Winston W. Penny v. Minister of National Revenue, [1991] 1 CTC 2288, 91 DTC 307

Taylor, T.C.J.:—These are appeals heard in Toronto, Ontario, on November 7, 1990, against income tax assessments for the years 1980, 1981, 1982 and 1983. At the time of the trial, there remained only two items in dispute—an amount included in the appellants income as an appropriation for the year 1981 under subsection 15(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72,

c. 63) (the "Act"), and penalties added in respect of that appropriation, under subsection 163(2) of the Act. Only matters dealing directly with those points will be referenced in these reasons for judgment.

From the pleadings I would note:

Notice of Appeal

—From 1974 to March, 1979, the Appellant was the President and a principal shareholder of Canada Tube Company Limited (referred to herein as " Canada Tube”), a corporation engaged in the manufacture and sale of steel tubes. From 1976 to March 1979, the Appellant and one Brian Pinkney each owned 50% of the issued shares of Canada Tube.

—On March 13, 1979, the Appellant sold his 50% interest in Canada Tube to Brian Pinkney and granted a two-year covenant not to compete in the manufacture and sale of steel tubes.

—Under an agreement dated March 13, 1979, Canada Tube was required to pay to Bolton Steel Sales Limited C BSS") commissions at the rate of 21/2% of steel product sales, so long as such commissions did not exceed in the aggregate $800,000.

—By the end of March, 1981, Canada Tube was unable to continue its tube manufacturing business. The Appellant and two other individuals formed a new corporation, Bolton Steel Tube Co. Ltd. (BST). . .

—The Appellant was a 35% shareholder in BST; and he or members of his family owned directly or indirectly all of the issued shares of BSS.

—When Canada Tube sold part of its tube manufacturing assets on April 13, 1981, the amount of $322,422 was owing by Canada Tube to BSS as commissions for sales already made, or such amount was a liability in respect of future sales.

—When BST purchased certain manufacturing assets from Canada Tube in April, 1981, BST paid most of the purchase price by assuming part of a mortgage ($1,650,000) owing to Canada Permanent and by assuming the liability to BSS in the amount of $322,422 (plus accrued interest of $14,263). . .

—In the Statement of Adjustments for the purchase transaction . . ., the actual purchaser (BST) was given credit for an aggregate amount $336,685 owing by the Vendor to BSS, one of the parties to the agreement identified as a" Purchaser".. . .

—The aggregate liability of $336,685 was not paid by BST until February, 1983 when it was part of an aggregate amount of $850,000 paid by BST to its shareholders or their affiliated companies.

Reply to Notice of Appeal

—BST was credited with the amount owing to BSS under the agreement. . ., being principal of $322,422.17 as at November 30, 1980 and interest of $14,262.79 to 13 April, 1981;

—BSS did not include the account receivable from Canada Tube of $336,685 in the computation of its income at any time;

—BST credited the Appellant's shareholder loan account with the aforementioned $336,685.00 as at 30 September, 1981, with interest being earned at 15% per annum from 13 April, 1981; this interest was either credited to the Appellant's shareholder loan account or paid to him by cheque during 1981, 1982 and 1983;

—on or about 10 February 1983, the balance owing to the Appellant in his shareholder loan account with BST, being the aggregate amount of $525,000.00, was paid to the Appellant;

—the Appellant, in his capacity as shareholder, appropriated funds or property of Sales during his 1981 taxation year in the amount of $336,685.00, which amount he failed to include in the computation of his income for that year; . . .

In addition to the above, the appellant put forward these contentions:

— . . . When the purchase transaction was recorded in the books of BST, the aggregate liability of $336,685 was shown, in error, as owing to the Appellant and not to BSS.

— ,.. Because BSS and BST and Canada Tube were parties to the agreement, BSS was in fact consenting to the transfer of its receivable from Canada Tube to BST, and BSS was releasing Canada Tube from any further claim; and BST was assuming the liability of $336,685 to BSS.

—After April, 1981, certain financial records of BST continued to show, in error, the aggregate amount of $336,685 owing to the Appellant and not to BSS. There is an obvious discrepancy (and not to be assessed) between (a) the Statement of Adjustments showing BST assuming Canada Tube's liability of $336,685 to BSS; and (b) certain financial records of BST showing its liability of $336,685 as owing to the Appellant (and not to BSS).

. —In 1981, there was no taxable event for the Appellant with respect to the BSS receivable in the amount of $336,685. The Appellant reports his income on a "cash basis” and he did not receive in 1981 any part of the said amount of $336,685.

—As long as the liability of $336,685 owing to BSS remained unpaid, there was no reason to assume that the receivable in that amount had been 'appropriated" by the Appellant. . . .

—If there should be any basis for adding the said amount of $336,685 to the Appellant's reported income for 1981, the Appellant is then entitled to an offsetting doubtful debt of equal amount because BST had just acquired certain assets from an insolvent company (Canada Tube), and had paid for those assets (in part) by assuming the liability of $336,685. . . . Also, the receivable had no value at the time of“ appropriation”, any subsequent payment would result in a capital gain. . . .

Evidence

The appellant, Mr. Penny, a Mr. Henry Koury, a lawyer who had been involved in the proceedings, and a Mr. Errol Chin, now the accountant with BST testified at this trial.

The testimony showed that there was a lack of functional distinction for Mr. Penny, between himself as the individual Penny and " himself" as BSS. That issue—Penny or BSS—is not before the Court in these appeals, and the Court simply accepts that BSS was the proper agent for credit, recognition and receipt of the commissions from an income tax viewpoint. Mr. Penny's testimony also made it clear that he was more than adequately familiar with the corporate format and it is obvious from the incorporation of BSS and the control of shareholdings in it by Penny, that it was his preference to continue the relationship with Canada Tube under a corporation. His authority to conduct the affairs of BSS and his right to the proper benefits arising therefrom as a shareholder, probably even as an employee, are unchallenged. But that leaves him at a serious disadvantage in pursuing these personal appeals if his involvement with and utilization of the assets of BSS exceed that authority under the Act. The respondent characterizes such utilization as excessive and as "appropriation", in the circumstances of these appeals.

Much of the balance of the evidence submitted dealt with events and transactions which occurred subsequent to March 13, 1979 on which date the critical agreement was completed between BSS and Canada Tube. While interesting, it is my opinion the determination of these appeals rests largely upon what happened on that date—March 13, 1979, rather than later.

Analysis

With respect, it is my view that the method described above by which the alleged "error" was corrected is irrelevant to these proceedings. Neither do contentions such as those raised in the notice of appeal, supra, that" there was no taxable event; the appellant reports his income on a'cash basis'. . .; 'the only appropriation' would be any amount (purporting to be interest on the liability of $336,685) which, from time to time, may have been paid by BST to the Appellant. -. . .” address the issue. I am not aware of provisions of the Act which permit, without appropriate recourse, the devolution of property from one taxpayer to another. Equally, I am unaware that such a prohibition is lessened simply because one taxpayer is a corporation, or that the corporation is controlled by another taxpayer. It is my view that the antennae to prevent just such a misdirection should be even more acutely tuned in the last noted set of circumstances, directly relevant to these appeals, and that the prospects of escape from the consequences under the Act are slim indeed. I would quote from Dramar Investments Ltd. v. M.N.R., [1978] C.T.C. 2936; 78 D.T.C. 1675 at 2940 (D.T.C. 1678):

I would point out that while the corporate format for business operations is recognized and acclaimed by investors and businessmen alike for its convenience and advantageous characteristics, its use for such commercial purposes carries with it the distinct obligation for the same parties to understand and accept the restrictions and parameters inherent in the corporate structure, from a taxing perspective.

In this matter, Mr. Penny used the assets of BSS—the account receivable in the amount of $336,685 as payment or partial payment for his shares in the new company BST (or for shares for others) and he made no restitution at that time to BSS. It only remains to be seen whether that conduct provides a substantive base for the respondent's assertion as:

15. (1) Appropriation of property to shareholder. Where in a taxation year

(b) funds or property of a corporation have been appropriated in any manner whatever to, or for the benefit of, a shareholder, or. . . .

In a part of the testimony of Mr. Penny, he indicated that in March 1981, at which point BST was formed, resulting in the business arrangements relevant to these appeals—particularly the account receivable of $336,685, Canada Tube could not have paid that liability to BSS, and I quote:

. . .. Canada Tube owed Bolton Steel Sales some $326,000.00 and the only way to receive those moneys was to purchase the equipment. Save and except that the money was history as Canada Tube was going broke and Bolton Steel Sales had no recourse in receiving the $326,000.00. . . .

At the time it was reducing the purchase price of the $2.1 million, so it was taken as a credit against the equipment, lands, and buildings.

While that may have been the case in March 1981, I am not convinced that Mr. Penny can advance as any rationale for his conduct, the viability of the account receivable. The very fact that in a rather complicated series of inter-corporate payments made in February 1983, the records of BST show that restitution was made by Mr. Penny has no value to him in the appeals. But it would indicate that some profit had been made between 1981 and 1983 from which the funds arose and were used by Mr. Penny for this purpose, a matter which is at the very root of the respondent's dispute with these appeals.

As I have already noted, the transactions following March 13, 1979 have little bearing on the outcome of these appeals, in my view, but the interim financial statements of BST as at May 31, 1981, which were filed with the Court do contain some rather interesting information brought out in the questioning:

Q. Would you turn to tab 14, please. These are interim financial statements for Bolton Steel Tube to May 31, 1981. These were prepared by Wagman Ross & Teachman, as you indicated.

A. Yes.

Q. Could I ask you to turn to note number 2, Mr. Penny.

A. Yes.

Q. Note number 2 describes the purchase transaction. It says the company purchased the fixed assets of a steel conversion plant for $2.1 million and it cites the payments terms. On the next page the second paragraph says:

The purchase transaction has not yet been finalized, although the Company has commenced operation of the plant. The balance due on closing will be paid by a cash contribution of $100,000 from Hans Fetting, and by the application of a $350,000 loan receivable from the vendor to Winston Penny.

Mr. Penny, did you tell Wagman Ross & Teachman that there was a $350,000 loan receivable from the vendor to you?

A. No.

Q. As far as the $350,000 is concerned, did you loan that amount to Bolton Steel Tube?

A. No.

The point I wish to make is that the $2.1 million above which is the gross amount of the purchase price of the assets, included the amount of the disputed account receivable of $336,685 and if that account receivable was uncollectible from Canada Tube at that time, the assets of Canada Tube acquired by BST must have been inflated by that amount. This appellant therefore is faced with considerable difficulty now to explain why the amount was not written off the books of BSS as uncollectible at that time, and presumably as unpayable in Canada Tube, rather than remaining as some form of capital contribution for the appellant himself. The Court is entitled to assume that the account receivable had some value—it was certainly used in place of other funds which would have been needed for the purchase—and the full value was eventually recognized and paid by the inter-corporate transactions in February 1983 noted earlier. That value came directly to the appellant in the form of shares in the new corporation BST and must be regarded as a benefit. I can think of no more reasonable fulfilment of the terms of subsection 15(1) of the Act, and the characterization of "appropriation" by the respondent is to be upheld.

We turn now to the question of the imposition of penalties under subsection 163(2) of the Act. It was brought to the attention of counsel for the respondent by the Court for the record, that she had not introduced evidence in support of the penalty, and she chose to make submissions based entirely on the evidence submitted by the appellant. These may be a set of circumstances under which the imposition of a penalty under subsection 163(2) of the Act could fulfil without direct supporting evidence the respondent's obligation under subsection 163(3) of the Act, which reads:

Burden of proof in respect of penalties. Where, in any appeal under this Act, any penalty assessed by the Minister under this section is in issue, the burden of establishing the facts justifying the assessment of the penalty is on the Minister.

However, I do say that the task would be difficult indeed, and I do not believe it has been accomplished here. It seems to me that it would be necessary in this case for the respondent to show that Mr. Penny not only "appropriated" the account receivable for his own benefit—a finding I have made—but that he did so in such a manner to take into account the phrase—" knowingly, or under circumstances amounting to gross negligence”. I certainly do not accept Mr. Penny's assertion that he had no understanding of the transactions involved (he left that to the accountants and lawyers, and accepted their advice, he said), but I am not prepared to find that his conduct in utilizing the account receivable as a part of the payment to Canada Tube was done knowingly—in the sense that he was consciously appropriating these funds; nor with gross negligence,that is doing so after clearly and directly disregarding the duties and responsibilities imposed under the Act. In my view, his testimony left the impression that he actually regarded the company BSS as merely an extension of his own person, and giving him the benefit of the doubt I am prepared to say that if he had been given unambiguous advice he might have taken the steps necessary to place the account receivable under his proprietorship, not merely under his control. Perhaps it might not have been a difficult task for the respondent to show the Court a different view, but that was not done. Simply put, I have not been persuaded—and I suggest that such persuasion is required under the Act—that the respondent has established facts which on their own merit would justify the assessment.

The result therefore is that the appeals are allowed in order that the penalties should be deleted. In all other respects the appeals are dismissed. The entire matter is referred back to the respondent for reconsideration and reassessment. No costs are to be awarded.

Appeals allowed in part.