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Most financial advisors have a story, or several, about clients who have run afoul of the contribution limits for RRSPs. While there is some relief from penalties and taxes for taxpayers who can show that their errors were reasonable – as were their actions to correct the errors -clients should not expect unlimited mercy.

A recent ruling from the Federal Court of Appeal (FCA) indicates that allowing years to pass before becoming familiar with the limits, perhaps relying heavily on an accountant for advice about limits, and then moving slowly to correct the errors will not be viewed as “reasonable.”

The FCA’s ruling, handed down this past spring in Connolly v. Canada (Minister of National Revenue), upheld the rulings of two lower courts, which held that Patrick Connolly failed to take reasonable steps to understand the RRSP overcontribution rules, then failed to remove excess contributions. Those failures, which occurred over several years, left him with a final bill of almost $63,000, including accrued interest. He was not, however, required to pay legal costs to the Canada Revenue Agency (CRA) due to his financial circumstances.

Perhaps foreshadowing Connolly’s future troubles, he failed to file tax returns for the tax years 1988 through 2002, believing it was not necessary because he did not owe any taxes for those years. Partly as a result, he was unaware of his RRSP contribution limits when he began filing tax returns for the 2003 tax year, particularly as those rules apply to taxpayers with registered pension plans. In Connolly’s case, pension contributions had reduced his RRSP contribution room to almost zero. Nevertheless, he relied on his accountant’s advice, which said he would be able to contribute $45,000 to his and his spouse’s RRSPs for the 2003 and 2004 tax years.

In 2007, the CRA noted the overcontributions and directed Connolly to withdraw the excess amounts and file the appropriate paperwork. Still, Connolly’s accountant did not do so for another year. In 2008, the CRA gave Connolly 30 days to correct the overcontribution errors. When that was not done, the CRA issued an arbitrary assessment and imposed penalties and taxes. However, the required withdrawals of $44,000 did not take place until 2010.

During Connolly’s trial in the Tax Court of Canada, he cited the errors of his advisor, whom Connolly had relied upon. He also said he was suffering from severe depression due to constructive dismissal from his job and the death of his son. The court, however, found that Connolly failed to establish a connection between these events and his failures to inform himself about contribution limits, as well as the steps to be taken once the errors were identified.

The Tax Court allowed Connolly’s claim for relief in part and suggested that penalties be waived; however, the CRA did not follow the court’s recommendation on penalties. Connolly appealed the CRA’s failure to waive his penalties to the Federal Court, which agreed with the CRA. Connolly then appealed to the FCA, where he also lost.

However, you and your clients can take some comfort from the FCA’s ruling. While that court agreed with the rulings reached by the lower courts, the FCA used a different line of reasoning to get there. In particular, the FCA found that the tests of reasonableness applied by the CRA and the lower courts against Connolly were too strict.

While the Income Tax Act (ITA) provides relief for taxpayers who make reasonable mistakes about overcontribution limits, the FCA rejected the CRA’s contention that the reasons for reasonable mistakes must amount to “extraordinary circumstances” – which would be well beyond an erroneous understanding of contribution limits. The court went so far as to conclude that such a reading of Sec. 204.1(4) of the ITA would result in that section having “virtually no scope.”

The FCA also disagreed with the CRA’s view that reliance on a third party for advice, such as an accountant, is always unreasonable.

Nevertheless, despite the FCA’s less restrictive interpretation of reasonableness, that court found that Connolly’s actions and responses to the errors did not meet even this lower standard.

The FCA’s decision is a timely reminder that clients considering RRSP contributions must inform themselves carefully about the contribution limits applicable to their situations.

“That’s why it’s important to always check your plan limits,” says Jamie Golombek, managing director of tax and estate planning, CIBC financial planning and advice, with Canadian Imperial Bank of Commerce in Toronto, commenting generally and not in reference to the Connolly decision. “While these are easily available online through the CRA My Account service, advisors should encourage their clients to check their contribution limits every year to ensure they’re not offside. And if they are, take immediate action to withdraw the overcontribution, deal with the penalties and ask for relief.”

Otherwise, as the decision in Connolly shows, the costs can be devastating. IE