Tax disputes on the rise as government increases audit resources

In response to mounting public concern over tax avoidance and evasion, the federal government in Budget 2016 announced the dedication of an additional $444.4 million to the Canada Revenue Agency (CRA) over the next five years to combat these issues. A Standing Committee on Finance was convened to study the CRA’s efforts in this regard. The federal funds are slated for hiring additional auditors and specialists and combatting criminal tax evasion, and are expected to generate an additional $2.6 billion in revenue for the federal government.

In light of public scrutiny, it is not surprising that 2016 has seen the CRA increase the number and scope of its audits, take aggressive positions under the general anti-avoidance rule (GAAR) and the transfer pricing rules, and impose penalties at unprecedented levels.

We expect this environment of heightened audit and assessment activity to persist in the near term. Businesses should closely examine tax risk management practices, monitor key legal developments and adjust tax planning accordingly, as well as ensure that appropriate processes are in place to prepare for increased audit scrutiny.

Elevated audit activity

The Standing Committee on Finance reported to Parliament in October that the CRA currently has 20% more auditors than it had in 2006. The CRA continues to take a risk-based approach when auditing large corporations, focusing its efforts on aggressive and international tax planning. The CRA also noted before the Standing Committee that the reputation of a company’s tax advisors can influence its decision about whether to audit.

Information gathering efforts by the CRA have increased in 2016, a trend that is expected to continue in light of the additional resources devoted to audit activity and the advent of country-by-country reporting, an audit risk assessment tool arising from the OECD/G20 base erosion and profit shifting project. Broadly worded requests and formal information requirements are now routinely used to compel delivery of taxpayer information. These can represent a significant burden on taxpayer resources, almost akin to a litigation discovery process.

Guidance expected on critical issues

A number of large corporate taxpayers are poised to take their high-profile disputes with the CRA over GAAR and transfer pricing reassessments before Canadian courts. Decisions in these and similar cases will be critical in defining key issues facing Canadian corporate taxpayers, including multinationals with operations in Canada.

The interaction between the GAAR and legislative amendments that apply prospectively to counter particular forms of transactions that the CRA finds objectionable was debated in two Tax Court of Canada cases in 2016, with different results. In the Univar case, the taxpayer unsuccessfully appealed a GAAR reassessment of transactions that were targeted by a specific anti-avoidance rule introduced after the transactions took place. In the Oxford Properties decision, however, the Tax Court declined to accept the CRA’s argument that legislative changes introduced after the taxation period at issue reflected pre-existing tax policy. Both decisions have been appealed to the Federal Court of Appeal.

In a number of pending appeals, the Tax Court will also be called upon to consider the scope of the CRA’s “recharacterization” power under the transfer pricing rules to override the legal effect of transactions undertaken by multinational groups. Although these rules have been in place for nearly 20 years, the recharacterization provision has yet to be interpreted by the courts.

Transfer pricing penalties soar

Transfer pricing penalties have continued to soar in 2016. CRA data shows that penalties were up tenfold in 2015 from the previous year. Total penalties assessed for transfer pricing cases in the aggregate have increased from $58.6 million in 2012 to $479 million in 2015, with $225 million assessed between January and June 30, 2016. The average penalty for individual transfer pricing reassessments has risen from $3.45 million in 2012 to $16 million in 2015, with an average of $12.5 million in 2016. Penalties weigh heavily on taxpayers, not only because they can cause reputational damage, but also because they cannot be offset by other tax attributes. As with the recharacterization rule, the transfer pricing penalty provisions have not yet been the subject of judicial guidance, and will be on the Tax Court’s agenda for 2017.

With the devotion of more resources to the CRA’s audit division and the public scrutiny of its commitment to combatting perceived tax avoidance, we expect that the number and significance of tax disputes in Canada will continue to rise in the near term. The courts’ decisions in the coming years will be important in achieving fairness and predictability for taxpayers, a key goal of the Canadian tax system.