Parkland Operations Limited v. Her Majesty the Queen, 90 DTC 6676, [1991] 1 CTC 23 (FCTD)

Jerome, A.C.J.:—This matter came on for hearing on September 7, 1989, in Edmonton, Alberta. In due course, the decision of Cassidy's Ltd. v. M.N.R., [1990] 1 C.T.C. 2043; 89 D.T.C. 686 came to my attention. It is a decision of the Tax Court of Canada, released October 26, 1989. Since it appeared to all parties that the Cassidy's decision might have a bearing on this matter, I arranged for further submissions on the relevancy of the Cassidy's jurisprudence, and that argument took place on February 22, 1990.

The action is brought pursuant to subsection 172(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the"Act"), by way of appeal of the plaintiff's tax liability for its 1982 and 1983 taxation years. During the period in question, the plaintiff suffered a loss of $563,396 which it seeks to deduct in calculating its income tax liability. An agreed statement of facts and issues submitted by counsel has greatly simplified the matters in dispute, and the only issue before the Court is whether the taxpayer is entitled to deduct the loss of $563,396, which amount itself is not in dispute.

The plaintiff, Parkland Operations Ltd. (Parkland) is an Alberta corporation which carried on an oilfield construction and service business in an oil patch near Drayton Valley, southwest of Edmonton. The ownership of Parkland changed in 1980, when the company was purchased by four individuals who soon thereafter transferred their stock in the company to their respective holding corporations. These corporations, and the four individuals corresponding to them were Neil Orser Holdings (Neil Orser), 226614 Alberta Ltd. (Michael Piro), E. Dyck Holdings Ltd. (Earl Dyck), and 223015 Alberta Ltd. (James Herringer). In August 1980, Joelene Holdings Ltd. (Joseph Makarowski), and Lyle McGinn Holdings Ltd. (Lyle McGinn), former Parkland shareholders, reacquired 10 per cent each of the common shares of Parkland from the four existing corporate shareholders, leaving 20 per cent each of the company's common shares to the other four shareholding corporations.

At the time of the change in ownership, Parkland became part of a corporate structure referred to by all witnesses as a"hub". The intent, as I understand it, was to form a "wheel" of related companies, with Supercorp Management Inc. (Supercorp) at the "hub" and seven other companies, including Parkland, at the“ rim". The" hub” concept was developed by Mr. Orser, and the intent was that it would enable each company in the wheel to help the others, particularly in financial matters. Supercorp was to provide accounting and management services, and its presence was to assist in arranging financing for the companies on the rim.

Mr. Makarowski and Mr. Orser explained the corporate structure involved here. The hub concept was an idea of Mr. Orser and one premise of the concept was that Supercorp would be able to arrange financing to the companies on the rim. The existence of the hub enabled each company in the wheel to help the others, particularly in financial matters. In the direct examination of Mr. Orser, the following exchange took place: (at 56)

Q. Can you tell the Court how the motion of the hub concept came about, and relate that to the various companies shown in this diagram.

A. The hub company was Supercorp, which was to be the accounting and the sort of the management of the other companies involved.

Q. When you considered investing in Parkland, what was important about Parkland?

A. Parkland had a good cash flow and excess cash.

Q. And can you expand for us how that would fit into the concept of having Supercorp at the hub.

A. Well, if the other companies were ever in trouble or needed financing, it was supposed to have been a lot easier to arrange a loan through Supercorp to keep the other companies floating.

Parkland had a $750,000 operating line of credit with the Canadian Imperial Bank of Commerce. A "signature card" on which the signatures of all six shareholders appeared does not explicitly make joint signatures necessary to carry out a banking transaction. The set-up of the card does, however, and it leaves the impression that a joint signature requirement was intended. Based on the appearance of this card and discussions among the parties, both Makarowski and Orser, the only principals who appeared as witnesses, were of the view that two signatures would be required for withdrawals from Parkland's funds: one at least of Makarowski or McGinn, and one of the four "new" owners, Orser, Piro, Dyck, or Herringer. Many cheques were signed in that manner. Mr. Makarowski, who had taken steps to acquire signing authority for cheques precisely so that he would have knowledge and some measure of control over Parkland’s spending, signed most of the cheques, and Herringer and Dyck, between them, signed all the cheques. Nonetheless, some withdrawals were made without the knowledge or approval of either Mr. Makarowski or Mr. McGinn, or even Mr. Orser, and funds were moved by Earl Dyck and James Herringer which have yet to be accounted for.

In effect, Dyck and Herringer were in control of Supercorp, but by the fall of 1981 there was growing dissatisfaction with them. Mr. Makarowski became aware of the more than half a million dollars paid out by Parkland to Supercorp, which came as a surprise to him since despite the arrangement within the company whereby he and/or Mr. McGinn were to sign all cheques issued, these withdrawals had been made without his knowledge. On December 16, 1981 Earl Dyck and James Herringer were removed as directors of Parkland.

Staff Sergeant David Bradley of the RCMP testified that he received complaints concerning diverted funds from Parkland and Island Recreational Inc., another company on the” rim”, which led to an RCMP investigation. There was sufficient evidence to proceed against Dyck and Herringer in one criminal matter, the one concerning Island Recreational. Dyck and Herringer evidently sold property belonging to this company and misappropriated a sum of about $200,000, for which they were convicted and served a term of imprisonment. With respect to Parkland, however, Staff Sergeant Bradley was of the view that while they were certain that the funds had been diverted by Dyck and Herringer from these companies, they were not satisfied that there was sufficient evidence to support criminal proceedings, particularly due to some vagueness in the banking arrangements or signing authority.

Mr. Jack Foulds, the chartered accountant in charge of the books for Parkland was also called as an expert witness. He testified as to generally accepted accounting principles (GAAP), based in part on his interpretation of sections 3480 and 3610 of the accounting profession Handbook. He expressed the opinion that an unlawful misdirection or disappearance of funds, which is not a capital transaction, is a loss that should be claimed as an expense deduction. According to him, the loss here would, in accounting circles, be considered deductible as an extraordinary item, as defined in section 3480 of the Canadian Institute of Chartered Accountants Handbook, and therefore one on account of income. Mr. Foulds was also of the opinion that based on the assumption that the plaintiff carried on a money-lending business, this loss would again be deductible on the basis of the money-lending business as an enterprise of the plaintiff.

Subsection 9(1) of the Act provides that, subject to Part 1 of the Act, "a taxpayer's income from a taxation year from a business or property is his profit therefrom for the year". Plaintiff contends that the losses suffered by Parkland as a result of a "wrongful taking" of funds by Dyck and Herringer are deductible in computing Parkland's profit from a business and are not prohibited by virtue of any provisions of the Act. Alternatively, it is argued that the losses arose in the course of the taxpayer's sideline business of money lending, and are therefore deductible under section 9 or paragraph 20(1)(p) of the Income Tax Act.

The defendant, however, takes the position that the sum is not deductible because there was no wrongful taking, and if there was wrongful taking, it did not constitute an expense incurred for the purpose of earning or producing income from a business. The defendant further takes the position that the plaintiff did not carry on a sideline business of money lending.

The decision of the Tax Court in Cassidy's came shortly after I took this matter under reserve, and following further arguments of counsel, I gave the matter further consideration. I am called upon to consider, therefore, whether the facts establish that the money which was wrongfully taken firstly was expended for the purposes set out in paragraph 18(1)(a) of the Income Tax Act, in order that it come within the exceptions contained in that section. Both counsel appear to agree that while GAAP do not constitute an overriding principle and cannot be .used to determine the question of deductibility, where the amount is not prohibited from deduction by paragraphs 18(1)(a) or (b), the amount is deductible from income in accordance with GAAP.

It is agreed that the deduction, if allowed, and if based on the "wrongful taking" theory, applies fully to the 1982 tax year; if based on the sideline money lending premise, the deduction applies in full to the 1983 taxation year.

Paragraphs 18(1)(a) and (b) of the Income Tax Act state as follows:

18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

The right to claim a deduction pursuant to paragraph 18(1)(a) was reviewed thoroughly by Mr. Justice Rip in the Tax Court of Canada in the Cassidy's decision. I am satisfied that the position taken by counsel in this case is in accord with the position advanced by Mr. Justice Rip at page 690 (D.T.C. 2049-50), with respect to the relevance of GAAP to the provisions of the Act. I turn, therefore, to a consideration of the conditions necessary to establish a right to claim a deduction pursuant to paragraph 18(1)(a).

Was the " expense" in question incurred by the taxpayer for the purpose of gaining or producing income from the business? The plaintiff submits that:

In Parkland, it is noteworthy that the embezzled funds came out of the operating funds of the company by drawing down its operating line of credit which was secured by its trade receivables. This stamps the transaction as being an income account.

The plaintiff has referred me to the case of Mattabi Mines Ltd. v. Ontario (Minister of Revenue), [1988] 2 S.C.R. 175; [1988] 2 C.T.C. 294, wherein Madame Justice Wilson, in the Supreme Court of Canada, has quoted with approval the following comments of President Thorson of the Exchequer Court of Canada in Royal Trust Co. v. M.N.R., [1957] C.T.C. 32; 57 D.T.C. 1055 at 44 (D.T.C. 1062):

The essential limitation in the exception expression in section 12(1)(a) is that the outlay or expense should have been made by the taxpayer “for the purpose" of gaining or producing income"from the business”. It is the purpose of the outlay or expense that is emphasized but the purpose must be that of gaining or producing income "from the business" in which the taxpayer is engaged. . . . Thus, in a case under the Income Tax Act if an outlay or expense is made or incurred by a taxpayer in accordance with the principles of commercial trading or accepted business practice and it is made or incurred for the purpose of gaining or producing income from his business its amount is deductible for income tax purposes.

The plaintiff takes the view that the "expenses" in this case came out of the income-earning process and are thus not prohibited from deduction by paragraph 18(1)(a).

The defendant, of course, submits that the expenses claimed were losses occasioned through theft and defalcation by an employee, officer and director of the plaintiff, and did not constitute expenses incurred for the purpose of earning or producing income from a business within the meaning of that section. To quote from the defendant's submission:

In the case at bar the money at the time of the theft was not in the till, not in the form of receipts, not in the nature of trade accounts and not part of the normalrevenue receiving activities of the company. When stolen, the money was not at any stage of the income earning process.

Notwithstanding this submission, I am satisfied that in the case before me the expense in question was incurred by the taxpayer for the purpose of gaining or producing income from a business; and further that this expense was incurred in accordance with the principles of accepted business practice. I find that the funds in question were wrongfully drawn from the company's operating line of credit which, as the plaintiff suggests, stamps the transaction as being on account of income. I cannot accept the defendant's submission that the money at the time of the theft was not part of the normal revenue receiving activities of the company. The funds in question came out of the company's operating funds, which indeed constitute a part of the company's normal revenue receiving activities.

I have reached the conclusion, therefore, that the expense in question is contemplated by the exception set out in paragraph 18(1)(a). The defendant, however, has also raised the issue of Interpretation Bulletin 11-185, dated November 4, 1974:

1. A loss of trading assets such as stock in trade or cash through theft, defalcation of embezzlement normally is allowed as a deduction in computing income where a taxpayer’s business involves this risk. In determining whether such a loss is allowable the Department uses the following guidelines.

2. Loss through

(a) theft, holdup robbery by a stranger, or

(b) theft, defalcation or embezzlement by an employee, unless he is a senior official or major shareholder,

is allowed. Loss through theft, defalcation or embezzlement by a partner is not allowed.

Based on this Bulletin, it is the defendant's submission that, whether it has the force of law or not, if it correctly interprets the law and establishes policy dealing with the level of the theft, then the plaintiff cannot succeed. The plaintiff argues, on the other hand, that a Departmental Interpretation Bulletin is merely that: the Tax Department's interpretation of the legislation it administers—its version of the law or a public warning of the assessing practice it intends to adopt, and therefore not binding on the Court. I accept and endorse this position. Nevertheless, counsel for the defendant is correct in suggesting that this Bulletin, particularly inasmuch as it suggests that a loss will not be allowed where it is occasioned by theft by an employee who is a "senior official or a major shareholder", is in line with much of the jurisprudence dealing with the “level of the thief". This was the problem raised in the Cassidy's decision, which I felt required further argument here.

In reaching the conclusion that the mere fact that a thief is a senior employee should not preclude the deduction, Rip, J. referred to a New Zealand decision, W.G. Evans and Co. v. C.I.R., [1976] 1 N.Z.L.R. 425 at 435:

The fact that he was also a director, shareholder and officer of the company does not alter the fact that he misappropriated the money while dealing with it as part of the company's activities, and not be the exercise of overriding power or control outside those activities altogether, as did the sole managing director in Curtis’s case. The risk of such defalcations was inherent in the operations of the company carried on by necessity in this way, and accordingly the resulting loss is fairly incidental to the production of the assessable income and is deductible.

The reasoning of Mr. Justice Casey in Evans is particularly appropriate here. Dyck and Herringer may have been minority shareholders of Parkland, but they misappropriated the funds in question not in their capacity as shareholders, but rather as thieves, with neither the knowledge nor consent of the other shareholders. They misappropriated the money while dealing with it in the course of the company's activities, and not by exercising some overriding control over the funds which existed outside of those activities. The principle which ultimately decided Cassidy's, that the distinction in the level of employment should not make a difference as to whether an employee theft is deductible is no less applicable here. The taxpayer is entitled to the same relief where a minority shareholder, oblivious to the plans or desires of the other shareholders, misappropriates funds as he would be where a senior employee was the thief.

The amount lost due to the “wrongful taking” committed by Dyck and Herringer was a non-capital loss, the deduction of which is contemplated in accordance with GAAP, and is not prohibited by any of the provisions of the statute.

The appeal is therefore allowed and the matter is referred back to the Minister of National Revenue for the appropriate reassessments in accordance with these reasons. The plaintiff is entitled to costs.

Appeal allowed.