DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

They’re Not As Dumb As You Think

In Canadian Income Tax, Tax Avoidance on March 21, 2010 at 7:55 pm

Once in a while, a client will suggest a scheme that makes me wonder if he is really living out there in the real world.

The case of Jacob Erlich is interesting in that it represents a set of facts which is not all that uncommon in my experience. It tells the story of a taxpayer who is willing to take the risk of excluding certain amounts in reporting his income, and the dire consequences that may befall him if his actions are subsequently investigated by the revenue authorities.

The facts were not complicated. Mr. Erlich was the owner of a chain of retail clothing outlets for a number of years, since he took the business over from his father in 1972. In 1992, someone (although not addressed in the text of the case, that someone was likely a disgruntled former employee with a cross to bear) made a report to the Special Investigations division of the Canada Revenue Agency, with regard to some unreported sales of the business.

During the audit that ensued, the CRA discovered that somehow, the cash register tapes which would verify sales from 1988 to 1991 were nowhere to be found. The Minister accordingly assumed that they had been destroyed by Erlich.

In 1992 Mr. Erlich made a series of deposits to his corporation’s bank account, totaling $367,000. The amounts were credited to his shareholder loan account. The Minister assumed that these amounts represented sales collected directly by Mr. Erlich, and not reported by the company.

In addition to the above, this was not the first time Mr. Erlich was under the gun for a similar offence. He had previously deposited unreported sales of a predecessor company into his shareholder loan account.

At this point, let me make an important point about the burden of proof. Quite simply, it rests with the taxpayer. In other words, the Minister made certain assumptions based on the evidence or lack thereof, issued a net worth assessment against Mr. Erlich, and assessed his company a similar amount with respect to unreported sales. This double tax assessment is one of the ways the government can punish a taxpayer for abusive transgressions.

Often, a client will be under the wrong impression that if the CRA can’t prove their case, they will lose. Unfortunately, as stated above, they don’t have to prove their case. The taxpayer does.

Furthermore, a client will sometimes believe that a suitable story will make the problem disappear. When asked where the money came from to make the deposits in question, Mr. Erlich had such a story. He stated that his mother had found the cash in boxes in a closet of her home, possibly left there by his father (now deceased), who may have had some rich (and, no doubt, generous) friends in Hong Kong.

Not surprisingly, the CRA did not take this explanation at face value. Nor, to their credit, did they reject it out of hand. They actually went back through the records of Mr. Erlich’s parents to determine whether any income source existed that would justify the amount of cash found. Unfortunately, no such source was found.

Without proof to substantiate Mr. Erlich’s his story, the court rejected it, and upheld the Minister’s assessments. This case illustrates in vivid fashion, something I try to impart on my clients on a regular basis. The CRA and the courts are not as dumb as you think.

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