Feredoun Hadad, Fathollah Goharian, Daniel Basco, Charles Snodgrass, Floyd Cochran and George White v. Her Majesty the Queen, [1994] 2 CTC 2214, 94 DTC 1848

Christie A.C.J.T.C.:—The issue is whether the appellant is vicariously liable as a director thereof for the unpaid tax liability and related interest incurred by King Solomon Resources Ltd. ("Solomon") under Part VIII of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). That Part pertains to refundable tax on corporations in respect of scientific research and experimental development tax credit.

On June 3, 1985, Solomon was assessed under subsection 195(8) of the Act in respect of its liability under Part VIII. It was reassessed regarding that liability on September 1, 1987. Paragraph 4(l) of the reply to the notice of appeal reads:

As at November 10, 1987, the Part VIII tax liability of the company (Solomon) was $1,003,551 calculated as follows:

Part VIII Tax Liability as of September 1, 1987	$ 880,020
Less:
Voluntary payment	84,134.50
Amount Collected	34.05
Balance of Part VIII Tax	795,851
Add:
Interest	207,700
Part VIII Tax Liability	$1,003,551

What is relevant to this appeal in subsection 227.1(1) of the Act provides that where a corporation has failed to pay an amount of tax for a taxation year as required under Part VIII,the directors of the corporation at the time the corporation was required to pay the amount are jointly and severally liable, together with the corporation, to pay that amount and any interest relating thereto. Subsection 227.1(3) provides:

227.1(3) A director is not liable for a failure under subsection (1) where he exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.

On November 10, 1987, the appellant was assessed under subsection 227(10). The notice thereof reads:

Liability under subsection 227.1(1) of the Income Tax Act for $1,003,551.90 being the amount of tax King Solomon Resources Ltd. has failed to pay for 1985 as required under Part VIII and was required to pay at a time when you were a director thereof and interest relating thereto. [1]

The amounts involved in the assessment or reassessment are not in issue. Nor, as occurred, for example, in Sass Manufacturing Ltd. v. M.N.R., [1988] 1 C.T.C. 2524, 88 D.T.C. 1363 (T.C.C.), and Revelations Research Ltd. v. M.N.R., [1992] 1 C.T.C. 2136, 92 D.T.C. 1036 (T.C.C.), is there a dispute about whether Solomon was engaged in scientific research. It was.

The only question to be answered is whether the evidence adduced on behalf of the appellant encompasses facts that establish, on a balance of probability, that he is within the scope of subsection 227.1(3) of the Act.

The appellant was born in Iran and when 16 years of age his father sent him to the United States to further his education. He finished high school in New York and in 1964 he graduated from the University of Kansas with a degree in chemical engineering. He worked in the United States until 1969 when he returned to Iran. He was employed there in forestry, which included involvement with pulp and paper. Canadian interests became involved in a large undertaking in Iran related to forestry and the pulp and paper industry. This led to the appellant spending about 50 per cent of his time in Canada after 1974. Consequent upon the 1979 revolution in Iran he encountered serious difficulties, including imprisonment by the revolutionary authorities. He was permitted to leave Iran in 1981 and joined his family in France. In March of 1983 they emigrated to Canada. He has since resided in Vancouver.

Through a Vancouver lawyer he became involved with Pharaoh Industries Inc. ("Pharaoh"), a California corporation the shares of which were owned by two Americans, Mr. Craig Rhoades and Mr. Thomas Meeks. Pharaoh was working on a concept to pump heavy oil located at considerable depth in wells from which the more fluid oil was extracted by conventional methods. It involved making heavy oil fluid with the aid of steam. Others had employed steam for the same purpose, but it had been created above ground and then pumped down the well in the course of which a great deal of the heat was lost. Pharaoh’s intention was to avoid this by generating the steam down the well.

Solomon was a public British Columbia company, the shares of which were traded on the Vancouver Stock Exchange. On January 31, 1984 Rhoades and Meeks gained control of it. In the process Pharoah became a subsidiary of Solomon and the latter thereby secured control of the assets and technology of Pharoah related to the extraction of heavy oil. The intention behind the takeover was to raise capital to pursue the heavy oil pumping project.

The appellant was employed by Solomon. He had great confidence in its future. In 1984 he became a director, His appointment fulfilled the requirement that the majority of the directors of Solomon be persons ordinarily resident in Canada. Research into the project was being carried on in Compton, California. Capital Services Corporation which had offices in Vancouver, was retained by Solomon to advise on raising money for its purposes. This led to the scientific research tax credit transactions that gave rise to the liability in dispute.

On March 19, 1985, Solomon entered into an arrangement under which it issued and sold to British Columbia Sugar Refining Company Limited (“B.C. Sugar") a promissory note referred to as “scientific research note" in the amount of $2.7M for a consideration of $4.5M. On receipt of the note B.C. Sugar paid Solomon $4.5M and thereupon Solomon paid B.C. Sugar $2.7M. In accordance with subsection 194(4) of the Act Solomon then designated $4.5M for the benefit of B.C. Sugar whereupon the latter obtained a scientific research tax credit of 50 per cent of $4.5M or $2.25M. By operation of subsection 195(2) of the Act Solomon became liable to pay the Receiver General on or about April 30, 1985, on account of its tax payable under Part VIII 50 per cent of the $4.5M designated or $2.25M.

When the liability was incurred it was open to Solomon to discharge it by paying the tax or by spending $4.5M on qualifying research and development expenditures. It chose the second course of action.

On the same day the note was issued and the designation made a trust agreement was entered into among Solomon as “the company”, Guaranty Trust Company of Canada as “the trustee" and B.C. Sugar as “the purchaser". The recitals read:

WHEREAS the company has issued a scientific research note (the "note") to the purchaser for a consideration of $4,500,000 (the "consideration").

AND WHEREAS the company has agreed to designate, pursuant to subsection 194(4) of the Income Tax Act (Canada) (the "Act"), an amount in respect of the note by executing and delivering the prescribed election forms (the "forms") to the Minister of National Revenue;

AND WHEREAS the company shall become liable for tax pursuant to Part VIII of the Act in the amount of $2,250,000 (the “Part VIII Tax") as a result of making such designation and the filing of the Forms;

AND WHEREAS the company has agreed with the purchaser to deposit the principal amount of $1,800,000 [2] (the "deposit") with the trustee, together with irrevocable letters of credit in a form satisfactory to the purchaser in the amount in the aggregate of $380,000 (U.S.) (the "security"), [3] which deposit and security shall be dealt with in accordance with and subject to the terms of this trust agreement;

The agreement consists of 12 pages and contains four articles: ARTICLE I, THE TRUST; ARTICLE Il, DRAWS AND DISBURSEMENTS; ARTICLE III, RESPECTING THE TRUSTEE; ARTICLE IV, GENERAL CONTRACT PROVISIONS. In brief the following is what is contained in the articles. ARTICLE I provides that the trustee will deal with the $1.8M plus interest thereon and the $380,000 U.S. (which together constitute "the funds”) in accordance with the terms of the agreement. ARTICLE II stipulates that the company may direct the trustee to release all or any part of the funds by delivering to the trustee a written direction directing it to pay to the Receiver General of Canada the amount specified therein on account of the liability of the company for tax and interest under Part VIII of the Act. The article also authorizes the trustee to release the funds on a written direction of the company to pay to or to the order of the company an amount specified therein if it is (i) accompanied by a statutory declaration of a director of the company to which is attached a budget of expenditures that the company proposes to make in the following 90 day period and which the company is entitled to specify as qualifying research and development expenditures; ana (ii) a letter from a national firm of chartered accountants to the trustee stating that they have reviewed the Statutory Declaration and are satisfied that the expenditures referred to therein would, if and when made, be qualifying research and development expenditures. The article also provides that in the case of a second or subsequent request by the company for the release of the funds a certificate of a director of the company stating that all expenditures contemplated in the Statutory Declaration delivered in support of the immediately preceding request have been made or have not been made in their entirety ana identifying and specifying such amount of such expenditures as have not been made. ARTICLE III states that the fees and expenses of the trustee shall be paid by the company. It also spells out the terms and conditions that govern and control the trustee with respect to its rights, duties, liabilities and immunities. The trustee is required to report from time to time to the purchaser respecting transactions under Article Il. ARTICLE IV prescribes the manner in which notices shall be given under the agreement; that time is of the essence and that the agreement is to be governed by and construed in accordance with the laws of British Columbia.

The appellant stated that the trust agreement was made “upon my suggestion and my insistence.” He added: "The only way to release the money was for the company to develop a budget, have the budget authorized by Touche and Ross, write a letter of comfort, send it to Guaranty Trust and only that much money releases to the company. This was done to the end."

Joyce Russell, a chartered accountant with income tax experience, was hired by Solomon. She was charged with the responsibility of ensuring that Solomon did "adhere to the rules and regulations.” She was a signatory on all cheques issued by it and was involved in budget development.

The California office was closed and everything was moved to Vancouver where some research was carried on at 701 West Georgia Street and later at 1166 Alberni Street. Arrangements were made for the storage of equipment pending construction of a structure for research purposes. A building was then constructed at Langley to house the research facility for the project. It was intended that subsequently it would be the factory for manufacturing. Langley became the head office of Solomon. The appellant and others including Messrs. White, Rhoades and Snodgrass, who were also directors, were very preoccupied with the raising of capital for the research. Numerous avenues were explored. One difficulty encountered was that potential investors were holding back until other investors were seen to be investing.

Many oil wells containing congealed oil were located in places like Kansas, Kentucky, California and Colorado. In this regard on February 29, 1986, a limited partnership was formed under the California Revised Limited Partnership Act. Its principal place of business was to be at 1166 Alberni Street, Vancouver. It also had a California address in Los Angeles. A newly incorporated California corporation, KSR Oil Recovery Inc., was the general partner. It was a wholly-owned subsidiary of Solomon. Its intended business was: ”. . . to acquire an interest in producing oil properties commonly termed 'stripper wells’ through a contract with the operator or, when appropriate, with the owner of the oil rights. Under this contract the partnership will furnish and install a portable steam generator for the purpose of injecting steam into the oil reservoir to enhance the production of oil.” Persons would become limited partners who met the requirements of a subscription agreement and were accepted by the general partner. The “Private Placement Memorandum" related to the limited partnership stated that: “THIS OFFERING INVOLVES A HIGH DEGREE OF RISK.” It went on to elaborate on the nature of the risk. It was hoped to raise $300,000 by selling 30 units of $10,000 each. Selling commissions on all 30 units would total $30,000. Additional subscriptions were planned for the future. A lot of effort went into the selling of the units. Prospective investors were located, but in the end the sharply declining price of oil frustrated the endeavours to raise capital and the partnership never became operational. The price went below $15 a barrel which the appellant described as "the breakeven point". In January of 1986 Rhoades, who was chairman of the board, president and chief executive officer of Solomon, was dismissed because of his failure to raise capital. He was replaced by the appellant on what was intended to be an interim basis. By June of 1986 Solomon's finances were exhausted and by October or November of that year it was “finished”.

Solomon also incorporated a subsidiary, KSR Engineering Ltd. ("KSR"). It hired researchers and other staff. KSR entered into a contract with its parent on June 1, 1985, to provide engineering and research services. The payment for these services were intended to qualify as scientific research expenditures.

The research building was constructed by Marietta Management Corp. ("Marietta"). It provided financing and secured its loan by a first mortgage for $740,000. The construction contract was dated August 31, 1985, and the structure was occupied in November 1985. Because of default of payment of money owed to it Marietta took possession of the building and padlocked it. This occurred in June 1986. None of the corporation records that were there were recovered.

Solomon had also arranged to acquire $737,090 worth of equipment from Gross Machinery Group under a lease with an option to purchase. A dispute arose about whether the machinery which was delivered was new. The upshot was that the machinery was seized by Gross Machinery Group from the Langley building.

Mr. Charles K. Snodgrass is an American. Prior to his association with Solomon he had been an investment banker in Colorado and California. He then engaged in the business of importing sugar into the United States. This was followed by employment in the business of arranging financing for emerging or startup corporations in California. This led to his meeting Mr. Craig Rhoades. The wife of Mr. Snodgrass had a nephew who was a stockbroker in Vancouver and he was introduced to Mr. Rhoades. The nephew was successful in raising some funds in Vancouver for Solomon. About this time Mr. Snodgrass became a director. He believed in the oil pumping scheme and said that there was "a continuing, constant effort” to find the necessary investment capital to carry it forward.

On May 24, 1984, Solomon issued a "Rights Offering Circular” addressed to holders of its common shares resident in British Columbia. It offered the right to subscribe for up to 329,000 units each consisting of one common share and two series "A" share purchase warrants. Two purchase warrants entitled the holder to purchase one additional common share at a specified price. The offering expired on July 4, 1984. Included in the summary of the offering is this:

The net proceeds of this issue are estimated at $952,999, assuming full exercise of Rights and payment of the maximum amount Brokers Fees (see “Plan of Distribution”) of $83,351. Two hundred thousand dollars Cdn of the proceeds will be used to develop a Lab Unit model of the Down-Hole Steam Generator and approximately $400,000 Cdn will be used to build a 1/7 working scale model of the Down-Hole Steam Generator. The balance of approximately $327,999 will be added to the company’s working capital.

The gross amount realized by Solomon was $641,394. Under cross-examination the witness said he did not regard this as disappointing. Indeed he thought that Solomon did very well.

In the course of argument on behalf of the Crown Mr. Torrie said that at the time of the designation a diligent director would have elected one of three options. The first was to pay the tax when it came due in April 1985 out of the funds received from B.C. Sugar and to which Solomon had access at that time. The second option was to raise sufficient additional funds to enable Solomon to make $4.5M worth of qualifying expenditures before any such expenditures were made. Finally: “The third option, I suspect, would be, in a way it’s a combination of the two, hold the money in trust, the $2.25M that you have, and then keep that in trust, raise money and spend the money that you raise on the qualified research, thereby getting rid of some of your tax liability.”

Each of these courses of action would have virtually assured payment of the Part VIII tax liability incurred by Solomon. With respect I do not regard that stringent a standard as being required of a director in order for him to qualify for the exoneration from liability provided under subsection 227.1(3) of the Act. Whether an individual is within the ambit of this subsection is a question of fact to be determined in light of the circumstances of particular cases.

In Cloutier v. M.N.R., [1993] 2 C.T.C. 2038, 93 D.T.C. 544 (T.C.C.), the appellants had, as in the case at hand, been assessed in respect of alleged liability incurred by operation of subsection 227.1(1) of the Act. The sole issue was whether they were relieved of liability under subsection 227.1(3). Bowman J.T.C.C. said at page 2048 (D.T.C. 551): "The directors of a corporation are neither trustees for nor insurers of the Minister of National Revenue.” Earlier he had made these observations at pages 2040-41 (D.T.C. 545-46):

The question [to be decided] therefore becomes one of fact and the Court must to the extent possible attempt to determine what a reasonably prudent person ought to have done and could have done at the time in comparable circumstances. Attempts by courts to conjure up the hypothetical reasonable person have not always been an unqualified success. Tests have been developed, refined and repeated in order to give the process the appearance of rationality and objectivity but ultimately the judge deciding the matter must apply his own concepts of common sense and fairness. It is easy to be wise in retrospect and the court must endeavour to avoid asking the question “What would I have done, knowing what I know now?” It is not that sort of ex post facto judgment that is required here. Many judgment calls that turn out in retrospect to have been wrong would not have been made if the person making them had the benefit of hindsight at the time.

Section 227.1 is an example. That section imposes a standard of care on directors that requires reasonable prudence and skill in ensuring that the money raised through the SRTC program be in fact used for scientific research or else that the Part VIII tax be paid either out of the money so raised or otherwise. In determining whether that standard has been met one must ask whether, in light of the facts that existed at the time that were known or ought to have been known by the director, and in light of the alternatives that were open to that director, did he or she choose an alternative that a reasonably prudent person would, in the circumstances, have chosen and which it was reasonable to expect would have resulted in the satisfaction of the tax liability. That the alternative chosen was the wrong one is not determinative. In cases of this sort the failure to satisfy the Part VIII liability usually results either from the making of a wrong choice in good faith, or from deliberate default or wilful blindness on the part of the director.

As I understand it the basic argument being made on behalf of the respondent is that the appellant fails to come within the scope of subsection 227.1(3) of the Act because at the time the assignment was made there was no basis upon which to found a reasonable expectation that Solomon could raise the approximate $2.3M [4] required to enable it to discharge its Part VIII tax liability in accordance with the method it chose to accomplish this. As previously indicated that method was to spend $4.5M on qualifying expenditures.

The whole of the evidence leads me to the conclusion that the fundamental reason Solomon failed to discharge its tax liability for which it is now sought to make the appellant liable was the decline in the price of oil. Failure to be prescient about the price of a commodity like crude oil for a period in excess of a year can occur with individuals highly regarded as prognosticators in that market. To my mind, in the absence of a special circumstance of which there is no evidence, default of that kind cannot be construed as a director of a corporation not having exercised the degree of care, diligence and skill to prevent the failure by the corporation to discharge a debt that a reasonably prudent person would have exercised in similar circumstances.

The appellant testified that the trust agreement of March 19, 1985, among Solomon, Guaranty Trust and B.C. Sugar was made at his suggestion and insis- tence. That may be, but the whole tenor of the document is that it is designed to meet the desire of B.C. Sugar to ensure to the extent possible that the $1.8M which Solomon received from it is allocated to qualifying expenditures. In a letter dated March 18, 1985, to B.C. Sugar Solomon undertook to deliver the agreement to the former at the time of the completion of the purchase and sale of the note. Nevertheless I am prepared to infer that the agreement was entered into with the consent and approval of the appellant. Its intended effect being a reduction in the part VIII tax liability of Solomon, it follows that it is a factor in the appellant's favour.

The appeal is allowed with costs.

Appeal allowed.