“One can never know for sure which way the Tax Court will rule.”
One “sin of omission” that occurs more often than tax preparers would care to admit is the failure to report a tax-free capital gain, such as the gain on the sale of shares of a “small business corporation” that is eligible for the $750,000 capital gains exemption. This exemption is technically called the “capital gains deduction,” as it is a deduction of up to $375,000 taken in computing taxable income, after first reporting the taxable capital gain (which is one-half of the capital gain).
A common tax planning technique is a “crystallization” transaction, whereby shares of a small business corporation are sold so that the capital gains deduction can be used and the cost base of the shares increased. When this is done, the capital gain must be reported and the capital gains deduction can be claimed. We have seen many situations where the tax return preparer, for whatever reason, fails to report the capital gain and the capital gains deduction on the tax return.
When this happens, the taxpayer faces the risk that Canada Revenue Agency (CRA) may deny the capital gains deduction if the omission is eventually discovered. In addition, in a future year, the taxpayer could mistakenly claim the capital gains deduction again because the balance may appear to be available.
Where a taxpayer either knowingly, or under circumstances amounting to gross negligence, fails to report an eligible capital gain on their tax return for the applicable year, or includes it but fails to file the return within one year of the date the return was required to be filed, the CRA may deny the capital gains deduction.
If this issue is appealed to the Tax Court of Canada, the onus is on the CRA to prove gross negligence. Fortunately for taxpayers, the courts have generally agreed that “gross negligence” requires a certain degree of intentional acting or complicity, or something close to willful blindness, on the part of the taxpayer, and not mere ignorance. However, each case depends on its facts and one can never know for sure which way the Tax Court will rule.
As a result, taxpayers have been successful in the majority of cases. Furthermore, the CRA has confirmed that it will not deny the capital gains deduction if the taxpayer voluntarily reports the capital gain after the time frame referred to above.
Nonetheless, this is one omission that it is best to avoid. The last thing most taxpayers want is an expensive and uncertain Tax Court fight with the CRA, even if they win in the end.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.