One of the most alluring benefits of being self-employed is the ability to write off a variety of business expenses for tax purposes. But if you push the envelope of expense deductibility, either by claiming questionable expenses with little business purpose or by overstating the quantum of your expenses, you could find yourself in hot water with the taxman. You may even be assessed a gross negligence penalty, on top of the tax owing and arrears interest.
That’s what happened in a tax case decided earlier this month involving a self-employed Windsor, Ont., mortgage agent. In her 2010 and 2011 tax returns, she reported gross revenues of approximately $148,000 and $146,000 respectively; however, she also claimed business expenses of approximately $138,000 and $145,000 in those two tax years, resulting in net income of about $10,000 in 2010, and only $1,000 in 2011. Her high levels of gross revenues compared to minimal net business income in those years caught the attention of the Canada Revenue Agency, which reassessed both of her 2010 and 2011 tax returns, disallowing much of her claimed expenses. It also imposed gross negligence penalties.
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The taxpayer objected and the CRA allowed some of her expenses, but refused to allow $76,000 of her 2010 expenses and $74,000 of her 2011 expenses. The taxpayer went to Tax Court to dispute the denied expenses and challenge the gross negligence penalties.
Her questionable expenses were mostly related to excessive restaurant dining, phantom wages and nearly $5,000 in unsubstantiated legal fees. The CRA also challenged the taxpayer’s non-qualifying claim of home office expenses, despite the fact that she rented commercial office space in Windsor, as well as various personal expenses, such as a Costco bill for pork tenderloin, Special K and red peppers.
Meals and entertainment
The taxpayer explained that, in order to obtain business, she engaged in a certain number of entertainment expenses. The CRA did not dispute this but rather questioned the quantum of these expenses.
For the 2010 tax year, the CRA ultimately allowed 58 per cent of the meals and entertainment expenses she claimed, after reviewing the information the taxpayer had provided. For 2011, however, rather than reviewing each individual receipt, the CRA simply allowed 58 per cent of the amount claimed that year as well.
The taxpayer challenged the CRA’s methodology, saying that the CRA should have examined each individual meal claim for 2011 (as it did for 2010) and not simply allowed merely the same 58 per cent used for her 2010 claim.
The judge disagreed, noting that in the 2011 tax year, the taxpayer made claims for some 360 meals totalling about $16,000. As the judged remarked, “When one goes through the … list, given the sheer number and timing of the meals it is implausible for all these meals to be business meals. A fair number are on Saturdays or Sundays.”
There were also instances where the taxpayer submitted both the restaurant bill and the credit card slip for a particular meal, and the names of the persons entertained written on the back of the bill and back of the credit card slip were different. The judge noted that some receipts were altered to increase the amount: a restaurant receipt for $34 became a receipt for $134, while a gift receipt was altered from $3.50 to $33.50
Among the meals claimed in 2011, there were a total of 36 meals at the Palette Dining Lounge and Breeze Restaurant, both restaurants at the MGM Grand casino, located in Detroit, across the river from Windsor. After examining the receipts, the judge felt that “they were all or mostly personal meals of the (taxpayer) and her husband.”
In each of 2010 and 2011, the taxpayer claimed wage expenses of $38,500. Of these amounts, $12,500 in each year was paid to the taxpayer’s husband and was accepted by the CRA as a deductible expense. The remaining $26,000 claimed in each year related to “cleaning and computer services,” yet the taxpayer could provide neither the names nor any details as to whom she hired, or how they were paid, testifying that “she paid cash and had no documents to support the claim.”
The judge stated, “I simply do not believe that someone who kept hundreds of restaurant receipts, a few of which are below $10, would obtain no documentation when paying the $52,000 in wages in issue over the course of two years…. The only reasonable inference that can be made is that $26,000 in salary expenses in each of the years were fictitious.”
In 2010, the taxpayer claimed $4,932 paid to a Windsor law firm. The taxpayer “was unsure what this specific cheque was for and stated that the handwriting on the cheque appeared to be her husband’s.” The judge was not convinced that this was an appropriate business expense, saying, “Given all the meal receipts kept by the (taxpayer) one would expect (her) to have also retained a bill for almost $5,000. Also, had the bill been lost, one might expect (her) to have tried to obtain a copy from her lawyer.”
Gross negligence penalties
The CRA can assess a gross negligence penalty if a taxpayer “knowingly … has made … a false statement … in a tax return.” The judge noted that it was clear that by claiming numerous non-existent or personal expenses as business expenses, that false statements were, indeed, made by the taxpayer in her 2010 and 2011 tax returns.
As to the question of whether they were made knowingly, the taxpayer attempted to argue that “she had no specialized training in tax or accounting and she did her best with respect to her expense claims.” While the taxpayer testified that she hired someone to prepare her tax returns, it’s ultimately the taxpayer’s responsibility to ensure that the amounts reported therein are accurate.
In upholding the penalties, the judge commented: “One needs no special training or expertise to know that one cannot claim an expense that was never made. Nor does one need such knowledge to know that having dinner with one’s spouse is not normally a business expense….Given the sheer magnitude of the invalid expense claims, I infer that the (taxpayer) was indifferent to whether her expense claims were valid or not. Such indifference constitutes wilful blindness and meets the requirement of ‘knowingly’ making a false statement.”