McGrath v. R., [1998] 1 CTC 3038, 98 DTC 1009

Bowie T.C.J.:

This appeal is from an assessment by the Minister of National Revenue pursuant to subsection 227.1(1) of the Income Tax Act, by which the directors of a corporation are made jointly and severally liable with the corporation for unremitted source deductions. The assessment also encompasses amounts which should have been but were not remitted under the Unemployment Insurance Act and the Canada Pension Plan.

There are a number of limitations upon the operation of subsection 227.1(1). The only one invoked by the Appellant in this case is what is sometimes called the due diligence defence found in subsection (3). Subsections 227.1(1) and (3) read as follows:

227.1(1) Where a corporation has failed to deduct or withhold an amount as

required by subsection 135(3) or section 153 or 215, has failed to remit such an amount or has failed to pay an amount of tax for a taxation year as required under Part VII or VIII, the directors of the corporation at the time the corporation was required to deduct, withhold, remit or pay the amount are jointly and severally liable, together with the corporation, to pay that amount and any interest or penalties relating thereto.

(3) A director is not liable for a failure under subsection (1) where he exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.

The assessment under appeal is in respect of the liability of Collins Seafood Ltd. (Collins) for unpaid deductions for federal and provincial income tax, Canada Pension Plan contributions and unemployment insurance premiums which Collins failed to remit to the Receiver General for Canada. The unremitted amounts, augmented by interest and penalties, total $33,383.12.

The Appellant is a lawyer who has practiced in Moncton, New Brunswick since 1973. Together with a partner, Mr. Tippett, he engaged from time to time, with some success, in the business of developing real estate. More recently they, with a third partner, Mr. Eaton, bought into a lobster processing business at Cap Brulé, near Moncton. The Appellant had little to do with the day-to-day operation. This was run by Mr. Tippett and a Mr. Cormier, who had been the long-time owner of the business. The partners expanded their venture in the seafood industry in 1988 by purchasing the business of Mr. and Mrs. Collins at Alma, New Brunswick, some 120 kilometres from Moncton. Unlike Cap Brulé, where the principal business was processing and canning lobsters, the business at Alma was the purchase from fishermen of lobsters for resale live to restaurants and wholesalers, and to a small extent for sale at a retail outlet on the premises. Market lobsters are larger than canners, and they must be kept alive under very carefully controlled conditions until they are resold. The pound where they are stored must be kept supplied with salt water whose oxygen content, temperature and salinity must all be carefully maintained. The facility at Alma was capable of holding approximately 10,000 lbs. of live lobster for resale. The salinity of the water was maintained by means of a saltwater well in the Bay of Fundy designed to feed the lobster pound.

When the Appellant and his partners purchased the business, they incorporated Collins Seafood Ltd. to own and operate it. The Appellant was president, and a director. In 1989, they added a further business, Buctouche Fish Market (Buctouche), to their enterprise. For various reasons, which are not material to the decision of this appeal, the partners decided to divide their various businesses among them. The Appellant and Mr. Tippett became the owners and operators of Collins and Buctouche. The Appellant was engaged on a full-time basis in the practice of law, and Mr. Tippett also had other interests to attend to. They soon sold the Buctouche business, and the Collins business was operated for them by a series of managers. The first was Mr. Wood, who managed Collins in 1989, and then left to return to fishing. In that year the business broke even, more or less. The manager in 1990 was Mr. Hyslop. According to the Appellant’s evidence, Mr. Hyslop was not capable of managing the business, and he ultimately resigned, but not before beginning a series of losses from which the business never was able to recover. The losses that year were no doubt due, at least in part, to the fact that the United States market was closed to Collins by an embargo on Canadian lobsters, and to depressed prices in Canada.

In 1991, they hired Mr. Sutherland to be the on-site manager of the Collins operations at Alma. By late 1991, it was becoming apparent to the Appellant and Mr. Tippett that the business was not likely to prosper, and they were looking for an opportunity to sell it. The company had a $40,000.00 line of credit at the Royal Bank of Canada which was more or less fully utilized most of the time. There was also a mortgage to Mr. and Mrs. Collins, the vendors, which had to be paid. It is clear from the evidence that in 1991, the business was undercapitalized. The cash flow situation was such that when lobsters were delivered by the fleet of a dozen or so vessels fishing out of Alma, the funds to pay the fishermen, and for the withholdings for income tax, unemployment insurance premiums and Canada Pension Plan contributions which Collins was required to remit, could only be paid out of the proceeds of the sale of those lobsters; there simply was not sufficient working capital to make the payments any other way.

This chronic shortage of working capital had caused Collins to be in default of its obligations to remit withholdings as early as 1990. It made no remittances from August 1990 to November 1990. In November, in response to pressure from officers of Revenue Canada, Mr. Tippett provided Revenue Canada with two cheques for $4,000.00 each, in payment of the company’s arrears as revealed by an audit done at that time. From then on, the company was more or less perpetually in arrears. An audit on January 15, 1991 found arrears in excess of $18,000.00. In July 1991, the arrears were slightly more than $19,000.00 and in August 1992, the total arrears amounted to $27,696.23, of which the company paid $11,459.99, representing the arrears for the period from January to July 1992. The previous arrears of $16,236.24 remained outstanding. It was apparent to the Appellant by the spring of 1992 that Collins was not profitable, and that its operations would probably have to be discontinued at the end of that year. The Appellant’s hope and expectation was that by operating through the summer season of 1992 it would be possible to produce sufficient profits to pay the indebtedness to Revenue Canada and to the Royal Bank, and then return the lobster pound and other operating assets to Mr. and Mrs. Collins to discharge the mortgage debt, and thereby wind-up the business debt-free. Unfortunately, that was not to be.

Mr. McGrath knew in the spring of 1992 that there was a significant debt owing to Revenue Canada in respect of unremitted withholdings. By this time, Mr. Tippett had gone on to other ventures, leaving the Appellant to run the company, along with Mr. Sutherland. He gave instructions to Mr. Sutherland that he was not to pay the fishermen for lobster delivered until such time as the lobster had been sold, the proceeds of the sale deposited in Collins’ bank account, and the funds cleared. Deliveries were to be made by Collins to its customers on a cash basis, and the accounts payable, including those for source deductions, were to be met as they fell due, out of the proceeds of the sales. In the middle of August 1992, the fishers at Alma, who were the company’s suppliers, demanded of Mr. Sutherland that they be paid for their product immediately upon delivery. For reasons that were not fully explained in his evidence, Mr. Sutherland chose to accede to this demand, without consulting the Appellant. There were some funds available in the bank to pay source deductions owing to Revenue Canada, and it was these funds which were used to pay the fishers. In Mr. Sutherland’s mind, according to his evidence, the sale of the inventory which he was paying for with these funds would enable the company to meet its liability for source deductions. Unfortunately, between the time that the customer, Bluenose Fishmarket of Riverview, New Brunswick, gave Mr. Sutherland its cheque payable to Collins for $11,827.73, and the time that it was presented for payment, Revenue Canada had served a third-party demand upon Bluenose Fishmarket’s bank, effectively freezing the account of Bluenose. In the result, the bank was unable to honour the Bluenose cheque payable to Collins, and Collins in turn was unable to apply the proceeds against its arrears of source deductions owing.

While this was a serious setback for Collins, Mr. McGrath and Mr. Sutherland did not view it as fatal. Their expectation was that the inventory in the pound of some 10,000 lbs. of lobster could be sold, and the proceeds used to pay off the outstanding liabilities for source deductions to Revenue Canada, and the other outstanding debts. Some or all of the line of credit at the Royal Bank might remain outstanding, but Mr. McGrath still considered that he could discontinue the operations of Collins, return the property to Mr. and Mrs. Collins, and wind up the business with all of the debts retired, other than the line of credit, by the end of 1992.

The second catastrophic event came in late October or November. A severe storm in the Bay of Fundy caused fresh water to get into the saltwater well, and from there into the lobster pound. The inventory in the pound at that time was approximately 8,000 lbs., having a value of about $55,000.00. Approximately one-half of this inventory died as a result of the fresh water entering the system, causing a loss to the company of some $20,000.00 or $25,000.00. The remaining inventory was sold, but the proceeds were insufficient to pay off the existing debts. The company ceased operations, and the mortgage on the lobster pound and other property was foreclosed. Some creditors, including the fishers, were paid, but the indebtedness to the Royal Bank remained outstanding, as did some $30,000.00 worth of indebtedness to Revenue Canada for unremitted withholdings which, together with interest, forms the basis of the assessment under appeal.

As I stated earlier, the Appellant contests the assessment only upon the basis of subsection 227.1(3) of the Act. He says that he acted with the degree of care, diligence and skill to prevent the failure to remit that the subsection calls for, which is to say that degree which a reasonably prudent person would have exercised in comparable circumstances. In support of this contention his counsel points to the following facts:

l. The Appellant borrowed some $25,000 to inject into the company as working capital at the beginning of the 1992 season, without which the company could not have operated at all that year;

2. The Appellant’s instructions to the plant manager, Mr. Sutherland, that no payments were to be made until the inventory had been sold, and that the source deductions must be paid out of the proceeds of each catch;

3. The Appellant had no prior knowledge when Mr. Sutherland chose to depart from these instructions and pay the fishers for their catch before it was sold and paid for;

4. The arrears of withholdings owing would have been paid but for two events beyond his control; the cheque of the Bluenose Fish Market, which Sutherland had accepted contrary to his instructions, was not honoured by the bank, and the storm in the fall of 1992 killed much of the inventory on hand.

But for these latter events, he says, the arrears would have been paid before the end of the 1992 season, and the business wound up. It therefore would not be fair to penalize him for the company’s failure to pay, as these events were outside his control.

This argument overlooks a number of important facts. First, the failure to remit in a timely way began as early as July 1990, and after that time, not more than two monthly remittances which were made when they were due. After the middle of 1991, the company made virtually no remittances, and it was only through audits by Revenue Canada that the arrears were established from time to time. It is clear that the other trade creditors were being paid throughout this period; if they had not been, there would have been no product to sell, and the pound would have been shut down for lack of electric power. In effect, the unremitted funds were being used, as well as the line of credit, to provide working capital to the business. Throughout most of the period there was not adequate office staff to ensure that the bookkeeping was done and the remittances paid. The cheque from Bluenose Fish Market being dishonoured at the bank no doubt was a blow to the company, but if those funds had been available they would have discharged less than one-half the outstanding liability to the Crown at that time. Finally, cheques on the company’s bank account required the signature of two people; at the time of the payment to the fishers in August 1992, which was made contrary to the Appellant’s express instructions, Mr Sutherland was making payments to creditors using about 50 cheques on the company’s account which had been signed in blank and given to him by the Appellant. Mr. Sutherland may have acted contrary to his instructions, but it was the Appellant who, by by-passing a normal safeguard of business practice, put him in a position to do so.

In support of his argument, counsel for the Appellant referred me to a number of cases decided in this Court, and to the decision of Addy J., as he then was, of the Federal Court - Trial Division in Robitaille v. R.. [1] As Addy J. correctly observed in that case:

...when dealing with ‘the degree of care, diligence and skill’ to be exercised by ‘a reasonably prudent person’ in ‘comparable circumstances’, each case must necessarily depend on its particular facts,....

I do not find any helpful principle in the cases to which counsel referred me; they all turn on their own facts, which differ greatly from those of the case at bar.

The Federal Court of Appeal has recently considered the due diligence defence found in subsection 227.1(3) in Soper v. R. [2] In reasons concurred in by Linden J.A., Robertson J.A., after a review of the decided cases, concluded that the test to be used in applying the subsection requires that both subjective and objective factors be taken into account. At pages 23-25 he said:

... The standard of care laid down in subsection 227.1(3) of the Act is inherently flexible. Rather than treating directors as a homogeneous group of professionals whose conduct is governed by a single, unchanging standard, that provision embraces a subjective element which takes into account the personal knowledge and background of the director, as well as his or her corporate circumstances in the form of, inter alia, the company’s organization, resources, customs and conduct. Thus, for example, more is expected of individuals with superior qualifications (e.g. experienced business-persons).

The standard of care set out in subsection 227.1(3) of the Act is, therefore, not purely objective. Nor is it purely subjective. It is not enough for a director to say he or she did his or her best, for that is an invocation of the purely subjective standard. Equally clear is that honesty is not enough. However, the standard is not a professional one. Nor is it the negligence law standard that governs these cases, Rather, the Act contains both objective elements - embodied in the reasonable person language - and subjective elements - inherent in individual considerations like “skill” and the idea of “comparable circumstances”. Accordingly, the standard can be properly described as “objective subjective”. At the outset, I wish to emphasize that in adopting this analytical approach I am not suggesting that liability is dependent simply upon whether a person is Classified as an inside as opposed to an outside director. Rather, that characterization is simply the starting point of my analysis. At the same time, however, it is difficult to deny that inside directors, meaning those involved in the day-to-day management of the company and who influence the conduct of its business affairs, will have the most difficulty in establishing the due diligence defence. For such individuals, it will be a challenge to argue convincingly that, despite their daily role in corporate management, they lacked business acumen to the extent that that factor should overtake the assumption that they did know, or ought to have known, of both remittance requirements and any problem in this regard. In short, inside directors will face a significant hurdle when arguing that the subjective element of the standard of care should predominate over its objective aspect.

This Appellant certainly has “superior qualifications”, and so must be held to the highest standard of care. As a practicing lawyer for some twenty years, he must have understood his obligations as a director. He has a degree in business administration, and some years of experience as a businessman. He must be taken to understand the importance of following sound business practices, and what those practices are. Throughout the life of this company he was an inside director, and by the summer of 1992 he was, if not the only director, then at least the only one actively participating in the business.

Even an outside director has a positive duty to act, upon learning that there is a problem. Robertson J.A. puts it this way: [3]

In my view, the positive duty to act arises where a director obtains information, or becomes aware of facts, which might lead one to conclude that there is, or could reasonably be, a potential problem with remittances. Put differently, it is indeed incumbent upon an outside director to take positive steps if he or she knew, or ought to have known, that the corporation could be experiencing a remittance problem.

The duty of an inside director is necessarily no less.

In the present case the Appellant clearly was aware of the failure to make the required remittances as early as 1990. He was involved in discussions with Revenue Canada officials about the arrears on numerous occasions thereafter. The positive action that he cites is the borrowing at the bank, and his instructions to Mr. Sutherland to sell only C.O.D., and to make no payments from the proceeds of a delivery to the pound until after the remittances were paid to Revenue Canada. As to the first of these, the borrowing at the bank was to obtain the necessary working capital to open the business for the 1992 season; it was certainly not used to pay off the arrears owing to the Crown, although some part of it may have gone to pay some part of the arrears.

The Appellant’s instructions to Mr. Sutherland in 1992 fall far short of satisfying the duty on him. First, it is a clear case of locking the barn door long after the horse has gone. As Robertson J.A. said in Soper: [4]

the purpose of subsection 227.1(3) is to prevent failure to make remittances and not to cure default after the fact (though, as a practical matter, the provision should have the latter effect as well).

The Appellant was under a duty to take positive steps, both to remedy the default and to prevent recurrences, at least as early as April 1991 when he learned that the audit had shown arrears of more than $18,000. Moreover, at the same time that he was issuing his instruction to Mr. Sutherland, he was furnishing him with blank cheques bearing his signataure, thus thwarting the most effective control he had over the company’s bank account. The explanation offered for this was that the business was located a long way from the Appellant’s office in Moncton, and that it would be inconvenient if he had to sign cheques one by one as they were issued. I am not impressed by this reasoning. It was up to the Appellant to devise a means of control under the circumstances. It is no doubt correct to say that directors can delegate to managers, and that to do so is not of itself a breach of their duty. In the circumstances prevailing here, however, where the company had a long history of arrears, chronic cash flow problems, and limited available credit, I am of the opinion that the one active director of the company handed blank cheques signed by him to the manager at his own peril.

The Appellant was in breach of the duty imposed on him by section 227.1 from at least April 1991 onward. The appeal is dismissed, with costs.

Appeal dismissed.