Kenneth E Crawford v. Minister of National Revenue, [1982] CTC 2679, 82 DTC 1698

D E Taylor:—This is an appeal heard June 17, 1982 in London, Ontario, against an income tax assessment for the year 1979 in which the Minister of National Revenue added an amount of $5,000 to the reported taxable income of the appellant as an “appropriation”, and imposed penalties under the Income Tax Act. The respondent relied, inter alia, upon subsections 15(1) and 163(2) of the Income Tax Act, SC 1970-71-72, c 63, as amended.

The assumptions of the Minister were:

— The appellant is the major shareholder of K E Crawford Limited (“Crawford Ltd”);

— Crawford Ltd is a company engaged in the business of oil and gas well operation and consultation;

— Cambrian Disposals Limited (“Cambrian”) is a company engaged in the business of brine disposal of underground wells;

— $5,000 paid to Crawford Ltd by Cambrian in respect of management fees was appropriated by the appellant for his own benefit;

— The appellant knowingly or under circumstances amounting to gross negligence in the carrying out of a duty or obligation imposed by the Income Tax Act has made false statements or omissions in his 1979 income tax returns with the result that less tax appeared payable by him for the said taxation year than was in fact payable for the said taxation year.

The appeal was based on the following contentions by the taxpayer:

— The appellant now resides at R R #7, Chatham, Ontario.

— Cambrian approved consulting fees during its 1979 fiscal year. It also declared and paid dividends during that same year.

— Crawford Ltd has an ongoing agreement to perform and receive payment for its consulting services to Cambrian.

— The appellant personally owns shares of Cambrian. The appellant also maintains the records and is a signing officer of Cambrian.

— At the time of the payout of the monies related to the 1979 reassessment, the appellant, due to conflicting conversations surrounding the payout, became confused over the nature of the payout and mistook the payment to be a dividend payment. The payment was in fact payment of the consulting fees and should have been paid to Crawford Ltd.

— Crawford Ltd owed moneys to the appellant in excess of the above noted payout. Accordingly, he was entitled to withdraw funds from Crawford Ltd without tax consequences.

— The discrepancy was corrected upon the normal year end review of Crawford Ltd and Cambrian.

— The appellant views the matter as a normal bookkeeping error that was corrected in the normal course of business.

— The 1979 Reassessment has the effect of taxing the payout in the hands of the appellant and that of Crawford Ltd.

— The Minister has not established any grounds that the appellant “knowingly” or “under circumstances amounting to gross negligence” participated or acquiesced in the making of a statement or omission in a return as required by or under the Act. The onus of so claiming is on the Minister and such onus has not been discharged.

At the commencement of the hearing counsel for the respondent referred to the recent cases of Peter Rawsthorne v MNR, [1981] CTC 2187; 81 DTC 116, and Wellington Taylor v MNR, [1980] CTC 3003; 81 DTC 3, which deal with the onus of proof under subsection 163(2) of the Act. Counsel noted that Taylor (supra) took the position that the Minister had the responsibility for establishing the basis of the assessment of tax as well as the imposition of penalty and it had been appealed to the Federal Court by the Minister. Nevertheless, counsel suggested, without prejudice, that he was prepared to proceed first and present all the Miister’s evidence — both as to tax and as to penalty. Counsel for the appellant agreed, and accordingly the hearing was conducted in that manner.

Mr James Powell, an auditor with Revenue Canada, described in the circumstances under which the amount at issue had come to light. Essentially, he was performing an examination of the records of Cambrian and noticed that a cheque in the amount of $15,000, made out in favour of K E Crawford Ltd (“Crawford Ltd”) had been altered to scratch out the “Ltd”, and the stamped “For deposit only to the credit of K E Crawford Ltd” endorsement on the back had also been correspondingly altered. It appeared that the cheque had been negotiated through the personal bank account of the appellant. The Cambrian cheque had been signed by the appellant as a signing officer of that company and both of the alterations noted above bore his initials. The amount of $15,000 had been in payment of an invoice for “consulting fees” from Crawford Ltd to Cambrian. It had been charged as such an expense in Cambrian, but there was no record of its receipt in Crawford Ltd. The cheque was entered as Exhibit R-1. In a subsequent interview with the accountants for Cambrian — Martin, Tilley & Co, chartered accountants of Chatham and London, Ontario — Mr Powell was informed that there had been an unaccounted for $10,000 deposit certificate which showed up in the bank confirmtion of Crawford Ltd at the fiscal year end, and the accountants, lacking any information on it, credited that amount to income of Crawford Ltd. Based on the assumption that this $10,000 might have had some relationship to the $15,000 cheque noted above, Mr Powell reduced the amount at issue to $5,000 for income tax assessment purposes. Mr Powell agreed that except for the matter at issue in this appeal, the records of Cambrian and Crawford Ltd, as well as the personal tax return of the appellant, had not previously been questioned by the department, and that he had registered no other criticism as a result of his work.

Mr Thomas R Close, CA, from the firm of Martin, Tilley & Co testified that he had the overall responsibility for the audit of Cambrian and the year-end accounting for Crawford Ltd. His firm also prepared the personal income tax returns for the appellant. He agreed that the matter of the $15,000 cheque alteration had been unknown to him until it had been raised by Mr Powell. He had corrected that situation by journal entries at the earliest possible opportunity, charging the amount at issue ultimately against the advances or drawings accounts of the appellant. Mr Close also provided copies of certain accounting records, as well as corporate resolutions which were designed to indicate that at the year end of Crawford Ltd, there should have been sufficient credit to the advances or shareholders’ drawings accounts to accommodate the $5,000 at issue, and very probably the entire $15,000.

In argument on the income tax assessed itself, counsel for the respondent proposed:

.. whether it came out of his account or not, we do have evidence that at least $5,000 of the amount payable to Crawford Ltd was retained by Mr Crawford. We don’t have any evidence as to what he did with the $5,000 extra. We don’t have any evidence whether he gave it back to the company. We just have evidence that he got it and in a dearth of evidence of what he did with it, I think you can assume he has it. I think if he wants to show he didn’t keep it, I think the onus switches to him once it’s shown it’s been received by him.

The amount was paid to Mr Crawford which should have been paid to the company and the company’s books and position with respect to Mr Crawford stayed the same. There’s no evidence, the evidence indicates the mistake might have been caught but if it wasn’t caught then in another year, 1980 I believe, money was paid to Mr Crawford and he could have received the entire amount owing to him. That amount wouldn’t have been taxable and we would have had a benefit. If you accept the argument that you have to wait until the books of the company are cleared out before you can accept an appropriation in any case where the company that is subject to the appropriation owes the money to the taxpayer, then it’s rare that, well it’s not rare, but, in every case you can never assess an appropriation as long as there was some money owing by the company and yet the limitation period might pass, the money would be paid out and then the Department would be faced with the matter of, well this area you are looking at was years down the road, and you can’t assess on the basis of that. My position in this matter is not totally unsupported . ..

With regard to the penalty issue, it was contended by counsel that:

We don't have any of his explanation as to what went on. All we have is a cheque payable to Crawford Ltd, altered to be paid to Crawford, no explanation. Now, I would submit that that is a situation where either the taxpayer knowingly omitted that $5,000 from his income, or it was grossly negligent in the circumstances.

In response, counsel for the appellant noted:

dealing with the question of penalties, we have one isolated instance in 1979. Under cross-examination Mr Powell said that the books of account of this company of Mr Crawford were kept in accordance with the Income Tax Act and apart from one minor matter, he didn’t see anything wrong with them. So, obviously it’s an isolated circumstance happening. It also must be borne in mind that, at the time that this payment was made or, not precisely at the time but, at or about the time this was made, Mr Crawford was owed by Cambrian over $5,000. In fact, he was owed $5,400 as of June 30, 1979. So that, if that amount had been taken from Cambrian, the $5,000, he would have no occasion to put that in his records at all because it’s strictly repayment of capital. And that, I submit, is the inference that one must take to why the $10,000 was replaced some time in 1979 and why the $5,000 was kept.

Reference was made by counsel to the cases of Michael S Mark v MNR, [1978] CTC 2262; 78 DTC 1205, and Reginald Snelgrove v MNR, [1979] CTC 2938; 79 DTC 780, and he added:

. .. you know the whole thing would have been different if Mr Powell, when he found out about this, all he had to do was make a little phone call to Mr Crawford, or to Mr Close, and to say hey what about this cheque? I think you have made a mistake here. But the answer to that one is, oh yes, well, it’s government policy. We can’t do that. We are only to assess history. We don’t look forward to the future. Surely in doing an audit of a set of books which he found otherwise to be accurate, he finds one error. Surely, if he had brought that to the attention of either Mr Crawford, or Mrs Crawford, or Mr Close, or the firm, it would have been attended to. But he chose not to, but to sit back and wait and see what happened. Then we deal with the possible question of whether this assessment should have been a section 15(1) or a section 15(2) reassessment and we have that situation. We have Mr Close’s uncontradicted evidence of a running account in the drawings and his uncontradicted evidence that this matter was set up as a loan when it was corrected in 1980. Now, we have, I suppose my friend could argue that looking at all the facts we may have a debit, although not a proper debit, but an actual debit, in the loan account of ’79 if the transaction had been put through at that time, the $5,000 which would have put that account into debit and we might have one in 1980 and hence we were subject to the 1980 15(2) assessment. But that isn't what we have been assessed for. It’s a 1979 15(1) assessment and I submit the evidence is overwhelmingly in favour of the fact that we have this outstanding drawing account, and that this means we have a debit-credit relationship between the two and this matter, with respect, was a loan and obviously, as a result of a mistake, but nonetheless a loan, and it’s therefore my submission that if there is any reassessment at all, it should be 15(2) assessment and in 1980, not a 15(1) in 1979. So, in my submission, the taxpayer has discharged the onus that is upon him in all the circumstances, that this is not, with respect, an appropriation.

Findings

On the question of the income tax, I am not impressed with the argument of counsel for the appellant that if the amount is taxable, the proper subsection of the Income Tax Act would be 15(2). The Minister has assessed the tax under subsection 15(1), and it falls precisely under the terms of paragraph (b) of that section. The testimony and evidence are consistent and clear, both from the respondent and the appellant — the cheque for $15,000 (Exhibit R-1) was diverted by Mr Crawford to his own account from funds which should have been available to Crawford Ltd. It ts the contention of Mr Close, and the argument of counsel for the appellant, that Mr Crawford could have understood that the amount was a return of capital or a payment of some kind to which he was entitled without incurring tax liability (based on available shareholders’ accounts, accrued bonuses, drawings accounts, etc). While that is a possibility, it cannot be substantiated, based on the testimony and evidence made available at the hearing. That possibility is vastly different than establishing that it was in the appellant’s mind, and governed his actions relative to the funds diverted. The appellant did not take the stand to review that possiblity, nor to explain the basis of his own thinking when he altered the cheque. Therefore, as I see it, irrespective of the treatment accorded the transaction by the Minister (permitting a set off of $10,000 which appeared as an unexplained “term deposit” in Crawford Ltd), the diversion of the $15,000 cheque was appropriation in the simplest sense of the word. Whatever the appellant may have done with the funds subsequently is pure speculation, and has no bearing on the determination of that part of the appeal. The Board, because of the assessment at issue, is limited to dealing only with the net amount of $5,000 in this decision. that amount is subject to tax as assessed.

There remains then the issue of the penalty imposed. It was the position of the Minister that, by the very act of altering the cheque (Exhibit R-1) in his own favour, the term “knowingly” must be applied to the conduct of the appellant, thereby fulfilling a major condition for imposition of penalty under subsection 163(2) of the Act; or that he was “grossly negligent” in not having recorded it as a withdrawal rather than as an expense in the records of Cambrian. The appellant appropriated the funds in February 1979, but that appropriation does not deal with either the point in time or the conduct of the appellant when preparing his 1979 income tax return — dated in April 1980. It is the act of omitting the amount at issue from his reported income that raises the possibility of enforcing the provisions of subsection 163(2) of the Act. It is no longer the act of appropriation for which he is being taxed under subsection 15(1) of the Act which is in question now, as I see it. As I read section 163, for the term “knowingly” to have effect in this appeal, the Minister must show that the appellant was fully aware when filing his income tax return that the amount at issue was taxable income to him — and proof of that has not been provided at this hearing. For the term “gross negligence” to apply, it would probably be necessary for the Minister to show that the appellant’s acknowledged negligence in not adjusting the accounting records of Crawford Ltd or Cambrian to reflect the $15,000 as a withdrawal, or so instructing his accountants, was done consciously and was not merely the result of an oversight on his part. In my view the Minister has not so established.

The net effect is that the reason for the alteration of the cheque put forward on behalf of the appellant — that he believed he was withdrawing his own funds — has not been sufficiently supported to permit the appellant to escape the provisions of subsection 15(1) of the Act for purposes of the assessment of tax. Conversely, the Minister has not eliminated this as a possibility, and the imposition of penalty is not warranted.

Decision

The appeal is allowed in part in order that the penalty imposed shall be deleted. In all other respects the appeal is dismissed. The entire matter is referred back to the respondent for reconsideration and reassessment in a manner not inconsistent with the above Reasons for Decision.

Appeal allowed in part.