A recent decision by the Canadian Federal Court of Appeal in BP Canada Energy Company v. MNR1 reversed the judgment of the lower court and held that the Canada Revenue Agency (CRA) is not entitled to routinely demand access to taxpayers’ tax accrual working papers in the course of an audit. Taxpayers view this as a welcome curtailment of the CRA’s broad audit powers, reinforcing the public interest in encouraging full disclosure to independent financial statement auditors. The Court was clear that the CRA requires some particular justification in order to demand disclosure of working papers; however, the limits of what constitutes acceptable justification remain unclear.
Tax accrual working papers are prepared by or for independent auditors to facilitate the audit of financial statements, which are generally required to be disclosed by public companies under securities laws. The purpose is to identify uncertain tax positions (or “soft spots”) and establish appropriate reserves. Working papers contain highly sensitive information regarding a company’s uncertain tax positions, including an analysis of the positions and the likelihood of success if challenged by the tax authorities. They constitute a virtual roadmap for revenue authorities conducting a tax audit.
Unlike the U.S., Canada has not enacted legislation to govern the tax authorities’ access to tax accrual working papers. This matter falls instead under the CRA’s general information-gathering powers under the Canadian Income Tax Act (ITA). These powers are extremely broad. Subject to limited exceptions (such as information protected by solicitor/attorney-client privilege), the CRA can demand disclosure of any information that relates or may relate to any amount payable under the Act and can seek a compliance order from the court upon a failure to comply.2 Canadian courts have interpreted these powers broadly, requiring only a low threshold of relevance. Indeed, in the BP Canada case the Federal Court of Appeal commented that the applicable provision “could not have been drafted in broader terms.”3
Prior to 2010, it was CRA’s publicly stated policy not to seek general access to “accountant’s working papers” for audit purposes. In 2010, CRA restated its published policy to clarify that its officials were authorized to request and receive any documents needed for a proper audit (subject to privilege), adding that tax accrual working papers would not be routinely required.
Despite this policy, CRA requested working papers in the BP Canada case on a routine, ongoing basis and for multiple taxation years to further the efficiency of its audits by obtaining a clear roadmap of BP Canada’s uncertain tax positions.
The taxpayer, BP Canada, is a Canadian subsidiary of BP, p.l.c., a United Kingdom public company. The dispute stemmed from a request by a CRA auditor for disclosure of BP Canada’s tax accrual working papers in connection with a relatively narrow question concerning BP Canada’s 2005 taxation year. BP Canada provided a redacted version of the working papers showing the amounts of “tax at risk” and annual reserves but redacting the uncertain tax positions and related analysis. The redacted documents answered the auditor’s question. However, they raised the new concern that the identified “tax at risk” appeared to significantly exceed the taxes that CRA proposed to assess, signaling to the auditor that the CRA may have missed an issue. In light of this concern, the CRA demanded the production of the working papers in unredacted form. It maintained this request even after BP Canada demonstrated that the amounts associated with its uncertain tax positions were actually lower than the amount assessed. Ultimately, the CRA reassessed BP Canada’s 2005 taxation year without the tax accrual working papers, but continued to demand the production of the working papers for all subsequent taxation years.
In a 2015 decision that concerned many public corporations, the trial judge at the Federal Court found for the government.4 He was dismissive of BP Canada’s arguments, framing the issue as one of accountability and holding that tax accrual working papers come within the scope of documents that may be demanded by the CRA. Moreover, he declined to exercise his discretion not to compel disclosure, noting that CRA acted in accordance with its policy and that it was fair and just that uncertain tax positions be identified by the tax authorities, since “if the CRA does not uncover the tax positions in time…the taxpayers of Canada lose.”5
In a judgment released on March 30, 2017, the Federal Court of Appeal unanimously set aside the decision of the trial judge. The Court accepted that the CRA could demand access to tax accrual working papers in some circumstances under its broad audit powers, such as where such papers are required to respond to a specific audit inquiry. CRA was not entitled, however, to demand unrestricted access. According to the Court, “Parliament intended that the [CRA’s] broad [information-gathering] power … be used with restraint when dealing with [tax accrual working papers].”6
The Court held that there was an unwritten rule that the CRA cannot compel taxpayers to self-audit by revealing their soft spots. It also accepted the argument that allowing the CRA unfettered access to tax accrual working papers would induce public corporations to be less forthcoming in disclosing and documenting their tax risks to their external auditors. This would in turn reduce the utility of audits to ensure that financial statements fairly represent a company’s financial position, to the detriment of investors and the securities markets. It is noteworthy that the Chartered Professional Accountants of Canada were granted intervenor status in the appeal.
In contesting the public policy concern, the government referred to two U.S. cases, Arthur Young7 and Textron.8 In Arthur Young, the U.S. Supreme Court held that securities markets would not suffer if it were to deny an accountant-client privilege with respect to tax accrual working papers, and in Textron the U.S. Court of Appeals for the First Circuit held that the disclosure of tax accrual working papers would not undermine the disclosure of information to external auditors. The BP Canada Court noted, however, that neither of these cases involved the unrestricted disclosure of working papers on a routine basis; rather, they involved targeted requests for information that occurred within a regulated framework under which the IRS only seeks access to working papers in the context of certain limited designated transactions. Indeed, the Court concluded that the regulated approach employed in the U.S. implicitly supported the view that allowing unrestricted access to working papers would have a negative impact on financial reporting.
Aside from the CRA’s legal powers under the ITA, the trial judge found the CRA’s published policy to be that tax accrual working papers were compellable without restriction. The Federal Court of Appeal disagreed, finding that the policy was not to use its powers routinely to require the disclosure of working papers. Even if the ITA did permit the CRA to gain unfettered access to tax accrual working papers, the Court held that CRA acted against its published policy on requesting access. Since this policy was based on a public interest imperative, the trial judge should in any event have exercised his discretion not to compel disclosure of the working papers.
The Federal Court of Appeal decision is likely to be welcome to public corporations and their subsidiaries that are subject to tax in Canada. In particular, the Court’s recognition of the unwritten rule against forcing taxpayers to self-audit and of the public interest reasons for resisting routine disclosure of tax accrual working papers to the tax authorities are likely to be well-received. Although the Court found that the CRA is not entitled to demand routine access to working papers without advancing any particular justification for their production, it is clear that the CRA can require disclosure of working papers in certain circumstances. The limits of what constitute acceptable circumstances are unclear. The Court implied that a material gap between the “tax at risk” amounts identified in working papers and the amount proposed to be reassessed could be a legitimate reason for requiring disclosure. It will have to be seen how the CRA will apply this decision in its audit policies and practices going forward. In addition, the judgment is still open to appeal to the Supreme Court of Canada, so we may not have heard the last from the Canadian courts on this matter. ■
2 CRA’s powers to demand information are found in sections 231.1 and 231.2 of the ITA, and section 231.7 provides for compliance orders.
3 BP Canada Appeal Judgment at para. 58.
4 2015 FC 714 (“BP Canada Trial Judgment”).
5 BP Canada Trial Judgment at para. 47.
6 BP Canada Appeal Judgment at para. 80.
7 United States v. Arthur Young & Co., 465 U.S. 805 (1984).
8 United States v. Textron, Inc., 577 F.3d 21, 26-30 (1st Cir. 2009) (en banc).