Roger Kosowan v. Minister of National Revenue, [1990] 2 CTC 2580, 91 DTC 32

Mogan, T.CJ.:— When the appellant applied to the Court for a hearing date, the respondent had not filed a reply to notice of appeal. The respondent therefore brought a motion under the Rules of Practice and Procedure asking leave to file a reply to notice of appeal. The appellant contested the respondent's motion and, in turn, brought a motion under Rule 8 for judgment allowing the appeal. On November 9, 1988, this Court ([1989] 1 C.T.C. 2044; 89 D.T.C. 58) dismissed the respondent's motion and also dismissed the appellant's motion but directed that, upon the hearing of the appeal herein (pages 2047-48 (D.T.C. 60)):

. . . the allegations of fact contained in the notice of appeal are to be presumed to be true for the purposes of the appeal and that the respondent will be required to assume the onus of rebutting those facts and of establishing the assumptions of fact upon which the assessment was made.

As a result of the above pre-trial proceedings, the appeal herein was heard with only one pleading (the notice of appeal); the appellant did not call any evidence; and the respondent assumed the onus of rebutting certain facts in the notice of appeal and of proving the assessment and the reasons for assessing. The basic issue in this appeal is whether the appellant, as director of a corporation, is required to pay an amount 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"). When the hearing commenced, counsel listed certain dates on which they agreed that specific events occurred.

At all relevant times, the appellant and one Ron DeLuca were the only directors of Metropolitan Graphics Ltd. (“Metropolitan”), an Alberta corporation which commenced carrying on business in 1980. After September 1981, the issued shares of Metropolitan were held as to 50 per cent by a corporation controlled by the appellant and as to the remaining 50 per cent by a corporation controlled by Ron DeLuca. In October 1980, when 80 per cent of the issued shares of Metropolitan were held by Deluca's corporation, Metropolitan delivered a guarantee to the Toronto Dominion Bank with respect to the debt of DeLuca's corporation up to the amount of $100,000. About the same time, Metropolitan purchased certain assets from Allarco Developments Ltd. ("Allarco") and issued a debenture to Allarco to secure the unpaid portion of the purchase price.

On June 10, 1982, the Toronto Dominion Bank (the "bank") demanded that Metropolitan repay all of its indebtedness to the bank. In the weeks prior to June 10, 1982, Metropolitan was unable to collect amounts owing by some of its customers because the bank had asked such customers to remit any amounts owing directly to the bank. Also in 1982, the bank called on Metropolitan to honour its guarantee with respect to the indebtedness of DeLuca's corporation.

During the spring of 1982, the appellant was heavily involved in attempting to arrange additional financial assistance for Metropolitan and had received a positive response from one private investor who was prepared to inject capital into Metropolitan. Information concerning the private investor was disclosed to the bank but, in fact, the appellant was not successful in his attempts to arrange additional financial assistance. On August 5, 1982, Allarco relied on the terms of its debenture referred to above and appointed Peat Marwick Mitchell as receiver of Metropolitan.

Certain representatives of the bank had indicated to the appellant that the accounts of Metropolitan had been frozen and that Metropolitan would not be able to make any payments from those accounts. Notwithstanding those representations, the bank did allow Metropolitan to cover two or three payroll obligations (apparently paying only employees' net take-home pay and not source deductions like income tax, U.I. and C.P.P.) in June and July 1982 so that the Metropolitan employees would finish the work to progress. Apart from covering those few payroll obligations, neither Metropolitan nor the appellant had access to or freedom to deal with any of Metropolitan's funds which were held by the bank in June and July 1982, thus making it impossible for Metropolitan to remit to Revenue Canada, Taxation the employees' source deductions.

Almost all of the above facts are alleged in the notice of appeal and, according to the pre-trial proceedings described above, such facts are presumed to be true subject to being rebutted by the respondent. Although the respondent did assume the onus of proof and did lead evidence at the hearing, the above facts were not rebutted. There is, however, one fact alleged in the notice of appeal which was contradicted by the respondent's evidence. Paragraph 5 of the notice of appeal contains the following sentence: “Up until the time that the bank took control of Metropolitan's funds, Metropolitan had made all source deduction payments as required.”

The only witness called by the respondent was Mr. J.R. Down, a payroll auditor employed by Revenue Canada, Taxation. Mr. Down was a unit head who had supervised the work of Mr. J. Burko, the payroll auditor who had gone to the premises of Metropolitan on or about September 17, 1982 to perform a field audit of Metropolitan's payroll records. Mr. Down identified as Exhibit R-1 a photocopy of Mr. Burko's “Payroll Audit Report". Mr. Burko had recorded in Exhibit R-1 a summary of Metropolitan's source deductions for the period January to July 1982 and a total of the amounts remitted. He then computed the shortfall ($39,085.31) in the amounts remitted and added the penalty and interest to the date of his audit. A summary of Mr. Burko's computations in Exhibit R-1 is set out in Schedule A to these reasons for judgment.

Exhibit R-1 shows that for the months January, February and March 1982, there was no significant discrepancy in the source deductions and the amounts remitted. The significant shortfall in amounts remitted began in April when source deductions exceeded amounts remitted by $7,991.64. And for May, June and July, the respective source deductions of $14,749.80, $11,151.77 and $5,833.11 were not remitted at all.

On September 28, 1982 a notice of assessment was sent to “Metropolitan Graphics Ltd. in Receivership, c/o Peat Marwick" requiring payment of the relevant amounts totalling $44,334.84 with the notation: "You are hereby assessed the amounts indicated for failure to remit as required". Mr. Down also identified as Exhibit R-2 a three-page document which he described as a working form PD26F being a printout of Metropolitan's employer payroll account with Revenue Canada, Taxation showing a remittance shortfall of $39,085.31 to September 27, 1982. Counsel are in agreement that the Receiver paid some amount in partial satisfaction of the assessment on June 27, 1984. With the consent of appellant's counsel, respondent's counsel tendered three further exhibits:

It is acknowledged in the notice of appeal that the appellant and Ron DeLuca were directors of Metropolitan. The respondent has proved that Metropolitan failed to remit certain source deductions for the months of April, May, June and July 1982. Therefore, the basic facts are established for the potential liability of the appellant as a director of Metropolitan under subsection 227.1(1) of the Act. In Exhibit R-3, there is a reference to “a certain sum or sums that were certified to be payable by Metropolitan Graphics Ltd. in favour of Her Majesty in a Certificate registered in the above-named Court . . .”. And Exhibit R-4 is the execution returned nulla bona. Therefore, the conditions in paragraph 227.1(2)(a) of the Act have been satisfied. The real issue is whether the appellant has satisfied the so-called "due diligence” test in subsection 227.1(3) of the Act:

227.1(1) Where a corporation has failed to deduct or withhold an amount as required by subsection 135(3) or section 153 or 215 or has failed to remit such an amount, the directors of the corporation at the time the corporation was required to deduct or withhold the amount, or remit the amount, are jointly and severally liable, together with the corporation, to pay any amount that the corporation is liable to pay under this Act in respect of that amount, including any interest or penalties related thereto.

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.

With respect to subsection 227.1(3), paragraph 11 of the notice of appeal states:

11. It is the appellant's position that he exercised the degree of care, diligence and skill to prevent a failure that a reasonably prudent person would have exercised in comparable circumstances by using all of his efforts to keep Metropolitan operating in order that the bank’s demands could be met. He further exercised and fulfilled that duty by ensuring that source deductions were paid while he was in a position of control over Metropolitan's funds and in a position to ensure that such deductions were made. Such actions are consistent with s. 227.1(3) of the Income Tax Act.

Whether the appellant exercised the degree of care, diligence and skill described in subsection 227.1(3) is a conclusion of law to be decided in this appeal and it is not an allegation of fact which is presumed to be true in accordance with the pre-trial order of this Court. The main thrust of paragraph 11 is that the appellant fulfilled his obligation as a director (i) by using all his efforts to keep Metropolitan operating in order that the bank's demands could be met; and (ii) by ensuring that source deductions were paid while he was in a position of control over Metropolitan's funds. I propose to consider these allegations separately.

The first allegation was not rebutted. Therefore, I accept as a fact that the appellant used all his efforts to keep Metropolitan operating so that the bank's demands could be met. Why should those efforts fulfil the appellant's obligations under subsection 227.1(3)? Is the bank a more important creditor than Revenue Canada? When the source deductions are deemed to be held in trust under subsection 227(4), how can the bank’s demands be on a higher plane than the demands of Revenue Canada? If the bank controlled Metropolitan's line of credit, and if the bank agreed to honour the net take-home pay cheques of employees but refused to honour the cheque to Revenue Canada for source deductions, and if the bank held an assignment of Metropolitan's receivables, has the bank not co-operated with Metropolitan and its directors to obtain a reduction of the bank's loans to the detriment of Revenue Canada?

I reject the appellant's claim that his efforts to keep Metropolitan operating so that the bank's demands could be met fulfilled any of his obligations under subsection 227.1(3). The important words in subsection 227.1(3) are: "where he exercised the degree of care, diligence and skill to prevent the failure. . .”.

Those words refer to the corporation's failure to withhold or remit source deductions. The appellant's efforts to have the bank’s demands met did not in any way prevent the failure of Metropolitan to remit its source deductions.

The second allegation that the appellant ensured that source deductions were made while he was in a position of control over Metropolitan's funds raises the question as to whether the appellant, at some relevant time, ceased to control Metropolitan’s funds. In my view, this second allegation has been rebutted by the combined facts (i) that there were unremitted source deductions in April, May, June and July 1982; and (ii) that the bank did not demand payment of all Metropolitan's debts until June 10, 1982. I infer that the appellant and Ron DeLuca, as directors, were in control of Metropolitan's business affairs prior to June 10, 1982.

Once the respondent accepted the onus and proved Metropolitan's failure to remit substantial amounts of source deductions, the appellant's decision not to lead any evidence in this case leaves too many questions unanswered. For example, what role did the appellant play in the management of Metropolitan and what knowledge did he have of the company's financial difficulties in the spring of 1982? Relying on the appellant's unrebutted allegation that he was "heavily involved in attempting to arrange additional financial assistance for Metropolitan” during the spring of 1982, I conclude that he participated in management and was aware of the financial problems. There was no evidence concerning the business carried on by Metropolitan and whether the company was adequately capitalized. A corporation which is undercapitalized with respect to its business will, in difficult times, more likely turn to unremitted source deductions as a means of short-term financing. It may be more difficult for the director of an undercapitalized corporation to satisfy the due diligence test in subsection 227.1(3).

The appellant apparently concluded that his case was established by the allegations of fact in his notice of appeal and he relied on the decisions of this Court in Fancy v. M.N.R., [1988] 2 C.T.C. 2256; 88 D.T.C. 1641, Cybulski v. M.N.R., [1988] 2 C.T.C. 2180; 88 D.T.C. 1531, and Edmondson v. M.N.R., [1988] 2 C.T.C. 2185; 88 D.T.C. 1542. The facts in the Edmondson case are easily distinguished from this appeal. Mr. Edmondson had no previous business experience when he invested $30,000 in a corporation identified as UCR. When he learned that UCR had failed to remit certain amounts to Revenue Canada, he invested a further $40,000 to pay all unremitted source deductions; he insisted that his daughter (an experienced bookkeeper) work for UCR; and he insisted that he co-sign all UCR cheques. Later, it was learned that certain cheques to Revenue Canada which he had co-signed were held back by the manager of UCR. Mr. Edmondson's appeal was allowed because this Court held that he did what was reasonably prudent when he insisted on being a cosigner of all cheques and in having his daughter hired as bookkeeper, and that he was deceived by the manager who did not forward the signed cheques to Revenue Canada.

In this appeal, we do not know what discussions took place between the appellant and the other director, Ron DeLuca, in April, May and June 1982 when Metropolitan was falling behind in its source deductions. Specifically, we do not know whether the appellant took any steps to ensure that the source deductions would be remitted and whether he was misled in any way by his fellow director. The decision in Edmondson v. M.N.R., supra, does not assist the appellant.

In Fancy v. M.N.R., supra, Mr. Fancy had only a grade 8 education and he worked on construction jobs until 1961 when he started his own excavation business. He incorporated his business in 1970 and accumulated retained earnings of $706,000 by October 1981. This Court allowed the appeals of Mr. and Mrs. Fancy under section 227.1 of the Act mainly because their company had assigned its receivables to the bank, a situation which restrained their control over the company's cash. The Court also found that Mr. and Mrs. Fancy had lived frugally on modest salaries without additional benefits and that they had not diverted any company funds to their own benefit. In this appeal, there is no evidence concerning the appellant's business experience or the extent of his formal education. Also, there is no evidence as to whether the appellant was a Salaried employee of Metropolitan and whether he received any compensation, frugal or generous.

The only proven date for bank intervention is June 10, 1982 when the bank demanded repayment of all Metropolitan's debts. Both before and after June 10, 1982, on each payroll date Metropolitan must have provided the bank with a list of employees and the respective amounts of their net take-home pay if the bank was monitoring all cheques. There is no evidence that cheques to Revenue Canada for the source deductions were prepared even for discussion purposes with the bank.

This case is unusual because the respondent was not permitted to file a reply or statement of defence to the notice of appeal and the case proceeded with only one pleading. The appellant did not lead any evidence but relied on those statements in his notice of appeal which were not rebutted. There is some uncertainty as to whether the directors of Metropolitan were in effective control of the corporation after June 10, 1982, when the bank demanded repayment of all loans and also demanded that Metropolitan honour its $100,000 guarantee for the debts of another corporation. With reluctance, I am prepared to apply the decision in Fancy v. M.N.R., supra, and hold that the bank was in effective control of Metropolitan's funds after June 10, 1982. I would, however, repeat the caution of Chief Judge Couture in Fancy v. M.N.R., supra, when he stated at page 2260 (D.T.C. 1644) that a director would not automatically escape the application of subsection 227.1(1) when his corporation assigns its receivables to a third party.

The above finding requires an allocation of the appellant's liability for unremitted source deductions before and after June 10, 1982. The relevant amounts are as follows:

Assuming that the bank was in effective control of Metropolitan after June 10, 1982, I would hold the appellant responsible for all amounts not remitted prior to June 1 plus one-third of the amounts not remitted for the month of June. The total of amounts not remitted are therefore allocated as follows:

If the above allocations were final, the appellant would be liable for 66 per cent of the unremitted source deductions. At the hearing, however, counsel were in agreement that the receiver paid some amount in June 1984 in partial satisfaction of the unremitted source deductions. Assuming that any payment made by the receiver would be applied to the oldest amounts not remitted, the appellant's pro rata liability for amounts not remitted will be reduced from 66 per cent to some lower percentage determined by subtracting the amount paid by the receiver from $25,817.69 and from the total not remitted.

The appellant has made two further claims. He claims that he ceased, de facto, to be a director of Metropolitan after the receiver was appointed on August 5, 1982. This claim is not relevant because I have concluded that the appellant is liable under section 227.1 only for those source deductions withheld prior to June 11, 1982 and not subsequently remitted.

And secondly, the appellant claims that the assessment under appeal dated July 11, 1986 (four years after Metropolitan's failure to remit) constitutes a deprivation of his right to life, liberty and security of the person not in accordance with the principles of fundamental justice, contrary to section 7 of the Canadian Charter of Rights and Freedoms. Specifically, the appellant complains about the respondent's four-year delay in issuing the assessment. There is no evidence that the appellant was prejudiced by the four-year delay. Indeed, there is evidence that the appellant benefitted from the delay because it gave the receiver an opportunity to recover some funds and make a payment in 1984 with respect to the unremitted source deductions. The amount assessed against the appellant in 1986 is less than the amount assessed against Metropolitan on September 28, 1982. The appellant has not suffered any kind of deprivation referred to in section 7 of the Charter.

The appeal is allowed in part without costs in accordance with the above reasons.

Appeal allowed in part. To Corporation