John Jones v. Minister of National Revenue, [1992] 1 CTC 2175, 92 DTC 1085

Garon, T.C.C.J.:—This is an appeal from a reassessment of tax and penalties made on August 31, 1989, by the Minister of National Revenue under the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") in respect of the 1984 taxation year. By his reassessment the Minister of National Revenue added to the appellant's income for the year in question the amount of $42,031.67 representing funds or property of a corporation by the name of 147 Ranch Ltd. (the "Corporation") allegedly appropriated by the appellant in the course of the 1984 taxation year. By the same reassessment the Minister of National Revenue also levied a penalty in the amount of $2,737.60 pursuant to subsection 163(2) of the Income Tax Act.

The appellant, in terms of education, had three years of college. He stated that he is not versed in accounting matters. At the time of the hearing of this appeal, he was a mutual fund dealer. For some years prior to 1975, the appellant had carried on business in the United States. He owned at that time a car dealership. He ran a fairly substantial business and he disposed of it in the fall of 1974 for proceeds in the range of $250,000 to $300,000. The appellant asserted that, as far as accounting in respect of the latter business was con- cerned, he was assisted by an office manager and an accountant. The more complex accounting services were provided to his firm at the time by a widely known accounting firm.

The appellant started, through the vehicle of the corporation, his ranch business in 1976 while he was 50 years of age. It was a horse ranch situated in a remote area, in Pink Mountain, B.C. The land was very rich. The access to this property was difficult, the roads were hard four-wheel driving roads that were at times impassable. The property was not serviced by electrical power. The ranch was approximately 120 miles from Fort St. John, B.C. The appellant owned in the taxation year in issue 25 per cent of the shares in the capital stock of the corporation. His wife and his two daughters were the only other shareholders. He was the sole director. As president of the corporation, he was responsible for the day-to-day affairs of the corporation. He had the sole signing authority. The appellant was the directing mind and will of the corporation.

In these circumstances, it is easily understood that the business conducted at the ranch was handled in a rather informal manner. Business was dealt with in this way from its inception in 1976. The appellant did not keep a set of his accounting records at his residence. Also, most of his communications with bankers, accountants and lawyers were carried out through radio-telephone as opposed to personal contacts. Verbal instructions were issued by the appellant to his advisers.

The only source of income of the corporation in 1984 was from a joint venture carried out through a partnership operating under the name of B.J.R. Ventures. As a matter of fact, some time in 1982, the appellant, through the corporation, embarked upon a joint venture with two other individuals by the name of Wallace Boring and Lynn Ross. It was essentially an instrument whereby the appellant and the two other partners pooled their assets in terms of gravel pits and arranged for sale of gravel at appropriate times. The procedure that was followed by B.J.R. Ventures in respect of the proceeds of sales of gravel was explained thus:

Cheques representing payment for the sales of gravel were made out to B.J.R. Ventures and recorded in an account set up by the latter firm. Subsequently, cheques signed by two of the three partners were written on this account to the various joint venturers for their portion of the proceeds of the sales.

The evidence shows conclusively that during the 1984 taxation year the appellant received on the corporation's account three cheques, although the third cheque was not filed with the Court, at the times and in the amounts indicated below:

The March and June cheques in the amounts of $94,454.05 and $30,093.79 respectively were deposited into the savings account in the name of the appellant and his wife while the January 1984 payment in the amount of $195,790.50 originating from B.J.R. was parcelled out into three amounts that were deposited into the following accounts:

However, the accountant's working papers for the corporation entitled “Gravel sales" show for the 1984 taxation year an amount of $278,306.67 as representing the total receipts from gravel sales. As well, it should be noted that the statement of income and retained earnings for the year ended December 31, 1984, for the corporation shows that the latter's gross income from gravel sales amounted to $278,307. On the other hand, the appellant admitted that the corporation's total gross income from gravel sales for the 1984 taxation year was in the amount of $320,338.34 but he was unable to explain how the shortfall arose. Throughout, the appellant stressed that he relied on his accountant with respect to the inflows and outflows of funds between the appellant and the corporation.

He also indicated that these movements of funds were handled through adjustments to the shareholder's loan account in the books of the corporation and he denied that he appropriated any funds of the corporation.

In addition to the appellant himself, his former banker, Mr. Richard Marshall Sherwood, and his present accountant, Mr. Presizniuk, were called upon to testify, as part of the appellant's case.

Mr. Sherwood was in the employ of the Royal Bank of Canada (the"Bank") from 1972 to 1984. From 1978 to 1981, he was the senior assistant manager of the Fort St-John's branch of the bank where the appellant and the corporation conducted their business during the years 1979 to 1984. Mr. Sherwood confirmed that in practise the bank did not make any distinction whatsoever between the appellant and the corporation. They were treated as a single entity. There was basically a free-flow or a constant commingling of funds between the appellant's personal accounts and the corporate accounts of the corporation. A lot of business between the appellant and the local branch was done by radio-telephone in view of the fact that the appellant was living in a remote location. He clearly asserted that the majority of communications with his professional advisers were verbal. Mr. Sherwood stated that he met the appellant less than half a dozen times over a period of approximately two and a half years and that he dealt with him verbally and with confidence. Mr. Sherwood explained in those terms why corporate funds were often held in personal accounts at the relevant times:

On deposit accounts the reason is very simple. It pays a higher interest. A business account, a business current account, if you will, which is what they were called, pays no interest whatsoever and they charge horrendous amounts for processing cheques and everything else, which they did in the 70's and 80's and again in the 90’s. Probably you have accounts,and very difficult to get any credit for a business account.

Whereas personal accounts, on the other hand, you can get maybe six per cent interest or maybe service charges and this type of thing, and especially with shortterm deposit rates, there's usually anywhere from an eighth to a half point benefit to a short-term deposit being in an individual’s name than a corporate name.

It was made clear, in particular, that there were sound business reasons as to why corporate funds might be held in the personal name of the de facto controlling shareholder of a small company. This practise is not at all uncommon for small businesses. In effect, individuals received in some situations but not in all from a banking standpoint preferred treatment over corporations. To the best of Mr. Sherwood's knowledge, there were no changes in the appellant's banking arrangements subsequent to the witness’ departure in 1981 from Fort St-John up to the end of 1984. Mr. Sherwood was able to testify with respect to banking arrangements subsequent to 1981 given the fact that, although he had left Fort St-John in the latter year, he remained associated with the Bank through to the end of 1984.

Details about the accounting practices adopted by the appellant and the Corporation were provided by Mr. Colin Dale Presizniuk, C.G.A. whose services were retained by the appellant and the corporation in November 1989. Prior to that and for a number of years including the year in issue, the accounting for both the appellant and the corporation, had been handled by Mr. I. Still, C.A. Mr. Presizniuk was given access to and examined the accounting records, banking statements, cancelled cheques and deposit books as far back as 1980 of both the appellant and the Corporation.

In his analysis of the situation, Mr. Presizniuk started by pointing out that there were three main types of accounts involving the appellant and the corporation in respect of the payments for the sales of gravel. One was the current chequing account in the corporation's name, the second one, a passbook savings account in the appellant's name where the bulk of all the gravel sales were deposited and the third account in the appellant's name had to do with term deposits. He indicated that the passbook savings account, even though in the name of the appellant, was basically a corporation's account. When the money was needed for the corporation's business, for instance, the payment of its bills, it was transferred out into the Corporation's current chequing account. Excess moneys in the passbook savings account were converted into term deposits to maximize interest return. He confirmed that in the case of small businesses corporate funds are often deposited into an account in the name of an individual. Mr. Presizniuk admitted that the corporation's income was understated in respect of the 1984 taxation year by an amount of $42,031.67. He attributed this discrepancy to an accounting error. At one point, this witness expressed the following opinion with respect to the nature of the error:

Looking at the working papers and the journal entries it appeared the accountant did not pick up maturing term deposits as it related to the gravel sales being deposited into the accounts that were used by the company.

After having insisted on this explanation for the error, Mr. Presizniuk seemed to qualify his views on this matter in the course of the cross- examination in the following excerpt:

Q. But that is essentially speculation? I mean, you can’t point to meanywhere that there's a $42,000 term deposit at the end of the year, can you?

A. No, because the $42,000 figure is a residual reconciled amount. Because of again how the accounting was handled, it's comprised of several amounts. Term deposit, interest that has been earned. It’s a residual amount. It's not as if that number just pops out and you're able to just trace it in and out.

Q. Well —

A. It comes about from a series of accounting transactions which took place in June and July, yet the year end is at the end of December.

Later on he added this, speaking about the amount of the term deposit:

It could be varying amounts. It would have to—it would have to be substantial, in the area of, you know, 30—I'm speculating, 30, 35,000, because the $42,000 results, it's a residual calculated amount taking place in the June and July banking transactions. So in order—there would have been interest accruing on it. It would have had to have been received say in early part of the year.

Mr. Presizniuk also explained that as a result of the funds flowing back and forth between the corporation and the appellant throughout the course of the year the accountant was required to recreate at the end of a taxation year the flow of transactions, adjust the accounts in the books of the corporation and effect a reconciliation through the shareholder's loan account. Incidentally, the appellant's shareholder's loan account at the end of 1984 showed on the credit side an amount of $275,274. It was also admitted by Mr. Presizniuk that the shortfall in the corporation's gross income in the amount of $42,031.67, as noted earlier, did not show up in any form in the corporation's financial statements for 1984.

Mr. William Wayne Surby, the auditor who was involved in the audit which led to the reassessment in issue, testified for the respondent. The following excerpt from his testimony, in which is included an observation from counsel for the respondent, is of some significance:

So it was up to Mr. Jones basically to tell the—to tell the accountant what the gravel sales were, and then he would make the appropriate journal entry at year end. And in this case the journal entry was short by $42,000. And I guess it was entered in as an exhibit, the accountants working paper.

Mr. Curley: That would be I think, sir, R-3. If you could show the witness, perhaps, R-3.

A. Number 15—yes, that's it. You can see there where the taxpayer and his accountant had gone through his bank accounts and determined where the moneys were deposited, or the first three were deposited into his account 700-871-7, then the next one was deposited—well, there was one deposited into the 147 Ranch Ltd., and the other one appears to be a journal entry balancing a figure that they assumed to be—or I don't know where they got that figure, the contract figure, of $278,306.67.

And another thing seems quite unusual, is that the accountant got him to sign this, saying—to me obviously the accountant was not able to verify this amount. So he got the taxpayer to sign it saying this is the correct amount. It’s very unusual for an accountant to get a signed working paper like that. Especially if he can document it or verify it from records.

In cross-examination, Mr. Surby testified regarding the movement of cheques revealed by the records of B.J.R. Ventures in these terms:

Okay, the records of B.J.R. showed three cheques paid to John Jones and 147 Ranch Ltd. The first one was for $195,790, which 9790 was deposited to 147 Ranch Ltd. account, 36,000 was deposited to John Jones’ savings account, 150,000 went to a term deposit in the name of John Jones. Second cheque for $94,454 went to the savings account of John Jones, 30,093 went to the savings account of John Jones.

Okay, the discrepancy appears to be in, when the taxpayer and the accountant got together after, remember the paper we just referred to? And it seems to be a plugged figure that term deposit of 107,000, the real odd number? The term deposit was in fact for 150,000.

Later on, in cross-examination, speaking about the appellant and Mr. Still, C.A., Mr. Surby gave his views about the question whether the shortfall in the amount of $42,031.67, which was rounded down to $42,000, was the result of a conscious decision or an accounting error in these terms:

A. Well, they got together and decided that the gravel sales between the two of them, using whatever method, decided that the gravel sales were $42,000, less than the actual amounts received. So that's what the journal entry is made out for.

Q. So you're saying that was a conscious decision as opposed to an error?

A. I'm not saying it was a conscious decision. I said that's what the journal entry is made out to—as.

Q. Okay, so you're not saying that it was an error then?

A. Well, the 42,000 got lost in the transfers.

Q. Okay.

A. It doesn't matter what it was spent for. It was just—he was not—his shareholder's loan wasn't debited for it and the corporation did not include it in their income.

Q. Could that have been the result of an error?

A. Sure.

Q. But do you know for a fact that Mr. Jones appropriated to his own benefit the $42,000?

A. He got $42,000 without having to pay tax on it, without having to reduce his shareholder's loan.

Submissions of the Parties

The appellant's position is that the matter of the shortfall in the amount of $42,031.67 has arisen as a result of an error by the accountant at the time and that there was no benefit conferred on the appellant by the corporation.

The respondent's contention is that an appropriation of funds in the amount of $42,031.67 by the appellant results from the fact that the appellant received in 1984 cheques totalling $320,338.34 on the corporation's account and the corporation in turn came into possession of funds amounting to only $278,307, as disclosed by the accounting records and financial statements of the corporation.

Analysis

In light of the evidence, I am therefore required to determine if the amount of $42,031.67 was appropriated by the appellant.

As has been said by Judge Kempo of this Court in the case of G.D.L. Simons v. M.N.R., [1985] 1 C.T.C. 2116, 85 D.T.C. 105, at page 2120 (D.T.C. 108):

On the authorities the question of whether or not funds or property of the company were appropriated to or for the benefit of the appellant as a shareholder, or that a benefit or advantage had been conferred by the company on the appellant as a shareholder is primarily a question of fact rather than a conclusion of law... .

In the present case, it is not disputed that the appellant received in 1984 cheques on behalf of the corporation totalling $320,338.34. These cheques were in part deposited into the corporation's current account, in part in the savings account in the name of John and Margaret Jones and the balance was converted into a term deposit in the name of the appellant. It is also beyond controversy that in the statement of income and retained earnings of the corporation for the year ended December 31, 1984, the sum of $278,307 is shown as representing the total amount of "Gravel sales". The appellant admitted that the corporation's gross income from gravel sales was understated by an amount of $42,031.67. The corporation's balance sheet as at December 31, 1984, was prepared on the basis of, inter alia, data reflecting this shortfall of $42,031.67.

Since it has not been suggested that the funds received by the appellant representing the amount of $42,031.67 went directly to a third party through some inadvertence or were lost in some way, it follows that in all likelihood these funds remained under the appellant's control or possession. It was incumbent on the appellant, who was not an unsophisticated individual, to provide evidence as to the movement of funds that were under his control. Neither the appellant nor his accountant whose services were retained many years after the event were able to give valid explanations about this shortfall. As well, no evidence was adduced that adjusting entries in the accounting books of the corporation were made in 1984 or in subsequent years through the shareholder's loan account or in some other manner to correct this discrepancy in the amount of $42,031.67 and to effect the required reconciliation. In addition, the accountant who prepared the income tax return for the appellant and the corporation for the 1984 taxation year and the accompanying financial statements for the corporation for the same year was not called upon to give evidence. No clear reasons or explanations were given for his absence, apart from a vague comment from counsel for the appellant. He might have been the person in the best possible position to explain this discrepancy.

In considering the totality of the evidence, I am also influenced by the unchallenged statement made by Mr. Surby, the auditor in this case, who indicated that it was unusual for an accountant to require his client to sign the accountant's working papers. These very same papers understate the corporation's gross income for the year 1984 by establishing it at $278,306.67 rather than $320,338.34 and set out a balancing figure in the amount of $107,968.33 in respect of which no details were given for its justification. I also had some difficulty in reconciling different parts of the evidence given by the accountant with respect to the discrepancy in the amount of $42,031.67.

From these facts, I am of the view that the proper inference to be drawn is that the amount of $42,031.67 out of the total amount of $320,338.34 received by the appellant never reached the corporation's coffers in the 1984 taxation year and it therefore follows that it is likely that funds or property of the corporation worth $42,031.67 were appropriated in some manner to or for the benefit of the appellant.

The present situation is not at all on all fours with the facts considered by Judge Brulé of this Court in the case of William G. Docherty v. M.N.R., [1991] 1 C.T.C. 2409, 91 D.T.C. 537. In the latter instance, unlike the present case, the learned judge found that there was credible evidence, inter alia, in the accountant's working papers that a set-off was intended between the Corporation and the taxpayer with respect to their mutual debts.

The facts in the present case are in some significant respects different from those considered by Judge Kempo in the Simons case, supra. In the Simons situation, the Court found that “neither party was the richer or the poorer either immediately before or after the event" of the erroneous balancing entry and concluded that the taxpayer did not receive any benefit as a result of this entry. Here, I have found on the evidence that the appellant has benefitted from the movement of funds between himself and the corporation.

I am therefore of the view that the respondent's reassessment to the extent that it deals with the tax portion thereof is fully justified.

It remains to determine if the assessment of a penalty was correctly levied under the circumstances. By virtue of subsection 163(3) of the Income Tax Act the burden of proof is on the respondent to establish the facts justifying the assessment of a penalty.

The respondent's auditor, Mr. Surby, stated in cross-examination that he did not know if the shortfall in question was the result of a conscious decision on the part of the appellant or of a simple accounting error. The precise role of the accountant handling the appellant's affairs at the time is not clear. It would appear that the respondent chose, as did the appellant, not to call Mr. Still, C.A. as a witness. I accept that the commingling of the appellant's funds with those of the corporation is an acceptable way of doing business for small corporations.

I conclude that it has not been demonstrated on a balance of probabilities that the appellant knowingly or under circumstances amounting to gross negligence failed to report the inclusion in his income of an amount of $42,031.67 resulting from his appropriation of the corporation's funds. Consequently the penalty portion of the assessment is vacated.

For these reasons, the appeal is allowed, with costs, and the reassessment is referred back to the respondent for reconsideration and reassessment on the basis that the penalty levied under subsection 163(2) of the Income Tax Act should be vacated. I am awarding costs to the appellant as I am of the view that the appellant has “ substantially succeeded" in his appeal, within the purview of the "Tax Court of Canada Rules of Practice and Procedure for the Award of Costs (Income Tax Act)”.

Appeal allowed in part.