Clarence Charkowy and Dan Charkowy and Kenneth Charkowy v. Minister of National Revenue, [1991] 1 CTC 2095, 91 DTC 284

Mogan, T.C.J.:—At the commencement of the hearing, counsel agreed that the appeals of Clarence Charkowy (88-2114), Dan Charkowy (88-2115) and Kenneth Charkowy (88-2116) would be heard together on common evidence. The three appellants were the only directors of Spanish Tavern Ltd. (the "company") at all relevant times. The appellants were assessed under section 227.1 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") with respect to certain amounts that the company had withheld but failed to remit as required by section 153 of the Act. The only issue in these appeals is whether the appellants, as directors, are required to pay the amounts assessed under section 227.1 of the Act.

The company was incorporated in 1973 and, from that time, it owned and operated a tavern in the City of St. Catherines, Ontario. The company was profitable from 1973 to 1981 and its business appeared to be growing each year. In 1981-82, the company borrowed approximately $260,000 to expand and remodel its facilities. As the expansion and remodelling project ended, interest rates increased and an economic recession followed. The company had trouble maintaining its loan payments and it was in a risky position from 1982 to 1985. Its gross sales were $893,000 for the fiscal year ended June 30,1981 but only about $600,000 for the 1985 fiscal period.

To finance the renovations, the company had borrowed $100,000 from the Family Savings and Credit Union (Niagara) Ltd. (the"Credit Union”) and had issued a debenture as security for the loan. The debenture was, in effect, a second mortgage because in 1982 the Royal Trust Company held a first mortgage of $171,000 on the land and building of the company. In addition to holding the debenture, the Credit Union was the company's banker.

Up until March/April 1985, the company was able to operate in its normal pattern although it was in a precarious financial condition. As the company's financial condition worsened after March/April 1985, the Credit Union started to exercise discretion as to which cheques would be honoured. Under Regulation 108, amounts deducted from salary and wages in one month must be remitted to the Receiver General on or before the 15th day of the following month. On May 15, 1985, the company issued the cheque for the April source deductions but that cheque was not processed by the Credit Union and charged against the company's account until June 25, 1985.

The cancelled cheques for May 1985 would normally have been sent to the company by June 10. If the cancelled cheques for May had been reconciled soon after June 10, the company would have known that the May 15 cheque for April source deductions had not been processed by the Credit Union in May. On June 15, 1985, no cheque was issued to the Receiver General for May source deductions although the company's employees were in fact paid in May and in June. Kenneth Charkowy, the appellant who seemed to know most about the company's tavern business, stated in evidence that the company must have known on June 15 that the May 15 cheque had not yet been processed. He concluded that the June 15 remittance would not be honoured if, on that date, the May 15 cheque had not been processed.

On July 9, 1985, the Credit Union sent seven letters which were hand delivered to the company, the three appellants and the three wives of the appellants. The letter to the company demanded payment of $240,622.38 being the amount of its indebtedness to the Credit Union. The six letters to the appellants and their wives were identical in content demanding payment of the same amount ($240,622.38) in accordance with the terms of their respective guarantees. On that same date (July 9), the three appellants met with the manager of the Credit Union and learned that the Credit Union would not honour any further cheques for salary and wages. The appellants told the manager that the company might as well go out of business if the employees could not be paid. The company’s tavern ceased business on July 9.

The Credit Union then gave notice of its intent to sell the company's assets under the provisions of its debenture. On November 15, 1985, the company's assets were sold under a power of sale for $498,000. After all of the company's indebtedness to the Credit Union had been repaid and all expenses and claims connected with the sale had been disbursed, there was a balance of $12,006 to be returned to the company. The balance was held by the lawyer for the Credit Union pending the delivery of mutual releases. In due course the balance was deposited in the company’s account at the Canadian Imperial Bank of Commerce and seized by the sheriff on behalf of certain creditors. The company did not go bankrupt but it was dissolved in 1988.

On March 2, 1988, the respondent issued three notices of assessment to the three appellants requiring each to pay the amount of $8,951.59 on the basis of joint and several liability under section 227.1 of the Act. The amount of $8,951.59 was the aggregate of the company's unremitted source deductions for May and June 1985 plus interest and penalties. The company had failed to remit on June 15 and July 15, 1985 the source deductions which had been withheld for the months of May and June respectively. The notices of assessment under appeal each refer to amounts payable by the company "in respect of a notice of assessment dated September 5, 1985”. I therefore assume that a notice of assessment was sent to the company on September 5, 1985 with respect to the unremitted source deductions.

Counsel for the appellants argued that they had only 30 days to act from June 10, 1985 (when they received the cancelled cheques for May and could have realized that the May 15 cheque for April source deductions was not processed in May) to July 9 (when the Credit Union demanded repayment of its loans and forced the company out of business). In his submission, the appellants as directors had exercised the degree of care, diligence and skill within that 30 days that reasonable persons would have exercised in comparable circumstances.

It was also pointed out that Dan Charkowy had loaned $7,000 to the company in early 1985 which amount was never repaid, and that Clarence Charkowy had loaned $3,000 to the company in 1985 which was not repaid. I will comment below on these loans. Finally, counsel relied on the decision of this Court in Fancy v. M.N.R., [1988] 2 C.T.C. 2256; 88 D.T.C. 1641 at 2260 (D.T.C. 1644).

There is one extraordinary fact in these appeals which distinguishes them from the decision in Fancy v. M.N.R., supra, and makes it difficult for the appellants to avoid liability by relying on subsection 227.1(3) of the Act. That fact is the opportunity which was presented in December 1985 when the proceeds from the sale of the company’s assets were disbursed. In a letter dated December 9, 1985 from Mr. Edwards (the Credit Union's lawyer) to Mr. De Lisio (the company's lawyer), there is an accounting for the proceeds of sale and the following statements:

You will note that there is a surplus of funds available for return to Spanish Tavern Limited. We would ask that you please review these numbers and if you have any questions, please contact the writer. Prior to the disbursements of the funds we will require that mutual releases be executed.

An attached schedule showed that the surplus was $12,006.

At the time of the letter (December 9, 1985), the appellants knew that the source deductions for May and June had not been remitted and the company had received its notice of assessment dated September 5, 1985 with respect to those source deductions. The appellants could have and should have Instructed their lawyer or the Credit Union's lawyer to remit to the Receiver General the amount that was assessed on September 5, 1985. That amount would have been less than $12,006 because the amount assessed in these appeals (with interest from September 1985 to March 1988) is only $8,951.59. That opportunity was lost when the surplus funds were deposited in the company's bank account at the CIBC and then seized by the sheriff on behalf of creditors who probably had a lesser claim than the respondent having regard to the deemed trust and separation of funds in subsections (4) and (5) of section 227.

In my view, the failure of the appellants to ensure payment of the source deductions for May and June 1985 out of the surplus funds ($12,006) available in December 1985 is fatal to their case. The appellants did not exercise the degree of care, diligence and skill that a reasonably prudent person would have exercised in comparable circumstances when they permitted the surplus funds to slip through their fingers into the hands of ordinary creditors and out of reach of the respondent.

Subsection 227.1(3) refers to a director who has “ exercised the degree of care, diligence and skill to prevent the failure . . .”. The word "failure" relates back to the liability under subsection 227.1(1) which in these appeals was a failure to remit. The question arises whether such failure is an isolated event like the failure on June 15 to remit source deductions for the month of May, or an ongoing event like the status of being in default from the time when the remittance was required to be made. Cases in this Court like Fraser v. M.N.R.,

[1987] 1 C.T.C. 2311; 87 D.T.C. 250 and James White v. M.N.R., [1990] 2 C.T.C. 2566; 91 D.T.C. 54 indicate that the failure is an isolated event. In the White case, Taylor, J. stated at page 2574 (D.T.C. 59):

As I read that subsection, it would seem to me that the direct responsibility of a director—any director—is to prevent the failure (to deduct or remit), not to attempt to rectify or remedy the failure at a point in time subsequent to the failure itself.

If the “ failure” in subsection 227.1(3) is an isolated event, then the conduct of a director after that event would in most circumstances be irrelevant. In other words, a director who has not exercised the required degree of care, diligence and skill to prevent the failure cannot bootstrap himself under subsection 227.1(3) by. proving how hard he tried after the event to rectify or remedy the default. In the extraordinary circumstances of these appeals, however, the company actually had in December 1985, six months after the first failure to remit on June 15 and five months after it went out of business, funds ($12,006) adequate to pay all amounts which were not previously remitted in June and July. In my opinion, when those funds came under the control of the company, the directors had a second opportunity in December to” prevent the failure” by ensuring that the delinquent remittances were paid out of those funds. In December 1985, the company had not been put into bankruptcy or been dissolved and the directors were still in office.

If I am not entitled to examine the conduct of the directors in December 1985 because it is after the failure to remit in June and July, then I would still dismiss these appeals because there was no evidence that the appellants, as directors, exercised any degree of care, diligence and skill in June or July to prevent the failure to remit. They permitted the Credit Union to determine which cheques would be honoured. Around June 10, they knew that the May 15 cheque for April source deductions had been withheld by the Credit Union and was not processed in May. Indeed, that cheque was not processed until June 25. The company's response to this situation was not to issue a cheque on June 15 for the May source deductions.

When a corporation reaches the point where it does not even issue the remittance cheque on June 15 for fear that it will not be honoured, it is time to lock the door and go out of business. Otherwise, the Receiver General becomes the involuntary banker of the corporation's failing business. Part of the directors' care, diligence and skill is the prudence of knowing when to close down a business rather than prolong the agony with the unlawful use of funds which are impressed with a trust under subsection 227(4) of the Income Tax Act.

In early 1985, Dan Charkowy loaned $7,000 to the company and Clarence Charkowy loaned $3,000. There is no evidence that those fun S were used to finance the payroll or assist in the remittance of source deductions. There is no evidence that any one of the appellants after June 10, 1985, took steps to ensure that the source deductions for May and June would be remitted, or applied his mind to the possibility of closing down the company's business when it could not meet its full payroll. Continuing to operate with involuntary financing by the Receiver General with respect to unremitted source deductions was neglectful and not a demonstration of care or diligence. The appeals are dismissed.

Appeals dismissed.