence exemption which he claimed. In total, five houses and one vacant lot were sold by Mr. Hansen.
The decision of the court linked above provides many detailed facts which are worth reading to understand the context of the decision. To quickly summarize, most of the reasons for the sale of the houses were for the welfare of the Hansen’s two adopted daughters. Mr. Hansen has a sympathetic narrative which the court considered credible. We do not know all the evidence provided by Mr. Hansen, but testimony from his accountant, and affidavits and statements from neighbours were mentioned.
Main issues
There were several issues decided by the court but I’ll discuss the most important ones for future tax planning.
1. Was the CRA entitled to reassess the 2007, 2008, and 2009 tax years which were outside the normal assessment period?
The normal assessment period for an individual taxpayer is typically three years after the date of the notice of assessment or the last reassessment. If the CRA wants to reassess returns beyond this period, the CRA must establish on a balance of probability* that the taxpayer made a misrepresentation attributable to neglect, carelessness, or wilful default.
2. Whether the gains from the sale of the houses was business income or an adventure in the nature of trade.
If the income is reassessed as business income, the taxpayer loses the principal residence exemption AND the capital gain tax treatment. Instead of 50% of the gains being taxable, 100% of the gain will be taxed as business income. Furthermore, the taxpayer will owe GST on the transaction. Mr. Hansen must establish on a balance of probability that the income falls under the principal residence exemption.
3. Whether s163(2) penalties apply.
The CRA may impose s163(2) penalties on taxpayers who knowingly or under circumstances amounting to gross negligence make, participate in, asset to, or acquiesce in the making of a false statement or omission in a tax return. The penalty is the greater of $100 or 50% of the additional tax payable with the reassessment. This is a heavy penalty. For example, if you are reassessed to owe an additional $100,000, the s163(2) penalty would be $50,000 making the total amount payable $150,000. The CRA must establish on a balance of probability that the the taxpayer has acted with gross negligence.
1.The CRA could not reassess 2007, 2008, 2009 tax years.
The court held that the CRA did not prove, on a balance of probabilities, that Mr. Hansen made a misrepresentation attributable to neglect, carelessness, or wilful default.
This goes to show that even a history of transactions which the CRA might characterize as a history of improper characterization of income does not on its own necessarily demonstrate that the taxpayer has made a misrepresentation.
Below is a selection of the cases the court cited to support this position:
– Savard v. The Queen: The taxpayer has the right to disagree with the CRA in their interpretation of the Income Tax Act without this necessarily being considered a misrepresentation.
– Regina Shoppers Mall Ltd. v. The Queen: There is no misrepresentation when a taxpayer thoughtfully, deliberately, and carefully assesses the situation
– Chaumont v. The Queen: Taxpayer’s interpretation was incorrect, but it was neither far-fetched nor unreasonable enough to conclude that it was a wilful default or mistake with the intent to escape from his tax obligations
In this case, Mr. Hansen gave a reasonable explanation for the disposition of the property in the years outside the normal assessment period. Presumably, there were few inconsistencies in his testimony and there was documented proof of his claims which is why the court believed it was a credible narrative. The CRA did not provide sufficient evidence that Mr. Hansen tried to deceive the CRA in his tax filing.
Ultimately, the court did not determine whether the taxpayer was correct in designating the properties sold in 2007, 2008, and 2009 as principal residences since the CRA was barred from reassessing those years. But based on the court’s reasoning, even if the taxpayer was incorrect and the gains should have been reported as business income, the CRA would not be able to reassess those years since the CRA did not provide sufficient evidence of misrepresentation.
My personal opinion on this issue is that it could have easily gone in the CRA’s favour and really depended on the court’s weighing of the evidence. This issue is probably why the case did not settle and went to trial.
2. The principal residence exemptions did not apply for the properties sold in 2011 and 2012.
The court held that the Mr. Hansen did not meet the burden of proving the properties were a capital asset, where the proceeds would be considered a capital gain and potentially sheltered with the principal residence exemption, or as an adventure in the nature of trade.
The factors in this determination were laid out in Happy Valley Farm Ltd. v. MNR: Nature of the property sold, Length of ownership, Frequency of similar transactions, Effort expended in bringing the property into a more marketable condition, Circumstances responsible for the sale of the property, Intention at the time of acquiring the property.
The court’s held that Mr. Hansen had an intention to profit from the sale of the property when he acquired the property. Furthermore, the court again reiterated that a primary intention to profit is not necessary. Even if you establish that you had a primary intention of using the property as a capital asset, if there is sufficient evidence to establish a secondary intent to profit, that might be enough to weigh the “intention factor” towards a determination of an income asset.
3. S163(2) penalties did not apply.
Since the CRA did not establish that Mr. Hansen made a misrepresentation for the 2007, 2008, and 2009 tax years, s163(2) penalties were not applicable for those years.
The court held that Mr. Hansen made a false statement in claiming the principal residence exemption for the 2011 and 2012 properties sold.
But the court held that the CRA did not meet the burden in establishing that Mr. Hansen made the false statement knowingly or in circumstances amounting to gross negligence.
Again, the court relied on the credible testimony and evidence provided by Mr. Hansen. Mr. Hansen’s testimony provided a non-farfetched explanation for his incorrect interpretation of the Income Tax Act. Mr. Hansen also used a CPA for his tax filings. The CPA’s testimony indicated that Mr. Hansen provided the necessary information for the CPA to advise Mr. Hansen that the principal residence exemption was applicable. The court held that it was reasonable for Mr. Hansen to rely on the CPA’s advice.
Takeaways
Regarding assessments outside the normal assessment period.
- Be aware of the normal assessment period. The normal assessment period outlined in s152(4) of the Income Tax Act is an important protection for the taxpayer. If the CRA reassesses a year outside the normal assessment period, this ground for dispute should always be at the forefront of your objection. I have seen far too many situations where a taxpayer has disputed the substance of the CRA’s reassessment without considering their rights outside the normal assessment period.
- A history of incorrect/false tax filings does not, on its own, or even with additional supporting evidence, indicate misrepresentation. I think this case is a great example of this. Mr. Hansen bought and sold five houses and even a vacant lot. Mr. Hansen was essentially the general contractor for several of the houses he built and sold. General contractors are considered experienced real estate professionals and often are looked at with more scrutiny since they are more knowledgeable in the industry. These factors in favour of the CRA’s position can still be overridden which brings me to…..
- A taxpayer’s well documented and thoughtful consideration of his interpretation is key. The central question is whether the taxpayer carefully considered his position AND attempted to deceive the CRA. The CRA must prove misrepresentation but you should keep in mind that the court still looks at the reasons you provide for reaching your position. Therefore, having a clear outline of your narrative and providing supporting evidence to support your position is vitally important especially at the objection stage where you can prevent the dispute from escalating further to an expensive appeal.
Regarding the characterization of a capital asset vs adventure in the nature of trade.
- Intention of the taxpayer at the time of acquisition is the single biggest determining factor. If there is an intention, whether primary or not, to profit from the sale of a house at the time of acquisition, the transaction will likely be considered an adventure in the nature of trade. Since there is often very little physical evidence of your intention at the time of acquisition, the most important evidence is a credible testimony and providing circumstantial evidence to support your real intention, which presumably is not to profit from the sale of the house.
Regarding s163(2) penalties.
- It is reasonable to rely on a tax professional’s advice. It should be noted that the tax professional should have the full picture of your situation to give the proper advice. It follows that it is less reasonable to rely on the tax advice provided by your “uncle who is a really good business man”.
Seek Professional Help.
If you receive a call from the CRA asking for additional information about previous real estate dispositions, chances are that the CRA has either obtained information from a third party or that your previous tax filings has triggered a red flag which has resulted in an audit.
Before answering any questions, seek professional help.
The CRA will likely call and tell you that they will be sending you a questionnaire, you should not fill out this questionnaire before consulting a professional. We have seen far too many clients dig themselves a hole that took years of negotiations with the CRA to resolve.
*In the legal context, a balance of probability means “more likely than not” or numerically speaking, more than 50% chance that something is true. This is in contrast to “beyond a reasonable doubt” which is often applicable in criminal cases.