Arbitrary Discretion and the Rule of Law

By Vern Krishna

The Canadian income tax system requires taxpayers to voluntarily self-assess their tax liability and file tax returns without demand or notice according to prescribed forms and specified schedules. Canadians are generally compliant and most (approximately 30 million) will file tax returns annually. However, the term “voluntarily” is a misnomer. It is the equivalent of a colonel asking a private if he would volunteer to paint a fence. There are consequences and costs for non-compliance. The CRA has a big stick that it wields enthusiastically backed by substantive and procedural law. With very limited exceptions, the Charter of Rights and Freedoms does not protect individuals as taxpayers.

Of the 30 million individuals who  file income tax returns every year, one-third are non-taxable. Individuals file them only for the purpose of claiming tax benefits and credits. The remaining two-thirds account for about 50 percent of annual federal government revenues. Corporate returns make up another 10 percent. The income tax system is essentially redistributive.

Although it is the taxpayer’s responsibility to file his or her tax return by its due date, the Minister is not bound to accept the taxpayer’s income tax return as filed. The CRA can “arbitrarily” assess the taxpayer using any appropriate method for determining the tax payable by the taxpayer. It does so by issuing a “net worth” or arbitrary assessment (NWA) of the estimated tax payable. NWAs are particularly useful in assessing taxpayers who engage in illegal activities or receive “under the table” cash. Drug dealers, gun runners and money launderers are particularly prone to not filing tax returns.

A NWA is based upon inferences. The Minister estimates the taxpayer’s worth at the beginning and at the end of the taxation years in question. This gives an increase, if any, in the taxpayer’s net worth. Income for the period is calculated by adding to the increase any non-deductible expenditures, such as personal consumption, and deducting therefrom any appreciation in the value of the taxpayer’s capital assets. Having determined the total increase in the taxpayer’s “net worth” between two points in time, the Minister allocates the estimated net income between the taxation years in question.

The Minister does not need to specify a theory or source for a NWA and, in most cases, will overestimate the taxpayer’s income as this will be an incentive for the taxpayer to produce records to bring down the value of the assessment or else suffer the consequences. A NWA is deemed to be valid even if it contains an error or defect or has been incorrectly calculated or improperly issued. The burden of proof rests squarely on the taxpayer to show that the assessment is wrong. Thus, a taxpayer is liable for the assessed tax unless he or she can prove otherwise.

By its very nature, a net worth assessment is prone to errors of classification of the various sources of income. Inaccuracy is inherent in the method of calculation. It is a blunt instrument at best and the Minister is prone to maximize the taxpayer’s income. However, the taxpayer is the architect of his or her own misfortune by not maintaining proper bookkeeping records.

The CRA need only demonstrate that the taxpayer’s net worth (adjusted for consumption) increased in the taxation year. It is not required to prove the taxpayer’s particular sources of income. Once the CRA demonstrates an increase in net wealth, the taxpayer has the onus to separate his or her taxable income from other various sources, such as, for example, business income, capital gains, or non-taxable sources receipts.

The explanations that individuals frequently provide for undisclosed increases in net worth are that they had windfall gambling gains or received a substantial bequest from an elderly aunt (since deceased) in a distant land. The reasons for such explanations are that gambling gains are usually not taxable to amateurs, and gifts are never taxable. However, given the frequency of these explanations, the CRA adopts a jaundiced view of such theories and requires substantiating evidence in support of the assertions. It is usually difficult to substantiate such explanations because it is the absence of adequate records that led to the assessment in the first place.

To be sure, the Crown has a duty to fully disclose its findings of fact and rulings of law: Hence, before the CRA exercises its discretion in assessing a taxpayer, there must be a basis upon which a reasonable person could support it. The taxpayer must have a “fair opportunity” to meet the case against him or her. It is here that tax counsel can provide value in objecting to the NWA through disclosure and discovery procedures. To be sure, the CRA has a big procedural stick in arbitrarily assessing taxpayers but it is subject to the rule of law.

Vern Krishna is a Professor at the University of Ottawa Faculty of Law, Executive Director of the CGA Tax Research Centre, and Counsel at TaxChambers LLP.