TaxMatters@EY – May 2023

Krista Fox and Alan Roth, Toronto

The 2022 personal income tax season has just concluded,¹ and if you’re required to pay tax by instalments for the 2023 taxation year, you’ll need to make your next instalment payment by June 15.

Considering the recent rise in interest rates due to inflationary pressures, it’s particularly important to carefully consider which instalment calculation method is most appropriate in your circumstances. Failure to apply the appropriate method correctly could potentially result in the assessment of arrears interest at high rates — 9% in the second quarter of 2023 — and, in certain cases, penalties as well.

Background

If the difference between your tax payable and the total amount of tax withheld at source is greater than $3,000 — for residents of Québec, $1,800² — in both the current year and in either of the two preceding years, you’re generally required to pay quarterly income tax instalments.

For this purpose, tax payable includes the combined federal and provincial or territorial income tax payable amount, except in Québec.³ If you’re a resident of Québec, you are required to pay federal tax instalments if the difference between federal tax payable and federal amounts withheld at source is greater than $1,800 in the current year and in either of the two preceding years.⁴ This difference between your tax payable and total withholdings at source is generally referred to as your net tax owing or balance due amount. The CRA will send you an instalment reminder if they have determined at that time that your prior years’ net tax owing amounts meet the thresholds for paying tax instalments.⁵

For individuals other than farmers and fishers, quarterly instalments are due on March 15, June 15, September 15 and December 15.⁶ The February instalment reminder is in respect of the March and June instalment payments, and the August reminder is in respect of the September and December instalment payments.

If an instalment due date falls on a Saturday, Sunday or holiday, the CRA considers the payment to be made on time if it is received or postmarked on the next business day.

Calculation methods

There are three allowable methods of calculating instalment payments.⁷ The following looks at the application of these three methods in respect of the 2023 taxation year:

No-calculation option

You may simply choose to pay the stipulated amount on the instalment reminders the CRA sends you. The CRA's instalment reminders generally use the no-calculation method, which requires each of your first two 2023 instalments to be equal to one quarter of your balance due for the 2021 taxation year, and each of your third and fourth 2023 instalments to equal 50% of the excess of your 2022 balance due over the amounts payable in your first two instalments.

By following the no-calculation option and paying the stipulated instalments when required, you avoid the risk of being subject to interest or penalties on deficient instalments. Even if your final tax payable is higher than the stipulated instalments paid for the year, the CRA will not charge instalment interest or a penalty. However, if your net tax owing for the current year is expected to be significantly lower than in the previous two years, the no‑calculation method may result in excessive instalments, and one of the other methods may be more appropriate.

Prior-year option

You may choose instead to calculate each instalment payment to be equal to one quarter of your 2022 total balance due. Provided the instalments have been correctly determined under this method, interest will not be charged even if the actual current-year net tax owing exceeds the total amount of instalments made.

Current-year option

The third alternative allows you to calculate each instalment payment to be equal to one quarter of your estimated 2023 balance due. Using the current-year option can result in lower instalment payment requirements if your income tax liability is expected to be lower in 2023 than in 2021 and 2022. But if you underestimate your 2023 balance due and pay deficient instalments, you’ll be charged arrears interest and may also be subject to a penalty under certain circumstances. Therefore, this instalment calculation method can be the riskiest method.

Instalment interest

The CRA assesses non-deductible instalment interest if you are required to pay by instalments for the year and you receive an instalment reminder for that year but you either don’t make your instalment payments, are late in making your payments, or pay less than what you are required to pay. Interest payable on late or deficient instalments is calculated using prescribed rates, which vary quarterly and are compounded daily. The federal prescribed rate for overdue taxes is 9% for the second quarter of 2023.⁸

The interest charge is calculated from the date each instalment is due. However, you may be able to reduce or eliminate interest and penalties charged on late or deficient instalments by overpaying your next instalment and/or paying it before the due date, provided it relates to the same taxation year.⁹

Instalment penalty

In addition to the interest charged on late or deficient payments, instalment penalties also apply if the amount of interest charges owing in the year exceeds $1,000. When this applies, the penalty is equal to half of the amount by which the actual interest owing on the late or deficient instalments for the year exceeds the greater of $1,000 and 25% of the interest that would be payable if no instalments had been made for that year.¹⁰

For example, if an individual’s total instalment interest owing for 2023 is $1,500 and the amount of interest that would be charged if no instalment payments were made at all in 2023 is $2,300, the amount of instalment penalties charged would be $250, calculated as:

50% x ($1,500 – (greater of $1,000 and (25% x $2,300))

= 50% x ($1,500 - $1,000) = $250.

This penalty does not apply for Québec tax purposes. For that province, if the amount of instalments paid is less than 75% of the required instalments, additional interest of 10% per year, compounded daily and over and above the amount of regular arrears interest, is charged on the unpaid portion of the instalment.

Gagnon et al v The King¹¹

This recent Tax Court of Canada case, decided under the informal procedure, highlights the consequences of applying the wrong instalment calculation method for a taxation year and, in particular, the risks associated with selecting the current‑year method.

The taxpayers, a married couple, were required to pay tax instalments for the 2019 taxation year, since their minimum net tax owing in each of the previous three taxation years exceeded the minimum threshold of $3,000. The taxpayers opted for the current-year method to calculate their 2019 instalment payments. By choosing the current-year method, for example, the wife was able to reduce the total amount paid for her first three 2019 instalment payments by almost 50% since she paid a total of $70,500 instead of the $133,470 she would have had to pay under the no‑calculation method proposed by the written instalment reminders issued by the CRA.

In November 2019, the taxpayers’ holding company declared a dividend payable before December 15, 2019, based on speculation that the upcoming federal budget may include a change in the tax treatment of Canadian dividend income. As a result, the taxpayers each received a $300,000 dividend, which substantially increased their respective incomes and tax liabilities and, therefore, the required instalment payment amounts under the method they chose. The taxpayers increased the amount of their December 15 instalment payment because of the additional dividend income received, but the first three instalment payments for 2019 were now deficient.

The CRA assessed the taxpayers for arrears interest in respect of deficient instalments they remitted in March, June and September 2019 and, in the case of one of the taxpayers, a penalty in respect of the deficient instalments.

The taxpayers argued that the November 2019 dividend was unanticipated and unforeseen, and without it, their initial estimates of tax payable and required instalment payments under the current-year method would have been sufficient. As such, they stated they should not be required to pay arrears interest on the amounts owing for the March, June and September instalments because at the time those remittances were made, they did not expect to receive that dividend income later in the year, so it would have been impossible to make these instalments based on unknown future information. They further argued that if any interest was applicable, it should only be applied to the amount payable between the period when the dividend was declared and the December 15, 2019 instalment date.

In dismissing their appeals, the Court concluded that the taxpayers had made a deliberate choice to declare a sizeable dividend through their holding company as an end-of-year provisional tax plan, and the resulting instalment interest and penalty were “the costs of that avoidable choice.”

Conclusion

In reviewing your instalment obligations for the year, it is important to consider the potential consequences associated with selecting your instalment calculation method. Although the current-year option can result in lower instalment payment requirements if you expect your taxable income for the current year to be lower, underestimating your current taxation year’s balance due could be a costly mistake given the recent increases to the prescribed interest rate. If you're unsure which option is best for you, consult your professional advisor.

1. Self-employed individuals and their spouses or common-law partners have until June 15 to file their income tax returns, but any balance of tax owing has to be paid by April 30.
   
   
2. Subsection 156.1(1) of the Income Tax Act (the Act), “instalment threshold.”
   
   
3. However, instalments may not be required if the individual had no tax payable balance in the prior year and selects the prior-year method (see below) for calculating instalment payments.
   
   
4. Note that Québec tax instalments may also be required. For all other provinces and territories, your tax payable amount is equal to your combined federal and provincial/territorial tax payable, but for Québec purposes a separate Québec payable amount applies. Therefore, if you are a resident of Québec, you are required to pay provincial tax instalments if the difference between Québec tax payable and Québec withholdings at source is greater than $1,800. This is separate from the federal threshold of $1,800. Note that Revenu Québec will send you an instalment reminder. See “Instalment Payments” on Revenu Québec’s website for further information.
   
   
5. Note that you may still be subject to instalment payments if you don’t receive an instalment reminder from the CRA. For example, you may have met the required thresholds, but the CRA may not be aware of that if the relevant tax returns have not been assessed yet. If you have not received any instalment reminders from the CRA but you believe you may be subject to instalment payments, we suggest you verify your potential instalment obligations with the CRA directly to minimize the risk of incurring arrears interest and penalties.
   
   
6. Although individuals whose chief source of income for a taxation year is farming or fishing use the same instalment base as other individuals, they are only required to make one instalment payment equal to two thirds of that base by December 31 of that taxation year and then pay any remaining balance of their tax liability on filing their T1 personal income tax return.
   
   
7. Subsection 156(1) of the Act.
   
   
8. The prescribed rate has been rising steadily since the third quarter of 2022, when it increased from 5% to 6%. The rate then increased to 7% for the fourth quarter of 2022, to 8% for the first quarter of 2023, and to 9% for the second quarter of 2023.
   
   
9. The CRA uses the offset method to calculate instalment interest charges, which means that when you prepay or overpay your instalments, the CRA will calculate interest on the overpayments and prepayments, which the CRA refers to as credit instalment interest, and offset it against the interest charges for late and insufficient payments. This credit instalment interest is calculated at the same rate as the interest charges on late or deficient instalments. It is important to note that the CRA will not refund credit instalment interest as it is used only to reduce or eliminate instalment interest charges.
   
   
10. Section 163.1 of the Act.
    
    
11. 2022 TCC 139.

Kelsey Horning and Winnie Szeto, Toronto

In the recent case of Bousfield v The King, the Tax Court of Canada addressed alternative assessment techniques and how a taxpayer might challenge them.

The taxpayer in this case operated a taxi business and the CRA reassessed him on the basis of the average of four different alternative assessment techniques. In response, he put forward three alternative techniques. The judge ultimately devised his own alternative assessment technique that was a partial victory for the taxpayer.

Facts

The taxpayer was the proprietor of a taxi and transportation business. He owned the vehicle that he used as a taxi and leased the taxi plate from a company that also acted as the dispatcher. The vehicle was often subleased to other drivers. The taxi business was also involved in transporting children for the local school board or various social agencies. These trips were handled by one of the drivers who subleased the taxi and who served as the primary daytime drive

The taxi business was largely cash based. Drivers recorded trip information and fare amounts on white envelopes, regardless of whether the customer paid using cash or credit card. Drivers would then calculate and take their agreed-upon 50% share of the fare and fuel expenses and leave 50% of any remaining cash collected inside the envelope for the taxpayer. However, many of these envelopes were either missing entirely or the information written on them was incomplete.

A logbook used by the primary daytime driver as an alternative to the envelope system was not shared with the taxpayer, and could not be reconciled with the taxpayer’s own system — or lack thereof — for tracking the primary daytime driver’s fares. Non-cash fares were collected by the dispatch company and remitted to the taxpayer, who would then pay the drivers their 50% share.

The taxpayer did not file his 2006 and 2007 tax returns, so the CRA issued arbitrary assessments for those taxation years to encourage him to file. The taxpayer responded by filing returns for 2006, 2007 and 2008, which the CRA then audited and reassessed. The reassessments increased the taxpayer’s income from his taxi and transportation business and also imposed gross negligence penalties. The CRA also made corresponding adjustments to the taxpayer’s GST liability.

Arbitrary vs. alternative assessments

The minister may issue an arbitrary assessment to encourage a taxpayer to file a return that they have failed to file. An arbitrary assessment is normally based on little or no analysis. In contrast, an alternative assessment technique usually includes some or very detailed analysis and calculations to determine a taxpayer’s income. A net-worth assessment is a sub-type of alternative assessment. Therefore, the three terms — arbitrary assessment, alternative assessment and net-worth assessment — have different meanings and should not be confused.

Rather than relying on a taxpayer’s records, the CRA may use an alternative assessment technique. This is typically done when the CRA regards a taxpayer’s records as inadequate or unreliable. Alternative assessment techniques can include a bank deposit analysis or a net-worth analysis where assets are compared at the beginning and end of the relevant period. The CRA may also incorporate statistical information, such as industry averages, as assumptions in its analysis.

Court’s analysis and decision

In this case, the CRA had averaged the revenues determined under four different assessment techniques and the taxpayer proposed three others. Ultimately, the Court created its own assessment technique, varying the reassessments and reducing the unreported income and tax owing.

The Court provided an overview of possible approaches to challenging an alternative assessment, as well as comments on the party responsible for providing evidence to support certain arguments. Possible methods to challenge an alternative assessment include:

• Demonstrating that the taxpayer’s own records are a more accurate source of information for calculating the taxpayer’s income
• Attacking components of the computation in the alternative assessment
• If the year is statute barred, showing the alternative assessment technique is fundamentally flawed
• Providing a more accurate alternative assessment technique
• Showing that the income was from a non-taxable source

Simply saying that the alternative assessment was flawed is not enough when the normal reassessment period has not yet expired. During the normal reassessment period, the taxpayer must show that the minister’s assumption that they earned additional income is wrong.

The taxpayer argued that his records were adequate to determine his revenue. The Court rejected this due to the information that was missing from the records.

The taxpayer also argued that other alternative methods produced a more accurate picture of his income than the methods used by the CRA.

The CRA had used the following techniques:

• Applying the average daily taxi income for the city to an assumed number of days of operation per year
  
• Applying an assumed average trip length, fare and number of trips per day to the assumed number of days of operation per year
• Assuming the cash-to-non-cash payments ratio based on industry norms, using the non-cash amount from the dispatch company and adjusting cash amounts to match
• Adjusting the cash amounts to match the cash-to-non-cash ratio based on a ratio determined from the business’s documents

The Court identified problems with each of these techniques. Some of these were factual errors, such as an error in incorporating the average daily taxi income amount from the study that provided that average. Another concern was that the use of industry averages may not be appropriate because the business had certain unique characteristics, such as the payment structure associated with the subleases. The business used a 50-50 arrangement rather than the flat fee that was typical. Arrangements to transport children for the school board and social services were also not typical and would have skewed the cash-to-non-cash payment type ratio as they were all non-cash.

The Court noted that another key flaw with the CRA’s assessment techniques was that the minister did not plead many of the assumptions underlying the techniques. In other words, the minister’s documents setting out their initial case for the Court did not specify that they were assuming these points. When the minister’s assumptions are not included in the pleadings, the minister bears the burden of demonstrating that those assumptions were correct. That did not happen for many of the assumptions used in this case, including key assumptions like industry average daily taxi revenue and the industry cash-to-non-cash ratio.

The taxpayer proposed three alternative techniques:

• Conducting a net-worth assessment
  
• Determining revenue based on average hourly revenue for the industry and the business’s hours of operation
• Adjusting cash to match a cash-to-non-cash ratio modified to take the children’s transportation trips into account

The Court identified concerns with each of these approaches. The taxpayer bears responsibility for providing the evidence to support his position. A taxpayer cannot rely on assumptions like the minister can since the taxpayer should have access to the necessary information to establish their own income and expenses.

In this case, the taxpayer was not able to provide reliable evidence for many of the elements of the net-worth assessment, the hours of operation of the taxi business or the daytime driver’s cash fares. Similarly, the taxpayer did not establish the truth of the contents of the study that provided the average hourly revenue for the industry by, for example, having the author testify.

In light of the flaws with all of the assessment techniques presented, the Court devised its own calculation.

The Court looked at samples of the daytime driver’s logbook and arrived at a 45% cash ratio for that driver, including the child transportation trips. Based on the envelopes that were available, other drivers were determined to have 80% cash payments and 20% non-cash. Using those amounts, the Court applied the payment type ratio technique, which had the effect of reducing the taxpayer’s income from the amount originally assessed by the minister. As a result of this partial win, the taxpayer’s income from his taxi business was reduced by $45,509 for the 2006 taxation year, $49,584 for the 2007 taxation year, and $46,265 for the 2008 taxation year.

Lessons learned

This case provides a number of useful reminders. First, it is important that taxpayers file their annual tax returns by the due date so as not to trigger alternative assessments. Second, it is important to maintain proper records so that it is possible to establish an accurate picture of income. Third, it’s important to obtain professional tax advice to understand who bears the burden of proof when a tax matter goes to court. This enables taxpayers and their representatives to identify gaps in the minister’s assumptions and to have appropriate evidence to meet their burden of proof. And finally, taxpayers should be aware that the courts are not bound to accept either the CRA’s estimation techniques or the methods suggested by the taxpayer, but may instead devise their own alternative method, as in Bousfield.

Tax Alerts – Canada

Tax Alert 2023 No. 21 – Federal budget: Changes to the definition of “financial service” under the Excise Tax Act