Ken Clayholt v. Minister of National Revenue, [1990] 2 CTC 2163, 90 DTC 1543

Mogan, T.C.J.:—Each year, the appellant computed his income and filed an income tax return. For the taxation years 1978, 1979, 1980 and 1981, the respondent issued to the appellant notices of reassessment based on a "statement of net worth" prepared by an employee of Revenue Canada, Taxation. The reassessments added certain amounts to the appellant's reported income for that four-year period and also assessed certain penalties under subsection 163(2) of the Income Tax Act (the "Act"). The appellant appeals to this Court claiming that (i) the net worth statement was not necessary because his books and records were adequate for the computation of his income; (ii) the net worth statement contained certain errors; and (iii) the penalties were not justified. Those are the three issues in this appeal.

The appellant operates a feed mill at Madden, Alberta, a small settlement with about 50 residents, 30 miles north and west of Calgary. At Madden, there is a general store, a garage/service station and the appellant's feed mill. At the mill, the appellant is engaged in grinding, rolling and cleaning grain and in the buying and selling of grain. In conjunction with the mill, the appellant operates a hardware business selling twine, fertilizer, chemicals, some appliances and other hardware supplies needed by farmers in the vicinity of Madden. Adjoining the mill, the appellant has a machine shop where he repairs electric motors; does some welding; and manufactures and sells a "rod-weeder" on which he holds a patent. The only customers of the appellant's business (feed mill, hardware supplies and machine shop) are local farmers. The appellant has owned and operated the feed mill at Madden since 1956 and, when this appeal was heard in 1989, he was 63 years of age. He owns a half section of land (320 acres) four miles from Madden where his sons work the land while he uses the barns to raise some hogs and cattle. The appellant and his wife reside in the farm house on the half section of land.

The books and records of the feed mill business are maintained by the appellant and he described them in detail at the hearing. His grain purchase orders are kept in a separate file and a copy of each order is given to the selling farmer. His hardware purchases are separated according to the supplier from whom he buys. If he has many purchases from a single supplier, there would be a separate file containing all the invoices from that supplier alone. And immediately after the end of each year, he would make up a hand-written summary of all his purchases.

Each sale is entered in a counter book being a small pad (approximately 51/2" x 3V2") containing 50 duplicate pages numbered in sequence and printed especially for the appellant because each page bears the heading "Madden Feed Mill—Ken Clayholt". The counter books are usually made out in the appellant's own handwriting with the date, the name of the customer, the items purchased and the sale amount. The original handwritten record of each numbered sales page is given to the customer but the carbon copy is left in the counter book. The appellant would use approximately 50 books each year. The counter books recorded all sales at the feed mill except sales of grain which were recorded on a four-copy grain sales form.

In January or February of each year, the appellant would sit down with all his records from the preceding calendar year—counter books, grain sales forms, invoices, bills, etc.—and make up a handwritten ledger summarizing his sales, purchases and expenses for the preceding year. The appellant stated in evidence that he had an invoice for every item entered in his ledger as a purchase or expense but this statement was contradicted by a witness for the respondent. After making up the ledger, the appellant would put all the invoices and other similar documents on different spikes according to their categories and store them in a box with the counter books. The appellant had a box for each year containing all of his original records pertaining to the particular year, and the boxes were stored at the feed mill.

The appellant did not have any cash register at the feed mill. He had a drawer for loose change and he would carry up to $300 in folding currency in his pocket. He did not prepare his own income tax return but took his handwritten ledger and any other relevant documents to a commercial organization (not professional accountants) engaged in the business of preparing income tax returns for individuals. The operation of the appellant's feed mill and the operation of his farm were reported separately on his income tax return. For the years under appeal, the relevant amounts were reported as follows:

The bottom line in the above table is not the precise total of the three preceding lines for 1979 and 1980 because of other amounts reported by the appellant which are not relevant here. Apparently, the appellant filed an amended income tax return for 1981 reducing his reported income to approximately $19,000 but that amended return was not entered as evidence.

Sometime in 1982 or early 1983, Mr. Gregoire, an auditor from Revenue Canada, Taxation, arrived at the appellant's feed mill stating that he wanted to audit the appellant's income tax returns for the years 1978-81. The appellant produced the four boxes containing the records for those years and, after some discussion, Mr. Gregoire took the boxes away with him. On August 19, 1983, notices of reassessment were issued to the appellant increasing his reported income for each year by the following amounts which were described as "personal and unvouchered amounts" and “personal portion of utilities":

Revenue Canada, Taxation, sent a letter to the appellant dated February 2, 1983, informing him of the above proposed additions to his reported income. It appears, however, that the letter was placed in one of the four boxes which were returned to the appellant in February 1983 and he did not find the letter until he went through his records following receipt of the notices of reassessment in August 1983. The appellant filed notices of objection to these reassessments stating that he had documents to support all of his revenue and expense items. The appellant's objections were reviewed by a Mr. King who was, in 1984-85, an appeals officer with Revenue Canada, Taxation. After meeting with the appellant and an accountant whom he had retained to assist with his objections, Mr. King concluded that to go through the appellant's receipts, invoices and other records would only duplicate what Mr. Gregoire had done; and so Mr. King decided, with the approval of his supervisor, to verify Mr. Gregoire's audit by preparing a net worth statement for the period 1978-81.

Mr. King attempted to record the appellant's assets and liabilities as at the 31st day of December in each of the years 1977, 1978, 1979, 1980 and 1981. By subtracting the liabilities from the assets, he determined the appellant's net worth on each of those dates. And then, by comparing the net worth at the end of one year with the net worth at the end of the subsequent year, the respondent determined if there was an increase in net worth during the subsequent year. An apparent increase in net worth was adjusted downward to recognize non-taxable amounts received in the subsequent year (e.g. an inheritance) and was adjusted upward to recognize personal expenses in the subsequent year (e.g. food and clothing). After taking into account all relevant adjustments, the respondent determined a final amount as the change in adjusted net worth from the end of one year to the end of the subsequent year. If this change in adjusted net worth was a positive amount (i.e. if the adjusted net worth at the end of the subsequent year exceeded the adjusted net worth at the end of the immediately preceding year), the respondent would assume that such positive amount (i.e.the excess) was the taxpayer's net income for the subsequent year.

For obvious reasons, a statement of net worth is not the best way to measure annual income. In Urchyshyn v. M.N.R., [1971] Tax A.B.C. 307; 71 D.T.C. 234, W.O. Davis, Q.C. stated at page 313 (D.T.C. 238):

. . . The employment of a net worth statement as a basis for an assessment to income tax is well recognized as a “last-ditch” attempt to establish a fair basis on which to assess in the absence of acceptable bookkeeping records.

And in Djoboulian v. M.N.R., [1979] C.T.C. 2074; 79 D.T.C. 87, the late Honourable L.J. Cardin stated at page 2075 (D.T.C. 88): "The Minister, in the absence of reliable records, was justified in assessing the appellant by way of net worth assessments."

And in Zagumeny v. M.N.R. (1963), 33 Tax A.B.C. 100; 63 D.T.C. 718, J.O. Weldon, Q.C. stated at page 719:

It is conceded of course that the above method ["net worth" type] of calculating income is in reality a makeshift method. However, the respondent in resorting to same does so in order to justify the assessment ultimately made and for the reason that records which could or should show the income for the period are either nonexistent, destroyed, or otherwise not produced.

Although the above cases acknowledge the shortcomings of the “net worth” method as a means of determining annual income, the cases have accepted such method in circumstances where the taxpayer has not maintained adequate books and records.

Because the appellant filed income tax returns for all years, the respondent took the change in adjusted net worth for each year and subtracted the net income as reported by the appellant for each respective year. The remainder resulting from this subtraction was then integrated with the amounts added to the appellant's reported income in the reassessments issued on August 19, 1983 as follows:

The bottom line in the above table was the amount used by the respondent as “total income" for purposes of issuing the notices of reassessment dated October 8, 1985 which are the assessments under appeal herein.

Although Mr. Gregoire and Mr. King both testified at the hearing, I do not fully understand why the respondent changed to a net worth method of measuring income when responding to the appellant's objections to the 1983 reassessments. If the appellant's books and records were adequate to permit Mr. Gregoire to identify certain expenses which he disallowed as "personal and unvouchered amounts", and if the appellant claimed in his 1983 objections that he had receipts for every expense that he deducted, why was Mr. King's review in 1984-85 not restricted to the list of expenses which had been disallowed in 1983? And if the object of the net worth method in 1985 (as stated by Mr. King in evidence) was to verify Mr. Gregoire's audit in 1983, was the audit in fact verified by the net worth method? For example, in 1978, the net worth reduced income to an amount below what the appellant had reported; in 1979, the net worth reduced income from the level of the 1983 reassessment but left it higher than what the appellant had reported; and in 1980, the net worth increased income above the level of the 1983 reassessment.

Mr. King was asked if he could, using the appellant's counter books, handwritten ledgers and other documents in his boxes of records, make up an accurate profit and loss statement for the appellant's feed mill and farm. Mr. King answered that he did not determine whether he could do that or not. I should have thought that such a determination was necessary before the respondent would change from an existing but imperfect set of books and records to a less precise method of income measurement like a net worth statement. On the other hand, the respondent proved some significant errors in the appellant's reported income. In 1981, the appellant built an addition to his house and deducted the amount of $7,971 as part of the feed mill expenses when that amount was, in fact, part of the cost of the house addition. In his own handwritten ledger (Exhibit A-6) under the tab "Repairs", there was an entry for December 22, 1981 "Repairs and Material - $4,000” which the appellant admitted under cross-examination was part of the $7,971 (transcript pages 111-12). In the same ledger, under the tab "Feed Mill Purchases", the appellant had entered an item for November 27, 1981 as "Hardware - $1,198.30” which was, in fact, the cost of a fireplace for his house (transcript pages 156-58).

Mr. Gregoire stated categorically under cross-examination by appellant's counsel that the appellant had listed certain amounts as business expenses for which there were no vouchers (transcript page 178). The respondent may have concluded that the appellant's records (i.e. his boxes of documents) did not provide or permit an accurate measurement of his business income. Indeed, that conclusion may be implicit in the 1985 reassessments which are based on a statement of net worth but Mr. King did not give a clear and effective utterance to that conclusion in the witness box. Evidence in this area is important because it goes to the heart of the appellant's first claim that the statement of net worth was not necessary because his books and records were adequate for the computation of his business income.

The appellant did not have an organized system to transfer financial information (week-by-week or month-by-month) from original documents like counter books and invoices to a general ledger. In short, he had no procedure for consolidating his revenue and expenses on a periodic basis through the year. With respect to books and records, is it sufficient for the appellant to store all of his invoices in a cardboard box in the hope that he will remember, after the end of the calendar year, which invoices are related to his business and which are personal? His admission in the witness box (and, through his accountant, in the preparation of the respondent's net worth statement) that he deducted in 1981 as a business expense the amount of $7,971 which was in fact part of the cost of his house addition is an adverse reflection either on his bookkeeping or his honesty. The same can be said for the fireplace which cost $1,198.30. For the purposes of resolving the first issue, I regard those significant and unwarranted deductions as strong evidence that the appellant's books and records were not adequate.

The main problem appears to be on the "expense" side of the appellant's operations. In the 1983 reassessments, it was unvouchered expenses which were disallowed and, in evidence, the glaring errors in his income computation were the unwarranted deductions described above. There could also be a problem on the "revenue" side. The absence of a cash register is significant and indicative of the appellant's inadequate recordkeeping. A drawer of loose change and a pocket full of folding money may be an adequate cash record for a one-day enterprise like a cookie booth at a church bazaar but it does not appear to be adequate for a business grossing $127,000 to $259,000 in the years 1978 to 1981. Certain sales which would be recorded with a cash register could be omitted, even innocently, with the appellant's kind of counter books and grain sales forms.

Mr. Gregoire and Mr. King both testified that the appellant had no record of accounts receivable (transcript pages 162 and 203). Also, the appellant's closing inventory at the feed mill was approximately $3,300 for each year even though "merchandise purchased" each year was in the range of $111,000 to $248,000 for the period 1978-1981. There was no evidence as to whether this closing inventory was hardware, grain or both; or whether the value was reasonable. In argument, there was no reference to subsection 230(1) of the Income Tax Act or to the cases following Ken Steeves Sales Ltd v. M.N.R., [1955] C.T.C. 47; 55 D.T.C. 1044. Without the benefit of hearing counsel on these questions, I conclude on the evidence that the appellant's books and records were not adequate; and that the respondent was justified in resorting to some other method of income measurement. This conclusion raises the second issue as to whether the net worth statement is accurate.

If the appellant had kept no books or records and if he had filed no income tax returns, the respondent may have had to rely on a net worth statement as the most practical method of measuring income. I am impressed, however, by the fact that Mr. Gregoire—the Revenue Canada employee who went out to do the field audit—did not use a "net worth” method but identified certain expenses as “personal” or "unvouchered" and, in his 1983 reassessments, increased the appellant's income by the total of such expenses. The 1985 reassessments which were based on Mr. King’s net worth statement had the effect of nullifying Mr. Gregoire's 1983 reassessments (Abrahams (No. 1) v. M.N.R., [1966] C.T.C. 690; 66 D.T.C. 5451); but the appellant entered the 1983 notices of reassessment in evidence (Exhibit A-7) and they were explained by Mr. Gregoire.

In the unusual circumstances of this case, there are before the Court both the 1985 reassessments which are under appeal and the 1983 reassessments (Exhibit A-7) which were the result of Mr. Gregoire's original field audit but were nullified by the 1985 reassessments. Although I accept Mr. King's evidence that the net worth statement was conservative and that any doubtful amount was resolved in the appellant's favour, I am not certain that there was adequate matching of assets and liabilities as at December 31,1977 with respect to certain cattle which were purchased with a bank loan of approximately $38,000. I will therefore respond to the second issue by using both the 1983 and 1985 methods of reassessment.

For 1981, the 1985 reassessment added approximately $9,000 to the income reported by the appellant in his amended return for 1981. That amount of $9,000 may be regarded as representing the unjustified deductions of $7,971 for house repairs and $1,198.30 for the fireplace. I would not change the appellant's 1981 income as computed in the 1985 reassessment.

For 1978, the appellant's income ($36,580) as computed in the 1985 reassessment was less than his income ($41,488) as reported in his 1978 return. Having regard to the evidence which was adduced at the hearing, I am of the view that the appellant's income should not be assessed for tax in any year at an amount which is less than what he reported. The 1985 reassessment gave a benefit to the appellant for 1978 which I think was not deserved. If I were permitted to do so at law, I would order the respondent to assess tax for 1978 on the appellant's income as reported in his return and not on the lower amount of income as computed in the 1985 reassessment which is under appeal. Because I am not permitted to issue such an order, I would not change the appellant's 1978 income as computed in the 1985 reassessment.

For 1979, the original 1983 reassessment had added to the appellant's reported income the amount of $35,784 representing deductions which were identified as "personal" or "unvouchered". The 1985 reassessment reduced the revised income by $23,468 leaving the appellant with income which, for tax purposes, was $12,316 greater than the amount of income which he reported. Having regard to Mr. Gregoire's statement under cross-examination that the appellant had deducted certain amounts as business expenses for which there were no vouchers, and having regard to other amounts which were deducted and then shown to be personal outlays, I have concluded that the appellant's 1979 income as computed in the 1985 reassessment should not be disturbed.

For 1980, the 1983 reassessment had added to the appellant's reported income the amount of $4,498 as personal or unvouchered expenses. The 1985 reassessment added a further amount of $22,138 based on an increase in net worth. Notwithstanding the inadequacy of the appellant's books and records, I was generally impressed with his honesty. Therefore, on a somewhat arbitrary basis, and in the absence of any precise evidence from the appellant, I shall assume that the appellant, if he had unlimited time to review his box of documents for 1980, would be able to show that one-half of the 1983 amount ($4,498) was deductible and that one-half of the 1985 net worth amount ($22,138) should be taken out of income. Acting on this assumption in the appellant's favour, I have concluded that his income of $32,303 for 1980 as computed in the 1985 reassessment should be reduced by the amount of $13,318 (being the total of $2,249 plus $11,069).

The third issue is whether the penalties are justified. For 1978, no penalty was assessed probably because the amount of income computed in the 1985 reassessment under appeal is lower than the income reported by the appellant in his 1978 income tax return. For 1981, a federal penalty of $434.21 was assessed under subsection 163(2) of the Income Tax Act. I would, without doubt, sustain this penalty because the amounts of $7,971 and $1,198.30 referred to above should not have been deducted by the appellant in computing his income for 1981. Assuming that the appellant's attempt to deduct such amounts was innocent and not mischievous, then he was grossly negligent in maintaining the kind of books and records which could permit him to mistake such amounts for business costs when they were clearly personal expenses. With respect to 1979 and 1980, no specific items were proved in connection with amounts which the respondent added to the appellant's reported income for those years. As noted in the preceding paragraph, I formed the impression from observing the appellant in Court that he is an honest person. I shall therefore give him the benefit of any doubt and cancel the penalties for 1979 and 1980.

In summary, the appeals for 1978 and 1981 are dismissed. The appeals for 1979 and 1980 are allowed in part and the reassessments are referred back to the respondent for reconsideration and reassessment on the basis that (i) penalties assessed under subsection 163(2) of the Act for 1979 and 1980 should be cancelled; and (ii) the appellant's income for 1980 as computed in the 1985 reassessment should be reduced by the amount of $13,318.

The appellant's counsel made a special submission concerning costs. It should be noted that the appellant filed his own one-page notice of appeal which did not disclose any facts which were of assistance in deciding this matter. Also, the respondent's counsel was not informed until four days before the hearing that the appellant would make his primary claim as to the adequacy of his books and records. In these circumstances, the appellant shall be allowed the absolute minimum amount of costs which may be awarded for the partial success he achieved in the 1979 and 1980 taxation years.

Appeal allowed in part.