412237 Ontario Ltd. v. The Queen, 94 DTC 1022, [1994] 1 CTC 2177 (TCC)

Sarchuk, J.T.C.C.:—This is an appeal from reassessments of tax for the 1987 and 1988 taxation years by virtue of which the Minister of National Revenue (the Minister) disallowed the deduction by the appellant of certain legal and accounting fees incurred by its controlling shareholder and president, Joseph McKenzie (McKenzie). The Minister also disallowed the deduction of certain travelling expenses incurred by McKenzie in each of the taxation years in issue, and imposed penalties. pursuant to subsection 163(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") with respect to these expenses.

The appellant was incorporated under the laws of the Province of Ontario on April 12, 1979 and has its principal place of business at 249 Queens Quay West, Toronto, Ontario. At all relevant times it carried on a marina business on Toronto Island on land owned by the Municipality of Metropolitan Toronto (Metro).

The Toronto Island Marina (the Marina) had been operated by others for a number of years. It was in financial difficulty and in January 1978 Paul A. Jordan (Jordan) was retained by a receiver to act as site manager. In 1979 the assets of the Marina were offered for sale by tender. McKenzie was interested. He had management experience but had never operated a marina. On the other hand, Jordan had been involved in its management and this led to their association. They incorporated the appellant for the specific purpose of acquiring the assets of the Marina and to carry on the business. From its inception McKenzie was the president, controlling shareholder (40 per cent) and a director of the appellant. Jordan was also a director and a 30 per cent shareholder. [1]

A. Legal and accounting fees

The appellant commenced business at the end of April 1979. Both McKenzie and Jordan were to play a role in the management of the Marina, however, within a short period of time there was an acrimonious falling out as a result of which McKenzie “dismissed” Jordan as an employee of the appellant. Their disputes continued and in October 1979 Jordan applied for an order winding up the appellant under the relevant provisions of the Ontario Business Corporations Act, R.S.O. 1970, c. 53. He was unsuccessful.

In 1980 McKenzie instituted an action against Jordan seeking specific performance of an agreement dated July 9,1979 wherein Jordan agreed to deliver all his shares in the appellant to McKenzie for certain consideration. On December 16, 1980 Jordan instituted an action against McKenzie and the appellant for specific performance of a written undertaking dated April 25, 1979 providing, inter alia, that McKenzie would enter into a shareholder’s agreement which was to have contained a standard "shotgun" clause on terms previously agreed on by them. Jordan’s action against the appellant was discontinued on September 23,1981.

In due course these actions were heard by Mr. Justice Anderson of the Supreme Court of Ontario. The issue related strictly to the question of the validity of the agreements. There was no wrongful dismissal allegation at this point of time. On July 4, 1985, the Court held that McKenzie was in breach of his undertaking pursuant to the shareholder's agreement and that Jordan was entitled to damages. In the words of Anderson, J.:

Damages in this set of circumstances being a sum of money which would put him as nearly as possible in the position he would have been in had the undertaking been performed in timely fashion.

On the balance of probabilities I find that he (McKenzie) would have so chosen, and that Jordan would have ended up selling his shares. The result would have been that Jordan would have obtained the value of his shares as at July or August of 1979. I think it is reasonable to infer that the price at which the shares would have been sold and purchased would be a reasonable price in the circumstances which then existed.

[Emphasis added.]

The actual assessment of damages was limited to a valuation of the shares and was referred to the Master with the direction that upon payment of the damages so assessed Jordan was to deliver to McKenzie his shares in the appellant. McKenzie appealed this decision. It was dismissed.

In its 1987 and 1988 taxation years the appellant paid legal and accounting fees incurred by McKenzie in the amount of $110,844 and $19,940 respectively (the fees). In computing income for these years the appellant deducted the fees as expenses incurred by it. It is not disputed that most of the fees were incurred in connection with the reference to the Master for the purpose of determining the value of the shares and thereby determining the amount of damages to be paid by McKenzie to Jordan for breach of the shareholder's agreement. [2] The appellant concedes that it was not a party to any of the litigation in which gave rise to the fees in issue. Furthermore it admits there are no resolutions or by-laws authorizing the retainer of a solicitor in respect to litigation between Jordan and McKenzie.

Appellant's position

The inclusion of these expenses in the computation of income was justified by McKenzie on the basis that given the nature of the business it was in the appellant's interest to ensure that its president and chief executive officer not be burdened by outstanding debts or the inability to pay a debt of major significance. In 1987 McKenzie was facing legal fees in excess of $100,000 as well as the judgment in favour of Jordan, soon to be quantified. Counsel contended it was in the appellant's interest to maintain McKenzie's financial viability so that his control and management of the Marina could continue. This would not be the case if he were to lose or be forced to sell his shares.

When the opportunity arose to acquire the business McKenzie believed that Jordan had something specific to offer in terms of "on hand" experience in previously managing it. This was, he said, an incorrect assumption. In short order Jordan's shortcomings became apparent and led to extremely bitter disputes and the suit and counter-suit. Furthermore, Jordan had not been employed by the appellant since 1979, yet the profitability of the Marina after his departure was excellent. McKenzie had taken full control of the operation and was the only logical person to deal with its affairs in an economic and business sense. In addition, a clause in the Metro lease required the appellant to ensure that the Marina was managed through the direct or indirect supervision of Jordan or McKenzie or both. That eliminated Jordan since the judgment of Anderson, J., when complied with, would leave McKenzie as the sole shareholder.

Counsel argued that since incorporation McKenzie was primarily responsible for the profitability of the appellant and that he was:

. . . not remote from the company, but he was the leader of that company, was the owner and operator of that company, and to attempt to interplay anyone else in that was not possible under the lease with Metro Toronto, amongst other things, and anyone starting from business from scratch.

He submitted that McKenzie produced an “unblemished profit record" for the appellant and for all practical purposes was the only one to look to, from the appellant’s standpoint, with respect to complying with the terms of the Metro lease. Thus, for all practical purposes, if he were to lose control of the company by reason of his pending financial obligations the appellant stood to lose the lease with Metro and there would be no ability for it to generate income, at least not in the immediate sense.

In support counsel primarily relied on Ben Matthews & Associates Ltd. v. M.N.R., [1988] 1 C.T.C. 2372, 88 D.T.C. 1262 (T.C.C.); Border Chemical Co. v. The Queen, [1987] 2 C.T.C. 183, 87 D.T.C. 5391 (F.C.T.D.); and Friedland v. Canada, [1989] 2 C.T.C. 79, 89 D.T.C. 5341 (F.C.T.D.). [3]

Respondent's position

The fees in issue were not outlays or expenses made or incurred by the appellant for the purpose of gaining or producing income from a business and thus were not deductible. In the civil action judgment was awarded against McKenzie prior to the appellant's 1987 taxation year. Most of the fees paid during the taxation years in issue were incurred in connection with the assessment by the Master of the damages to be paid by McKenzie to Jordan for breach of a shareholder’s agreement. Thus, the amounts claimed by the appellant as expenses were in fact incurred by or on behalf of McKenzie personally and were not made by the appellant.

In the alternative, only the capital ownership of the appellant, not its ability to earn operating revenue, was directly affected by the civil litigation between Jordan and McKenzie. Counsel for the respondent contended that if any of the fees being claimed were expenses they would have been made for the purpose of preserving a capital asset and not for the purpose of producing income and thus subject to the provisions of paragraph 18(1)(b) of the Act.

Counsel cited and relied on Border Chemical Co. v. The Queen, supra; Friedland v. The Queen, supra; Athenon Travel Services Ltd. v. M.N.R., [1985] 1 C.T.C. 2092, 85 D.T.C. 91 (T.C.C.); Belair v. M.N.R., [1989] 2 C.T.C. 2186, 89 D.T.C. 429 (T.C.C.); William F. Koch Laboratories of Canada Ltd. v. M.N.R. (1956), 16 Tax A.B.C. 39, 56 D.T.C. 489 (T.A.B.); Rigmil v. M.N.R., supra, MacDonald Sales Ltd. v. M.N.R. (1962), 16 Tax A.B.C. 49, 62 D.T.C. 208 (T.A.B.); B.C. Power Corp. Ltd. v. M.N.R., [1968] S.C.R. 17, [1967] C.T.C. 406, 67 D.T.C. 5258; Hoffman Estate v. M.N.R., [1992] 2 C.T.C. 2645, 92 D.T.C. 2290 (T.C.C.).

Analysis

In Friedland, supra, the Court accepted the argument that a corporation’s ability to earn income may in some circumstances be hampered by undefended civil actions against its principal shareholder and allowed a deduction for legal fees paid by a taxpayer corporation to defend actions against him. Friedland was a business economics consultant. He incorporated S.F. Ltd. and began to channel his clients to it although he himself continued to do all of the work. In 1973 litigation was commenced by certain dissatisfied clients against Friedland and the corporation. Those legal proceedings gave rise to the costs in issue. Collier J. found that Friedland was the "sole and real source" of the corporate income. He also found there was nothing remote about the relationship between Friedland and the corporation whose income depended on the ability of Friedland to produce, unsullied by convictions or tarnished by verdicts against him in civil law suits. There was also evidence that the suits adversely affected Friedland's ability to produce and made the corporation no longer practically viable.

The facts in Friedland are markedly distinguishable from those before me. In the appellant's case the business of the Marina was not affected despite the failure of McKenzie's defence to Jordan's civil actions. Furthermore, its real source of income was the Marina and the services it provided and not McKenzie, although he no doubt played a significant role in its management.

The decision in Matthews, supra, is also distinguishable. As Rip, J. concluded at page 2380 (D.T.C.1268):

The expenses incurred in the defence of Muroff were similarly incurred in the normal course of business: they were expenses of an employee incurred as a result of actions executed by him within the scope of his employment and in the course of, and for the purposes of, the appellant's business. It is an implied term of Muroff's employment contract with the appellant that the appellant will bear the kind of costs necessarily incurred in a successful defence in respect of charges that an employee may have committed a criminal offence in the course of his employment Vide Halsbury's Laws of England, 4th ed., vol. 16 at paragraph 568. Such costs are the appellant’s ordinary expenses of carrying on his business and are properly deductible by him pursuant to paragraph 18(1 )(a) of the Act.

[Emphasis added.]

There is no suggestion that the legal fees were incurred as a result of McKenzie’s actions carried out by him within the scope of his employment. I note as well that Rip, J. distinguished Border Chemical, supra, on this very ground.

Another relevant decision is that of Muldoon, J. in Border Chemical. The president of the taxpayer was charged with criminal offences. A related corporation paid the legal fees incurred to successfully defend him. On appeal the Federal Court, Trial Division addressed the issue of paragraph 18(1)(a). In deciding that the expenses were not incurred for the purpose of earning income, Mr. Justice Muldoon said at page 193 (D.T.C. 5398):

The taxpayer's interjection into [the president's] affairs, even though he exerted a great influence in its policies and operations, is too remote, too long a reach, for the purpose of the Income Tax Act.

At page 194 (D.T.C. 5399) Mr. Justice Muldoon commented that:

Not every outlay of cash by a corporation—especially for its president's criminal or other legal defence—is an expense contemplated by paragraph 18(1)(a) of the Act.

To be successful the appellant must establish some nexus or other connection between the earning of income and the payment of the fees. It is only in a remote sense that the outcome of the litigation between Jordan and McKenzie could be said to be beneficial to the appellant, and indeed it could just as readily be argued that the steps taken by McKenzie were detrimental to it. [4] I note also that the reputation of McKenzie was not in issue, since the dispute between he and Jordan was essentially contractual in nature. Thus the alleged principle that damage to the reputation of the president will necessarily tarnish the reputation of a company has no applicability.

In my view the following words of Muldoon, J. in Border Chemical at 194-195 (D.T.C. 5399) are quite applicable to the present case:

Concerned as Mr. Smerchanski [the president] and his fellow directors (and perhaps the shareholders, too) were about the companies acquiring a bad name, they have not shown how payment of the lawyers’ bill was made or incurred by the taxpayer for the purpose of gaining or producing income from the business. Unless they mean to say that any payment made remotely in the interests of the good name of the company’s president and from which the company's reputation might stand to benefit, is an expense in contemplation of paragraph 18(1)(a), which it clearly is not, the plaintiff cannot succeed. One might suppose metaphysically that any remote benefit could be diffusely said to produce income, even if not truly an expense of the taxpayer.

The deduction of legal and accounting expenses by the appellant in the years in issue were properly disallowed by the Minister. These expenses were not incurred for the purpose of gaining or producing income and cannot be said to form any part of the normal business activities of the appellant.

B. Travelling expenses—penalties

During the 1987 and 1988 taxation years the appellant paid travelling expenses incurred by McKenzie in the amounts of $7,800 and $4,307 respectively. Only the penalties are in issue, the appellant having conceded that these expenses were personal to McKenzie. It takes the position that it did not knowingly or under circumstances amounting to gross negligence make false omissions in the income tax returns filed and therefore the penalties should be vacated. If the returns contained misstatements or omissions they were inadvertent and arose from clerical or accounting errors which did not amount to gross negligence.

Evidence

McKenzie could not explain why the expenses in issue were deducted by the appellant in its income tax returns. He stated that the services of Commodore Travel were utilized for all travel. Invoices were directed to him and when received it was his practice to initial them. They were then turned over to the appellant's bookkeeper with directions that the amounts be paid and charged to McKenzie's drawing account. He attributed the failure to properly record these amounts to errors on the part of staff and to his absences from the office due to ill health.

Mr. Mohamad Mourendin is employed by Revenue Canada as a senior auditor. He has a Bachelor's degree in Commerce and a designation as a certified management accountant. He was responsible for the audit of the appellant and his analysis of the disallowed expenses was filed as Exhibit R-5. With particular reference to the travel expenses Mourendin noted that most of the invoices were forwarded to McKenzie's residence. His analysis also disclosed a pattern of recurring expenses of similar nature being charged to the appellant with no indication of their personal nature. When the matter was discussed with McKenzie and the appellant's accountants no explanation was forthcoming as to how these amounts came to be charged to the appellant's accounts was given. He noted from his discussions that McKenzie had a reasonable knowledge of the requirements of the Act with respect to the deduction of business expenses.

Conclusion—penalties

Subsection 163(2) provides for the levying of penalties against:

Every person who, knowingly, or under circumstances amounting to gross negligence in the carrying out of any duty or obligation imposed by or under this Act, has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return, form, certificate, statement or answer (in this section referred to as a "return") filed or made in respect of a taxation year as required by or under this Act or a regulation, is liable to a penalty of. . . .

The penalties were properly assessed. McKenzie's testimony that he gave instructions to the bookkeeper to charge the invoiced amounts to his drawing account and his assertion that it was his practice to initial them is inconsistent with the documentary evidence produced. I refer specifically to a number of invoices on which no such initialling was found. Furthermore many of the invoices would not by their nature necessarily direct the attention of the appellant's accountant to the fact that the expenses referred to were personal to McKenzie or that they were to be charged to his drawing account. His explanation that certain invoices slipped through the cracks while he was in hospital and later recuperating in Florida also does not stand up to close scrutiny since the dates upon which some of those invoices were submitted are inconsistent with that assertion. With respect to the expenses incurred for a trip to Tahiti McKenzie testified that it was cancelled because of ill health. He further stated that he claimed against his travel insurance policy, obtained reimbursement in whole or in part from the insurance company and that he counter-signed the cheque to the appellant. None of the documentary evidence which should have been available to support this assertion was produced.

The validity of the reassessments was also challenged on the basis that the omissions were inadvertent and represented mere accounting errors. Counsel for the appellant suggested that the discrepancies assessed were not particularly large in the context of the totality of expenses incurred by the appellant and thus could readily have been overlooked without representing anything more than mere carelessness.

This may be a valid argument in some cases. However, discrepancies do not have to be large to constitute gross negligence. That determination is one that is to be made in the light of all the circumstances. Here, there appears to be a pattern from which an inference can be drawn that McKenzie deliberately had the appellant pay the costs of his and his wife's personal travel. This goes beyond merely being a slip-shod way of doing business.

At the commencement of the trial counsel advised the Court that the respondent consents to judgment to the extent of referring the appellant's 1987 and 1988 taxation years back to the Minister of National Revenue for reconsideration and reassessment on the basis that its business limit, for the purposes of section 125 of the Income Tax Act, was in the amount of $200,000 in the said years.

The appellant is entitled to no further relief. Costs are awarded in favour of the respondent, to be taxed.

Appeal dismissed