Citation: 2008TCC199
Date: 20080410
Docket: 2005-2544(IT)G
BETWEEN:
GREGORY SCOTT MOHOS,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Jorré, J.
Introduction
[1] This is an appeal
from an assessment of the Appellant pursuant to section 227.1 of the Income
Tax Act (the “Act”) for unpaid source deductions, interest and
penalties payable by Engine Tech Inc. (“Engine Tech”). The amount of federal
tax not remitted was $5,231.24 in 1996 and $16,038.95 in 1997. With other
source deductions and interest, the total amount of the assessment is $86,989.07.
[2] The Appellant
appeals on two grounds. Firstly, he takes the position that he was not a
director. Secondly, he argues, in the alternative, that if he was a director
then he exercised due diligence bringing him within the defence set out in
subsection 227.1(3) of the Act.
The Facts
[3] The Appellant has a
grade 12 education and has worked as a mechanic for 15 years.
[4] Prior to his involvement
with Engine Tech, he worked at McDonald Douglas.
[5] The Appellant
became involved with Engine Tech in 1993 when Ray Crosato, who was the
majority owner, hired him as an employee. At that time, Engine Tech was a
partnership.
[6] His girlfriend,
Heather McLeod, worked at Engine Tech prior to the Appellant’s involvement
with Engine Tech. The Appellant and Heather were already living together when
the Appellant started to work at Engine Tech.
[7] After three months,
Ray Crosato invited the Appellant to become his partner and replace Ray’s
previous partner. The Appellant bought the 49% share of business of the
previous partner for $40,000. He borrowed the $40,000 to purchase the interest.
Ray had a 51% interest.
[8] Engine Tech
repaired and rebuilt engines. It outsourced some of the work. The Appellant
would take out engines, prepare them for machining and then reassemble them.
[9] The Appellant was
in charge of the shop, the technical side.
[10] Ray was in charge of
everything else: administration, hiring employees, dealing with customers,
obtaining customers, dealing and paying supplies although the Appellant
sometimes dealt with suppliers in ordering parts.
[11] The Appellant worked
at least five days a week, sometimes six or seven.
[12] Ray was mostly at
the front counter and would only occasionally work in the shop.
[13] Heather did the
office work. The office was located upstairs above the reception.
[14] Both the Appellant
and Ray earned $500 a week and Engine Tech also made payments of $325 a month
on the Appellant’s truck. He received no management fees and, as far as he
knows, Ray did not.
[15] Engine Tech had
about six or seven employees, not including Ray and the Appellant; the number
varied over time.
[16] In late 1995, Engine
Tech was incorporated. The Appellant testified that Ray had the incorporation
done for some legal or accounting reason. He does not know why. He also said he
still understood this to be a partnership.
[17] Ray was the one who
gave instructions to the lawyer. The lawyer prepared the necessary documents
and arranged for Ray and the Appellant to become directors. Ray was the initial incorporator in
the Articles of Incorporation that took effect on November 23, 1995
(Exhibit A‑1-18).
[18] On
November 23, 1995, the Appellant signed, as Secretary of the company,
a true copy of a special resolution of the company establishing that the
company would have two directors (Exhibit A-1-24). This was the same day as the
share certificates were issued.
[19] He received 49
shares and Ray received 51 shares. The Share certificates were signed by Ray as
President and the Appellant as Secretary.
[20] Ray signed an
Initial Notice under the Ontario Corporations Information Act (Exhibit A-1-23) that
indicated both Ray and the Appellant were directors. The form was filed on
November 30, 1995.
[21] The Appellant
testified that, while he knew that he had the title of director he did not know
what that meant. His understanding was that the partnership continued. No one
explained to him what a director was.
[22] The Appellant only
went to the lawyer’s office once or twice. He was always with Ray. When he went
to the lawyer, the meeting was not long. He did not know how long it lasted but
it might perhaps have been half an hour. He recalled the lawyer saying there
would be two directors.
[23] There was no
evidence that Ray instructed the lawyer to do anything to which the Appellant objected.
The Appellant could have asked the lawyer more questions but did not.
[24] The Appellant was
unsure if he had signing authority for company cheques, but if he had the
authority, he never exercised it and he never signed any payroll cheques.
[25] Bill Fallwell was
the accountant for Engine Tech. He did the books at the end of the month as
well as the tax returns. The Appellant did not normally deal with him.
[26] The Appellant had no
prior experience in business and no specialized business training.
[27] Engine Tech was a small
company and the Appellant testified that he expected that he would be told if
there were financial difficulties. He also testified that he was unaware that
they had financial problems until early 1997.
[28] Once he became aware
of the financial problems, he borrowed money from time to time and put in
significant amounts of cash in order to put money into the business and keep
the company going. He either put funds into the company bank account or paid
suppliers. He first put funds in at the end of February or the beginning of
March 2007.
[29] The funds injected
were used for a variety of purposes. There is no evidence that the Appellant
made any efforts to ensure that source deductions were remitted.
[30] The evidence leads
to the conclusion that the Appellant and Ray hoped to be able to turn things
around and run the company profitably.
[31] The company continued
to have difficulties. In July 1997 Revenue Canada issued a requirement to pay to the
Canadian Imperial Bank of Commerce for the withholding tax liability of Engine
Tech. This had the effect of freezing the company’s bank account. As a result,
Ray and the Appellant went to the offices of Revenue Canada and met with Mr. Henry Borgs on
July 11, 1997. At the meeting the Appellant signed a document
(Exhibit R-1-9) prepared by Revenue Canada which includes the passage: “I am or have been a
director of Engine Tech…”. The document stated the amount of the liability of
Engine Tech at the time as well as the fact that directors may be held liable
for unremitted source deductions.
[32] On the same day arrangements
were made for the bank to pay two months worth of source deductions and, as a
result, Revenue Canada wrote to the CIBC on July 11, 1997 and advised the bank that the
requirement to pay was withdrawn thereby unfreezing Engine Tech’s bank account.
[33] The company shut
down during the Christmas break at the end of 1997 due to the financial
problems.
[34] Neither Ray nor the
lawyer who incorporated Engine Tech were called as a witness.
Was the Appellant a
Director?
[35] The Appellant’s
position is that he never consented to being a director and that he was not a
director.
[36] While there is no
document signed by the Appellant that says he agreed to become a director, the
Appellant testified that he knew he was called a director. He also signed the
Special Resolution of Engine Tech dated November 23, 1995 stating that there
would be two directors and, on July 11, 1997, he also signed the document
prepared by Revenue Canada where he acknowledges being a director.
[37] Other documents
signed by Ray indicate that the Appellant was a director.
[38] The Appellant’s and
Ray’s arrangement was that the Appellant would run the mechanical and technical
part of Engine Tech and Ray would run the rest including the administrative and
commercial part.
[39] Clearly, the
Appellant trusted Ray and when Ray said they should incorporate, he was
prepared to go along with it. He was content to go along with Ray’s
recommendation, do what was asked without making inquiries, go to the lawyer’s
office when requested, sign documents when asked to and concentrate his energies
on the technical side of the business without concerning himself with the
consequences of incorporation or of becoming a director.
[40] I do not accept that
the Appellant did not consent to being a director. Such a conclusion is
inconsistent with the rest of the evidence, particularly his knowledge of being
called a director or his having signed the document dated July 11, 1997 that
acknowledged being a director.
[41] I find that the
Appellant consented to becoming a director and was a director.
Is a defence made out under
subsection 227.1(3)?
[42] The second argument
of the Appellant is that the defence set out in subsection 227.1(3) is
applicable. Subsection 227.1(3) states:
A director is not liable for a failure
under subsection 227.1(1) where the director exercised the degree of care,
diligence and skill to prevent the failure that a reasonably prudent person
would have exercised in comparable circumstances.
[43] In Soper v. R.,
[1997] 3 C.T.C. 242 the Federal Court of Appeal reviewed subsection 227.1(3) at
length. In paragraphs 29 and 30, Robertson
J.A. set out the legal test for the defence:
29 This is a
convenient place to summarize my findings in respect of subsection 227.1(3) of
the Income Tax Act. The standard of care laid down in subsection
227.1(3) of the Act is inherently flexible. Rather than treating directors as a
homogeneous group of professionals whose conduct is governed by a single,
unchanging standard, that provision embraces a subjective element which takes
into account the personal knowledge and background of the director, as well as
his or her corporate circumstances in the form of, inter alia, the
company's organization, resources, customs and conduct. Thus, for example, more
is expected of individuals with superior qualifications (e.g.
experienced business-persons).
30 The
standard of care set out in subsection 227.1(3) of the Act is, therefore, not
purely objective. Nor is it purely subjective. It is not enough for a director
to say he or she did his or her best, for that is an invocation of the purely
subjective standard. Equally clear is that honesty is not enough. However, the
standard is not a professional one. Nor is it the negligence law standard that
governs these cases. Rather, the Act contains both objective elements —
embodied in the reasonable person language — and subjective elements — inherent
in individual considerations like “skill” and the idea of “comparable
circumstances”. Accordingly, the standard can be properly described as
“objective subjective”.
[44] In Peoples
Department Stores Inc. (Trustees of) v. Wise, 2004 SCC 68, the Supreme
Court of Canada analyzed the language in paragraph 122(1)(b) of the Canada
Business Corporations Act that is virtually identical to the language of
subsection 227.1(3). In Higgins v. The Queen, 2007 TCC 469, Webb J.
concluded that the Supreme Court had modified the test in Soper:
8 The Supreme Court of Canada in
Peoples Department Stores Inc. (Trustee of) v. Wise, 2004 SCC 68, [2004]
3 S.C.R. 461, made the following comments in relation to the objective
subjective test as set out by the Federal Court of Appeal in Soper:
63 The standard of care embodied in
s. 122(1)(b) of the CBCA was described by Robertson J.A. of the Federal
Court of Appeal in Soper v. R. (1997), [1998] 1 F.C. 124 (Fed. C.A.), at para. 41, as being "objective
subjective". Although that case concerned the interpretation of a
provision of the Income Tax Act, it is relevant here because the
language of the provision establishing the standard of care was identical to
that of s. 122(1)(b) of the CBCA. With respect, we feel that Robertson
J.A.'s characterization of the standard as an "objective subjective"
one could lead to confusion. We prefer to describe it as an objective standard.
To say that the standard is objective makes it clear that the factual aspects
of the circumstances surrounding the actions of the director or officer are
important in the case of the s. 122(1)(b) duty of care, as opposed to
the subjective motivation of the director or officer, which is the central
focus of the statutory fiduciary duty of s. 122(1)(a) of the CBCA.
9 The Supreme Court of Canada again noted that because the language in paragraph
122(1)(b) of the CBCA is identical to that found in subsection
227.1(3) of the Income Tax Act (which is also identical to the language
set out in subsection 323(3) of the Act) the provisions are to be
interpreted in the same manner. Therefore, in my opinion, the conclusion is
that the Supreme Court of Canada has modified the objective subjective test as
set out by the Federal Court of Appeal in Soper and instead has adopted
an objective standard that now should be used not only for the purposes of
paragraph 122(1)(b) of the CBCA but also for the purposes of
section 227.1(3) of the Income Tax Act and subsection 323(3) of the Act.
10 The Supreme Court of Canada in Peoples Department Stores Inc. also made
the following comments in relation to this duty:
67 Directors and officers will not be
held to be in breach of the duty of care under s. 122(1)(b) of the CBCA
if they act prudently and on a reasonably informed basis. The decisions they
make must be reasonable business decisions in light of all the circumstances
about which the directors or officers knew or ought to have known. In determining
whether directors have acted in a manner that breached the duty of care, it is
worth repeating that perfection is not demanded. Courts are ill-suited and
should be reluctant to second-guess the application of business expertise to
the considerations that are involved in corporate decision making, but they are
capable, on the facts of any case, of determining whether an appropriate degree
of prudence and diligence was brought to bear in reaching what is claimed to be
a reasonable business decision at the time it was made.
11 Therefore the issue in this
case is whether the Appellants have acted prudently on a reasonably informed
basis and have met the objective standard imposed upon them of exercising the
duty of care, diligence and skill to prevent the failure to remit the
HST that a reasonable prudent person would have exercised in comparable
circumstances.
The Federal Court of
Appeal in Hartrell v. Canada, 2008 FCA 59, did not have to decide
whether Peoples modified the test in Soper. Ryer J.A. commented:
12 The appellant
argued that the decision of the Supreme Court of Canada in Peoples
Department Stores Inc. (Trustees of) v. Wise, 2004 SCC 68 changed the test
with respect to the due diligence defence from the "objective
subjective" test, in Soper, to simply an "objective"
test. Whether Peoples Department Stores can be said to have eliminated
the subjective aspects of the due diligence defence in subsection 227.1(3) of
the ITA is not entirely clear since that the decision dealt with a provision of
the Canada Business Corporation Act R.S.C. 1985, c. B-3. In that regard,
the Supreme Court of Canada, in paragraph 63 of the decision, stated that:
With respect, we feel that Robertson
J.A.'s characterization of the standard as an "objective subjective"
one could lead to confusion. We prefer to describe it as an objective standard.
To say that the standard is objective makes it clear that the factual aspects
of the circumstances surrounding the actions of the director or of the officer
are important in the case of the s.122(1)(b) duty of care, as opposed to
the subjective motivation of the director or officer, which is the central
focus of the statutory fiduciary duty of s.122(1)(a) of the CBCA.
If Peoples Department Stores did
change the test to be applied under subsection 227.1(3) of the ITA to one that
requires due diligence to be demonstrated on a purely objective standard, such
a new test would be more difficult to meet than a test that contains some
elements of subjectivity. As such, we are unable to see how the potential
application of Peoples Department Stores could be helpful to the
appellant.
[45] In this case, the
Appellant took the position, inter alia, that he was in a situation akin
to that of an outside director and that, as a result, the defence of subsection
227.1(3) applied. The Appellant also argued that he did take steps by providing
funding to the company.
[46] Whatever the impact
of Peoples, the difficulty with this argument is that, even if the
Appellant was akin to an outside director, the Appellant did nothing to prevent
the failure to remit in spite of the financial difficulties. While the
Appellant did put significant funds into the company after February 27,
1997, this was directed at keeping the company going in the hope that the financial
situation would improve. This did not constitute an effort to prevent a failure
to remit.
[47] Consequently, the
subsection 227.1(3) defence does not apply.
What about prior to February 1997?
[48] However, there
remains a more limited question regarding subsection 227.1(3). The Appellant
fails to meet the due diligence test once he is aware of the financial
difficulties. On the evidence, that awareness occurred on or before
February 28, 1997 when he first borrowed money to put into the company.
What about the period prior to February 1997?
[49] In that prior period
is it enough that the Appellant simply relied on Ray?
[50] The evidence of the
Appellant was to the effect that he and Ray divided up the work. He was
responsible for the operational/technical part of the operation; Ray was
responsible for the business part of the operation. He relied on Ray for the
business end and expected to be told if there were financial difficulties.
[51] It is important to
note that the evidence does not show much of an effort by the Appellant to
follow the general financial situation of Engine Tech prior to February 1997.
[52] In Soper, Robertson J.A.,
with respect to outside directors, commented:
40 Likewise, some commentators
have advised directors that, if they wish to be able to rely successfully on
the due diligence defence, it would be wise for them to consider undertaking a
number of "positive steps" including, in certain circumstances, the
establishment and monitoring of a trust account from which both employee wages
and remittances owing to Her Majesty would be paid: see e.g. Moskowitz, supra
at 566-68.
41 While such
precautionary measures may be regarded as persuasive evidence of due diligence
on the part of a director, in my view, those steps are not necessary conditions
precedent to the establishment of that defence. This is particularly true with
respect to the establishment of a separate trust account for source deductions
to be remitted to the Receiver General. It is difficult to hold otherwise given
the fact that Parliament abolished that express requirement for the purpose of
achieving other legislative goals. Above all, a clear dividing line must be
maintained between the standard of care required of a director and that of a
trustee. Accordingly, an outside director cannot be required to go to the
lengths outlined above. As an illustration, I would not expect an outside
director, upon appointment to the board of one of Canada's leading companies, to go directly to the comptroller's office to
inquire about withholdings and remittances. Obviously, if I would not expect
such steps to be taken by the most sophisticated of business-persons, then I
would certainly not expect such measures to be adopted by those with limited
business acumen. This is not to suggest that a director can adopt an entirely
passive approach but only that, unless there is reason for suspicion, it is
permissible to rely on the day-to-day corporate managers to be responsible for
the payment of debt obligations such as those owing to Her Majesty. This falls
within the fourth proposition in the City Equitable case: see discussion
supra at page 15. The question remains, however, as to when a positive
duty to act arises.
42 In my view, the
positive duty to act arises where a director obtains information, or becomes
aware of facts, which might lead one to conclude that there is, or could
reasonably be, a potential problem with remittances. Put differently, it is
indeed incumbent upon an outside director to take positive steps if he or she
knew, or ought to have known, that the corporation could be experiencing a
remittance problem. The typical situation in which a director is, or ought to
have been, apprised of the possibility of such a problem is where the company
is having financial difficulties. For example, in Byrt v. Minister of
National Revenue, (1991), 91 D.T.C. 923 (T.C.C.), an outside director
signed financial statements revealing a corporate deficit and thus he knew, or
ought to have known, that the company was in financial trouble. The same
director also knew that the business integrity of one of his co-directors, who
was the president of the corporation too, was questionable. In these
circumstances, having made no efforts to ensure that remittances to the Crown
were made, the outside director was held personally liable for amounts owing by
the corporation to Revenue Canada. According to the Tax Court Judge the
outside director had, in contravention of the statutory standard of care,
failed to "heed what is transpiring within the corporation and his
experience with the people who are responsible for the day-to-day affairs of
the corporation" (supra at 930, per Rip J.T.C.C.).
[53] If an outside
director must make some efforts in examining and considering information then
an inside director must do at least as much and somewhat more.
[54] The Appellant worked
on a daily basis at the company and would have seen his co-director on a daily
basis as well. He had the benefit of seeing from day to day what was going on
in the company. Even with the division of labour between the Appellant and Ray,
the Appellant’s situation is more that of an inside director.
[55] An inside director
does face a higher burden in establishing that he exercised the requisite case,
as explained in Soper:
33 At the outset, I
wish to emphasize that in adopting this analytical approach I am not suggesting
that liability is dependent simply upon whether a person is classified as an
inside as opposed to an outside director. Rather, that characterization is simply
the starting point of my analysis. At the same time, however, it is difficult
to deny that inside directors, meaning those involved in the day-to-day
management of the company and who influence the conduct of its business
affairs, will have the most difficulty in establishing the due diligence
defence. For such individuals, it will be a challenge to argue convincingly
that, despite their daily role in corporate management, they lacked business
acumen to the extent that that factor should overtake the assumption that they
did know, or ought to have known, of both remittance requirements and any
problem in this regard. In short, inside directors will face a significant
hurdle when arguing that the subjective element of the standard of care should
predominate over its objective aspect.
[56] To an extent, it is
reasonable for one director to place reliance on another director in a small
company with two directors. However, even if some tasks are effectively
delegated to one director, the other director cannot completely abdicate
responsibility and must at some point exercise his role as a director. One
would expect, for example, periodic inquiries into the general financial state
of the company, inquiries that might lead the director to become aware of issues
with respect to the remittance of source deductions. Of course in a situation like this with a small
company and two inside directors, this may well occur informally without board
meetings.
[57] Here there is an
almost complete absence of efforts to exercise the role of director and make
financial inquiries. Consequently, there was no possibility that the Appellant
might have discovered problems at an earlier date. Such inaction does not give rise to
a defence prior to the Appellant’s actual knowledge.
Conclusion
[58] I very much regret
the situation the Appellant finds himself in. He invested a good deal of
borrowed money to buy his interest in the business; later he put in more funds
and he only took out a modest salary from the business. This liability further
increases his losses.
[59] However, Parliament legislated
a system designed to protect employees whereby employees get credit for
withholdings made from their salary whether or not those withholdings are ever
received by the government. Indeed, the Appellant would himself have received
the benefit of this system insofar as he received full credit for the
withholdings made from this own salary even though some of those withholdings
no doubt form part of the unremitted amounts. When withholdings are not
remitted, the state — and, as a consequence, all taxpayers — becomes an involuntary
lender to the business. As a result, while Parliament did not legislate an
absolute liability on directors it did impose a duty of care.
[60] That standard of
care was not met and I must dismiss the appeal.
[61] With respect to
costs, I will ask the Court Registry to arrange a conference call in the next
few days so that the parties may make submissions on costs. I will issue the
Judgment after I will have heard those submissions.
Signed at Ottawa, Canada, this 10th day of April 2008.
"Gaston Jorré"
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