Oren Reynolds v. Minister of National Revenue, [1989] 2 CTC 2242, 89 DTC 484

Tremblay, T.C.J.:—This appeal was heard on August 26, 1987 and March 1, 1988 in Sherbrooke, Quebec. The Court reserved its decision on the appeal on November 7, 1988 when it received the last written pleadings.

1. Point at Issue

The question is whether the appellant, a farmer who owns 269 acres of land at Clarenceville, Quebec, correctly did not include the sums of $61,048, $28,920, $36,274 and $41,565 respectively in computing his income for the 1979, 1980, 1981 and 1982 taxation years.

In the respondent's submission the foregoing amounts are additional income not reported by the appellant and established by a capital difference.

Essentially the appellant argued, inter alia, that by computing the capital difference the respondent failed to take into account assets he owned at the start of the period. Interest of $4,492 in 1979, $2,837 in 1980, $10,183 in 1981 and $15,474 in 1982 were wrongly added to his income when they were actually his wife’s income. Penalties amounting to $6,000 were also imposed for gross negligence, spread over the four years at issue.

2. Burden of Proof

2.01 The appellant has the burden of showing that the respondent's assessments are incorrect. This burden of proof results from several judicial decisions, including a judgment of the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486; [1948] C.T.C. 195; 3 D.T.C. 1182.

2.02 In the same judgment the Court held that the facts assumed by the respondent in support of the assessments or reassessments are also assumed to be true until the contrary is shown. In the instant case, the facts assumed by the respondent are described in paragraphs 4(a) to (u) of the respondent's reply to the notice of appeal. This paragraph reads as follows:

[TRANSLATION]

4. In reassessing the appellant for his 1979-1982 taxation years, the Minister of National Revenue relied inter alia on the following facts:

(a) the appellant has been a self-employed farmer since 1940 and owns 269 acres of land at Clarenceville;

(b) the appellant had a herd of dairy cows until 1979 and subsequently went into the raising and sale of beef cattle;

(c) the appellant has always accounted for his farming income on a cash basis;

(d) in 1979 the appellant sold his herd of 46 dairy cows for a total of $48,000, $39,900 of which was paid by Mr. Maurice Audet of St-lgnace and $8,100 was produced by an auction sale at St-Hyacinthe;

(e) in submitting his 1979 tax return, the appellant added a net amount of $23,000 (from the sale mentioned in subparagraph (d)) to his gross farming income while the other part, namely $25,000, was excluded as a basic herd at December 31,1971 ;

(f) the entire amount of the $48,000 transaction mentioned in subparagraph (d) is taxable, since it is business income earned in 1979; the appellant had no basic herd at December 31, 1979 as he made no “election” in this respect as required in the prescribed form T-2019, which the appellant never submitted at the proper time;

(g) during his 1979 taxation year, the appellant sold a milk quota acquired without charge before December 31, 1971 for the sum of $53,215, sold at auction at St-Hyacinthe;

(h) in submitting his 1979 tax return, the appellant added a net amount of $10,643.15 (from the sale mentioned in subparagraph (g)) to his gross farming income computed by the following method:

Proceeds of disposition X prescribed rate: 2

$53,215 X 40% = $21,286.31 X 50% $10,643.15;

(i) the sum of $16,108 (from the sale mentioned in subparagraph (g)) is taxable as business income from the disposal of a government right; the said amount represents 50% of deemed proceeds of disposition, and these deemed proceeds are the lesser of 75% of the selling price ($53,215 X 75% = $39,912) or the difference between the selling price and the fair market value of the milk quota at December 31, 1971 ($53,215—fair market value, or $21,000 = $32,216); the deemed proceeds of disposition are thus $32,216 and half of this, or $16,108, is taxable in 1979;

(j) additionally, from December 31, 1978 to December 31, 1982 the appellant's capital increased from $185,742 to $436,760, as appears more fully in a balance sheet attached hereto to form an integral part hereof, as if stated at length;

(k) besides the additional taxable business income mentioned in subparagraphs (f) and (i) and the additional interest income mentioned in subparagraph (u), the appellant failed to report additional taxable income received during the years on appeal, namely:

1979	$26,091
1980	$26,091
1981	$26,091
1982	$26,091

as appears from a capital reconciliation and computation of additional unreported income attached hereto to form an integral part hereof, as if stated at length;

(l) although the appellant kept records of his farm income and expenditure, consistent with the reported farm income and expenditure claimed with supporting documentation, these accounting records cannot reflect the appellant's real taxable income;

(m) the net worth method cannot be avoided as even taking into account the farm income reported by the appellant, interest income reported and reinvested and the non-taxable portion of the appellant’s earnings, all these items added together do not account for the spectacular increase in the appellant's net worth;

(n) as the appellant uses the cash accounting method, goods in inventory cannot be included in starting capital at their fair market value;

(o) throughout his farming career, the appellant has always operated his farm alone and never formed a corporation with his wife to distribute the farm income and expenditure; at most the appellant was assisted and supported by his wife as an ordinary incident of their matrimonial union;

(p) the appellant's wife received no wages from outside work, but at various times did receive small legacies, $5,000 in 1966, $1,412.78 in 1967 and $2,388.18 in 1975;

(q) the appellant’s wife gave him the amounts mentioned in subparagraph (p) to assist him, but there was no agreement, the money was not kept in a separate account and she did not become her husband's "business" partner;

(r) in about 1977 or 1978, the appellant transferred the said amount of $8,800 to his wife, which she invested in his name; this amount, plus the interest income earned in subsequent years, namely $880 in 1979, $968 in 1980, $1,597 in 1981 and $1,469 in 1982, belong to the appellant’s wife in her own right;

(s) during the years on appeal, the appellant from time to time took the opportunity of transferring substantial amounts of his capital to his wife, which had the effect of dividing the appellant's interest income;

(t) during the years on appeal, the capital the appellant transferred to his wife (in addition to the wife's own money mentioned in subparagraph (r)) generated interest income of $4,492 in 1979, $2,837 in 1980, $10,183 in 1981 and $15,474 in 1982, which form the appellant's taxable income and is duly added to the appellant's other income;

(u) in computing his income for each of the taxation years at issue, the appellant knowingly or under circumstances amounting to gross negligence omitted to report substantial amounts of income subject to taxation, in particular income of $26,091 for each of the years 1979 to 1982 computed by the net worth method, and the penalty provided for in s. 163(2) of the Act is fully justified, especially as the appellant could not help recording that his investments had increased more quickly than his reported income and the part of his non-taxable income resulting from the disposal of property such as the herd and the milk quota in 1979;

However, the burden of proof regarding the penalty imposed under subsection 163(2) of the Income Tax Act ("the Act”) rests with the respondent pursuant to subsection 163(3) of the Act.

3. Facts

3.01 The respondent's position is quite clearly set out in paragraph 2.02 above. The income and the penalties imposed by the notices of reassessment are described in the table in paragraph 3 of the reply to the notice of appeal as follows:

3.02 Points at issue

As appears from the foregoing summary, the issue may be divided into five points:

(1) the taxable income from the sale of livestock in 1979 (para. 3.03);

(2) the taxable income from the sale of a milk quota in 1979 (para. 3.04);

(3) the additional income of $26,091 calculated by the net worth method for each of the taxation years 1979 to 1982 (para. 3.05);

(4) the additional interest income (paras. 3.06 et seg.);

(5) the penalties under subsection 163(2) of the Income Tax Act (para. 3.07).

3.03 Taxable income from sale of livestock in 1979

3.03.1 The respondent's position is set out in the facts assumed in paragraphs 4(d), (e) and (f) of the reply to the notice of appeal, supra, at para. 2.02.

3.03.2 The crucial point is not the selling price of $48,000, which is admitted. It is instead the question of whether any value should be regarded as a basic value at December 31,1971 for a number of animals equal to those sold in 1979, namely 46. In other words, did the appellant own a basic herd within the meaning of the Act at December 31,1971?

Mr. Gustave Séguin, the appellant's accountant since 1979, testified that in 1971 his client owned a basic herd of 50 Holstein cows, which are first-class cows. Mr. Séguin assigned them a value of $500 each, making a total of $25,000 (trans., pp. 62-63).

3.03.3 As regards form T-2019, which the respondent argued required the appellant to make an election of a basic herd when he filed his 1971 return, Mr. Séguin maintained first that the said form was never filed by the appellant with his 1971 tax return. Further, in his opinion it was not necessary to file it with his 1971 tax return: [TRANSLATION] ”. . there is still time, when we made our application the Minister did not say when it would end. Provided this basic herd existed before 1971, since it meets all the conditions required to establish capital, namely that the animals were paid for with cash which was not included in expenditure as an ordinary cattle raising operation, or which he inherited from his parents or some such thing" (trans. of August 26, 1987, p. 41).

According to Mr. Séguin, he went to the Department of National Revenue several times to file the said form on the appellant’s behalf, but the employee responsible for his case was not there (trans, of August 26, 1987, p. 41). Since the witness knew the appellant and began work as his accountant in 1979, his visits to the respondent's office must have taken place in 1979 or 1980, and perhaps later.

He also maintained that he had filed T-2019 forms with the Department of National Revenue for clients many times after April 1972, and that they had always been accepted if [TRANSLATION] "we showed that our basic herd existed at the time" (trans., p. 21).

To confirm his statements he filed as Exhibit A-6 a T7W-C form (a form sent by the respondent with the assessment) for one of his deceased clients whose estate problems he was working on. The taxation year on this form is 1982 and it contains the following details:

[TRANSLATION]

The witness further stated that his client had a community of property and was entitled to 50 per cent. This undoubtedly explains the fact that "50%" was handwritten on the said form. In his submission the basic herd was $29,800 ($14,900 X 2) (trans. of March 1, 1988, p. 26).

The following appears at the bottom of the said T7W-C form:

The foregoing corrections are the result of our audit of the documents and supporting evidence submitted to us and discussions which we had with your representative(s).

It is hard to say what corrections are meant. The form indicates a total original income of $19,774. To this is added after computation a taxable capital gain of $3,075, and $1,900 is then deducted to arrive at a total revised income of $20,949. The sum of $9,990 was deducted in calculating the taxable income, making this $10,959.

In cross-examination (trans, of August 26, 1987, pp. 69-76), Mr. Séguin argued that this evidence need only be presented by the filing of the tax return for the year of the sale. In his submission, the basic herd is an acquired right and the policy of the Department of National Revenue is to recognize this acquired right at any time (trans. of March 1, 1988, pp. 27-28).

3.03.4 This entire matter is covered by paragraph 29(3)(a) of the Income Tax Act, where “basic herd" is defined as follows:

29. (3) For the purposes of this section,

(a) a taxpayer's “basic herd" of any class of animals at a particular time means such number of the animals of that class that the taxpayer had on hand at the end of his 1971 taxation year as were, for the purpose of assessing his tax under this Part for that year, accepted by the Minister, as a consequence of an application made by the taxpayer, to be capital properties and not to be stock- in-trade, minus the numbers, if any, required by virtue of this section to be deducted in computing his basic herd of that class at the end of taxation years of the taxpayer ending before the particular time. . . .

[Emphasis added.]

I think it is clear that for the Minister to have been able to accept the basic herd which a taxpayer had in his possession at December 31, 1971, that taxpayer must have declared the said herd when he filed his 1971 tax return, that is by April 30,1972 at the latest, unless the taxpayer's fiscal year ended on some date other than December 31, 1971. The wording emphasized in subsection 29(3) above seems clear to me: “for the purpose of assessing his tax . . . for that year", that is, the 1971 taxation year.

In Roy v. M.N.R., [1979] C.T.C. 2545; 79 D.T.C. 204, at 205, the undersigned has already rendered a decision in a similar case. After citing subsection 29(3), I made the following comments which apply in substance to the appeal at bar:

It accordingly appears from this definition that, for animals making up the basic herd to be “capital properties and not. . . stock-in-trade", the taxpayer must make an application.

Without such an application, there is no “basic herd” and any animal sold will be regarded as stock-in-trade. It is up to each farmer to decide whether to establish a basic herd. There are advantages (capital gain on sale) and disadvantages (purchase cost may not be deducted). He must make a choice. The legislator leaves him free. If he makes no choice, all his animals will be regarded as stock-in- trade, also with advantages (deduction of the purchase price) and disadvantages (taxation of the selling price).

The evidence showed that the appellant made no election of basic herd (para. 3.09 of the facts). All his animals must therefore be regarded as stock-in-trade. The appellant lacked diligence or good advice. The Board, which has to interpret the Act as written, can come to no other conclusion than that the price for the sale of the appellant's cattle must be included in his income.

Finally, I must apply in the appeal at bar the theory of estoppel by representation as applied in Syrico v. M.N.R., [1988] 1 C.T.C. 2026; 88 D.T.C. 1001 at 1012, and I quote:

Moreover, since 1972, the appellant, in the computation of its income, deducted all the purchase prices of livestock including those used for the renewal of the basic herd. Then it did not treat them as capital asset [sic] and this was accepted by the respondent. Applying the theory of Estoppel by representation, the appellant cannot now contend that the basic herd be taxed as a capital property.

3.03.5 Conclusion on first point at issue

On this point regarding the taxable income of $48,000 from the sale of livestock in 1979, therefore, the reassessment must be upheld and the appeal dismissed.

3.04 Taxable income from sale of milk quota in 1979

3.04.1 The respondent's position regarding the milk quota is set out in paragraphs 4(g), (h) and (i) of the reply to the notice of appeal, cited above in para. 2.02.

3.04.2 The precise point at issue is whether the taxable amount is $10,643.15 as maintained by the appellant or $16,108 as the respondent contends. The amount for which the milk quota was sold in 1979 is admitted by both parties to be $53,215.

3.04.3 The basic fact on which the two parties are divided is that the milk quota, according to the appellant's accountant, is an intangible asset in the nature of goodwill. If so, computation of the taxable income if the quota is sold is covered in paragraph 21(1)(a) of the Income Tax Application Rules, 1971, hereinafter referred to as "the I.T.A.R.".

The respondent argued that this is a government right, and that being the case the taxable income resulting from sale of the quota must be computed in accordance with paragraph 21(1)(b). Paragraphs 21(1)(a) and (b) read as follows:

21. (1) Where as a result of a transaction occurring after 1971 an amount (in this section referred to as the “actual amount") has become payable to a taxpayer in respect of a business carried on by him throughout the period commencing January 1, 1972 and ending immediately after the transaction occurred, for the purposes of section 14 of the amended Act the amount that has become so payable to him shall be deemed to be the aggregate of

(a) an amount equal to a percentage, equal to 40% plus the percentage (not exceeding 60%) obtained when 5% is multiplied by the number of full calendar years ending in the period and before the transaction occurred, of the amount, if any, by which the actual amount exceeds the portion thereof referred to in subparagraph (b)(i), and

an amount equal to the lesser of

(i) the percentage, described in paragraph (a), of such portion, if any, of the actual amount as may reasonably be considered as being the consideration received by him for the disposition of, or for allowing the expiry of, a government right, and

(ii) the amount, if any, by which the portion described in subparagraph (i) exceeds the greater of

(A) the aggregate of all amounts each of which is an outlay or expenditure, made or incurred by the taxpayer as a result of a transaction occurring before 1972 for the purpose of acquiring the government right, or the taxpayer's original right in respect of the government right, to the extent that the outlay or expenditure was not otherwise deducted in computing the income of the taxpayer for any taxation year and would, if made or incurred by him as a result of a transaction occurring after 1971, be an eligible capital expenditure of the taxpayer, and

(B) the fair market value to the taxpayer as at December 31, 1971 of the taxpayer's specified right in respect of the government right, if no outlay or expenditure was made or incurred by the taxpayer for the purpose of acquiring the right or, if an outlay or expenditure was made or incurred, if that outlay or expenditure would have been an eligible capital expenditure of the taxpayer if it had been made or incurred as a result of a a transaction occurring after 1971.

3.04.4 Under paragraph 21(3)(a) I.T.A.R., a government right is defined as follows:

21. (3) In this section,

(a) a "government right" of a taxpayer means a right or licence

(i) that enables the taxpayer to carry on a business activity in accordance with a law of Canada or of a province or Canadian municipality, to an extent to which he would otherwise be unable to carry it on in accordance therewith,

(ii) that was granted or issued by Her Majesty in right of Canada or a province or a Canadian municipality, or by a department, board, agency or any other body authorized by or pursuant to a law of Canada, a province or a Canadian municipality to grant or issue such a right or licence, and

(iii) that was acquired by the taxpayer

(A) as a result of a transaction occurring before 1972, or

(B) at a particular time for the purpose of effecting the continuation, without interruption, of rights that are substantially similar to the rights that the taxpayer had under a government right held by him before the particular time;

The respondent based his argument that the milk quota is a government right on the fact that it is covered by the Farm Products Marketing Act, R.S.Q. 1977, c. M-35.

This Act provides that the Régie des marchés agricoles du Québec may approve plans for the marketing of farm products, including dairy products.

When a marketing plan is approved, the association sponsoring the plan (for example, the Agricultural Producers’ Union) becomes the producers' board, that is, the body responsible for carrying out and implementing the joint plan (section 33 of the Act).

This body has a number of powers mentioned in section 67 of the Act, including that specified in paragraph 67(c), which reads as follows:

(c) fix production . . . quotas . . .

It therefore seems clear that the milk quota must be regarded as a government right.

According to the writer D. Keith McNair in Taxation of Farmers and Fishermen (Richard De Boo Publishers), this concept of the government right as calculated applies specifically for the benefit of farmers (chapter 3, p. 3-55) in connection with the milk quotas which existed before 1972. In principle, the calculation mentioned in paragraph 20(1)(b) I.T.A.R. is thus supposed to give the taxpayer a more favourable result than that mentioned in paragraph 20(1)(a) I.T.A.R.

3.04.5 In the submission of the respondent s. 20(1)(a) I.T.A.R. applies in the case at bar as follows:

The appellant also applied this calculation, but made a mistake:

Selling price	$53,215.00
Deemed proceeds of disposition
(first segment of 20% +
another 20%). He used 2 /2%
per year instead of 5%.	x 40%
	$21,286.00
Amount reported:
$21,286 divided by 2	$10,643.00

His mistake resulted from the fact that by using 20 per cent initially and the 2 /z per cent rule he had already made the division by 2 mentioned in section 14. If Mr. Séguin arrived at $21,286 instead of $19,955.62 it is because he admitted that for the last year he applied five per cent instead of two and a half per cent which affected the result.

3.04.6 The calculation made in accordance with paragraph 21 (1)(b) I.T.A.R., which applies when a government right is in question, and which is supposed to be more favourable, is the following, bearing in mind that the taxable amount is the lowest of the three amounts indicated below:

From these calculations, the lowest amount is $16,108.

In applying clause 21(1)(b)(ii)(B), the respondent took the market value of the milk quota at December 31, 1971 as $21,000.

Mr Séguin said that his client, who inherited the farm from his father, paid nothing for the milk quota. He said that [TRANSLATION] “it was worth nothing" on December 31, 1971 (trans. of August 26, 1987, pp. 83-85). The least that can be said is that the appellant cannot charge the respondent with undervaluing the milk quota at December 31, 1971. The lower the value of the milk quota at December 31, 1971, the higher the taxable amount.

If Mr. Séguin is right as to the market value, the taxable amount calculated under clause 21(1)(b)(ii)(B) is also $26,607.50 at December 31, 1971. Accordingly, the taxable amount to be applied should be $19,955.62, that is the lowest of the following three figures: $19,955.62, $26,607.50 and $26,607.50.

3.04.7 Conclusion on second point at issue

As regards the taxable income of $16,108 from the sale of the milk quota, the reassessment should be upheld and the appeal dismissed.

3.05 Additional income of $26,091 calculated by net worth method for each of years 1979 to 1982

3.05.1 The respondent's position is described in the facts presumed in paragraphs 4(a) to (g) of the reply to the notice of appeal, cited above, at para. 2.02.

3.05.2 The appellant filed as Exhibit A-1 the accounting journal of his expenditure and income for 1978 to 1982 inclusive.

According to his accountant Mr. Séguin, [TRANSLATION] "this is so well done, so well entered, on a daily basis, sir, there is no question so far as I am concerned, I do not have the slightest doubt that the income and expenditure is accurate" (trans. of August 26, 1987, p. 88).

Mr. Séguin prepared the appellant's balance sheets at December 31,1978 and 1982 (Exhibit A-2) based on this information from the journal entries (Exhibit A-1). The statements of income and expenditure for the years at issue, 1979, 1980, 1981 and 1982, were filed with the tax returns. Exhibit A-3 was the gross income for these years only.

3.05.3 The opening balance at December 31, 1978, included in Exhibit A-2, reads as follows:

Balance-Sheet as at December 1978

Assets:

Quick Assets :

Cash-Saving Accounts		36,242.00
Checking account		2,500.00
Milk Quota (market value) sold in 1979 Sept. for		53,000.00
Basic Herd (market value) sold Sept. 1979 for		48,000.00
as reported in the income tax report:
as Capital	25,000
as income	23,000
RSP (Epargne retraite) withdrawn in 1979 and reported		5,004.08
Inventory 31/December/78		50,000.00
Hay, grain, corn, corn in silo, oat, Straw, and animals not included
in the basic Herd.
200 tons of hay, 100 tons of oat, 50 tons of straw, over 250 tons of
humid complete corn etc.
Machinery and equipment Cat. 8		7,460.00
Buildings (farm) Cat. 6		8,600.00
Shed for machineries Cat. 6		3,713.00
Farm: lots, buildings, residential house		23,000.00
Total Assets:		237,519.08
Liabilities :
Oren Reynolds' [sic] capital:		237,519.08

Mr. Séguin also gave the respondent a balance sheet for the same date of December 31, 1978 in which the appellant's capital was shown as $207,515 (Exhibit R-2). On this balance sheet R-2, however, the inventory is only $25,000 instead of $50,000 as shown in balance sheet A-2. Further, balance sheet R-2 does not contain the item "retirement savings" of $5,004.08 shown on balance sheet A-2.

3.05.4 The statements of the appellant's gross income for 1979 to 1982 on Exhibit A-3 read as follows:

1979

Declared revenues

Interest T5	6,653.22
T4 RSP	5,004.08
Milk and subsidies (9 /2 mos)	42,979.20
Sale of cows (basic herd)	48 ,000.00
Sale of milk quota	53,000.00
Refunds Govern.	905.12
	156,541.62	declared revenues
		(gross)
1980
Declared revenues
Interests T5	23,044.03
Sales Hay-cattle	18,548.65
Refunds-Government	225.30
	41,817.98	declared gross
		revenues
1961
Declared revenues
Interests T5	26,247.52
Sales Cattle and hay	40,430.75
Refunds-Government	1,902.47
	68,580.74	declared gross
		revenues
1982
Declared revenues
Old age pension	2,842.05
Que. Pension benefits	3,086.04
Interest T5	31,583.53
Rent-farm	7,200.00
Cattle sold	9,229.22
Refunds Govern.	940.93
Farm products sold	560.00
	55,441.77	declared gross
		revenues

3.05.5 The balance sheet at December 31, 1982 included in Exhibit A-2 as well as that of December 31, 1978 reads as follows:

Assets:

Quick Assets :

Cash-Bank of Imperial of Commerce-Bedford P.Q.	74,087.00
(term deposit)
Cash-Bank of Montreal-Bedford (term deposit)	130,000.00
Cash-Checking [sic] accounts—Bank of Montreal (Bedford)
Acc't No. 7027-664	269.18
Acc't No. 5019-556	4,798.80
Caisse Populaire Henryville P.Q.	5,678.63
Inventory-stock cattle (31/12/82)	12,022.58
Equipment and machinery Cat. 10	6,269.00
Buildings Cat. 6	6,269.00
Automobile: Oldsmobile	11,600.00
Shed for machineries	3,713.50
Farm: lots 232 & 204 (142 acres) bought in 1962
including residential house	15,000.00
Lot No. 227 (80 acres bought in 1967)	8,000.00
Summer Cottage near Lake Champlain, bought
in November 82	24,000.00
Total assets:	301,707.69
Liabilities :
Oren Reynolds' Capital:	301,707.69

3.05.6 Mr. Séguin also filed a capital reconciliation from 1978 to 1982 which was part of Exhibit A-2. It reads as follows:

3.05.7 The opening and closing balances prepared by the respondent and filed with the reply to the notice of appeal as part thereof read as follows:

Mr. Oren Reynolds Balance Sheets

December 31 31

Assets	1978	1978	1982	1982
Mr. Oren Reynolds
Bank of Montreal-Bedford #5019-556	—		1,602
Bank of Montreal-Bedford #5012-290	10,782		11,307
Bank of Montreal-Bedford #7027-664	—		1,519
Caisse Pop.-Henryville #2098 EOP	1,103		223
Caisse Pop.-Henryville #2098 ES-1	9,986		5,679
Bank of Commerce-Bedford #90-14667	7,433		4,090
Registered Retirement Savings Plan	5,004		—
Investments
Term Deposit-Bank of Montreal-Bedford	40,000		179,000
Term Deposit-Bank of Commerce-Bedford	15,000		70,000
		89,308		273,420
Mrs. Doris Reynolds
Bank of Commerce-Lacolle #53-39367	2,967		6,483
Royal Bank-St-Jean #53-839	16,975		1,392
Bank of Montreal-Bedford #5017-198	3,719		9,647
Investments
Term deposit-Bank of Commerce-Lacolle	5,000		—
Canada Savings Bonds	—		50,000
		28,661		67,522
Reported		117,969		340,942
Fixed Assets
House residence	$25,000		25,000
Building net	8,600		6,269
Shed net	3,713		3,713
Mach. & equipments net	7,460		5,526
Rolling stock net	—		7,735
Farm-lot 6	23,000		23,000
Summer cottage			24,575
		67,773		95,818
Total assets		$185,742		$436,760
Liabilities		NIL		NIL
Capital		$185,742		$436,760

3.05.6 Mr. Séguin also filed a capital reconciliation from 1978 to 1982 which was part of Exhibit A-2. It reads as follows:

Mr. Oren Reynolds

Capital re-conciliation

from December 31, 1978 to December 31, 1982

Capital as at December 31, 1982	$436,760
Capital as at December 31, 1978	185,742
Increase in capital	251,018
Add: Income tax paid	40,282
Withdrawals	25,000
Business Investment Tax Credit	139
Revenue for the period	316,439

Less: Declared income

Mr. Oren Reynolds	1979	36,200
	1980	19,573
	1981	28,200
	1982	22,629
Mrs. Doris Reynolds	1982	16,943
	1981	11,780
	1980	3,805
	1979	5,372	144,502
Additional income			$171,937

3.05.9 On the additional income of $171,937, the respondent also filed with the notice of appeal a statement in which he takes the sale of the milk quota in 1979 into account as a deduction in calculating the additional net income. It reads as follows:

3.05.10 To explain the breakdown in the various years at issue of the additional net income of $134,829 which is the basis for the notices of reassessment, the respondent filed as an integral part of the reply to the notice of appeal the following statement:

Net additional income $56,556 26,091 26,091 26,091 134,829

3.05.11 To confirm the conclusions of the reconciliation and the additional income (paras. 3.05.8, 3.05.9 and 3.05.10), the respondent filed the following statements for the years at issue:

— balance in Mr. and Mrs. Reynolds' bank accounts at December 31 of each year (Exhibit R-5);

— income reported by the appellant with increases and decreases in bank accounts and investments (Exhibit R-6);

— annual change in the appellant’s term deposits (Exhibit R-7);

— sources and uses of Mr. Reynolds' funds (Exhibit R-8);

— term deposits and bonds purchased by Mrs. Doris Reynolds (Exhibit R-9);

The amount of $1,769 concerning Mrs. Doris Reynolds comes from Exhibit 1-11. In the course of the evidence, as a result of corrections made, the total of the surplus of uses over sources was $2,992.

3.05.13 The evidence clearly established by both the testimony of Mr. Séguin and that of the appellant himself and his wife that during the period 1979 to 1982 the appellant and his wife received no inheritances or gifts.

The appellant and his wife also had no lottery winnings or other earnings of that kind, such as horse race winnings. Following a disposal of property, they did not make a capital gain half of which is not taxable. No transfer of property was made between the appellant and his wife, or vice versa. Finally, they received no exempt income such as damages, etc.

3.05.14 The appellant charged that the respondent did not take into account the $53,000 milk quota, the $48,000 herd of cattle and the $50,000 inventory in the opening balance sheet of December 31, 1978.

In the submission of counsel for the appellant and his accountant, if the respondent had taken this $151,000 of assets into account at the start of the period there would be no additional income. Further, counsel for the appellant added that if a balance sheet at December 31, 1978 had had to be shown to a bank in order to obtain a loan, such assets would certainly have been part of that balance sheet.

I agree with counsel for the appellant on this point. However, the reason is that the purpose of the balance sheet required by a lending institution is not the same as that of the Department of National Revenue when it prepares balance sheets in accordance with the net worth method.

In the first case, the purpose is to determine the value of the loan applicant's property and his debts, so as to guarantee payment of the loan. Naturally, the valuation is the fair market value at the date the balance sheet is prepared. Thus, in the instant case, inter alia, the value of the herd, the value of the milk quota and the value of the property inventory should in my view be included in the balance sheet that would be given to a financial institution. In such a case it does not matter whether the borrower has a cash basis or accrual basis of accounting.

In the case of opening and closing balance sheets prepared by the Department of National Revenue, the purpose is to first establish the capital difference between the dates of the two balance sheets, and then, after certain adjustments up or down (personal expenses, gifts received and so on), to determine whether the difference is equal to the reported income. If the latter is less than the difference, the Department then treats the amount equal to the difference as additional income for which the taxpayer must provide a reasonable explanation.

I am inclined to think that in a case of this kind, that is where the balance sheets are used to determine income, the accounting system used by the taxpayer (cash basis accounting or accrual basis accounting) must be taken into consideration.

In summary, the cash basis of accounting is the one which in calculating the income or loss for a period takes only cash income (revenue) and cash outflow (expenditure) into account.

The accrual basis of accounting includes income from sales made during the period, even though the payment is not collected and deducted as expenditure, and purchases of goods even though they have not been paid for.

3.05.15 In the appellant's submission, the inventory of $50,000 (hay, grain, corn and so on)-(Exhibit A-2, para. 3.05.3) should form part of the opening balance sheet at December 31, 1978.

In a balance sheet, the purpose of the inventories at the beginning and end of the year in question is to calculate the cost of goods sold during the year so as to arrive at gross income. For example:

As can be seen the closing cost of inventory, though used to determine the cost of goods sold during the year, is not directly involved as a deduction in computing the gross or the net income. There is thus a part of the goods bought and paid for which is not deducted in computing income for year A. However, the part which is the closing inventory is used to calculate the cost of goods sold in year B based on the opening inventory of year B.

This means that if all the goods bought during the years were entirely deducted directly in calculating income, there would be no need to use the inventories to calculate the cost of goods sold. Whether there are inventories or not, the latter are not useful in calculating the cost of goods sold. The cost of all the goods bought is deducted directly from income, again because of the accounting system.

In the appellant's case, his inventory (hay, grain, corn and so on) was valued at the fair market value. Ordinarily inventories are always valued at cost. Their main purpose is to calculate the cost of goods sold.

In the instant appeal, the evidence is that the expenses relating to these assets were deducted entirely from income (Exhibit A-1 and financial statements). Accordingly, any sale of any part of the inventory must be entirely included in income and it is not necessary to deduct the cost as this has already been deducted.

The fact that the inventory was entered in the opening balance sheet of December 31, 1978 would indicate that the cost had never been deducted from income. As it had been, this meant that the cost of inventory was deducted twice in computing income. The starting capital would thus be wrongly increased. As it is the difference between the closing and the starting capital which is the basis of calculating additional income, the inventory should not be included in the opening or the closing balance sheet.

Once again, however, inventory can be part of a balance sheet presented to a financial institution to obtain a loan. However, in my opinion inventory of this kind cannot be part of the opening balance sheet used to calculate a capital difference and from that the income for the period, as in the instant case.

3.05.16 In the Canadian Tax Reporter, para. 22,269, dealing with subsection 152(7) and in particular the net worth method, the CCH Canadian Limited publishers make the following observations:

22,269 The most frequently employed method of making arbitrary assessments is called the "net worth" method. This, while applicable to any period, is ordinarily used for periods longer than one year. The net worth is ascertained at the beginning and the end of the period in question. The taxpayer's income for the period is arrived at by adding the increase in net worth to his estimated expenditures which are not deductible and deducting the appreciation in capital assets and non-taxable receipts. /f the taxpayer is on the cash method, any stock on hand and accounts receivable either at the beginning or the end of the period is excluded from the net worth as at that date for purposes of the calculation. See Berry v. M.N.R., (T.A.B.) 50 D.T.C. 190 and Parker v. M.N.R., (T.A.B.) 50 D.T.C. 292. Compare also Garvey Estate v. M.N.R., (T.A.B.) 58 D.T.C. 263, where it was held that the livestock inventory of a deceased farmer who computed his income on a cash basis, should not be included in his net worth statement. [Emphasis added.]

In Berry, supra, Mr. Graham of the Tax Appeal Board made the following comments on the inclusion of unsold products (grain, cattle) in the opening and closing balance sheets of Mr. Berry, a farmer who was reassessed by the net worth method. These comments read as follows:

The appellant in his Notice of Appeal raised but one objection to the computation of his income in the period under review. This objection was that in compiling his statements of assets at January 1st, 1941, the Minister had failed to include as he should have done some 11,900 bushels of wheat grown in 1939 and 1940 but not sold until 1941, and in addition 57 head of cattle and 144 head of hogs owned by the appellant as of January 1st, 1941. At the hearing the appellant was permitted to raise one further objection to the assessment, to wit that the amount of $1 200 estimated as his cost of living for the year 1946 was in excess of the actual amount expended for this purpose.

I have some sympathy with the appellant in his first objection. The statement used as the basis of determining his income is headed "a statement of net worth" and one is easily misled by this entitlement. As a result it is easy to assume that all of the capital assets of the appellant should be shown as at the two dates chosen — January 1st, 1941, and December 31st, 1946. However, as I have pointed out, the heading is not a correct description of the document and a careful study of its contents and its purpose shows clearly it is not in fact a statement of net worth and why these assets were not included as of either dates.

The Minister in pursuing this method of determining the net income in a given period has to start from some arbitrary date. Of necessity this must be the commencement of the first day of a taxation year. It was apparent that the chief source of income to the appellant in his farming operations was from the sale of wheat. He himself gave evidence that he had filed no income tax returns prior to 1941 and had since reported on a cash income basis. He further stated that he had not sold a substantial portion of his wheat crops grown in 1939 and 1940 until 1941. I agree, therefore, that it was a reasonable assumption that there would be no taxable income in the years 1939 and 1940 and, as a result, January 1st, 1941, the year into which the unsold wheat and livestock had been carried, was a suitable date upon which to base the comparative statement.

The wheat and livestock were products of the farming operations of the appellant and did not become taxable until they were translated into cash. The same is true as of December 31 st, 1946. None of the holdings of grain or of the livestock owned by the appellant as of that date are shown in the statement since again these could not be considered as part of the net income until they had been sold and realized upon.

As I have stated, the method is applicable only to those who report their income on a cash basis. Had the appellant been reporting on an accrual basis in the years prior to 1941, then of course these assets would have been included as of January 1st, 1941, and a comparative statement of the assets of the same nature would have been inserted as of December 31st, 1946. However, as has been stated, the appellant chose to report his income on a cash basis and as a result, had these assets been included as of January 1st, 1941, the appellant would have escaped taxation on the sale proceeds of these farm products. For these reasons I am satisfied that the statement prepared by the officials of the department was in fact a proper statement determining the net income of the appellant during the years in question.

3.05.17 Should the value of the herd of cattle be included in the balance sheet of December 31, 19782

According to the evidence presented, as appears in Exhibit A-1, and the statement of income and expenditure for the years in question filed by the appellant with his tax return, all the livestock purchases were deducted annually as expenses, that is $17,125 in 1979, $4,300 in 1980, $12,022.58 in 1981 and $12,400 in 1982.

According to Exhibit A-1 the same was true of an amount of $6,025 in 1978. The herd of cattle must be treated as inventory. Indeed, a herd of this nature is inventory.

3.05.18 As regards the sale of the milk quota for $53,216, it is clear that the respondent did take this into account. It can be seen from referring to the table in para. 3.05.9 that while, on the one hand, the sum of $16,108 was included in 1979 income, the balance of $37,108, on the other hand, was deducted in calculating additional income.

3.05.19 Conclusion on third point at issue

As regards the additional income of $26,091 for 1979 to 1982, the Court after considering the points raised by the appellant feels obliged to affirm the figures arrived at by the respondent.

Did the appellant forget to tell his accountant of certain funds received in the form of gifts, legacies, etc.? The evidence (para. 3.05.13) is clearly to the contrary.

The reassessment must be allowed in respect of this additional income.

3.06 Additional interest income

3.06.1 The respondent's position is described in the presumed facts in paragraphs 4(o), (p), (q), (r), (s) and (t) of the reply to the notice of appeal, cited above at para. 2.02.

3.06.2 As explained by the respondent's witness Mr. Marois, this interest income added to the appellant’s income results from interest which Mrs. Reynolds allegedly earned from her capital received from the appellant. The respondent's position is as follows:

[TRANSLATION]

Interest income		Mrs. Reynolds'	Taxable Interest
"reported" by		actual interest	income of
Mrs. Reynolds		income	Mr. Reynolds
1979	$ 5,372.00	$ 880.00	$ 4,492.00
1980	$ 3,805.00	$ 968.00	$ 2,837.00
1981	$11,780.00	$1,597.00	$10,183.00
1982	$16,943.00	$1,469.00	$15,474.00
Total	$37,900.00	$4,914.00	$32,986.00

3.06.3 According to the information given to Mr. Marois by the appellant's accountant, Mrs. Reynolds received small legacies of $5,000 in 1966, $1,412.78 in 1967 and $2,388.18 in 1975. These amounts totalled $8,800.96 (para. 2.02, paragraph 4(p)).

Any capital amount exceeding $8,800.96 and shown for Mrs. Reynolds in the bank accounts or financial statements is capital of the appellant given to Mrs. Reynolds, again according to the information provided by Mr. Séguin to Mr. Marois.

Most of the funds ($8,800.96) which Mrs. Reynolds received and allegedly gave to her husband were given back to her by her husband in 1978. Accordingly, any amount of interest from capital other than the $8,800.96 should be included in the appellant's income.

3.06.4 However, Mrs. Reynolds' testimony contradicted the information provided by Mr. Séguin to Mr. Marois. Mrs. Reynolds said she received three legacies, $8,000 from her brother Lawrence in 1964, $1,400 from an uncle in 1967 and $2,300 from her brother Robert in 1970, making a total of $11,700. She said she did not give her husband this money, but invested it in bonds. Moreover, her husband had never given her any money.

According to Exhibit 1-4 filed by Mr. Marois following his investigation with the banks, Mrs. Reynolds' capital was as follows:

Mrs. Reynolds admitted she had no other bank accounts (trans., pp. 14-15).

According to Exhibit A-4 filed by Mr. Séguin, Mrs. Reynolds had the sum of $29,375 in cash and various bank accounts in December 1978.

The interest earned by Mrs. Reynolds on this capital of $29,375 allegedly totalled $37,902.16 in 1979 to 1982. According to Mrs. Doris Reynolds' balance sheet at December 31, 1978, prepared by Mr.Séguin (Exhibit A-4), it appears that the total interest for the years in question was $37,902.16, as indicated in the following table:

3.06.5 According to the T-5 forms filed as Exhibit R-12, and the information provided by Mr. Marois, the interest of $11,780.94 reported in 1981 breaks down as follows:

It should be noted that account No. 3 above, with the Canadian Imperial Bank of Commerce in Bedford, is in the name of Mr. Oren Reynolds and Mrs. Doris Reynolds. Mrs. Reynolds admitted she had no personal money in that account.

Additionally, account No. 90-14667 with the Canadian Imperial Bank of Commerce is shown on the list of the appellant Oren Reynolds' bank accounts. In 1981 the balance was $61,530, as indicated by document R-4 prepared by Mr. Marois entitled [TRANSLATION] "Bank accounts balance at December 31". This document was prepared with documentation supplied by the banks. Moreover, account No. 90-14667 is not shown on the list of Mrs. Reynolds' bank accounts on the same Exhibit R-4, a list which includes three bank accounts and is reproduced in para. 3.06.4.

It thus appears that the amount of $5,510.60 reported by Mrs. Reynolds as interest must be included in the appellant's income on a similar basis.

3.06.6 In 1982, of the $16,943 interest reported by Mrs. Reynolds, there was an amount of $8,716.71 which came from account No. 90-14667 with the Canadian Imperial Bank of Commerce in Bedford. According to the T-5 form, this account is also in the name of Oren and Doris Reynolds.

According to Exhibit R-4, this account belongs to the appellant and the balance at that time was $4,089.52. Once again, Mrs. Reynolds stated that she had nothing to do with this account. The amount of $8,716.71 included in her income as interest must be included in the appellant's 1982 income on a similar basis.

3.06.7 The interest from account No. 90-14667 with the Canadian Imperial Bank of Commerce was $5,510.60 in 1981 and $8,716.71 in 1982, totalling $14,227.31. However, this is far from being the same as the $32,986 of additional interest assessed, as appears in the table reproduced in para. 3.06.2. The difference of $18,768.69 ($32,986-$14,227.31) results primarily from the testimony of Mrs. Doris Reynolds, which contradicted the information given by Mr. Séguin to Mr. Marois.

According to the latter, Mrs. Reynolds received $8,800 as legacies between 1966 and 1975 and gave this money to her husband. The latter allegedly returned the money to her without interest in 1978. Any amount of interest in Mrs. Reynolds' name from capital in excess of $8,800 should be included in the appellant's income. That is in fact the basis of the reassessment (para. 3.06.3).

In her testimony Mrs. Reynolds said that she received $11,400 in legacies between 1964 and 1970. She said that she never transferred this money to her husband, but invested it in bonds. She also received no money from her husband (para. 3.07).

Which testimony is to be believed?-that of Mrs. Reynolds. It is confirmed by the respondent's own figures. In preparing Exhibit 1-4, the bank accounts balance at December 31 from 1978 to 1982, after checking with the banks, Mr. Marois concluded that Mrs. Reynolds had $23,661 in the bank. For a person who had about $12,000 in the bank in 1970, it is logical that she would have $23,661 in 1978. Finally, I consider that the statement by Mrs. Reynolds herself carries greater weight than what Mr. Marois may have learned from Mr. Séguin on the subject.

3.06.8 Conclusion on fourth point at issue

To conclude on this point, the only interest to be added to the appellant's income is $14,227.31, that is $5,510.60 in 1981 and $8,716.71 in 1982.

In making the reassessments for interest, the Minister allowed the appellant additional deductions of $7,756 as married persons' exemptions, $3,767 as a transfer of the interest deduction and regarded Mrs. Reynolds' tax in 1981 and 1982 as nil.

The Minister should take this into account mutatis mutandis in reassessing the appellant in accordance with this decision.

3.07 Penalties

While the penalties imposed under subsection 163(2) of the Act apply in their entirety to the additional income of $61,048 in 1979, $28,920 in 1980, $36,274 in 1981 and $41,565 in 1982 (para. 3.01), I consider that the amounts of $25,000 (income from livestock sales), $5,465 (income from milk quota sale) and even of $14,227.31 (interest) should be deducted from the penalty.

All these amounts have been deducted from income much more because of the way in which the accountant Séguin understood the accounting system and the provisions of the Act than because the appellant himself, by negligence or otherwise, did anything to result in the non-taxation of the income.

As regards the additional business income of $26,091 for each of the years at issue, resulting from application of the net worth method by the respondent, the Court must uphold the penalty because of the substantial amounts involved.

One can only regard as gross negligence an omission resulting from failure to include in income $104,364 of unexplained income over four years, when the total income reported for the same four years was $106,579.

4. Conclusion

The appeal is allowed in part without costs and the matter is referred back to the respondent for reconsideration and reassessment in accordance with the foregoing reasons.

Appeal allowed in part.