6 September 2012 Internal T.I. 2012-0452151I7 - S. 163(2) Penalty on Fictitious Business Losses

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: How to calculate the gross negligence penalty on fictitious business losses?

Position: 1. Calculate the revised taxable income by adding the amount attributable to the false statement to the reported taxable income.
2. Calculate the tax on the revised taxable income, taking into consideration all applicable deductions, such as non-refundable credits, and any amount that is wholly attributable to the amount of income understated.
3.Calculate the tax on the reported taxable income.
4. Determine the penalty, which would be equal to the greater of $100 and fifty percent of the excess of the tax calculated in #2 over the tax calculated in #3.

Reasons: S. 163(2) and (2.1).

September 6, 2012

XXXXXXXXXX Tax Services Office HEADQUARTERS
Income Tax Rulings
Directorate
Attention: XXXXXXXXXX Lindsay Frank
(613) 957-2097

2012-045215

Subsection 163(2) Penalty on Fictitious Business Losses

We are replying to your request for a technical interpretation regarding the calculation of the gross negligence penalty under subsection 163(2) of the Income Tax Act, where fictitious losses have been claimed.

A taxpayer filed a TI Return declaring actual taxable income for the year. Subsequently, the taxpayer filed a T1 Adjustment Request claiming the deduction of business losses. As a result, the losses exceeded the taxable income for that year. However, it was concluded that the losses were fictitious and gave rise to the assessment of the penalty.

Subsection 163(2) permits the Minister to impose the penalty on a taxpayer who knowingly, or in circumstances amounting to gross negligence, participates in, or makes a false statement or omission in a return. For the purposes of this provision, a return includes a form, a certificate, a written statement or a written answer. The penalty is the greater of $100 and fifty per cent of the tax attributable to the false statement or omission, and is calculated by adding to the taxable income reported by the taxpayer the amount by which the taxpayer has understated income for a particular year.

Paragraph 163(2.1)(b) defines “understatement of income” to include both unreported income and any amounts that the taxpayer has deducted, but were not deductible, in computing income reported for the year in that person’s return. Thus, where the taxpayer has deducted fictitious losses that exceed taxable income, the understatement of income includes the full amount deducted, and not just the portion that the taxpayer claimed to bring taxable income to nil.

It goes without saying that if there is no taxable income, there is no tax payable. However, the Tax Court of Canada in Chopp v. M.N.R., [1987] 2 C.T.C. 201, 87 D.T.C. 374, confirmed that the subsection 163(2) penalty applies, even if there is no tax payable for the year, provided that the requirements of this provision were met. In its decision, the Court stated:

“My initial reaction at the hearing was that penalties could not be levied in respect of taxation years where the reassessments are nil regarding tax payable because of a misconception that penalties under subsection 163(2) were invariably 25 per cent of an amount related to actual tax payable. On reflection I am satisfied that penalties of the kind mentioned can be assessed even if no tax is payable in a taxation year provided, of course, that the essential requirements of subsection 163(2) are met. This rule is understandable. For obvious reasons Parliament desires that, in the preparation of their self-assessments under section 150 of the Act, taxpayers shall not knowingly or in a grossly negligent manner be involved in the making of false statements or omissions. Conduct of this kind attracts penalties per se notwithstanding that there is no liability for tax in a particular taxation year because, for example, losses are carried over from another year.”

In the instant case, the T1 Adjustment Request is considered to be the taxpayer’s return. Therefore, based on the T1 Adjustment Request, the taxpayer’s reported taxable income would have been nil, in accordance with subsection 163(2.1), which deems the taxable income reported by the taxpayer in the return to be not less than nil.

Four steps are then necessary to calculate the gross negligence penalty under subsection 163(2). First, calculate the revised taxable income by adding the amount attributable to the false statement (the losses) to the reported taxable income (the nil amount). Second, calculate the tax on the revised taxable income, taking into consideration all applicable deductions, such as non-refundable credits, and any amount that is wholly applicable to the amount of the income understated. Third, calculate the tax using the reported taxable income (the amount on the Form). Fourth, determine the penalty, which would be equal to the greater of $100 and fifty per cent of the excess of the amount of the tax, calculated on the revised taxable income in the second step, over the amount of tax, calculated on the reported taxable income in the third step.

You advised us that, in your specific case, the false statement was caught prior to the processing of the T1 Adjustment Request. Nevertheless, the penalty applies to the false statement, regardless of whether it is found before or after the Minister has processed the return and issued a reassessment.

It is the making of a false statement that gives rise to the penalty. In the schedule that you have provided in your example, the taxable income, used in the lower base amount, should have been the taxable income reported in the T1 Adjustment Request, and not the amount initially assessed. As a result, the taxable income should been nil. Using the amount of taxable income, initially assessed, created an overstated amount of tax, and hence an overstated amount of the gross negligence penalty.

Should you have any questions or require additional information, please do not hesitate to contact Lindsay Frank at the number provided at the outset.

Terry Young CA
Manager
Administrative Law Section
International Division
Income Tax Rulings Directorate

c.c. Andre P Perrier
T1 Adjustments Section
Individual Returns Directorate