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1993 Report of the Auditor General of Canada

Assistant Auditor General:
Responsible Auditor:

Main Points

3.2 The "Other Audit Observations" chapter fulfils a special role in the annual Report. Other chapters normally describe the findings of the comprehensive audits we perform in particular departments; or they report on audits and studies of issues that relate to operations of the government as a whole. This chapter is used to report individual matters that have come to our attention during our financial and compliance audits of the Public Accounts of Canada, Crown corporations and other entities. It is also used to report some specific matters that have come to our attention during our comprehensive audits.

3.3 The chapter contains a wide range of observations. One concerns a reservation in the auditor's report on a Crown corporation's financial statements for the year ended 31 March 1993. The others concern departmental expenditures and tax revenues. The issues addressed generally concern failure to comply with authorities, poor cash management practices, inadequate control over revenue, and the expenditure of money without due regard to economy.

3.4 Although the individual audit observations report matters of significance, they should not be used as a basis for drawing wider conclusions about matters we did not examine.

Introduction

3.6 Section 7(2) of the Auditor General Act requires the Auditor General to call to the attention of the House of Commons any significant cases where he has observed that:

• accounts have not been faithfully and properly maintained or public money has not been fully accounted for or paid, where so required by law, into the Consolidated Revenue Fund;
• essential records have not been maintained or the rules and procedures applied have been insufficient to safeguard and control public property, to secure an effective check on the assessment, collection and proper allocation of the revenue and to ensure that expenditures have been made only as authorized;
• money has been expended other than for purposes for which it was appropriated by Parliament;
• money has been expended without due regard to economy or efficiency; or
• satisfactory procedures have not been established to measure and report the effectiveness of programs, where such procedures could appropriately and reasonably be implemented.

3.8 Consistent with Office policy on follow-up of matters in our annual Report, other audit observations included in this chapter are normally followed up two years after initial reporting. In our follow-up of the observations included in our 1991 Report, we found that for ten of the observations, either corrective action had been taken to address the matter or we no longer considered the matter to be an outstanding issue. The other nine observations involve matters that we are continuing to monitor, and corrective action or the lack thereof will be reported as deemed appropriate.

Observations on Crown Corporations

Atomic Energy of Canada Limited

Failure to record obligations for decommissioning and site remediation in the financial statements of Atomic Energy of Canada Limited for the year ended 31 March 1993

The Auditor General included a reservation in his report on the financial statements of Atomic Energy of Canada Limited (AECL) for the year ended 31 March 1993, concluding that the failure to record the total likely liability for costs of decommissioning and site remediation in AECL's financial statements was a departure from generally accepted accounting principles. Although the corporation estimated and reported in notes to its financial statements a range of 200 to 300 million dollars relating to a portion of these costs, it did not determine the overall estimated costs of much of the activities to be carried out over the next four to five decades.

3.11 For financial statements relating to years commencing on or after 1 December 1990, generally accepted accounting principles require that, where reasonably determinable, the total obligations related to such future costs for removal and site remediation be established, recorded and amortized over the useful lives of related facilities. Instead, the corporation records these costs as decommissioning activities take place.

3.12 In the Auditor's Report for the year ended 31 March 1992, the Auditor General drew to the attention of the Minister of Energy, Mines and Resources that the corporation is facing significant decommissioning and site remediation expenditures, which, under existing funding arrangements, are financed mainly through parliamentary appropriations. He noted that these costs will continue to be incurred over the long term, and their magnitude is such that there may be a significantly increased demand on government resources.

3.13 The financial statements of the corporation for the year ended 31 March 1993 include note disclosure indicating that the corporation has not recorded any liability for the costs of future decommissioning and site remediation that it will have to incur for nuclear facilities. Management's position is that, historically, these activities have been financed mainly by parliamentary appropriations and that they have not been able to estimate their total likely costs.

3.14 During the past year, the corporation prepared a broad plan of activities to be carried out over the next four to five decades. Although the corporation has estimated a range of 200 to 300 million dollars (in 1993 dollars) as the likely decommissioning costs of part of the program, the corporation has not determined the likely cost of the most significant portion of these activities. Management considers that the estimation of future costs for decommissioning and site remediation depends on the development of detailed plans acceptable to regulatory agencies. This requires a determination of the desired end-state, the technology to be employed and, in some cases, research and development. Industry practice is to prepare estimates based on current technologies, regulations and safety standards, and the cost of using and complying with them in the decommissioning process.

3.15 Issue. Contrary to current generally accepted accounting principles, AECL's policy for the year ended 31 March 1993 has been not to provide for future costs of decommissioning and site remediation in its financial statements. Further, management has not determined an overall estimate of the likely costs of the corporation's decommissioning and site remediation activities. As a consequence, we were unable to determine the magnitude of the impact on AECL's expenses, liabilities and deficit for the year ended 31 March 1993.

3.16 In future, the corporation intends to provide an allowance for the costs of decommissioning and site remediation only to the extent that funding from external sources is realized. For proper decision making, the corporation needs to know the full cost of current activities and the financial obligations they generate for the future. The recording of AECL's liabilities is important in order to fairly reflect the corporation's financial position, and to maintain accountability to Parliament for obligations and conditions known today that will result in claims on public resources.

Observations on Departmental Expenditures

Atlantic Canada Opportunities Agency

Failure to adequately evaluate, monitor and control a repayable contribution agreement under the Fisheries Alternatives Program

In July 1991, the Atlantic Canada Opportunities Agency approved a repayable contribution agreement under the Fisheries Alternatives Program, for a proposed project to establish a metal fabrication facility in Newfoundland. In our view, the Atlantic Canada Opportunities Agency failed to evaluate adequately the project's net economic benefit to Atlantic Canada and did not complete an evaluation of its commercial viability. Furthermore, the Agency disbursed $1.876 million even though it did not ensure that significant conditions of the repayable contribution agreement had been met by the company. The Agency failed to ensure that the risks associated with the project were shared by the proponents.

3.18 Issue - evaluation. After an initial review of the company's application and business plan, the Agency rejected the application on 17 July 1991. The review concluded that assisting the project would not provide a net economic benefit to Atlantic Canada. Agency officials noted that the metal fabrication industry in Canada "suffers from excess capacity and declining economic activity" and that, even if the company could access the work it was targeting in the Hibernia offshore oil project, it would likely struggle for work thereafter. The proposed facility would compete for Hibernia work with other metal fabrication facilities, including one in Cow Head, Newfoundland that had already received $36 million in assistance from the Canada-Newfoundland Offshore Development Fund for an expansion to meet the demands of Hibernia.

3.19 The Agency did not evaluate the commercial viability of the project, as it had already determined that the project would not provide a net economic benefit to Atlantic Canada and the company's application indicated that the proponents did not intend to inject cash equity into the project.

3.20 Subsequently, the Agency made a counter-proposal to the proponents requiring them to invest $2.5 million in cash equity. No other changes were made to their proposal. The Agency did not complete an evaluation of the project's commercial viability, as required under the terms and conditions of the Fisheries Alternatives Program. Less than eight days after initially rejecting the proposal, the Agency submitted the project to its Minister and recommended, given the proponents' agreement to provide cash equity, that the project be supported. The Agency indicated that the company had the expertise to compete for Hibernia work and eventually for national and international work beyond Hibernia. On 26 July 1991, the Minister approved the $2.6 million repayable contribution.

3.21 The company accepted the offer of a repayable contribution agreement on 14 November 1991. On 23 December, it requested that $.9 million of the cash equity requirement of $2.5 million be met by a loan from a local development agency that was fully funded by the Canada Employment and Immigration Commission. On 21 January 1992, Agency officials approved a reduction in the cash equity requirement to $1.6 million, if the company obtained the $.9 million it sought to borrow from the local development agency. The change increased the proportion of project financing provided by government rather than private sources. Ministerial approval was sought for this significant change, as required under the Fisheries Alternatives Program, but was never received.

3.22 Issue - monitoring and control. The repayable contribution agreement between the Agency and the company contained several significant conditions. They included a requirement that the proponents invest $2.5 million in cash toward the eligible capital costs of the project and that the company submit a copy of its shareholders agreement, which outlined the company's ownership structure, for the Agency's review and approval before commencing the project. The agreement also required the company to submit its audited annual financial statements within 90 days after the end of each fiscal year. The Agency made payments to the company totalling $1.876 million without assuring itself that these conditions had been met. Agency documentation of the project did not include the following information that we believe is important to project monitoring and control:

• evidence that the cash equity requirements had been met, either as approved initially by the Minister responsible for the Atlantic Canada Opportunities Agency or as subsequently reduced by Agency officials;
• evidence of the ownership structure of the company and the amount invested by each owner; and
• a copy of the company's audited annual financial statements.

3.24 The Agency had concluded that the company would be able to access international markets through the use of patents and technology to be transferred to the company by one of the proponents. Thus, the project would not be reliant solely on the Hibernia offshore oil project for its success. Prior to the disbursement of funds, the Agency failed to confirm the nature of the patents and technology transferred and the conditions of the transfer to the company. The Agency subsequently learned that the company had received the right only to use certain technologies for the North American market. This may limit the company's ability to access international markets as contemplated in the Agency approval documentation.

3.25 Conclusion. The Agency failed to give adequate weight to its own initial negative evaluation of the project, which had noted the excess capacity in Atlantic Canada's metal fabrication industry and the potential for negative effects on existing competitors. In addition, the Agency failed to perform an evaluation of the commercial viability of the project and to obtain ministerial approval for the reduction in the level of cash equity to be supplied by the proponents - both requirements of the Fisheries Alternatives Program.

3.26 The Agency did not ensure that significant conditions of the repayable contribution agreement were met before disbursing funds to the company, thus failing to ensure that the risks associated with the project were shared by the proponents.

3.27 We have made similar observations in recent annual reports on the adequacy of the Agency's procedures for evaluating, monitoring and controlling its projects.

Agency's response: To promote economic development and to allow for new or existing Atlantic Canadian companies to take advantage of opportunities in emerging industrial sectors, the Agency uses flexible and prudent means to provide funding. This approach is necessary for the Agency to respond to the changing circumstances and high risks often associated with such industrial sectors, which allow companies to take advantage of such opportunities before they vanish.

The Agency presented the facts of the case to a board of independent private sector representatives, who subsequently accepted the application.

The comments from the Office of the Auditor General have resulted in improved monitoring procedures and have highlighted the need for the maintenance of comprehensive documentation, supporting decisions.

Further, consistent with the Office of the Auditor General's comments referring to similar observations in recent reports, the Agency implemented an annual Quality Assurance Review, commencing fiscal year 1993-94. This process will assure the compliance of individual project management with the terms and conditions of the Agency funding programs.

Canadian Grain Commission

Ex gratia payments made by the Canadian Grain Commission were an inappropriate use of public money and, in some cases, were outside its mandate

The Canadian Grain Commission (the Commission) made ex gratia payments of approximately $657,000 to producers as compensation for losses incurred as a result of the bankruptcy of an unlicensed seed cleaning company. There was no legal obligation for these payments. The producers who sold seed to the company should have been aware of the risk of dealing with a company not licensed by the Commission. It is also unclear what public interest was served by these ex gratia payments. Moreover, a portion of the amounts paid was for canary seed, which does not fall within the mandate of the Commission. We also found that procedures used by the Commission to determine amounts to be paid to individual producers were inadequate.

3.29 In early 1993 the Commission made ex gratia payments of approximately $657,000 to certain producers to compensate them for losses incurred as a result of the bankruptcy of a seed cleaning company in 1992. The statement of affairs filed by the Trustee in Bankruptcy indicated that there was no grain or seed inventory on hand. The producers, as unsecured creditors, had no claim to any of the other assets of the company. The company had authorized-user status at the time the losses occurred, but was not licensed by the Commission to engage in activities such as buying and selling grain. Commission records indicate that a poster stating that the company was not a licensed dealer was posted on the company's premises. Most of the ex gratia payments were for losses suffered by producers on the sale of grain and canary seed to the seed cleaning company.

3.30 Issues. An ex gratia payment is a payment for which no legal liability is recognized, and which is made as an act of benevolence in the public interest. There was no legal liability on the part of the Commission and thus no legal obligation to pay these amounts. The Commission believed there was a "moral obligation" to compensate these producers, and used the ex gratia mechanism, which was within its legal authority, to make the payments. In our opinion, it is difficult to see how "the public interest" was served in making payments to producers who were aware, or who should have been aware, of the risks of dealing with a company not licensed by the Commission.

3.31 The Commission paid producers approximately $220,000 for losses related to canary seed. The courts had previously clarified that canary seed is not a prescribed grain covered by the Act. Accordingly, the Commission has denied claims by other producers, arising out of the failure of licensed dealers, for payment for canary seed. Since canary seed is outside the Commission's mandate, we concluded that no payments for canary seed should have been made, even on an ex gratia basis.

3.32 Subsequent to the Commission's decision to make the payments, there has been an increasing number of complaints and inquiries from licensees and producers questioning the decision. Although no formal claims or demands for compensation have been made, there is the risk that this may happen, and that licensed grain dealers may place less value on being licensed if they believe the Commission will cover all producer losses, regardless of the grains involved and whether or not the producer sells to a licensed dealer.

3.33 The Commission decided to pay the producers 75 percent of the amounts they claimed. The Commission was unable to provide us with any rationale or justification for this percentage. We also found that the amounts claimed by producers were not adequately documented. Based on our review, we estimate that only $390,000 of the $657,000 paid was supported by proper substantiation of the claims made. Complicating this was the fact that the Commission was advised that the records of the seed cleaning company for 1992 could not be located.

3.34 We noted during our review that one claim was reduced when the claimant remembered receiving a payment from the seed cleaning company. We have no means of verifying whether or not other claimants may have already had seed returned or received payment from the seed cleaning company, in whole or in part, for the amount claimed. We were unable to determine the amount that the producers may have been overpaid.

3.35 Conclusion. In our opinion, the decision by the Commission to make ex gratia payments of approximately $657,000 was not wholly within its mandate, was not adequately supported, and was inappropriate from a business perspective.

Canadian Grain Commission's response: The ex gratia policy provided the Commission with the authority to compensate the producers concerned. The decision created no legal precedent. It was the judgment of the Commission that the payments were warranted.

The Commission has undertaken a number of actions to minimize future exposure to liabilities recently identified in the licensing activity:

- Bill C-127, an Act to amend the Canada Grain Act, received first reading after a two-year period of development. The new Act, if passed, would have introduced optional licensing for special crops dealers and clarified producers' responsibilities to deal with licensees to obtain financial protection.

- The Commission's licensing and security policy and procedures have been under internal and external review since March to minimize risks to producers and taxpayers.

- The authorized-user program was cancelled, with Commission services being provided only to licensees or grain producers.

- Advertisements listing licensees and the advantages of dealing only with licensees will be placed in farm papers quarterly (first placed in August 1993).

- Procedures and reports are being enhanced to minimize the possibility of Canada Grain Act infractions.

- Representatives of special crops producers have been requested by the Minister to review the specific needs of the special crops industry, which could include separate legislation.

Department of Industry, Science and Technology

Investment agreement not structured to adequately protect the interests of taxpayers

In October 1986, the government signed a share subscription agreement that provided $79 million of equity to a publicly held company as part of a two-stage $260 million plant modernization project. In spite of the government's intent, the agreement was not structured in a way to provide for a reasonable sharing of the risks and returns of the investment and thus did not adequately protect the interests of taxpayers.

3.37 On 22 October 1986, the government signed a share subscription agreement with the company for a two-stage $260 million plant modernization project. The total capital expenditure for Stage I was estimated at $171 million, including $45 million to build an oxygen plant, for which another party was responsible. The company is required to spend a further $89 million if it proceeds with Stage II of the project. The company received an infusion of $134 million of equity from federal and provincial sources. Failure to complete Stage I by 31 December 1992 may require the company to repay a portion of the government's investment.

3.38 The information provided to Cabinet for its approval on 7 October 1986 identified a specific Russian technology for the project. This technology was described as the newest and best available in the world.

3.39 Issue. The company decided to switch from the Russian technology to a new German technology, which it purchased in September 1986. Cabinet was not informed of this major change in the project. The Department was unable to provide evidence that it assessed the impact of this change in technology on the viability of the project. The share subscription agreement did not legally oblige the company to use a specific technology.

3.40 The company's new plant, using the German technology, attempted start-up in December 1989 and suspended operations in March 1990. In December 1992, the company advised the Department of Industry, Science and Technology that it could not complete Stage I of the modernization project before 31 December 1992, for "reasons beyond its reasonable control", thereby suspending its obligations under the agreement.

3.41 In the Cabinet approval process, the Department advised Treasury Board of the intention of both the government and the company to share in the project risks and returns. However, in our opinion, the Department's agreement to invest in the special issue of non-marketable preferred shares was not structured to ensure a reasonable sharing of risk and returns.

3.42 The redemption of this investment and payment of dividends are not tied to the project. It is instead determined by a profitability index related to metal prices over the life of the agreement. The agreement provides for a renegotiation of the profitability index, but to date no renegotiation has taken place.

3.43 As early as 1990, the Department estimated that the Federal Business Development Bank was unlikely to recover its investment or earn any dividends. To date, the Bank has received no dividends nor had any of its shares redeemed. In March 1992, based on the advice of the Department, the Federal Business Development Bank "wrote down" the investment to zero. The agreement, however, remains in force until the year 2006.

3.44 The company's audited statement of total capital expenditures for the project at 31 May 1990 indicated that the company had incurred costs of $161 million. With the $134 million federal and provincial investment taken into account, the company was out of pocket $27 million and then only because of cost overruns. Had these cost overruns not occurred, the company's share in the project to that point would have been zero.

3.45 Conclusion. In our opinion, the Government of Canada's agreement to invest in the company did not provide for a reasonable sharing of risks and returns. This did not adequately protect the taxpayers' interests. The Department should also have informed Cabinet of the major change in the project.

Department's response: The agreement between the Minister of Regional Industrial Expansion and the company, designed to facilitate plant modernization, reduce environmental pollution and improve workplace hygiene, was structured to protect the public's interests. The company is bound to complete plant modifications and meet its obligations. The agreement contains specific performance targets that are to be met and adhered to by the company, regardless of the technology used. The Department continues to closely monitor the project.

There were no Cabinet requirements to impose restrictions on the technology to be used by the company.

Department of Industry, Science and Technology

Unrecorded liabilities result in an understatement of program expenditures

In 1992-93, the Department of Industry, Science and Technology had not followed the government's accounting policy requiring the recording of liabilities at the fiscal year end. If the government's accounting policy had been followed, the Department would have reported approximately $42 million in additional liabilities. If this amount is not recorded, it will result in an understatement of expenditures charged to the Department's parliamentary appropriation for grants and contributions.

3.47 Issue. Shared-cost agreements are the primary financial instrument used in Industry, Science and Technology's management of its parliamentary appropriation for grants and contributions. Many contribution agreements involve multi-year commitments where the government's annual financial obligations are dependent on the rate of progress made by the partners under the agreement. Forecasting the amount of likely expenditures in a particular fiscal year is difficult where such programs have large contribution elements. There is evidence that the Department has managed its appropriation by controlling the amount of payments made in a specific fiscal year, notwithstanding the government's policy that charges to appropriations are to be based on when the expenditure is incurred rather than when the payment is made.

3.48 The accounting implications associated with the management of shared-cost agreements are not new to the Department. In 1991 we reported the Department's practice of changing contribution agreements near year end for cash management purposes. We disagreed with this practice because it resulted in the avoidance of a lapse of $28 million in the appropriation.

3.49 In 1992, we reported in a management letter to the Department that liabilities for expenditures of $50 million had not been recorded in fiscal year 1991-92, when the expenditures were incurred. Instead, the Department recorded the expenditures in fiscal year 1992-93, when the payments were actually made. This practice is not in accordance with the government's accounting policy.

3.50 Our audit of the Department's financial records for fiscal year 1992-93 revealed similar problems in unrecorded liabilities. For shared-cost agreements we identified approximately $42 million in unrecorded liabilities. The impact of these unrecorded liabilities was to understate expenditures by this amount in the Department's appropriation for grants and contributions. At the time of our audit, the government had not formally closed the accounts for 1992-93, and this issue was under discussion by the Department and a central agency.

3.51 In our opinion, the Department is attempting to manage its appropriation by allocating expenditures to fiscal years on the basis of when payments are made. Liabilities associated with multi-year shared-cost agreements, however, should be recognized when costs are incurred by the partners in the agreements. While payments to partners should be structured in accordance with the cash management requirements of the government, liabilities must be recorded in the year in which they are incurred in accordance with the government's accounting policy.

3.52 Conclusion. The Department has not followed the government's accounting policy for the recording of liabilities. If this amount is not recorded, the Department of Industry, Science and Technology will have understated the expenditures charged to its parliamentary appropriation for grants and contributions by $42 million in the fiscal year 1992-93.

Department's response: As the Office of the Auditor General indicates, there is a genuine difference of opinion between the Department and the OAG on the complex, technical issue of accounting for annual expenditures when shared-cost, multi-year agreements are being administered.

Investment Canada

Duplication of presidential facilities without need

Investment Canada spent $132,000 on office renovations, including an office, bathroom and kitchenette for its President, even though similar facilities already existed in the premises of the agency.

3.54 Issue. Investment Canada spent $132,000 on renovations and new facilities that duplicated those already in existence in the agency. The existing facilities included an office, boardroom, bathroom and kitchenette for the President and space for two senior executives and support staff. Despite the existence of these facilities, a new office, kitchenette and bathroom were constructed for the President.

3.55 Investment Canada could not provide evidence that the existing office, bathroom and kitchenette no longer met the standards for the head of an agency. As we stated in our 1992 chapter "Change and Control in the Federal Government", adequate managerial control should require public employees not to "waste public money".

3.56 Conclusion. In our opinion, there was insufficient justification for the expenditure of public funds for these new facilities.

Agency's response: The agency undertook renovations in 1992 to correct several operational and security problems involving three offices and five workstations, as well as to provide a meeting place and facilities for Agency-wide activities and to open up access to boardrooms to all staff. Duplication of facilities was kept to a minimum.

Department of the Secretary of State

Urgent steps required to deal effectively with student loans in excess of the annual loan ceiling provisions of the Canada Student Loans Act

In 1990 and 1992, we reported that the authorized annual monetary ceiling established by the Canada Student Loans Act had been exceeded. For the lending year 1992-93, the annual ceiling was again exceeded, by $170 million. This represents an additional cost to taxpayers, which we estimate at $61 million. The Department had proposed corrective measures in 1992 to comply with the Act and Regulations and had formulated other means of controlling program expenditures. However, the remedial process initiated by the Department to rectify loan issuances in excess of established provincial loan ceilings has not yet been completed.

3.58 In the event that the loans authorized by a province exceed the amounts allocated to the province by the Minister, two remedial options are available under the Act and Regulations:

• The first option is for the Minister to reduce the following year's allocation for the province by the excess amount.
• The second option requires that, with the approval of the Governor in Council, the Minister enter into an arrangement with each provincial government to increase its allocation for the following year by the excess amount, if the province complies with the terms and conditions of the arrangement. The Act and Regulations do not specify the terms and conditions.

3.60 Based on the information provided to us by the Department, we estimate that at least 85 percent of the authorized loans are drawn down by the students and are therefore guaranteed. The cost to guarantee one dollar loaned is estimated at 42 cents. Therefore, the additional costs of exceeding the ceilings for 1991-92 and 1992-93 are estimated at $51 million and $61 million respectively.

3.61 The Department advised us that a new financial control mechanism is being developed, through amendments to the Canada Student Loans Act , which will introduce an effective means of controlling program expenditures. The Department also advised us that, pending these amendments, it has requested Governor in Council authority to enter into arrangements with provinces to increase the allocations available under the Act. This will accommodate provincial needs and comply with the current legislation. At the time of our audit, the Department had not yet formalized the agreements with the provinces to receive proper approval from Governor in Council for the excess of the annual loan ceiling for 1992-93 and previous years.

3.62 Conclusion. The annual ceiling has been exceeded by $312 million for the last two years alone. We have estimated that the resulting additional cost is about $112 million for those two years.

3.63 The Department needs to continue developing an improved expenditure control mechanism for the program, in the context of its review of the current legislation. However, we are concerned that the Department has not yet entered into an arrangement with provinces to ensure compliance with the current legislation. The additional costs of loans in excess of the annual ceiling imposed by the Canada Student Loans Act also need to be properly authorized.

Department's response: In the context of the recent announcement respecting the reform of the Canada Student Loans Program, the Minister-designate of Human Resources and Labour advised provincial ministers responsible for student assistance of the government's intention to enter into agreements with provinces to increase provincial loan allocations as provided for under the Canada Student Loans Act. It is anticipated that these agreements will be concluded in the current student loan year.

Observations on Tax Revenue

Departments of Finance and National Revenue

A resource allowance income tax provision did not clearly convey the government's intent. This will result in $636 million in refunds for income tax and interest, and will expose the Crown to at least an additional $538 million in potential refunds

A resource allowance income tax provision introduced in 1974 did not clearly convey the government's intent. This will result in $636 million in refunds for income tax and interest, and will expose the Crown to at least an additional $538 million in potential refunds. Recognizing that the Income Tax Act is a high-risk mechanism for delivering incentives, in 1986 the House of Commons Standing Committee on Public Accounts had recommended that the government develop a mechanism to quickly alter tax law when significant problems are encountered. If the government had moved quickly to clarify the regulations, the amount of income tax revenue lost and at risk could have been considerably less than the estimated $1.2 billion.

3.65 In its 1974 and 1975 taxation years, a taxpayer took the position that it could deduct scientific research expenditures and certain capital cost allowances in computing its income for income tax purposes, but that it did not have to deduct these expenses in computing its resource profits. Because the income tax allowance is based on resource profits, the higher this figure is, the greater the reduction in income tax.

3.66 The departments of National Revenue and Finance disagreed with the taxpayer's interpretation of the law. They argued that the law would require the taxpayer to deduct the expenses in computing its resource profits. The taxpayer was reassessed by National Revenue in August 1979 for its 1974 taxation year, and in September 1980 for its 1975 taxation year. The reassessments were challenged by the taxpayer. Both the Federal Court - Trial Division (October 1990, Gulf Canada v. The Queen, 90 DTC 6622) and the Federal Court of Appeal (January 1992, The Queen v. Gulf Canada, 92 DTC 6123) found in favour of the taxpayer.

3.67 Because the decision seriously impacts on the government's legislative intent by effectively granting additional income tax reductions to the resource sector, the government sought leave to appeal to the Supreme Court of Canada.

3.68 In its application for leave to appeal, National Revenue informed the Court that the issue in dispute is common to approximately 40 outstanding objections and appeals, and that the amount of tax and interest in respect of petroleum and mining corporations that would be affected by the proposed appeal is approximately $1.5 billion.

3.69 On 2 July 1992, the government was denied leave to appeal to the Supreme Court of Canada.

3.70 Issues. While there is consensus between National Revenue and the industry about the treatment of expenses specifically dealt with in the decision, it has not been decided how other expenses, now disputed by the industry following the Court's decision, will impact on the calculation of resource profits. After 14 years of dispute, litigation, negotiation and discussion, there is still no consensus on how resource profits for the taxation years 1974 to 1992 should be calculated.

3.71 National Revenue has advised us that it now estimates that the deficient legislation will result in $227 million in refunds for income tax related to research and development and preproduction expenses, and $409 million in refunds for interest on that amount. The issues still in dispute represent an additional $538 million in potential refunds, for a total estimated exposure of $1.2 billion. National Revenue has also advised us that further litigation may be required to resolve the issues still in dispute.

3.72 For taxation years ending after 23 July 1992, a proposed amendment to the income tax regulations, to clarify the law, was released to the public on that date. The Department of Finance stated that the proposed amendment would override the Court decisions prospectively. As of 30 September 1993, the proposed amendment was still being reviewed and was not in force.

3.73 Conclusions. In a report dated 26 June 1986, the House of Commons Standing Committee on Public Accounts recommended that the government "develop a mechanism to alter quickly a tax expenditure program where significant problems have been encountered." National Revenue has been aware since 1979 that the provision did not clearly convey the legislative intent. If the government had moved quickly in this case to clarify the regulations, the amount of income tax revenue lost and at risk could have been considerably less than National Revenue's estimate of $1.2 billion.

Department of National Revenue's response: The resource allowance provisions are complex. With any complex legislation, there are differing views as to its interpretation. When such differences cannot be settled administratively, taxpayers and the Department have the right to request the Courts to make a determination. Since this is often a lengthy and costly process, it is not invoked unless each party to the appeal feels that its case is meritorious. In the Gulf case, the Courts ultimately disagreed with the Department's interpretation of the law on two of the three issues that were the subject of the appeal. Until the decision of the Federal Court of Appeal, most of the resource industry had been filing their income tax returns in a manner consistent with the Department's interpretation of the law. As they had taken steps to ensure that their income tax returns for prior years were still subject to adjustment, they were able to revise the manner in which they had computed their income for years as far back as 1974.

Department of Finance's response: This audit observation criticizes the Department of Finance for its failure to react quickly to issues considered in the court case of Gulf Canada v. The Queen (90 DTC 6622 (F.C); 92 DTC 6123 (F.C.A.). This criticism is not warranted. In fact, the Supreme Court of Canada refused leave to appeal for the Gulf case on 2 July 1992 and draft regulations were released before the end of that month. Action immediately after the initial Gulf decision would have been inappropriate for two reasons:

1. The Department of National Revenue, the Department of Justice and the Department of Finance all were satisfied that the government's position in the Gulf case had merit.

2. The departments of Justice and National Revenue made strong representations to the Department of Finance that the introduction of clarifying amendments before the termination of the Gulf litigation would create a significant risk of prejudicing the government's case.

The draft regulations of July 1992 are currently being finalized, together with unrelated amendments to the allowance that are consequential to Bill C-92 (which was given royal assent in June 1993). None of the regulations consequential to Bill C-92 have yet been enacted. Contrary to the suggestion in the audit observation, the period of time for reviewing, finalizing and processing these draft regulations is not excessive and permits concerns on the text of the draft regulations to be fully considered before their enactment. Regardless of the time of their enactment, the amendments relating to the issues raised in the Gulf case will be effective from July 1992.

The Auditor General's criticisms of the Department of Finance in this matter derive from hindsight rather than from a balanced consideration of the management of the relevant issues. Given the facts it knew at the time, the Department's actions with respect to this matter were timely and appropriate.

Furthermore, the audit observation suggests that if action had been taken earlier the exposure to the government could have been eliminated. This is simply not correct unless the government had decided to make retroactive changes to the law. As a matter of long-standing government policy, it has rarely been considered appropriate to introduce tightening changes to the law on a retroactive basis.

The appendix below provides further comments on the audit observation and attempts to put the concerns raised in the observation in what the Department of Finance submits is their proper context.

Appendix

Background. The Gulf case considered whether certain deductions of scientific research expenditures and capital cost allowance claimed by a taxpayer were required to be deducted in computing the taxpayer's "resource profits".

Both the abatement and the allowance are determined with reference to "resource profits". The Gulf case determined that capital cost allowance relating to non-operating production facilities and scientific research expenditures were not required to be deducted by taxpayers in computing "resource profits". This has the effect of increasing the amount of the abatement or the allowance to which taxpayers are entitled.

Revenue at risk. The figures used by the Auditor General have been provided by National Revenue officials, who, we understand, are still in the process of refining the figures further. It should be noted that approximately two thirds of the $636 million exposure referred to in the audit observation relates to interest and that the government has had use of these funds.

Nature of the abatement and the allowance. By referring to a report dated 26 June 1986 by the House of Commons Standing Committee on Public Accounts (referred to below as the PAC Report), the audit observation suggests that the abatement and the allowance are incentives and tax expenditure programs. This is inaccurate. As described above, the abatement and the allowance were to compensate for the non-deductibility of provincial Crown royalties. The overall experience has been that the tax revenue resulting from the non-deductibility of provincial Crown royalties has consistently exceeded the tax revenue reduction resulting from the abatement and the allowance. For example, the Petroleum Monitoring Agency reported that, within the oil and gas industry, the total 1991 allowance was only 87 percent of provincial Crown royalties.

Income tax rules governing the abatement and the allowance. In the audit observation, it is stated that the "Resource allowance income tax provision did not convey the government's intent."

There is, in the Department's view, nothing on the public record or in internal files that can support a definitive statement as to the government's intent in 1974 and 1975 on the issues considered in the Gulf case. The Department of Finance, as well as National Revenue and the Department of Justice, were of the view that the law should and did require the deduction of both scientific research expenditures and capital cost allowance in the computation of "resource profits". The potential weakness of that position was realized only once the Federal Court decision in the Gulf case was given in October 1990. However, the suggestion that the relevant income tax provisions were deficient in any obvious way is unfounded and implies a misunderstanding of the judicial process. While the Courts in the Gulf case provided their interpretation of the relevant legal text, this cannot be taken as an indication that the opposite interpretation was without merit.

Time for resolution of Gulf case. The Gulf case dealt with the 1974 and 1975 taxation years, but was not ultimately resolved until 1992. From the perspective of the Department of Finance, it would certainly have been preferable for the case to have been resolved much sooner to limit the revenue exposure. However, litigation is typically a lengthy process. The Department of Finance does not have any influence whatever in expediting the process.

Mechanism to amend income tax law. By again referring to the PAC Report, the audit observation suggests there is no mechanism to quickly alter the income tax law when problems are identified.

In fact, there is considerable co-operation among National Revenue and the departments of Finance and Justice with respect to the identification of problems concerning the interpretation and administration of the income tax rules. For this reason, quick action was possible in the Gulf case following the end of the legal process.

Departments of National Revenue and Finance

A clause in the Government of Canada's tax collection agreements with the provinces and territories needs to be clarified

The Government of Canada's interpretation of a clause in the federal-provincial / territorial tax collection agreements means that the base used to calculate the federal and provincial / territorial sharing of income taxes has not included the income tax portion of certain amounts remitted by employers during the year. For the past six years, the excluded remittances have averaged $38 million per year, which is slightly less than one-twentieth of one percent of the average payroll deductions remitted by employers over the same time period. Most of the agreements have been in place since 1962.

3.75 The tax collection agreements are administered jointly by the Department of National Revenue and the Department of Finance. Finance maintains the tax collection agreement accounts and is responsible for the payments to the provinces. National Revenue performs the collection and assessment functions, and provides Finance with the applicable amounts.

3.76 During the year, employers deduct income tax, Canada Pension Plan (CPP) contributions and Unemployment Insurance (UI) premiums from their employees' pay, and remit these amounts to the federal government. The remittances are credited to the employers' accounts maintained by National Revenue.

3.77 At the end of the year, the employer submits T4 slips detailing the breakdown of income tax, CPP and UI for each employee. When employees prepare their income tax returns, they enter on the return the amounts for income tax, CPP and UI shown on their copies of the T4 slips. National Revenue later compares these amounts to those on the employers' copies of the T4 slips.

3.78 Based on the above, there are three key amounts - the total amount remitted by employers to National Revenue during the year, the total of the amounts reported on the employers' copies of the T4 slips, and the total of the amounts reported by individuals on their income tax returns. These three totals are Amounts A, B, and C respectively in Exhibit 3.1 .

3.79 In theory, the three amounts should agree. However, in practice this is not the case. Typically, the total amount remitted to National Revenue by the employers (Amount A) exceeds the total amount reported on the employers' copies of the T4 slips (Amount B), which in turn exceeds the total of the amounts claimed by individuals when they file their income tax returns (Amount C).

3.80 National Revenue believes that the excess of Amount A over Amount B may be caused by such factors as mathematical errors by employers, misallocated payments, and the fact that the Department's enforcement actions are geared toward the resolution of potential underpayments rather than overpayments. These enforcement actions primarily involve sending a notice of discrepancy to all employers whose difference exceeds a pre-determined amount. In the case of potential overpayments, if the employer does not adequately respond to the notice of discrepancy, and the excess amount is less than a pre-determined amount, the Government of Canada simply keeps it. Should the excess amount be greater than the pre-determined amount, National Revenue will perform additional reconciliation procedures. Any unreconciled balances are retained by the Government of Canada.

3.81 Most of the tax collection agreements have been in place since 1962. Our review of departmental records for the past fifteen years indicates that the remittances received from employers during the year with respect to income tax, CPP and UI (Amount A) have exceeded the amounts reported by the employers on the T4 slips (Amount B) every year. For the past six years, this excess averaged $38 million per year, all of which has been retained by the Government of Canada. This amount is slightly less than one twentieth of one percent of the average payroll deductions remitted by employers over the same time period.

3.82 Issue. Section 7(2)(b) of the tax collection agreements requires the federal government to remit to the provinces and territories their share of "amounts, as determined by the Minister, that have been deducted at source from employees in accordance with the provincial act in respect of individual income tax . . . and that have not, because of the failure of such employees to file returns, been applied . . . on account of the tax payable by such employees. . . ." These amounts are referred to as "unapplied taxes".

3.83 The agreements do not define "deducted at source". National Revenue has defined this term as the amounts reflected on the T4 slips filed by employers (Amount B). Using this definition, "unapplied taxes" represent the income tax portion of the difference between Amount B and the total reported by individuals on their income tax returns (Amount C).

3.84 It can be argued, though, that what is actually "deducted at source" is represented by the cash remitted by employers during the year (Amount A). This is essentially the approach mandated by the Income Tax Act in the various provisions relating to source deductions (liability of an employer for failure to deduct or withhold amounts as required, the interest charged on amounts that have not been deducted or withheld, the interest and penalties charged on amounts that have not been remitted, etc.). Generally, these are all enforceable from the date prescribed for remittance of the amount to National Revenue.

3.85 The issue to be clarified is whether amounts "deducted at source" comprise the amounts remitted by employers during the year (Amount A) or amounts reported by employers on their copies of the T4 slips (Amount B).

3.86 Conclusion. Given the magnitude of the amounts involved - for the past six years the excluded remittances have averaged $38 million per year and most of the agreements have been in place since 1962 - we recommend that the term "deducted at source" be specifically defined when the tax collection agreements are amended.

Department of National Revenue

Overdue goods and services tax continues to rise, and the volume of delinquent registrant accounts remains high

Since the goods and services tax (GST) came into effect, the volume of overdue GST has continued to rise. At the end of March 1993, overdue receivables surpassed $650 million. In addition, some 576,000 registrants were delinquent in filing returns. The Department has launched a number of initiatives focussing on revenue generation and has allocated additional resources to collections, but overdue receivables are forecast by the Department to reach $800 million to $900 million by the end of March 1994. Further, additional information will have to be generated by the automated systems for management to monitor, assess and make changes to the collections function. The support systems also need improvements to enhance the operational effectiveness of collections. In our view, collections is a key enforcement function and, in its initiative to integrate the GST program with that of income tax, the Department needs to ensure that timely actions are taken to address these concerns.

3.88 Collections activities for GST purposes are actions taken against those who are late in filing GST returns or in paying GST owing to the Crown as assessed or filed.

3.89 In 1992 we reported that, although the GST came into effect in January 1991, computer-generated reminder notices had to be withheld until fall 1991. This was a result of the large volume of data initially rejected, which caused long delays in updating the GST registrant accounts in the automated systems. We also commented that the collections activities still were not fully operational in March 1992.

3.90 In 1993, we followed up on these activities to assess the status of GST collections. Headquarters interviews and field visits were conducted in March, April and May 1993. The following paragraphs raise observations on two essential elements of GST collections - resource deployment, and information and support systems.

3.91 Until November 1992, the Department's emphasis had been on registration and vendor education activities to ensure that registrants were identified and encouraged to file; consequently, less attention had been placed on collections activities. We found that until then, regions and districts had conducted GST collections as they considered appropriate. In November 1992, GST revenue shortfall from budgetary forecast continued; departmental analysis showed $350 million in overdue GST. In addition, 640,000 registrants, or just over one third of all registrants, were delinquent in filing returns. In this category, some were delinquent in filing one or more returns and others had simply never filed a return since registering for the GST. Although there were no precise estimates of the revenue potential in these accounts, it was the Department's view that this potential would have exceeded the amounts in the overdue accounts recorded at that time.

3.92 Additional resourcing has shown positive results but many accounts remain overdue or delinquent in filing. Concerned with the state of delinquency in collections and the revenue shortfall from budgetary forecast, the Department initiated a number of revenue-focussed projects in November 1992. At the same time, the Department announced a plan proposing an integrated collections program for all National Revenue accounts.

3.93 The initiative in collections called for increasing resources for a four-month period ended 31 March 1993, through the use of temporary employees and the redeployment of other Excise staff to collect GST. This was to be supplemented with overtime, where feasible. The scope of the project included collecting overdue accounts as well as bringing other accounts into compliance by demanding that delinquent returns be filed. It was expected that an additional $400 million would be collected as a result of this initiative.

3.94 By the end of March 1993, the Department had exceeded its collections target. The collections staff took action on about 330,000 accounts. Preliminary analysis shows that collections for the four-month period included an additional $480 million of GST receipts that might otherwise not have been received. Their actions also generated new GST assessments totalling over $700 million.

3.95 However, collections data continue to show a substantial backlog. At the end of March 1993, total overdue receivables stood at $650 million, and 576,000 registrants remained delinquent in filing. Although the collections initiative generated significant revenues, actions taken on registrants who were delinquent in filing often added to the number of unpaid assessments and thus to the backlog of overdue accounts. The Department advised us that many of the overdue accounts and delinquent registrants may have little or no revenue potential.

3.96 Despite additional resources for collections, the upward trend in overdue GST is expected to continue, while the volume of delinquent registrant accounts remains high. In early April 1993, field offices were advised to continue the revenue initiative. The temporary resourcing was then confirmed for three additional months, to 30 June 1993.

3.97 In July 1993, the Department advised us that the collections function was allocated additional resources for 1993-94, over and above those deployed at the time of the revenue initiative. The final approved 1993-94 work plan reflects a 32 percent increase in full-time equivalent staff over the 1992-93 actual deployment of staff. The 1993-94 plan forecasts a payback of about 14 times the total direct salaries of collections staff.

3.98 However, despite the increased resources, we noted that the anticipated collections would still fall short of clearing the caseload that existed at the start of the fiscal year. According to the plan, the overdue GST as at 31 March 1994 is estimated to reach $800 million to $900 million. The upward trend of overdue GST is shown in Exhibit 3.2 . This trend is disturbing in light of the high volume of registrants who are delinquent in filing returns ( Exhibit 3.3 ).

3.99 The 1993-94 resourcing level for collections, as originally planned, turned out to be highly inadequate. It is encouraging that the Department has taken action to double the collections resources over the original plan. However, the collections function continues to face a workload that is many times higher than the staff can effectively handle. We are concerned about the current level of overdue GST and delinquent registrants. In our view, resource deployment is an essential element of the collections function that needs to be re-examined in terms of the Department's overall collections strategy to meet the workload demands of overdue and delinquent accounts.

Department's response: The Department addressed the overall collections strategy within the context of the announcement in October 1992 of the integration of Customs, Excise and Taxation. This will maximize the use of all departmental collections resources according to overall priorities. In addition, systems will be integrated to:

- improve management of accounts and reporting; and

- consolidate collection actions where the taxpayer has multiple tax debts.

3.100 The existing information generated by the Department's automated systems is not sufficient for GST collections. We found that the production reports generated by the GST automated systems did not meet the needs of the collections staff. Production reports, generated systematically and periodically, were developed to provide information on the results of collections actions. However, in 1991 and 1992, management at headquarters and in field offices felt that they could not rely on these reports. In their view, some reports lacked relevance while others lacked reliability or were difficult to understand.

3.101 We noted that headquarters' staff had to make many ad hoc requests for reports to monitor the state of delinquency. In 1993, almost all collections reports used by the Department have been ad hoc reports; results of the revenue initiative were reported entirely on the basis of ad hoc requests. The ad hoc reports provide collections information upon specific request but they do not offer the comprehensive information that managers need to manage collections.

3.102 In general, the collections cycle involves three stages - computer-generated reminder notices, telephone contacts and direct actions by collections staff. Accounts are assigned from one stage to the next by the automated systems, under parameters set by management. These parameters can be adjusted at the request of the managers. However, the automated systems do not provide adequate information to monitor the appropriateness of the existing cycle, to assess the effectiveness of one stage relative to another and to determine the need for further adjustments. Consequently, decisions and changes are made without the full benefit of such information. The Department advised us that new management information reports are being developed for use in the latter part of 1993-94.

Department's response: In 1992, the Department immediately addressed limitations in the reports generated by the GST automated system by creating "alternative" reports. Consequently, the field offices did have the required information, albeit by a different process, to manage the day-to-day workload in the appropriate order of priority. As well, the Department is reviewing its automated reporting process within the context of the integration of Customs, Excise and Taxation.

3.103 The support systems for GST collections need to be improved. As the collections function was not fully staffed until late 1992, many of the systems' features to aid collections actions were not tested in actual use and at full capacity until then. We noted that many changes to the systems were requested by field offices to improve the support for collections officers and to help expedite their actions.

3.104 The collections staff submitted over 20 requests for changes to be included in a systems update scheduled for July 1993. Half of these requests have been identified by the collections function as high priority. We noted that only two of the requests were acted upon in the July update. The Department advised us that the development of the GST system was affected by a number of competing priorities, and that systems improvements are a high priority.

3.105 In addition, the systems do not have the capability to issue a notice of assessment. In many instances, further collections actions cannot be taken until such a notice is issued by the Department. Since the notices have to be prepared manually, collections actions are delayed. At the time of our audit, the request for system-generated notices of assessment was still being pursued.

3.106 In our 1992 Report, we noted that many GST return and remittance entries failed to meet the edit requirements of the automated systems, with the result that many registrant accounts were not up-to-date. In 1993, we observed the effect on the collections function.

3.107 Data reliability became questionable as collectors attempted to demand payment and the filing of returns. Collections officers often contacted registrants when their returns or other account information were in the process of being updated. We found that many collections officers were spending their time updating accounts rather than taking collections actions. Approximately one fourth and one third of collections staff time were used to update accounts in 1992-93 and 1991-92 respectively.

3.108 We understand that the Department is taking steps to reduce the account maintenance workload of collections officers. In April 1993, further directions were given to field offices concerning updating registrant accounts. Nevertheless, the 1993-94 work plan calls for, on average, 15 percent of its collections resources to be used to maintain accounts. It is our view that collections resources would be better used in collections actions, and that most of the account maintenance workload could be handled by clerical staff. The Department advised us that these concerns are being addressed by the creation of clerical units and the streamlining of the workload at the interim processing centre.

Department's response: For 1993-94 the reference to 15 percent of the collections resources maintaining accounts reflects the use of clerical staff. Occasionally, a collections officer may change an account when it is more cost-effective; however, the percentage is minimal.

3.109 The collections function needs adequate, appropriate and timely information to monitor its progress, assess its results and make changes as necessary. In our opinion, more comprehensive information reports are required to ensure that the function's needs are met. The weaknesses in the support systems represent opportunities to improve the operational effectiveness of collections. In times of restraint, it is imperative to take advantage of these opportunities.

3.110 Conclusion. The early years of a new tax program are critical in establishing an effective enforcement presence. We understand that the Department has been embarking on many initiatives to integrate the GST program with that of income tax to achieve further administrative efficiency. However, as of 31 March 1993, almost one in three registrants was delinquent in some fashion. In our view, the Department needs to ensure that these initiatives encompass all essential aspects of its collections strategy, including addressing further the issue of resource deployment and taking timely action to improve its information and support systems.

Department's response: While the majority of GST registrants are complying with the law, the dollar amount of receivables has continued to rise. This increase was anticipated because the GST is still a relatively new tax. In addition, the Department's efforts directed toward non-compliant registrants, including those who have now established a liability, as well as the difficult economic times, have contributed to this increase.

The Department has taken and will continue to take action against outstanding receivables through a variety of initiatives. In addition to actively pursuing delinquent registrants, the Department is simplifying procedures to reduce administrative burden and thereby facilitate compliance. This includes reducing filing frequency for seasonal filers and simplifying input tax credits for small businesses. Enhanced programs and procedures arising from the integration of Taxation and Customs and Excise, as well as increased co-operation with the provinces, are also expected to produce beneficial results.

We anticipate that these initiatives, as well as improved systems capabilities, will enhance the collection of GST and will do so without the necessity of a significant additional increase in resources.