The Income Tax Act (subsection 163(1)) provides an innocuous-looking penalty which can prove to be devastating.
The penalty in question applies if you file a return that fails to report some amount of income, and you also filed a return for any of the 3 preceding taxation years that failed to report some other amount of income.
The penalty is 10%, which doesn’t sound like much. However:
- The 10% is 10% of the unreported income (in the later year), not of the tax.
- The penalty applies regardless of whether there were offsetting deductions so that little or no tax was payable.
- The penalty applies even if tax was withheld on the income, so that there might be little or no additional tax owing.
- Each province has in its provincial Income Tax Act a parallel 10% penalty, so the CRA will actually assess you a combined penalty of 20%. (In Quebec, the CRA will assess you 10% and Revenu Québec will assess you 10% if you failed to report the income on your provincial tax return.)
Here’s an example of how punitive the penalty can be:
When Joe gave his accountant his papers for his 2011 tax return, he misplaced one of the twelve T5 and similar slips he’d received for various kinds of investment income. The slip in question showed he’d earned interest of $75. So that $75 of income was omitted from his return.
In 2014, Joe retired and received a payout of $100,000, from which tax was withheld by his employer. Because of the tax withheld, he did not have to pay any additional tax on the $100,000. Again he misplaced the T-slip and neglected to tell his accountant about this amount, and his 2014 return was filed without showing the $100,000 of additional income or the tax that had been withheld on it.
The CRA will assess penalty of $20,000, even though the 2011 unreported income was trivial and the 2014 amount led to no unpaid tax. Joe’s only hope is to appeal to the Tax Court of Canada and seek relief on the basis that he exercised “due diligence”. Unfortunately, misplacing T slips usually does not qualify. Joe may be stuck with a $20,000, non-deductible, penalty. This situation has happened many times, and while the Tax Court judges have called the penalty “harsh” and unfair, they have in many cases upheld it because they are require to apply the law.
In some cases, depending on the numbers involved, it may be better to tell the CRA that the non-reporting of the income was done knowingly and have the CRA assess a “gross negligence” penalty of 50% of the unpaid tax. That penalty will often be less than 20% of the income.