Aditex Development Ltd., Shirley Anne Sykes, and Russel Boyd Sykes v. Minister of National Revenue, [1988] 2 CTC 2113, 88 DTC 1497

Bonner, T.C.J.:—These appeals were heard together on common evidence. An application to have them heard in camera was abandoned.

The appellant Russell Boyd Sykes is a chartered accountant. During 1979 he was employed on a full-time basis by a firm of chartered accountants. Subsequently, throughout the remainder of the years under appeal, he was employed as a tax manager ata bank. He was at all such times married to the appellant Shirley Anne Sykes and was sole shareholder and officer of the appellant Aditex Development Ltd. (hereinafter "the company").

Appeals were taken from assessments for the taxation years listed below:

The reassessments indicated by an asterisk were made in 1985 beyond the three-year limit laid down by subsection 152(4) of the Income Tax Act ("the Act") with the result that it was incumbent on the respondent to establish his right to reassess under subparagraph 152(4)(a)(i) of the Act. Subsection 152(4) provides in part:

152(4) The Minister may at any time assess tax, interest or penalties under this Part or notify in writing any person by whom a return of income for a taxation year has been filed that no tax is payable for the taxation year, and may

(a) at any time, if the taxpayer or person filing the return

(i) has made any misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing the return or in supplying any information under this Act, or

reassess or make additional assessments, or assess tax, interest or penalties under this Part, as the circumstances require, . . .

Penalties were levied under subsection 163(2) of the Act in respect of many of the adjustments to income which were made on reassessment. Subsection 163(2) reads in part as follows:

163(2) Every person who, knowingly, or under circumstances amounting to gross negligence in the carrying out of any duty or obligation imposed by or under this Act, has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return, form, certificate, statement or answer (in this section referred to as a 'return') filed or made in respect of a taxation year as required by or under this Act or a regulation, is liable to a penalty of. . .

It would not be useful to quote the statutory formula set forth in the remainder of the subsection. It is sufficient for present purposes to note that generally speaking the penalty is 25 per cent of the amount of tax on the overstated expense or understated revenue.

By subsection 163(3) of the Act the burden of establishing liability for penalties rests on the respondent. That provisions reads:

163(3) Where, in any appeal under this Act, any penalty assessed by the Minister under this section is in issue, the burden of establishing the facts justifying the assessment of the penalty is on the Minister.

The onus thus imposed on the respondent does not, however, require him to establish that the amounts added to declared income were properly added.* [1]

In assessing Mr. Sykes for tax the respondent made the following adjustments and levied penalties as follows:

Mr. Sykes' claim to deduct business losses rested on the premise that he carried on business as sole proprietor during the years 1979, 1981 and 1982 and that he and his wife carried on business in partnership during 1980. He attributed the losses to "start-up costs". The respondent assessed on the basis that no such business was carried on at all, that the expenses claimed were personal or living expenses and further that many of the expenses claimed were not incurred at all, that is to say, that frequently two or more claims were asserted in respect of one outlay.

Mr. Sykes contended that he did indeed carry on business. The following extracts from a schedule attached to his notices of appeal serve as a convenient summary of his testimony as to the background and nature of the alleged business activities.

In 1975, Mr. Sykes became disenchanted with his occupation as an employee and decided to make a strategic change in his occupation. He was convinced that he was not suited to or interested in aspiring to higher employment positions with large organizations over the long-term. As he was married (his wife was not employed), had two dependant children and had limited financial resources, it was not feasible for Mr. Sykes to terminate his full-time employment and commence self-employment activities on a full-time basis.

... Mr. Sykes commenced the business of Aditex Leasing in 1978 and continued to carry on this business until December 31, 1979. On January 1, 1980, Mr. Sykes formed with his wife a partnership, described as Aditex Leasing & Ventures (ALV) / which was discontinued December 31, 1980. On January 31, 1981, Mr. Sykes commenced business as Aditex Ventures (Unincorporated), referred to as AV, on a proprietorship basis. All of these businesses were established and carried on for the purpose of gaining or producing income from business.

. . . The activities carried on by Mr. Sykes were commercial activities engaged in for gain. These were enterprises in which Mr. Sykes showed willingness to invest time and money on future outcome. These activities were a principal serious concern or interest of Mr. Sykes. Mr. Sykes habitually devoted his time, attention, labour and efforts to such activities.

At all relevant times, actitivies undertaken by ADL, AV and ALV were a regular part of the income-earning process in the type of business carried on. There were specific concepts of the type of activities to be carried on, an organization in place to undertake the essential preliminaries to normal operations and a plan and operating structure to carry on the activities. Serious and continuous efforts were made. Market surveys were undertaken for the purpose of establishing the most appropriate way or place to carry on business. The businesses involved specific projects as well as the development in the form of adventures in the nature of trade. The business activities included the following projects: fast food Teriyaki burgers, auto leasing using letters of credit, fast food pasta, importing wine, purchase and sale of a flour mill, employee job counselling and relocation, timeshare units and the purchase and sale of a bicycle importing and distribution business.

The business activities included the purchase of materials, market surveys/re- search, product design and evaluation and analysis of operations and management. All activities were positive and continuous steps to develop products or services for sale as a business or investment package. The nature of the business projects involved required that studies and tests be carried out and that meetings be held.

The business activities of ADL, AV and ALV were perforce carried on during evenings and on weekends, as Mr. Sykes was a full-time management employee with large arm's length employers at all relevant times. This imposed serious restrictions on the manner in which the business activities were carried on. Business meetings were, therefore, held in restaurants at a time and place convenient to all persons attending.

Mr. Sykes called two independent witnesses to clarify the nature of his activities and to demonstrate that he had incurred entertainment and meeting expenses. One was a businessman named Cavenaugh with whom Mr. Sykes met for the purpose of discussing the possible acquisition of a firm which carried on the business of importing and distributing bicycles. He and Mr. Sykes also had some conversations about a flour mill and two or three other "situations". The bicycle business was the only one that Mr. Cavenaugh took some considerable time investigating. Mr. Sykes also met with a Mr. Yakiwchuk. He and Mr. Sykes, in June of 1980, went to visit a flour mill in Camrose, Alberta, with a view to purchasing it. In this case too Mr. Sykes did not acquire the business nor any interest in it. Neither witness was able to shed any light on what was spent by Mr. Sykes in connection with the meetings. Certainly Mr. Sykes did not do all the entertaining. Mr. Cavenaugh said that he had no recollection as to who paid. Mr. Yakiwchuk said that on several occasions he had paid.

Apart from the evidence of Mr. Cavenaugh and Mr. Yakiwchuk and generalizations of the sort set forth above, there was virtually no concrete evidence as to the nature and extent of business operations. No attempt was made to distinguish between promotional activities undertaken by Mr. Sykes on behalf of the company on the one hand and on behalf of either Mr. Sykes or the partnership on the other hand.

There was no suggestion in the evidence that Mr. Sykes' activities went beyond the investigation of ventures in which he might possibly become involved. The cost of such activities is, of course, capital in nature.* [2] The evidence does not suggest that Mr. Sykes carried on any ongoing business. The only revenue reported in respect of either the proprietorship or the partnership was car leasing income received in respect of an automobile which at all relevant times was owned not by Mr. Sykes, but by Aditex Development Ltd. I will deal with this matter later.

The partnership agreement between Mr. and Mrs. Sykes reads in part as follows:

WHEREAS we are interested in pursuing business development opportunities and ventures and WHEREAS it is our intention to form and constitute a partnership for purposes of the Income Tax Act, Canada and equivalent provincial statutes, we hereby agree to enter into a partnership for this purpose. Such partnership arrangement is to be on the basis of 55% to R.B. SYKES and 45% to S.A. SYKES for purposes of sharing profits and losses (such profits and losses shall be determined using accounting mutually acceptable to the partners).

It was terminated after one year. Mr. Sykes, when asked why it lasted for only one year, stated:

. . . Well, what happened was my wife pulled some money out of her RSSP, and we worked together and it didn't work very well. We weren't able to get the venture up and running. She was incapable, really, of doing the work, and we have two children, so we decided just to terminate it at the end of the one year.

As noted previously, the only revenue reported by Mr. Sykes from his supposed business over the years was from the leasing of one automobile. That automobile was registered in the name of the company. The company was insured as owner. The company was lessor. The respondent, on assessment, treated the revenue and costs of the leasing operation as the revenue and costs of the company and not of Mr. Sykes. Mr. Sykes asserted that the company acted as his agent under an agreement in writing. That agreement provides in part:

The purpose and intent of this agreement is to operate the business under the name of ADITEX VENTURES on an unincorporated basis for purposes of the Income Tax Act, Canada and equivalent provincial statutes and, further, at no time is it intended to operate on the basis of ADITEX DEVELOPMENT LTD. as principal or in any manner on its own behalf or account.

Mr. Sykes said that a corporate identity was more impressive for marketing purposes and that cars can be bought more cheaply by corporations than by individuals. Further, he said that the company held title to the car to enable him to avoid the liability which may be imposed upon the owner of a motor vehicle. In my view the business of leasing the car was in fact carried on by the corporation which ostensibly carried it on. Nowhere in the agreement between Mr. Sykes and the company did Mr. Sykes expressly appoint the company as his agent to carry on the car leasing business. The profit from a business is the income of the person who carries on the business. In Lagacé v. M.N.R., [1968] C.T.C. 98 at 107; 68 D.T.C. 5143 at 5149 Jackett, P. stated:

The most significant feature of the appellant’s contention in this Court, as it strikes me, is that it is inherent in the contention that profits that would otherwise have accrued to the appellants have ended up in the name of a company controlled by them, not because of bona fide business transactions between the appellants and such company, but because of transactions that have been arranged between them to implement a contract between the appellants and a third person to accomplish objects desired by the third person. In other words, the contention is based on the assumption that profits of the appellants' business operations were put into the hands of the company by a device and that the profits were not the result of the company having embarked on business transactions. In my view, therefore, the short answer to the contention, even assuming the facts to have been established, is that, for purposes of Part I of the Income Tax Act, profits from a business are income of the person who carries on the business and are not, as such, income of a third person into whose hands they may come. This to me is the obvious import of sections 3 and 4 of the Income Tax Act and is in accord with my understanding of the relevant judicial decisions.

The so-called business expenses claimed by the appellant were analyzed by Sam Liggett and Terry Ching, both employees of Revenue Canada. At the hearing of the appeals they gave evidence as to their findings. The preliminary work was done by Mr. Liggett. He received from Mr. Sykes lists of the expenses which had been claimed by the three appellants together with the supporting vouchers. He examined the material and arrived at the conclusion that the expenses were personal or living expenses and had nothing to do with any business activity carried on by any of the appellants. He produced copies of the supporting vouchers which had been obtained from Mr. Sykes.

Mr. Ching testified that he had reconciled the expenses from the general ledger to lists of expenses claimed and that he examined the supporting vouchers. He too concluded from his examinations of the vouchers, copies of which were entered in evidence, that they represented personal or living expenses of Mr. Sykes and of his family.

The vouchers covered expenditures which certainly appear, at least at first blush, to be of a personal nature. They include clothing, liquor, dry cleaning, meal costs of all kinds from first-class restaurant meals to food from fast food and take-out establishments, air travel including a trip from Winnipeg to Vancouver and return for Mr. Sykes' mother, travel related to the activities of the hockey team of the Sykes children, tickets to entertainment events such as movies, theatre, hockey, soccer and ice shows, groceries, liquor, eyeglasses, a wrist watch, prescriptions, a television repair bill and a haircut.

Mr. Ching testified that the expenses were frequently overstated. He pointed to specific examples. Credit card charge slips and restaurant stubs covering one single expenditure were often treated as evidence of separate expenditures and claimed two times. In some cases different amounts for tips were shown on the VISA slip and the corresponding restaurant stub in an apparent attempt to conceal the duplication. Another method of duplication involved using both billing statements and original vouchers. Duplication was also achieved by using photostats of the original invoice and the original. On occasion the same expenditure was claimed both as a cost of the proprietorship business and as a cost of the business of Aditex Development Ltd. In one instance a membership fee of $360 from the Institute of Chartered Accountants of British Columbia was claimed as a business expense in the proprietorship and again claimed as professional dues on the second page of Mr. Sykes' tax return.

Mr. Sykes did not, when giving evidence, offer any explanation for the duplications other than innocent mistake. The frequency with which attempted deception of the sort just described took place negatives that explanation. On cross-examination as to the nature of some of the expenditures he offered explanations which were contrived or vague or both. For example, as to the movie tickets, he said:

. . . There is one client that I have, he's a famous artist . . . he loves movies . . . when I was promoting with him we would go to movies and have our discussions

In relation to his mother's air travel from Winnipeg to Vancouver and back, the cost of which was claimed as a business expense of the company, he said:

.. . Well, there was a time when my wife and I were planning to do something and we were going to take a trip and I had to do some kind of a report. . . and instead of getting a housekeeper, we were going away on business, I asked my mother if she would come out and so I paid the airfare instead of incurring the cost of an independent babysitter . . .

The evidence as to the nature of the alleged business operations was vague and created an impression that descriptions used by Mr. Sykes were intended to conceal rather than to reveal. The evidence as to the nature of the business expenses claimed suggests that they were, for the most part, personal and wholly unrelated to any business activity. The evidence as to multiple counting of the same expense suggests that Mr. Sykes deliberately set out to claim fictitious costs. Mr. Sykes appeared evasive when testifying. From time to time he contradicted himself. I cannot rely on anything he says.

Mrs. Sykes was not called as a witness. It seems that her income tax return for 1980, the year of the partnership, was prepared by Mr. Sykes. It contained a claim to deduct a share of partnership losses which losses were composed of personal expenses and were swollen by multiple counting. Nevertheless she signed it. The same pattern is to be found in the computation of the company’s expenses and reported losses. In filing that return Mrs. Sykes made misrepresentations attributable to neglect. It must have been evident to her that the partnership did virtually nothing and could not in consequence have incurred expenses of the magnitude claimed. Obviously the position of the company and of Mr. Sykes can be no better. I therefore find that the respondent has discharged the subsection 152(4) burden in relation to the assessments of Mr. Sykes and of the company for 1979 and 1980 and of Mrs. Sykes for 1980.

The appeals of Mr. and Mrs. Sykes and of the company with respect to the disallowance of business losses must all fail. The expenses were personal. They do not meet the test laid down by paragraph 18(1)(a) of the Act.

The respondent, on assessment, disallowed claims by Mr. Sykes to deduct interest on borrowed money which, according to Mr. Sykes, was used to acquire shares of the capital stock of the company. The respondent assessed on the basis of a finding or assumption that the borrowed money was used by Mr. Sykes to acquire a personal residence. In June of 1978 Mr. Sykes wrote to the bank with a view to securing a $75,000 loan. A memorandum accompanying the letter expressed an intention to use the borrowed money for the purpose of subscribing for 75,000 $1 redeemable preference shares of Aditex Development Ltd. The letter went on to explain that the company planned to use the $75,000 proceeds to repay demand notes due to Mr. Sykes and to make shareholder's loans and that Mr. Sykes would use the $75,000 together with proceeds from his RHOSP to acquire a personal residence. The memorandum explained that the loan would not adversely affect Mr. Sykes’ net worth or cash flow because rent then being paid by him, which was non-deductible for income tax purposes, would be eliminated and the saving would be used to service the new bank loan, the interest on which would be tax deductible.

On August 29, 1978, Mr. Sykes and his wife signed an interim agreement to purchase the house which is now their personal residence. On September 21, 1978, the bank loaned $73,000 to Mr. Sykes. I note at this point that Mr. Sykes did say that $50,000 of the sum borrowed was used to refinance a loan of $50,000 made a short while before with a view to providing the company with money to acquire development property. Whether $50,000 had previously been borrowed or not, Mr. Sykes did admit on cross-examination that in fact the company never did acquire any development property but, rather that it loaned the borrowed money to him to purchase the residence.

Mr. Sykes is entitled to deduct the carrying costs in issue if the test laid down in paragraph 20(1)(c) of th Act is satisfied, that is to say, if the interest was paid pursuant to an obligation to pay interest on borrowed money used for the purpose of earning income from property. There was no evidence at all as to the dividend rate, if any, established for the preference shares. Indeed, there is no evidence that the shares were ever issued. There is no evidence that the company was likely to pay dividends. The events which did transpire point to a conclusion that Mr. Sykes borrowed the money with a view to carrying out a transaction generally similar to that outlined in the June 26, 1978, letter. The purpose of the borrowing was clearly to acquire the house. The shares, if any were in fact issued, entered the transaction only as a cloak and disguise. The paragraph 20(1)(c) test is not met and this branch of Mr. Sykes' appeals therefore fails.

In reassessing tax for Mr. Sykes' 1980, 1981 and 1982 taxation years the respondent disallowed claims to deduct allowable business investment losses amounting to $4,450.14 in 1980, $2,466 in 1981 and $4,126 in 1982. The deductions sought were said to be half of the adjusted cost base of debts due to Mr. Sykes from the company. The theory underlying the claim was that Mr. Sykes incurred expenses on behalf of the company in conducting its business and thereby advanced money to the company; that the resultant debts became bad; that there were deemed dispositions by virtue of subsection 50(1) of the Act giving rise to business investment losses within the meaning of paragraph 39(1 )(c) of the Act and giving rise to a deduction of the allowable amount under section 3 of the Act.

In my view the respondent properly disallowed the deductions. It is unlikely that Mr. Sykes advanced to the company any amount even close to the amounts claimed. In this regard I refer to Mr. Sykes' tendency to exaggerate expenditures and to claim personal costs as business expenditures. Further, section 50 does not operate to deem a disposition to have taken place except in respect of a debt which has been established to have become a bad debt in the year. There was no reason why any indebtedness owing by the company to Mr. Sykes could not have been discharged by setoff against the debt owing by Mr. Sykes to the company on the house loan. Mr. Sykes' reasoning was:

. . . Now, at this point it was simply a one man company and I could have walked away, I could have started a new corporation, and then the following year I could have set up another corporation, collapsed that one and then gone on and done each year, set up a brand new corporation to cover that particular year's business.

He could have done that. It was not shown that he was likely to do that. I find the argument unpersuasive. This branch of Mr. Sykes' appeal therefore fails.

In assessing tax for Mr. Sykes' 1979, 1980, 1981 and 1982 taxation years the respondent added to declared income as funds of the company appropriated to Mr. Sykes as its sole shareholder the amounts set forth in the table on page 3 of these reasons. The respondent relied on subsection 15(1) of the Act. The calculation of the amounts in question is set forth in schedule I to the reply to the notice of appeal.

The respondent's assessing action rests on a finding or assumption that Mr. Sykes treated personal expenditures such as restaurant meals, liquor, clothing and groceries as outlays made on behalf of the company and credited them to the shareholder's loan account. The evidence previously outlined establishes that that is exactly what happened. This branch of Mr. Sykes' appeals therefore fails.

In 1982 the respondent disallowed a $100 tuition fee deduction claimed under paragraph 60(f) of the Act. The statutory provision expressly excludes deductions in respect of fees paid which had been . . included in the calculation of a deduction under this section for a preceding taxation year . . . Mr. Ching's evidence and Exhibit R-8 confirm that the fee covered by the applicable invoice had already been claimed in 1981. This branch of the appeal fails.

Reference was made in Mr. Sykes' notice of appeal to the disallowance of deductions with respect to R.R.S.P. contributions and to an unemployment insurance overpayment. Neither of these matters was pursued at the hearing. No relief will therefore be granted.

The 1980 inclusion in income of $2,769.80 in respect to the unreported gains on the sale of shares was not referred to in the evidence. In the absence of any evidence as to the circumstances surrounding the failure to report the gain the penalty must by virtue of subsection 163(3) of the Act be deleted. The inclusion in income must, however, remain undisturbed.

I turn next to the penalties imposed on the first five of the inclusions in the income of Mr. Sykes. The circumstances giving rise to the assessing actions have already been outlined. The inevitable inference from all of the evidence is that Mr. Sykes who, after all, was a chartered accountant and who personally was responsible for the preparation of the financial records, statements and returns of income knowingly set out to understate his income in the amounts specified in A to E in the table on page 3. The penalties in respect of those items were properly imposed.

In the result the appeal of Mr. Sykes from the assessment for the 1980 taxation year will be allowed and the assessment will be referred back to the respondent to delete the penalty in respect of the gain on the unreported sale of shares. All other appeals of Mr. Sykes will be dismissed. No costs will be awarded.

In her return of income for the 1980 taxation year the appellant Shirley Anne Sykes claimed, as previously mentioned, a business loss of $5,196.50 being 45 per cent of the total business loss of the Aditex partnership. She claimed a child tax credit for that year and for the 1981 and 1982 taxation years as well. On assessment the deduction of the 1980 loss was disallowed and a subsection 163(2) penalty was imposed in respect of the claim to deduct the loss. Further, the child tax credits for all three years were adjusted in relation to the limit of five per cent of the amount by which family income exceeds $18,000, that is to say, the limit imposed by paragraph 122.2(1)(d) of the Act. I have already dealt with the deductibility of the supposed loss.

As noted previously, the evidence established that the return of income for Mrs. Sykes' 1980 taxation year was prepared by her husband but signed by her. In Cyrus C. Udell v. M.N.R., [1969] C.T.C. 704; 70 D.T.C. 6019, Cattanach, J. considered the meaning of subsection 56(2) of the former Act, the predecessor of subsection 163(2). At page 713 (D.T.C. 6025), he stated:

Accordingly there remains the question of whether or not section 56(2) contemplates that the gross negligence of the appellant's agent, the professional accountant, can be attributed to the appellant. Each of the verbs in the language "participated in, assented to or acquiesced in” connotes an element of knowledge on the part of the principal and that there must be concurrence of the principal's will to the act or omission of his agent, or a tacit and silent concurrence therein. The other verb used in section 56(2) is “has made". The question, therefore, is whether the ordinary principles of agency would apply, that is, that what one does by an agent, one does by himself, and the principal is liable for the actions of his agent purporting to act in the scope of his authority even though no express command or privity of the principal be proved.

In my view the use of the verb “made” in the context in which it is used also involves a deliberate and intentional consciousness on the part of the principal to the act done which on the facts of this case was lacking in the appellant. He was not privy to the gross negligence of his accountant. This is most certainly a reasonable interpretation.

In the present case the evidence does not support a conclusion that "deliberate and intentional consciousness” was present in Mrs. Sykes. The burden of establishing liability for the penalty rests on the respondent. He has failed to discharge it and accordingly the assessment of the penalty must be deleted. Since the respondent's findings as to the income of both Mr. Sykes and Mrs. Sykes during the relevant years have not been found to be wrong, it follows that the section 122.2 credit has not been miscalculated.

The appeal of Mrs. Sykes from the assessment for 1980 will therefore be allowed without costs and the assessment will be referred back to the respondent for deletion of the penalty. The appeals from the assessments for 1981 and 1982 will be dismissed.

I turn next to the appeal of Aditex Development Ltd. In assessing tax for the 1979 to 1983 taxation years, the respondent made the following adjustments:

I have already dealt with the first item. There is no evidence showing that the Minister erred in including in the computation of income rebates received by the company from the government of the Province in respect of gasoline tax. I have also previously dealt with the reallocation of the auto-leasing income. This branch of the appeals fails.

Mr. Sykes made frequent complaints with respect to a failure on the part of the respondent to allow capital cost allowance. Under paragraph 1100(1)(a) of the Income Tax Regulations deductions are permitted equal to

”. . such amounts as he may claim in respect of property . . . ”. The evidence of Mr. Ching, which I accept, was that the capital cost allowance which had in fact been claimed was allowed. This complaint therefore fails.

Finally, I turn to the question of the penalties imposed on the company. The evidence of Mr. Liggett as to the analysis of the disallowed expense amounts and an examination of the vouchers entered as Exhibit R-2 clearly supports a conclusion that the amounts disallowed were personal expenses of Mr. Sykes and his family which had been falsely claimed by the company as business costs. Mr. Sykes' assertion of innocent mistake is patently incredible having regard to the nature of the expenses and to the practice of claiming the same expense more than once. In the circumstances it is clear that the company knowingly made false statements in its returns of income and thus became liable to subsection 163(2) penalties in the amounts specified in paragraph 13 of the reply to notice of appeal. The appeals of the company therefore fail.

Appeals allowed in part.