N .J . Martin Management Services Ltd. v. R., [1997] 1 CTC 2005, 97 DTC 487

McArthur J.T.C.C. — Upon consent, the appeals of N.J. Martin Management Services Ltd. (the “Company”), Norman J. Martin (“Norman J.”) and Robert Farina (“Robert F.”) were heard on common evidence for the taxation year ending December 31, 1988 and the taxation years 1988, 1989, 1990 and 1991 for both Norman J. and Robert F., on January 24 and 25, 1996.

There were basically three issues.

1. Whether the Minister of National Revenue (the “Minister”) was correct in assuming that the customer list being in substance the good will of the business, was owned by the Company or was it owned by Norman J. and Robert F. personally?

2. Whether the Minister was entitled to assess the years 1988 and 1989 beyond the normal reassessment period, by reason of a misrepresentation as found in subparagraph 152(4)(a)(i) of the Income Tax Act (the “Act”).

3. Whether the Minister was justified in assessing penalties under subsection 163(2). This issue ultimately was the most difficult one.

Upon the opening of trial a procedural issue settled. The parties acknowledged that the Minister had the burden of establishing that the Appellants made a misrepresentation as described as subparagraph 152(4)(a)(i) and that the Minister had the burden of establishing penalties under subsection 163(2) were justified. The Court agreed with the consent arrived at between counsel, that the Appellants would present evidence first in the usual procedural manner prescribed by the Rules of Procedure. The Onus remained upon the Minister to establish that he was justified in reopening taxation years 1988 and 1989 and in assessing penalties.

The essential facts taken from the pleadings and established during the trial are as follows:

— The Company is a body corporate with fiscal year ending December 31.

- The Company was incorporated in 1976 by Norman J. to carry on the accounting business that he previously carried on as a sole proprietor.

— In 1978 Robert F. joined the Appellant as an employee.

— In 1981 Norman J., who until that time owned all of the outstanding shares of the Appellant, transferred approximately 23 per cent of them to Robert F. and at all times thereafter these two individuals were the guiding minds of the Corporate Appellant. Norman J. and Robert F. testified that at the same time, 25 per cent of the customer list (goodwill) was transferred from Norman J. to Robert F. by way of an oral understanding.

— From 1977 until 1988, both Norman J. and Robert F. were employees of the Company in its accounting business, both of them being accountants, and neither of the foregoing individuals carried on an accounting business of any type on their own account.

— The accounting business was sold to Ernest Boudreau and Joseph Hebert in 1988 for $125,000. The transaction included the sale of a client list.

Norman J. and Robert F. had accounting and business backgrounds. Both were employees of the Company that carried on the business, indicated on an invoice being Exhibit A-1, tab 22:

N.J. Martin Management Services Ltd.

45 Elmwood Drive, Moncton, N.B. El A 3W8

- Business Administration

— Bookkeeping Services

- Corporation Tax Returns

- Accounting Services

— Business Consultants

- Personal Tax Returns

The individual Appellants presented that they owned the client list goodwill personally and loaned it to the Company carrying on the business at no charge. There was no documentation presented, nor any other evidence to corroborate this rather extraordinary position.

In 1988, Norman J. answered the following advertisement in a local newspaper:

PUBLIC ACCOUNTANTS

Professional Public Accountant is looking to purchase a Public Accountant Practice. Reply in strict confidence to:

Box D-661

The Times Transcript

939 Main Street

Moncton, N.B. EIC 1G8

This resulted in the sale of the Company business as a going concern. An agreement for the sale contained in part the following:

THIS AGREEMENT MADE THIS 12th DAY OF SEPTEMBER, 1988.

BETWEEN: NORMAN MARTIN, of 30 Kelly Road, in the City of Moncton, County of Westmorland and Province of New Brunswick, and ROBERT FARINA, of 70 Summerhill Drive, in the City of Moncton, County of Westmorland and Province of New Brunswick, hereinafter called the “VENDORS”;

AND: ERNEST BOUDREAU, of 58 Donald Avenue, in the City of Moncton, County of Westmorland and Province of New Brunswick, and JOSEPH HEBERT, of 17 Burbank Court, City of Moncton, County of Westmorland and Province of New Brunswick, hereinafter called the “PURCHASERS”.

WHEREAS the Vendors have for some time past carried on the business of accountants under the firm name and style of MARTIN N.J. MANAGEMENT SERVICES LTD.;

AND WHEREAS the Purchasers have agreed to purchase from the Vendors certain assets hereinafter described;

NOW THEREFORE this Agreement witnesseth that in consideration of the mutual covenants herein contained, and upon the terms and conditions hereinafter set forth the parties hereto agree as follows:

1. The Vendors hereby sell, transfer and assign and the Purchasers hereby purchases

(a) the customer list as attached hereto as Schedule “A” and Schedule

“B” including both audit and non-audit services performed;

(b) customer files;

(c) office equipment, supplies and other intangibles at nominal value

situate at 45 Elmwood Drive, Moncton, New Brunswick;

(d) the goodwill of the business;

2. The purchase price for the asset being purchased in paragraph 1 herein shall be the sum of $125,000.

The individual Appellants took the position that they owned the customer list and goodwill personally and taking into account applicable capital gains exemptions, they were not liable to pay tax. The only asset of value was the customer list - customer files — which can be described as goodwill. A value of $3,000 was placed on the equipment set out above in #1.(c) and transferred from the Company to the individuals and included in the sale price.

It was not the list of names in itself for which the purchasers paid $125,000 but for the goodwill built by the efforts of the Company’s employees over the years so that gross earnings in the Company increased from $40,000 to $125,000 from 1977 to 1988.

The September 12, 1988 purchase agreement included the continuing services of Norman J. and Robert F. and a non-competition clause.

The purchasers in all likelihood hoped to retain the business goodwill which resulted in approximately $125,000 in billings by the Company in its last year of operation. The purchasers paid for the probability that the clients would continue to patronize the business. They wanted the advantage of the reputation of the business built up over the years by the employees of the Company providing good service. These were services to the Company’s clients. It was the Company’s business, the Company’s clients, and the Company’s customer list. The agreements do not set out the legal reality. The true legal ownership cannot be altered by documents or by individuals manoeuvring the structure to suit their needs at a given time.

Norman J. and Robert F. were presented as unsophisticated accountants. They were not chartered accounts, Norman J. was educated through the school of experience and in addition to experience, Robert F. had more formal academic accreditations. I cannot accept the position that the customer list, goodwill, was owned by the individuals and that the Company acquired no goodwill after 11 years of service to it by Norman J. and Robert F.

I am satisfied that the business attracted the smaller unsophisticated businessman and while they prepared tax returns, these were of an uncomplicated nature. Subparagraph 152(4)(a)(i) reads in part:

...the Minister may assess...at any time if the taxpayer or person filing the return 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.

I find that the Appellants made a misrepresentation in taking the position that the customer list, goodwill, belonged to Norman J. and Robert

F. personally and that the Company, that had carried on the business almost as long as it existed prior to sale and for whom Norman J. and Robert F. worked exclusively, was virtually without any value.

I conclude, without difficulty, that this misrepresentation was attributable to “neglect carelessness or wilful default”. The more difficult question remains whether penalties under subsection 163(2) should be imposed.

Counsel for the Respondent directed the Court to Farm Business Consultants Inc. v. R., (sub nom. Farm Business Consultants Inc. v. Canada) [1994] 2 C.T.C. 2450, 95 D.T.C. 200 (T.C.C.); affirmed at [1996] 2 C.T.C. 200, 96 D.T.C. 6085 (F.C.A.), where Bowman, J.T.C.C. was faced with the same question and, at pages 2455-56 (D.T.C. 204-05) he stated:

The issue under subparagraph 152(4)(a)(i) is not however unrelated to the third issue, that of penalties. If the misrepresentation is attributable to simple neglect or carelessness not amounting to gross negligence the penalties under subsection 163(2) cannot be supported. If, however, it is misrepresentation attributable to “wilful default” it is much more difficult to conclude that it is not equally a “false statement” which the appellant made “knowingly” within the meaning of subsection 163(2).

The type of carelessness or neglect encompassed by subparagraph 152(4)(a)(i) may include, but is not as extensive as, that contemplated in the words “gross negligence” in subsection 163(2) (“faute lourde”) which implies conduct characterized by so high a degree of negligence that it borders on recklessness. It would be difficult to conclude that the state of mind required for “wilful default” (“omission volontaire”) is not the same as that implicit in the word “knowingly” (“sciemment”).

Subsection 163(2) provides:

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 penalty of....

I have made a great effort to put the appellant’s conduct in as benign a light as possible, and to attribute it to a naive and foolish belief that schemes of the type involved here actually work rather than to a wilful misrepresentation of the true state of affairs. I have been unable to do so. The appellant either knew what it was doing or was reckless as to the legal efficacy of the arrangement. I am cognizant of the fact that subparagraph 152(4)(a)(i) has as its purpose the opening up of returns for statute-barred years where items of income, for a wide variety of reasons, are omitted or misstated, whereas subsection 163(2) is a penal provision and that in applying it if there is doubt as to the type of conduct to which the misrepresentation is attributable the benefit of that doubt should be given to the taxpayer.

A court must be extremely cautious in sanctioning the imposition of penalties under subsection 163(2). Conduct that warrants reopening a statute- barred year does not automatically justify a penalty and the routine imposition of penalties by the Minister is to be discouraged. Conduct of the type contemplated in paragraph 152(4)(a)(i) may in some circumstances also be used as the basis of a penalty under subsection 163(2), which involves the penalizing of conduct that requires a higher degree of reprehendsibility. In such a case a court must, even in applying a civil standard of proof, scrutinize the evidence with great care and look for a higher degree of probability than would be expected where allegations of a less serious nature are sought to be established. Moreover, where a penalty is imposed under subsection 163(2) although a civil standard of proof is required, if a taxpayer’s conduct is consistent with two viable and reasonable hypotheses, one justifying the penalty and one not, the benefit of the doubt must be given to the taxpayer and the penalty must be deleted.

I agree with the reasoning of Judge Bowman and have tried to apply it to the present facts. The Appellants were portrayed as having an unsophisticated approach to their work. I have no difficulty accepting this given the evidence including the inaccuracies in their personal income tax returns, their indifference with respect to documentation. They demonstrated little resemblance to the stereotype accountant who is dedicated to preciseness and accuracy.

Norman J. testified that he was aware that tax relief was available to them by selling shares of the Company. This contradicts the evidence presented that he knew little or no tax law. The assessment of penalties by the Minister is understandable. The Court has had the opportunity to hear one and a half days of evidence and argument. Giving careful consideration to all of the circumstances, I am prepared to give Norman J. and Robert F., the benefit of doubt and not impose penalties. While their actions may have been on the edge, I have taken into consideration their casual and broad stroke approach to their business affairs, their lack of attention to detail. I accept that they did not knowingly or under circumstances amounting to gross negligence make false statements or omissions. I am also mindful that, with a minimum of professional tax advice, the present situation could have been averted by the sale of shares.

In conclusion, the Court finds:

1. the client list sold was the property of the Company and the proceeds of its disposition were the property of the Company and properly included in the income of the Appellants, Norman M. and Robert F.

2. The Minister properly issued Notices of Reassessment beyond the time limitations otherwise imposed by subsection 152(4) of the Act.

3. No penalties are to be assessed pursuant to subsection 163(2) of the Act.

The appeals are dismissed. While there was no request for such, in the Respondent’s pleadings, costs are awarded to the Respondent.

Appeals dismissed.