Davies v. The Queen, 94 DTC 1716, [1994] 1 CTC 2744 (TCC)

Sarchuk, J.T.C.C.:— Donald W. Smith appeals from an assessment of liability arising under subsection 227.1(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") in respect of failures by Inova Optics Inc. (Inova) to remit tax withheld pursuant to section 153 of the Act from wages paid to employees.

The appellant relies on subsection 227.1(3) of the Act, the "due diligence” provisions, asserting that he was at all material times an "outside director" of Inova and reasonably believed that all its financial matters, including the appropriate income tax remittances, were being attended to by or under the supervision of the president and the chief financial officer of Inova, being the individuals specifically responsible for such matters.

The appellant testified as did John W. Davies and William M. Craigie, also directors of Inova.

The appellant is an engineer who at various stages in his career was employed by British Telecommunications Research Laboratories, Bell Northern Research and Mitel. With the latter he was a senior officer responsible for marketing. In 1986 he left Mitel to become president of A.I.T., a position he holds to this day. That same year he was approached about investing in Inova, and becoming a director. The appellant did not invest personally but accepted the appointment to the board of directors on January 15, 1987.

William M. Craigie (Craigie) holds a Masters degree in engineering. He was a design engineer for 17 years with Northern Telecom. He then joined Mitel where from 1980 to 1988 he was vice-president, engineering (general manager, operations). For several years thereafter he was a general manager with Canada Post. He invested in Inova and became a director at the time of or shortly after its incorporation. The particular skills he brought to Inova were in manufacturing and production.

John W. Davies (Davies) is a physician. He obtained his degree in London, England, then spent a number of years with the Department of Public Health (Epidemiology), Newfoundland. Since 1962 he has been with the federal Department of Health and Welfare. He invested in Inova and became a director in 1985.

Inova was incorporated to market what the appellant described as an interesting concept in the provision of eyewear. There were two facets to this concept, first, to franchise eyewear stores to market its products and be serviced by a central laboratory and, second, to market an employee vision benefit program to corporations ana other employers which would provide access to less expensive eyewear purchased through the retail franchises. The person primarily involved with promoting this concept was David Conway, the founder of Inova and its CEO in the early stages.

In 1985 Inova could best be described as a small under-capitalized business which was unable to obtain adequate financing. To rectify the problem the board of directors considered restructuring the company. It was decided that in order for Inova to develop it was necessary to attract individuals with experience in financial management who had the capability of finding investment capital. These needs were believed to have been addressed when Duncan Campbell joined the board of directors in late 1986 followed shortly thereafter by Donald Gibbs. In due course Campbell assumed the position of president and chief executive officer while Gibbs became the company’s chairman. In April 1987 Wayne Younghusband was recruited to be Inova’s chief financial officer.

Through 1986 and 1987 Inova continued having problems with its financing. Craigie and Davies described the difficulties as inadequate cash flow while the appellant saw it as a shortage of capital. This problem was hampering Inova's growth but was not substantially affecting its ability to pay creditors or carry on its daily business operations. To address the situation Inova contemplated a public offering intended to produce $1,125,000 in capital. Originally scheduled to be completed by the fall of 1987 it was delayed primarily due to the decline of the stock markets in October of 1987. The offering itself was the responsibility of Campbell, Gibbs, Younghusband and Conway. The final form of the prospectus, dated December 11, 1987, was filed with the Superintendent of Brokers of British Columbia with an effective date of December 31, 1987. At a meeting of the board of directors on January 8, 1988 the prospectus was ratified and confirmed (Exhibits A-18, A-20).

At a board of directors meeting on May 26, 1988 Campbell presented unaudited comparative statements of income and changes in financial position to February 29, 1988 and advised the board with respect to the public offering that affidavits from the directors were required to the effect that there were no material changes in the affairs of Inova since December 11, 1987. The board reviewed the material and authorized the affidavits. The offering was completed on or about June 28, 1988.

There were no board meetings between May 26 and November 28, 1988 nor were any financial statements provided to the appellant or his codirectors during this time. All directors continued to receive weekly events reports produced by Campbell which detailed franchise contracts signed, franchises sold and prospects. The reports provided during this period of time were positive and gave no indication that Inova was experiencing unusual or escalating financial difficulties. Then on November 25, 1988 the board of directors received a memorandum from Campbell the opening paragraph of which read 'Inova's cash flow problems are now at a crisis level. The company requires an immediate injection of cash in order to continue operating.” (Exhibit A-48) Financial statements for the period May-October 1988 and a cash flow forecast were enclosed (Exhibit A-50). The balance sheet as at October 31, 1988 disclosed a current liability for “payroll withholdings” in the amount of $59,000.

A meeting of the board of directors was held on November 28, 1988. Financial statements to Inova’s year end, August 31, 1988, and a document entitled "Update" — October 1988 (dealing with the proceeds from the public offering) were produced either at the meeting or shortly thereafter. The update disclosed that Inova experienced a $565,000 shortfall in capital from the public offering after repayment of certain moneys advanced by the brokerage firm. A number of acrimonious meetings followed. Suffice it to say that the appellant and his codirectors, Craigie and Davies, questioned the financial officers as to why Inova was in this position and why they had not been previously informed. No satisfactory answers were received. Although efforts were made to resolve Inova’s financial difficulties, they failed and a receiver was appointed on January 4, 1989.

I turn next to the testimony of the appellant as well as that of Craigie and Davies as to the manner in which they carried out their responsibility as directors to prevent the failure to remit in the circumstances as they existed. Each of them gave their testimony in a straightforward manner; there was no evidentiary contradiction of their assertions; nor did anything appear in the course of their testimony which was inconsistent with the preponderance of probabilities in the surrounding circumstances (see O'Halloran, J.A. in Weeks v. Weeks, [1955] 3 D.L.R. 704, 14 W.W.R. 529 (B.C.C.A.)) Although each was firmly cross-examined I am satisfied of their honesty in expressing their views.

All testified that the day-to-day financial operations of Inova were the responsibility of Campbell, Gibbs and Younghusband. These three were well known to both Smith and Craigie who had worked either directly or indirectly with them at Mitel where at various times Campbell had been executive vice-president, finance; Gibbs its chief financial officer and Younghusband assistant vice-president and comptroller. Campbell and Gibbs are chartered accountants and Younghusband a certified general accountant. Davies had no personal knowledge of their backgrounds prior to their involvement with Inova but their qualifications had been outlined to him by third parties at the time the board of directors approved their appointment and he relied on this information. It is common ground between them that they had no reason to question the professional integrity and competency of the three and that they relied on them to run the day-to-day financial operations of Inova.

At all times through 1987 and early 1988 when efforts were being made to obtain additional capital by way of a public offering, the appellant as well as Davies and Craigie attended board meetings which were held more or less regularly and reviewed all financial statements presented. Inova first failed to remit to Revenue Canada in January 1988 and failed to remit all sums due in every month thereafter to December 1988 with the exception of April. During this period of time there was no indication either at the board meetings or in the weekly events reports prepared by Campbell, or in the February 29, 1988 financial statement that a liability for failure to remit to Revenue Canada existed.

The appellant testified that he relied on the accuracy of the information provided in these reports and had no reason to question it. Craigie and Davies testified to similar effect In addition, since the appellant’s company, A.LT., had offices in the same building as Inova, he had the opportunity to speak with Campbell on a number of occasions during which they discussed the progress being made by Inova. At all times the appellant was assured that things were in order and received no indication that there were any ongoing problems with payment of creditors. Craigie also had occasion to speak to Campbell on a number of occasions and received the same assurances.

It was not until they received the financial statements to year end August 31, 1988 and the “update” on November 28, 1988 that they became aware of the full extent of Inova's difficulties. All three asserted emphatically that the information set out in this documentation was totally inconsistent with the information provided to them at previous directors' meetings and otherwise during the previous two years. The appellant clearly expressed the view that he had been misled by the officers of Inova and that no satisfactory explanation had ever been provided as to their failure to keep the board of directors advised.

Conclusion

Subsection 227.1(1) reads:

227.1(1) Where a corporation has failed to deduct or withhold an amount as required by subsection 135(3) or section 153 or 215, has failed to remit such an amount or has failed to pay an amount of tax for a taxation year as required under Part VII or VIII, the directors of the corporation at the time the corporation was required to deduct, withhold, remit or pay the amount are jointly and severally liable, together with the corporation, to pay that amount and any interest or penalties relating thereto.

Subsection 227.1(3) provides a safety net to directors. That provision reads:

227.1(3) A director is not liable for a failure under subsection (1) where he exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.

Each of the appellant, Craigie and Davies were asked to join the board of directors to provide a specific expertise. The appellant, because of his marketing background, was to provide advice on Inova’s marketing strategies. Craigie’s area of expertise was in production while Davies was looked to for advice on medical issues including statistical analysis. Both the appellant and Craigie had some experience in budgetary matters as heads of departments during the course of their employment with other companies. Davies had no experience in that regard. None of them had experience in the day-to-day financial management of a business, although it must be noted that the appellant was concurrently operating his own business. Both Craigie and Davies also continued to maintain full-time employment elsewhere.

Each was aware of his responsibilities as a director and of the statutory requirements regarding payroll deductions of tax and the remittance thereof to Revenue Canada. Each was also aware of his potential liability as a director in the event Inova failed to do so. It is appropriate to note that Craigie raised the issue of insurance for the directors at a meeting in 1986 following a series of highly publicized law suits against directors. His recollection was that Campbell rejected the need for such an expenditure with comments to the effect that class actions were rare and that he had no intention of running a company where liability insurance would be needed.

The appellant and his codirectors believed that a mechanism was in place to deduct and remit as required by the Act. No evidence to the contrary was adduced. Furthermore, it is undisputed that there was no failure to do so prior to January 1988. Since a mechanism to deduct and remit appears to have been in place it is a fair inference that the failure to do so as of January 1988 was not likely to have been inadvertent. That being said, it is equally unlikely that clerical staff made that decision. Rather, one can infer that it was a conscious decision by one or another (or all) of the officers responsible for the financial affairs of the corporation.

While there was a known monthly cash shortfall (Craigie said he knew things were "tight") the weekly event reports as well as the prospectus and financial statements provided to the directors buttressed the appellant’s belief that matters were progressing well. The same optimism permeated Campbell’s report to the board of directors on January 19, 1988 in which he stated that expected sales would generate positive operational cash flow in 1988 and allow Inova to show profits in 1989 (Exhibit A-21). Furthermore, during the period of delay in finalizing the public offering the brokerage firm arranged a loan of $200,000 to assist Inova pending completion of the transaction. This step further assured the appellant that the much needed capital would be available within a reasonable period of time. I accept that nothing that the appellant was privy to during the period January to May 1988 suggested that further inquiries should be made.

Subsequently weekly event reports continued to present the same rosy picture of the financial affairs of Inova and indeed, as counsel for the appellant noted, the reports for the week ending November 4, 1988 not only referred to prospects for franchises but also to "hot prospects".

The appellant's assertions that he and his codirectors were not being informed of the true financial picture are to an extent confirmed by the minutes of the meeting held on May 26, 1988 at which Campbell indicated that there were no material changes in the business affairs of Inova since the filing of the prospectus in December. He and the corporate solicitors recommended that the certificate of officers and the directors’ affidavits be amended to refer to Inova’s financial position as disclosed by its financial statements as at February 29, 1988. The directors acted on this advice. I note specifically that there was no indication in the financial statements that a liability to Revenue Canada for failure to remit existed. Yet that was in fact the case.

I am satisfied that the appellant relied on qualified and experienced financial officers who were responsible for the day-to-day operations of Inova. That reliance was reasonable as there was no basis at that time upon which to question their competence or their management of Inova. It had a system in place to ensure the proper remittances were made and the system worked properly in prior years. No mention of a debt to Revenue Canada is set out in the financial statements until the balance sheet of October 31, 1988 which document was not provided to the appellant until November 25, 1988. There was simply no reason for the appellant to suspect that the remittances would not continue to be made.

I agree with the submission made on behalf of the appellant that there is no evidence that he expressly or impliedly authorized the decision not to remit funds to Revenue Canada.

In Robitaille v. Canada, [1990] 1 C.T.C. 121, 90 D.T.C. 6059, a decision of the Federal Court-Trial Division, Addy, J., when discussing liability under subsection 227.1(1), stated at page 126 (D.T.C. 6063) that, "The exercise of freedom of choice on the part of the directors is essential in order to establish personal liability.” The failure of Inova's officers to keep the board of directors adequately informed precluded the appellant from exercising any discretion or choice with regard to this issue.

In Edmondson v. M.N.R., [1988] 2 C.T.C. 2185, 88 D.T.C. 1542 (T.C.C.) Brulé, J. said page 2187 (D.T.C. 1543):

A brief summary of how this subsection became a part of income tax legislation can be found in the case of Cybulski v. M.N.R., [1988] 2 C.T.C. 2180, 88 D.T.C. 1531, wherein Christie, A.C.J. of the Tax Court of Canada refers to the position at common law of a director regarding the basic requirements of care and skill imposed on a director.

He quotes from Canadian Business Corporations by lacobucci, Pilkington and Prichard at page 287:

The common law standard of care and skill which a director must meet is generally expressed as an objective standard: he must exercise the reasonable care and skill which an ordinary person might be expected to exercise in the circumstances on his own behalf. However as Mr. Justice Romer indicated, in the leading case of Re City Equitable Fire Insurance Company, [1925] Ch. 407 at page 428, aff'd [1925] Ch. 500 (C.A.), the common law standard is also partly subjective: a director need not exhibit a greater degree of skill than may reasonably be expected from a person of his knowledge and experience. At common law the degree of care and skill demanded of a director varies with the type and size of the company he serves.

Given the circumstances in 1988 I fail to see what further steps one could logically expect the appellant to have taken. In my view the appellant exercised the degree of care, diligence and skill required by subsection 227.1(3).

The appeal is allowed with costs to be taxed.

Appeal allowed.