When can the CRA impose a gross negligence penalty?

This case reminds us that we must weigh up the risks before implementing a tax optimization plan, and that it is above all important to be properly advised. Otherwise, the tax authorities may impose a penalty that will increase your bill by 50%. Think about it!

To remember, in 30 seconds:

• CRA imposes a gross negligence penalty on Mr. Paletta for misstating his income;
• Paletta disagrees and contests;
• The Court determined that the penalty had been justly imposed. Read on to find out why.

From 2000 to 2007, Mr. Paletta earned revenues worth $38 million. However, $37 million was offset for tax purposes by losses on forward foreign exchange transactions.

With respect to Mr. Paletta’s activities, the Canada Revenue Agency (CRA) issued him notices of reassessment in 2014, after the normal reassessment period had expired. With these new assessments, he was denied the $37 million in losses, in addition to incurring penalties for gross negligence.

Paletta challenged the reassessments before the Tax Court of Canada (TCC). The Court had to determine whether the foreign exchange activities constituted a source of business income. If so, the losses of 37 million were deductible. Otherwise, the losses of 37 million were not deductible. The CCI agrees and cancels the new dues. CRA has appealed this decision to the Federal Court of Appeal (FCA).

CAF overturns first instance decision. It concludes that Mr. Paletta’s foreign exchange activities were not of a commercial nature and rejects the losses of 37 million (Paletta case – Part 1 of 3). The court also ruled that the CRA could reassess the statute-barred years, as Mr. Paletta had shown a lack of due diligence (Paletta Case – Part 2 of 3).

The CAF had an additional question. The issue was whether the CRA was justified in imposing a gross negligence penalty on Mr. Paletta. To convince the court to rule in his favor, CRA had the burden of proving that Mr. Paletta had misstated income “knowingly or under circumstances amounting to gross negligence”.

According to the FCA, “Mr. Paletta and his son had been warned that the tax shelter plan they were considering could be problematic. They both knew from the outset that the sole purpose of the plan was tax avoidance. Rather than assess the risk, by obtaining a formal legal opinion, Mr. Paletta chose to ignore it. This attitude shows, at the very least, that Mr. Paletta was either indifferent or wilfully blind to the legal validity of his plan, and that he was only concerned with satisfying his desire not to pay taxes”. The CRA succeeded in demonstrating that “Mr. Paletta had committed gross negligence in presenting his foreign exchange losses as business losses when this was not the case”. CAF therefore concludes that the penalty for gross negligence was rightly imposed.

Reference: Canada v. Paletta, 2022 CAF 86

To remember

The final chapter of this story has not yet been written. The decision of the Federal Court of Appeal has been appealed to the Supreme Court of Canada. Stay tuned for the rest of this saga.