Date:
20030115
Docket:
2001-2406-IT-I
BETWEEN:
MARLENE
FRANCISCO,
Appellant,
and
HER MAJESTY
THE QUEEN,
Respondent.
____________________________________________________________________
Agent for
the Appellant: Richard Kittar
Counsel for
the Respondent: Lorraine Edinboro
___________________________________________________________________
Reasons
for Judgment
(Delivered
orally from the Bench
on December
13, 2002, at Toronto, Ontario)
Bowie
J.
[1]
Ms. Francisco appeals from assessments for
income tax for the years 1992, 1993 and 1994. The 1992 and 1993
taxation years are statute-barred, and so the Respondent has the
burden of proof for those years. 1994 is not
statute-barred, and so the Appellant has the burden of
proof for that year. Penalties under subsection 163(2) of the
Income Tax Act (the Act) were applied for all
years, and the Respondent has the burden of proof as to those:
see subsection 163(3) of the Act.
[2]
In 1992, and for some years before that, the Appellant was the
sole shareholder of a company called Aurora Marine Industries
Inc. She and Mr. Richard Kittar operated this business
together during all of the time period that is relevant to these
appeals. They also lived together as common-law spouses.
Mr. Kittar became a shareholder in Aurora during 1994. He
and the Appellant worked full-time to operate the business,
but they took their remuneration in the form of management fees
which were recorded at year end. Throughout the year, they drew
from time to time against their separate loan accounts in order
to meet their living expenses. They had no employment income or
dividend income from Aurora, nor any other source of income. The
Appellant declared income of $6,600 for 1992, $6,100 for 1993,
$7,600 for 1994 and $7,937.50 for 1995. The amounts declared by
Mr. Kittar were of the same approximate magnitude.
Mr. Kittar explained that they took only these modest
amounts for their efforts during the years in question because
the poor economic conditions of the late 1980s and early 1990s
had severely impacted the company through both reduced sales and
bad debts that had to be absorbed.
[3]
During 1997, the officials of Revenue Canada became suspicious
that the Appellant and Mr. Kittar were not declaring all
their income from Aurora, and so an audit was conducted during
the latter part of 1997 and the first part of 1998. I should
perhaps add that suspicion arose only out of the fact that the
Appellant's income tax returns revealed the fact that she was
claiming, for the purposes of the Ontario municipal taxation
rebate legislation, to be paying rent which exceeded her annual
income. So far as the evidence shows, there was no other reason
to suspect any undeclared income.
[4]
The audit was both lengthy and thorough. The Minister's
auditors were unable to find any evidence in the books of Aurora
of payments to the Appellant, or to Mr. Kittar, that were
unaccounted for, but, still of the view that there was undeclared
income, they proceeded to assess the incomes of the Appellant and
Mr. Kittar by the net worth method. The reassessments of the
Appellant from this process added significant amounts to her
income for each year from 1992 to 1995. These amounts were
reduced on objection, principally through the deletion of an item
of personal expense which related to the maintenance of a boat.
It was established at the objection process that this item was in
fact a legitimate expense of the company. (The company
manufactures and distributes boating supplies, the boat was used
for the purpose of testing those supplies, and so it was
appropriate that the company pay for the maintenance of
it.)
[5]
The impact of these reassessments of the Appellant can be shown
in this way:
|
|
1992
|
1993
|
1994
|
1995
|
|
Income
declared
|
$
6,600
|
$ 6,100
|
$ 7,600
|
$7,397.50
|
|
As reassessed
after audit
|
$25,155
|
$27,410
|
$19,415
|
$8,602.50
|
|
As reassessed
after objection
|
$19,674
|
$18,268
|
$13,160
|
$7,397.50
|
|
Allegedly
unreported
|
$13,074
|
$12,168
|
$ 5,560
|
-0-
|
[6]
One of Revenue Canada's assessors, Ms. DeGregorio, gave
evidence as to the manner in which the net worth assessment
calculations were carried out. She was clear and candid in giving
her evidence, and I find it to be reliable.
[7]
The net worth assessment process is simple in principle, but its
application in practice is sometimes complex. It depends upon an
ascertainment of the net worth of the taxpayer at the beginning
and at the end of each assessment period, and an ascertainment of
the taxpayer's consumption during the period. Consumption
plus increase in net worth, or minus decrease in net worth, is
assumed to be the income for the period, subject to adjustment
for any windfall or non-income amounts such as inheritances
or gambling winnings. The final estimate of income is, of course,
no better or worse than the estimates that are made of the assets
and liabilities of the taxpayer, and of the taxpayer's
personal living expenses and other items of
consumption.
[8]
It is trite to say that the net worth method is one of last
resort, applied where more conventional approaches cannot be used
because of a lack of reliable records. It is used most frequently
in situations where the taxpayer conducts a business that has
many cash transactions and the business records are incomplete,
non-existent or unreliable. In the present case, the
Appellant was operating a business which had virtually no cash
transactions. Its records were not incomplete, although I accept
Ms. DeGregorio's evidence to the effect that the state
of the books of Aurora made it difficult to be satisfied that all
of the compensation had been properly recorded. The assessors had
to make substantial adjustments to the two loan accounts of the
Appellant and Mr. Kittar before the net worth process could
begin. Nevertheless those adjustments were ones that they were
able to make and it is not at all clear to me why the Minister
felt it necessary to resort to the net worth method in the
present case. It is, of course, open to the Minister to use the
net worth method of assessment whenever he considers it
appropriate: see subsection 152(7) of the Act.
[9]
This method of assessment has been called a blunt instrument, and
there is no question that the Minister in this case took a very
blunt instrument to this Appellant. The assessors chose to
compute the net worth assessment of the Appellant and of
Mr. Kittar on a combined basis. Ms. DeGregorio said
that this was done because they lived together and shared
household expenses. Rather than do two computations of their
incomes on an individual basis, attributing part of the personal
living expenses to each of them, the assessments were made by
combining the assets and the liabilities of Mr. Kittar and
the Appellant at the end of each period, and using the change in
their combined net worth, together with their combined personal
living expenses, to produce an estimate of their combined incomes
for each relevant year. Those estimates are:
|
1992
|
$25,891
|
|
1993
|
$24,438
|
|
1994
|
$23,038
|
From these were
subtracted the sum of the declared incomes of the two individuals
to produce an aggregate undeclared income for them both. These
are:
|
1992
|
$13,074
|
|
1993
|
$12,168
|
|
1994
|
$
7,414
|
[10] The final
stage of the process was to allocate this between the two
taxpayers. Ms. DeGregorio explained that for 1992 and 1993
the entire amount was allocated to the Appellant because she was
the sole shareholder of Aurora, and it was assumed by the
Minister that all of the income of both taxpayers came from
Aurora. Indeed, that fact has not been ever put in doubt. For
1994, the combined allegedly understated income was prorated
between the two taxpayers because Mr. Kittar became a
shareholder during that year. Exactly how that was done was not
made clear to me, but my impression was that all the 1994
allegedly undeclared income, up to the point when Mr. Kittar
became a shareholder and one-half of it thereafter, was
attributed to and assessed against the Appellant. In any event,
75 percent of the amount for 1994 is what was attributed to and
assessed against the Appellant.
[11] There was
much evidence and much debate directed to whether the
assessor's estimate of living expenses for the taxpayers was
accurate or reasonable, and there was a good deal of evidence as
well about the state of the books of Aurora, and particularly the
loan accounts of the taxpayers, and a loan account of
Mr. Kittar's mother. I do not propose to deal with any
of these matters because it is apparent to me that, no matter how
accurately the living expenses may have been estimated, the
appeals must succeed on other grounds.
[12] I shall
deal first with the years 1992 and 1993 which are statute-barred.
For those years the Minister has the onus of proving the
unreported income alleged. If we assume for the sake of argument
that the combined unreported income is correctly computed, and I
want to emphasize that this is merely an assumption for the sake
of argument and I make no finding, the onus remains on the
Minister to establish what part of that unreported income was
received by the Appellant.
[13] As I
understood the Respondent's counsel, the argument is that as
the Appellant controlled the company she must have received the
unreported income. I do not accept that proposition. Each of the
two taxpayers performed services for the company for which they
were paid consulting fees. It is true that the Appellant was in a
position to determine how much they would each be paid, as she
owned all the shares. It does not follow, however, that she
alone, or at all, received any unreported amounts. Indeed, it is
theoretically possible, although I stress that there is no
evidence of it, that Mr. Kittar could have helped himself to
amounts that would account for all the unreported income without
the Appellant ever having any knowledge of it. I say this not
because I have any reason to believe that it happened, but simply
to illustrate that the Minister has fallen far short of
discharging the onus upon her. The appeals for 1992 and 1993 must
succeed on that basis alone.
[14] However,
there is a more fundamental reason why these assessments cannot
stand. I shall deal with it in connection with the year 1994, but
it has equal application to all the other years as well. I use
1994 because that is the year in which the onus is upon the
Appellant, in the words of the Supreme Court of Canada, to
demolish the Minister's assumptions on which the assessment
is based. So far as that year is concerned, the core assumption
is that in 1994 the Appellant understated her income by $5,560
and that this is established, and I quote here from the
Minister's assumptions underlying the assessment as they are
set out in paragraph 7 of the Reply to the Notice of
Appeal:
(f)
the Appellant's understated income amounts were determined by
the net worth method as per Schedule "A" attached
hereto.
Schedule "A" then
is the fundamental underlying assumption.
[15] In my
view, there is no validity to the methodology whereby a combined
net worth assessment of the unreported income of two people is
generated, and then some part attributed to each of them, thus
requiring that they then individually disprove the amount that
has been assessed against them. This is quickly demonstrated by
looking at the asset section of the computation of the income by
the net worth method that is Schedule "A" to the Reply
to the Notice of Appeal. As an aside, I might note that that
Schedule is a three-page document which, it is quite apparent,
has been created by cutting and pasting parts of other documents,
shrinking them on a photocopier at the same time, and making a
photocopy which borders upon illegibility. And I might
parenthetically note that it seems to me grossly unfair to
produce that sort of document as the fundamental assumption
underlying an allegation of undeclared income. The Deputy
Attorney General of Canada has perhaps reached a new low in the
quality of his pleading in this case.
[16] Returning
to the net worth computation, it shows in the asset section that
between 1991 and 1996 both Mr. Kittar and Ms. Francisco
had positive balances in their shareholder loan accounts. Between
the end of 1993 and the end of 1994 Ms. Francisco's loan
account balance decreased from $11,812.50 to $3,862.50, or in
other words by $7,950. During the same period, that is the year
1994, Mr. Kittar's balance increased by $953. There were
a few other very small changes in the elements of their net
worths, but for practical purposes those can be ignored. The
decrease in their combined net worth, which the Minister computed
to be $7,027.83, consists entirely of the decrease in the credit
balance of the Appellant's loan account. The Minister goes on
to conclude that their living expenses, which they paid jointly,
net of the GST credits which they each received, were $30,066.
Mr. Kittar reported income of $8,024, Ms. Francisco
reported income of $7,600, a total of $15,624. The decrease in
net worth was $7,027 for a total of $22,652. The Minister then
concluded that between them the two individuals had underreported
the difference between $22,652 and $30,066, which is
$7,414.
[17] Clearly if
the net worth calculation had been done separately for these two
people, using the same numbers and allocating one-half of
the living expenses to each of them, Mr. Kittar would have
been found to have slightly more than $7,414 in unreported
income, and Ms. Francisco would have been found to have
overreported by a small amount, because her decline in net worth
exceeds the unaccounted for amount by some $500, while
Mr. Kittar had a slight increase in his net worth. To put it
another way, by combining the net worth assessment process the
Minister has given one-half the benefit of
Ms. Francisco's decreased net worth to Mr. Kittar.
It is obvious that, quite apart from any allocation problem that
might arise at the end of the process, it can never be valid to
combine the assets and the liabilities of two different taxpayers
for the purpose of computing an estimate of their combined
incomes because the effect is to assume, quite incorrectly, that
any changes in the assets and any changes in the liabilities of
either one of them during the period being assessed are shared
between them. Without the need for the Appellant to lead any
evidence at all, it is evident that the assessment done by this
method is simply not valid. In fact, Schedule "A"
to the Reply to the Notice of Appeal, the net worth computation,
is a self-demolishing assumption.
[18] The
appeals for all three years are allowed, and the Appellant is
entitled to have the original assessments, which were based upon
her returns for the three years, restored. Judgment will go
referring the assessments back to the Minister for
reconsideration and reassessment on the basis that the Appellant
was correctly assessed for the years 1992, 1993 and 1994 by the
Notices of Assessments which are dated October 27, 1994,
September 1, 1994 and August 15, 1995.
[19] If I had
the power to award costs beyond the out-of-pocket
disbursements, if any, that the Appellant has sustained in this
case I would most certainly do so. In my view, it is a travesty
that the Appellant has been forced to go through this proceeding
for the purpose of demolishing an assessment which the Deputy
Attorney General of Canada should have been readily able to see
was simply done by an invalid method. This case should never have
had to come to Court. Unfortunately, I do not have any power to
compensate the Appellant for that.
Signed at
Ottawa, Canada, this 15th day of January, 2003.
J.T.C.C.
COURT FILE
NO.:
2001-2406(IT)I
STYLE OF
CAUSE:
Marlene Francisco
and Her
Majesty the Queen
PLACE OF
HEARING:
Toronto, Ontario
DATE OF
HEARING:
December 10, 11 and 13, 2002
REASONS FOR
JUDGMENT BY: The Honourable Judge E.A.
Bowie
DATE OF
JUDGMENT:
December 16, 2002
APPEARANCES:
Agent for
the
Appellant:
Richard Kittar
Counsel
for the
Respondent:
Lorraine Edinboro
COUNSEL OF
RECORD:
For the
Appellant:
Name:
N/A
Firm:
N/A
For the
Respondent:
Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
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