Aug

Taxpayer must pay taxes because of sham “pain and suffering” settlement

Posted By: Jonathan Crangle on August 17, 2012 at 12:26:18 in All , Case Comments

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Taxpayer ordered to pay taxes and penalties on payments from sham “pain and suffering” settlement

On August 13, 2012, the Tax Court of Canada released a decision written by Justice Paris in Joseph Mathew v Her Majesty the Queen (2012 TCC 289). The Court was faced with three issues:

1) whether the taxpayer failed to report income in the 2001 through 2004 taxation years;

2) whether the Minister was entitled to reassess the 2001 and 2002 taxation years (the normal reassessment period is 3 years pursuant to paragraph 152(3.1)(b) of the Income Tax Act (the “Act”); and

3) whether the taxpayer was liable to gross negligence penalties pursuant to subsection 163(2) of the Act for his failure to report income.

Facts

The taxpayer, Mr. Matthew, was a bankruptcy trustee working as an independent contractor for Financial Crisis Counselling Inc. (“FCC”). FCC was owned by Mr. Matthew`s sister and the shares were held in trust by his mother.

In November 2000, Mr. Matthew fell and injured his knee at the FCC office. He tore his ACL and required two surgeries to fix the damage. He claimed that he missed a great deal of work because of the injury and treatments. On the advice of a lawyer, Mr. Matthew sued FCC and his mother. A settlement agreement was negotiated to pay $650,000 over three years. The settlement agreement was signed “as of” March 15, 2001.

For tax years 2001, 2002 and 2003, Mr. Matthew received settlement payments from FCC that he did not report as income. Ordinarily, payments received for pain and suffering are considered “general damages” and are excluded from income (see Tsiaprailis v. Canada at para. 6). Mr. Matthew claimed that his relationship with his mother and sister soured and he never received a settlement payment in 2004. Justice Paris agreed that there was no evidence that payments were made in the 2004 taxation year.

The settlement agreement for pain and suffering was not bona fide

Justice Paris pointed out several problems with the series of events the taxpayer relied upon, notably:

·        the lack of convincing evidence that the injury occurred at the FCC office;

·        conflicting testimony between Mr. Matthew and his witness; and

·        that the taxpayer went to the gym the same day as the injury.

Additionally, the settlement agreement itself was highly suspect. The agreement referenced “a long rehabilitation and recovery process” only one month following one of the surgeries. The first disclosure of the settlement agreement’s existence coincided with an income tax audit of the taxpayer’s spouse. Additionally, the taxpayer did not exhaust all the compensation options under the agreement.

Finally, the evidence contradicted Mr. Matthew’s claim that he did not work a great deal during the 2001 through 2004 taxation years. The evidence showed that his monthly payments were related to his work at FCC, and he admitted doing bookkeeping for the company during these years.

Justice Paris concludes in paragraph 36:

I do not accept that the alleged settlement agreement between the Appellant, FCC and the Appellant’s mother was bona fide, nor do I accept that it was entered into in March of 2001. It appears much more likely to me that the Appellant created this agreement in 2004 as an attempt to camouflage substantial amounts of income he received for work done on the EPC file from 2001 on (and which he had not reported) as tax free damages for pain and suffering.

Normal reassessment period does not apply

The taxpayer’s attempt to deceive the CRA continued to work against him. Even though the 2001 and 2002 periods would normally be excluded from reassessment because 3 years had passed prior to the Minister’s assessment, Justice Paris held that the normal assessment period did not apply because Mr. Matthew had made misrepresentations that were attributable to wilful default.

Penalties

Additionally, the penalties imposed on Mr. Matthew by the Minister were upheld. The taxpayer knowingly made misrepresentations in filing his tax returns and created a sham settlement agreement after the fact, in an attempt to disguise his income as non-taxable receipts.

Analysis

Contracts signed “as of” an earlier date are common, particularly when there has been an oral agreement. This practice can be acceptable if it truly reflects an agreement between the parties. In this case, the taxpayer attempted to disguise his income using a sham settlement agreement with his mother and relied on this doctrine. This is the type of practice that causes CRA to consistently question the validity of documents with an “as of” date.

Additionally, CRA pays close attention to non-arm’s length transactions. This agreement was bound to be scrutinized by the Minister. The taxpayer’s actions after the fact further proved that his injury was not as bad as he described, and that he was, in fact, still working for FCC.

This case should be seen as a warning to taxpayers that if you knowingly lie to the CRA when filing your returns, you cannot rely on an argument that a reassessment of that year is statute-barred.  Instead, you may be stuck paying a large gross negligence penalty.

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