Advisors often assist clients with important decisions about pensions. A common one is whether he or she should take the pension or opt for a lump sum (commuted value), which can then be (partially) transferred into a locked-in retirement account.

But the tax rules are complex, and failure to report correctly to CRA could mean substantial penalties.

Transfer to LIRA, RRSP

That’s exactly what happened in a recent tax case (Morgan v The Queen, 2013 TCC 232). When John Morgan took early retirement from his job with the City of Calgary at age 55, he elected to withdraw his entire pension from his employer’s plan. That was in February 2009.

The bulk of the funds—nearly $270,000—had to be transferred to a locked-in retirement account (LIRA) and the remaining balance—nearly $180,000—could either be paid to him directly or transferred into an RRSP. He took approximately $144,000 directly and transferred the remaining $36,000 to an RRSP, presumably because he had contribution room available (court records do not explain).

Morgan received the $144,000 lump sum less a 30% withholding tax, which amounted to a bit more than $43,000. He arranged for his bank to “look after the funds,” testifying that “the bank assured him that tax would be taken care of and he did not think that he had to report it,” even though his employer sent him a T4A slip reflecting the withholding tax. The bank issued him an RRSP contribution receipt for the $36,000 contribution.

As in other years, Morgan prepared his own income tax return for the 2009 taxation year, but failed to report any of the pension funds as income, testifying that he “did not realize the pension monies were income and that he was concerned about double tax because he knew that tax had been taken at source.”

Since this was not the first time Morgan failed to include income on his returns, he was assessed a penalty of 10% federally and 10% provincially. This is the penalty when someone fails to include income for the current tax year and had a similar failure in any of the three immediately preceding taxation years. The 20% combined penalty of $36,000 was based solely on the $180,000 that made up the amount paid directly to Morgan plus the sum contributed to the RRSP. It excluded the amount transferred to the LIRA.

Due diligence defence

Prior jurisprudence says if you can establish that you were “diligent” with your tax filing, the penalty for repeated failure to report income on a tax return can be cancelled.

Thus, the issue before the Tax Court judge was whether or not Morgan had established an appropriate due diligence defence. In the words of the judge, “Did Mr. Morgan take all reasonable measures to prevent the failure to report income in the income tax return?”

The judge ruled he didn’t, for several reasons. First, Morgan was certainly aware—and indeed acknowledged in court—that he had an obligation to report all income, especially because he had previously been assessed penalties for failure to do so.

Secondly, his argument that his bank told him the tax “would be taken care of” was not a “satisfactory explanation” for not reporting the income. Finally, he received a T4A for the amount that was paid directly to him, which should have alerted him to the need to report something from this slip on his tax return. But the judge was willing to reduce the penalty slightly to take into account the $36,000 directly transferred into the RRSP. In her words, “there was no indication that Mr. Morgan was advised that this amount would be taxable at the time of transfer.”

The judge said even the slightly reduced penalty was “very harsh” because the source deductions in Morgan’s case were sufficient to pay the entire tax owing. The judge wrote, “In circumstances such as this, where there is no apparent intent to avoid the payment of tax, it seems excessive to impose a 20% penalty on top of (the income) tax. […] Despite the harshness, it is not up to courts to rewrite the law. Parliament has seen fit to enact the penalty […] and it is the duty of the courts to apply it.”