2018-0786101I7 Penalty under subsection 163(1.1)(b)

Principal Issues: Whether subsection 163(2.1) needs to be considered when calculating a penalty amount under paragraph 163(1.1)(b) for a taxpayer who had expenses attributable to unreported income.

Position: Yes.

Reasons: Paragraph 163(1.1)(b) requires the calculation of amounts in paragraphs 163(2)(a) to (g) as if subsection 163(2) applied. In order to calculate an amount under paragraph 163(2)(a), the expanded meaning of understatement of income under subsection 163(2.1) must be used.

Author: Clarkson, Julia
Section: Paragraph 163(1.1)(b) and subsections 163(2) and (2.1)

                                                                                                                                                   February 12, 2019

Technical Section                                                                                                                       HEADQUARTERS
Small and Medium Enterprises Directorate                                                                                Income Tax Rulings
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Attention: Minguy Choi                                                                                                               Julia Clarkson
                                                                                                                                                    613-670-9089

                                                                                                                                                    2018-078610

Subsections 163(1.1), (2) and (2.1)

We are writing in reply to your memorandum of October 9, 2018, regarding the interaction between subsections 163(1.1) and 163(2) of the Income Tax Act (the “Act”). More specifically, you wished to confirm whether subsection 163(2.1) needs to be considered when calculating a penalty under paragraph 163(1.1)(b) for a taxpayer who had expenses attributable to an unreported income amount.

You have provided the following details as an example of a taxpayer who had not included employment income reported on a T4 slip on his filed income tax return:

*     gross employment income of $30,000

*     withholdings of:

o     $4,000 of income tax

o     $600 of EI premiums

o     $1,200 of CPP contributions

*     deductible employment expenses of $1,800 that are wholly attributable to the employment income reported on the T4 slip and not deducted on an income tax return.

In your view, subsection 163(2.1) of the Act would apply where a taxpayer has incurred expenses that were attributable to an unreported amount subject to a penalty under subsection 163(1) of the Act. While not specifically stated in your example, we have assumed that the other conditions of subsection 163(1) were met, causing the taxpayer to be subject to a penalty under subsection 163(1) instead of subsection 163(2) or some other provision in the Act.

Our comments

Subsection 163(1.1) of the Act is a relatively new provision, having been enacted by S.C. 2016, c. 7, s. 43(1). It applies to taxation years that begin after 2014. It details the calculation of a penalty under subsection 163(1) of the Act.

When determining a penalty under subsection 163(1.1), the amount calculated under paragraph 163(1.1)(a) is made using the unreported income amount that has caused the application of a subsection 163(1) penalty. This amount does not rely on subsection 163(2) of the Act. For the example provided, the penalty amount calculated under paragraph 163(1.1)(a) is $3,000, calculated as 10% of the unreported income amount of $30,000.

However, the amount calculated under paragraph 163(1.1)(b) does rely on subsection 163(2). More specifically, variable A of paragraph 163(1.1)(b) is the total of the amounts calculated under paragraphs 163(2)(a) to (g) as if “subsection (2) applied in respect of the unreported amount.”  If subsection 163(2) were to apply to an “unreported amount” of income described in subsection 163(1.1), it would logically always require a calculation of tax payable on an “understatement of income” under paragraph 163(2)(a).

Subsection 163(2.1) of the Act applies for the purposes of subsection 163(2). It states that a person’s taxable income cannot be less than nil, and clarifies the meaning of “understatement of income” used in subsection 163(2). Therefore, a reference to “understatement of income” in subsection 163(2) must have the meaning assigned to it by subsection 163(2.1). As a result, we agree that a penalty under subsection 163(1.1) will have to consider both subsections 163(2) and (2.1).

The paragraph 163(1.1)(b) amount determined under paragraph 163(2)(a), taking into account the meaning of “understatement of income” in subsection 163(2.1), would include:

*     the unreported income amount that has resulted in the subsection 163(1) penalty,

*     any deductible, but not previously deducted, amounts that are wholly attributable to the unreported income amount, and

*     any amount deducted, but not deductible, in the income tax return filed by the person for the tax year, other than a deduction under section 111 (subparagraphs 163(2.1)(b) and (c)).

Based on the information provided in your example, it is not clear if paragraphs 163(2.1)(b) or (c) are applicable. On the assumption that they are not applicable, the income tax payable amount used in the paragraph 163(1.1)(b) calculation would be determined in the following manner.

First, a revised amount of income tax payable would be calculated as any excess of the adjusted income tax payable (clause 163(2)(a)(i)(A)) over adjusted amounts deemed paid on behalf of the taxpayer by subsections 120(2) and (2.2) of the Act (clause 163(2)(a)(i)(B)). These revised amounts determined by clauses 163(2)(a)(i)(A) and (B) would be computed using:

*     taxable income that has been increased by the understatement of income, or $28,200, and

*     non-refundable credits under section 118.7 of the Act that consider the additional EI premiums and CPP contributions payable on the unreported income.

This result under subparagraph 163(2)(a)(i) would then be compared to the tax payable amount calculated under subparagraph 163(2)(a)(ii), using amounts reported on the income tax return filed by the taxpayer for the year. Any excess amount would be included in variable A of the paragraph 163(1.1)(b) penalty calculation.

As well, the unreported income may cause additional inclusions to variable A to be required by paragraphs 163(2)(c) to (g).

Income tax withheld from an unreported income amount in accordance with subsection 153(1) of the Act would be included in variable B of paragraph 163(1.1)(b).

The amount calculated under paragraph 163(1.1)(b) would be 50% of the excess, if any of variable A over variable B.

The penalty amount calculated under subsection 163(1.1) would be the lesser of the amounts calculated under paragraphs 163(1.1)(a) and (b).

We trust these comments will be of assistance.

Unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process removes all content that is not subject to disclosure, including information that could reveal the identity of the taxpayer. The taxpayer may ask for a version that has been severed using the Privacy Act criteria, which does not remove taxpayer identity. You can request this by e-mailing us at: ITRACCESSG@cra-arc.gc.ca. A copy will be sent to you for delivery to the taxpayer.

Yours truly,

Terry Young, CPA, CA
Manager, Administrative Law Section
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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