Tobias v. R.!, [1999] 2 CTC 2351

O’Connor T . C.J.:

These appeals were heard together on common evidence at Toronto, Ontario on February 3, 1999. Testimony was given by the Appellant and by Gary Pollack (“Pollack”) and several exhibits were filed.

Issue

The issue is whether the Appellant, as a director of Country Pride Discount Stores Incorporated (“Discount”) and Country Pride Leasing Incorporated (“Leasing”), was liable for unremitted employee source deductions of these corporations (“Corporations”) pursuant to subsection 227.1(1) of the Income Tax Act (“Act”) or is the defence of “due diligence” available to him as contemplated in subsection 227.1(3) of the Act. As is well known, these provisions make a director liable for a corporation’s failure to remit employee source deductions, however the director escapes the liability if he exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.

Facts

The Appellant completed university, obtaining a Business Administration degree. He was also involved in several businesses since 1983. As such he was aware of the directors’ liability provisions of the Act.

The Appellant was a director of the Corporations for those periods in which there was a failure to remit source deductions. This was June to July of 1992 in respect of Leasing and February, May, June, July and August of 1992 in respect to Discount. Discount was incorporated on March 30, 1990 and Leasing was incorporated on January 22, 1991. The Appellant held 31 shares in each of the Corporations. A Mr. Bagri (“Bagri”) held 31 shares in each of the Corporations and Pollack held 38 shares in each of the Corporations. All three were initial directors of the Corporations. Pollack was the president, the Appellant was the secretary and Bagri was the treasurer of both Corporations.

The Appellant was also the manager and co-owner of another corporation named Delta Graphics.

Pollack was the driving force behind the Corporations. The business carried on by the Corporations was the operation of retail stores from various leased premises. Originally there were six stores. Later two more were added.

The head offices of the Corporations are located in the same premises as Simone Imports Incorporated, another corporation owned by Pollack. Further, Bagri had a business operation close to the said premises.

Pollack, Bagri and the Appellant got involved as shareholders and directors of the Corporations for various reasons and hoped that the retail stores would be profitable. In addition, their own personal businesses supplied products to the stores. Pollack’s business was the largest supplier to the stores. Combined, Pollack and Bagri supplied about 90% of the products supplied by the three personal businesses. The Appellant supplied only approximately 10%.

Pollack, assisted by his bookkeeper, was the hands-on, day-to-day, operator of the stores. He signed leases, hired managers who in turn hired employees, ordered inventory, arranged for deliveries. Payables were handled by him from the head office with the assistance of his bookkeeper. Pollack and the bookkeeper dealt with creditors, banks and arranged financing. There were no regular directors’ meetings and up until approximately April of 1991 only informal meetings were held, usually at Pollack’s office. Sometimes there would only be meetings between Pollack and Bagri. These meetings were essentially to find out how the stores were doing. No financial statements were reviewed but the Appellant was able to review statements of payables, inventory and sales. Major decisions were taken by Pollack and the Appellant was not involved in any major decisions. Bagri was a little more involved in the stores’ business than the Appellant. In the early stages there was never any problems with the payables. In the first year the stores were doing well and all source deductions were being paid to Revenue Canada and all creditors were being paid. There was no cause for concern at least up until April or May of 1991.

In April 1991 the Appellant, realizing he was not very active in the operation of the stores and because of some differences with Pollack over the high prices Pollack’s other business was charging to the stores, which made the stores less profitable and competitive, decided that he wanted out of the Corporations.

As a result, the Corporations, Pollack, Bagri and the Appellant entered into an Agreement executed May 21, 1991 wherein the Appellant promised to sell and Pollack and Bagri promised to buy the Appellant’s shares in the Corporations. The sale of the shares was to be completed on the date which was the earlier of January 31, 1992 or that earlier date selected by Pollack and Bagri upon the Appellant’s receipt of 10 days prior written notice. The Agreement also provided that the Corporations’ pay an amount of $159,027 to the Appellant’s corporation Delta Graphics. Also, Pollack and Bagri agreed to use their best efforts to have the bank release the Appellant from his guarantee on a loan of $200,000, failing which they would deliver to the Appellant certain indemnity agreements. The same provisions were also to be in effect with respect to any other debts and obligations which had been guaranteed by the Appellant. Pollack and Bagri also agreed to deliver on closing an indemnity saving harmless the Appellant from all losses, expenses and damages whatsoever which may have been incurred by any action or other proceeding or claim in respect of any debt or obligation of the Corporations. The Agreement further provided that the Appellant on the closing of the transaction would resign as a director and officer of the Corporations.

The Agreement also covered the following points. The Appellant had loaned $100,000 to Discount. To make the deal to sell his shares and have Delta Graphics paid, the Appellant agreed to reduce the $100,000 amount to $50,000. He took an allowable business investment loss in 1991 in respect to the $50,000 foregone. Schedules to the said Agreement provided for instalment payments of both the $159,027 and the said $50,000. The $159,027 was to be paid by six equal monthly instalments of $26,504 commencing June 21, 1991 and ending November 21, 1991. The $50,000 was to be paid by instalments of $16,666.66 on October 31, 1991, November 30, 1991 and December 31, 1991.

It was the testimony of the Appellant that the $50,000 was never paid and that of the $159,027 Delta Graphics only received the first two payments and part of the August payment.

The Appellant’s lawyer advised him to hold on to his shares until the foregoing debts had been paid and further not to resign as a director to retain some leverage to assure the debts would be paid as promised.

The Appellant considered himself out of the Corporations as of May 21, 1991 notwithstanding that he continued to hold the shares and did not resign as director. It became apparent in the fall of 1991 that the payments promised under the agreement were not being made on time. The Appellant attempted to push Pollack to come up with the payments. From and after May 21, 1991 the Appellant was unable to extract any information from Pollack as to the financial condition of the Corporations. He was not consulted on any matters and there were no directors’ meetings. Although the Appellant received no documentation, Pollack verbally advised the Appellant from the period after May, 1991 that the stores were doing all right but little specific information was given. Late in 1992 the Appellant learned that Revenue Canada had not received certain source deductions withheld by the Corporations and was considering proceeding against the Appellant as a director. The Appellant retained Stanley O. Kotick, Q.C. as his lawyer. Kotick wrote a letter to Revenue Canada — (Tab 4 of Exhibit A-1) outlining the fact that since May of 1991 the Appellant had nothing to do with the Corporations and could not get information from Pollack. The testimony of Pollack to a very large extent confirms the testimony of the Appellant, principally that Pollack ran the business of the Corporations and that the Appellant had little or no input. Also the stores were doing well in May, 1991 but sales started dropping thereafter and the stores were closed at the end of 1991. Pollack may have let Bagri know about the failure of remittances but he did not tell the Appellant of same as he considered that the Appellant was no longer a “partner” in the businesses of the Corporations.

Submissions of the Appellant

The Appellant’s Memorandum of Law and Argument states as follows:

Appellant’s Memorandum of Law & Argument

The issue in these matters is whether the Appellant, as a director of Country Pride Discount Stores Incorporated and Country Pride Leasing Incorporated (the “Corporations”), should be liable for the unremitted employee source deductions of the Corporations, or whether the Appellant is entitled to rely upon the due diligence defence in subsection 227.1(3) of the Income Tax Act, R.S.C. 1985, c. I (5th Supp), as amended.

I. Law and Argument

A. The Income Tax Act

1. Subsection 227.1 (1) of the Income Tax Act, R.S.C. 1985, c. 1 (5 Supp), as amended (the “Act”) provides as follows:

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 ... 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.

Income Tax Act, R.S.C. 1985, c. 1 (5 Supp), as amended, ss. 227.1(1)

2. Subsection 227.1(3) of the Act provides for a “due diligence” defence where the director exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.

Income Tax Act, supra, ss.227.1(3)

3, The Appellant was a director of the Corporations during the periods in

issue, being June to July, 1992 in respect of Country Pride Leasing Incorporated, and February, May, June, July and August, 1992 in respect of Country Pride Discount Stores Incorporated. The Appellant submits that he is entitled to rely upon subsection 227.1(3) of the Act on the basis that he exercised the degree of care, diligence and skill to prevent the failure to remit that a reasonably prudent person would have exercised in comparable circumstances. The Appellant’s position is based upon the fact that he had no influence over the day-to-day management and affairs of the Corporations and further that in May, 1991, a full 9 months prior to the first date of default, his relationship with the Corporations effectively ended.

B. Case Law

(i) The Standard of Care Generally

4. In determining whether a director is entitled to rely upon the “due diligence” defence, the appropriate standard of care involves an “objective- subjective” element. More particularly:

... The standard of care laid down in subsection 227.1(3) of the Act is inherently flexible. Rather than treating directors as a homogenous 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 businesspersons).

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”.

Soper v. R. (1997), [1998] I F.C. 124 (Fed. C.A.), at 155

5. The Appellant submits that when applying the “objective subjective” test, he acted with the degree of care, diligence and skill that a person in comparable circumstances would have exercised. He reviewed financial information but had limited influence over the management of the Corporations. Furthermore, following the date upon which he agreed to sell his shares, the Appellant received no information and was effectively barred from having influence over the affairs of the Corporations.

(ii) The Standard as Between Inside and Outside Directors

6. While liability as a director is not based simply upon a person’s classification as an inside versus an outside director, this is an appropriate starting point for the analysis in any given case. Further:

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... 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.

Soper, supra, at 156

7. The Appellant submits that he was not a “inside” director of either of the Corporations as he was not involved in day-to-day management and was not able to influence the conduct of the businesses. As a consequence, the Appellant is not held to the higher standard of care which may apply to inside directors.

8. In order to satisfy the due diligence defence, a director may take positive action by setting up controls to accounts for remittances, asking for regular reports and confirming that remittances have occurred. How- ever, such precautionary steps are not necessary conditions precedent to the establishment of a defence. An outside director cannot be required to go to such lengths. Unless there is reason for suspicion, it is permissible to rely on the day-to-day corporate manager to be responsible for the payment of debt obligations such as those owing to Her Majesty.

Soper, supra, at 159 to 160

Sanford v. R. (1995), 96 D.T.C. 1912 (T.C.C.), at 1914 to 1915

Cybulski v. Minister of National Revenue (1988), 88 D.T.C. 1531 (T.C.C.), at 1535

9 Further, where a person reviews financial statements and receives information

which supports the view that the financial situation of the company is healthy, the director is entitled to rely upon such information unless there is reason to believe otherwise. Where there is no reason to question the veracity of the statement and the reliability of assurances provided by other persons, the director should not be held liable.

Golfinan v. Minister of National Revenue (1990), 90 D.T.C. 1863 (T.C.C.), at 1868

10. The Appellant submits that prior to May 1991, positive actions were taken with respect to Revenue Canada remittances, including regular meetings to discuss business and financial information and regular reviews of financial statements. In fact, the Corporations were not in default to Revenue Canada during this period. The Appellant submits that as a director who was not involved in day-to-day management he had no obligation to take such positive actions in order to establish that he acted with due diligence. The fact that he took such positive action further supports his entitlement to the defence.

11. In Cloutier v. Minister of National Revenue (1993), 93 D.T.C. 544 (T.C.C.) Bowman, T.C.C.J. quoted with approval the decision of the Tax Court of Canada in Merson v. Minister of National Revenue (1988), 89 D.T.C. 22 (T.C.C.) which held that subsection 227.1 (3) of the Act does not require the care, diligence and skill that is exercised with an unduly excessive measure of prudence. Bowman T.C.C.J. further stated:

... The directors of a corporation are neither trustees for nor

insurers of the Minister of National Revenue. They are required under section 227.1 to act with reasonable skill and prudence to ensure that the Minister is paid that which is owing to him. Where, however, individual directors who control neither the company nor the board of directors are powerless to influence the course taken by the corporation the law does not require that they should be held responsible for the corporation’s obligations to the fisc.

Cloutier v. Minister of National Revenue (1993), 93 D.T.C. 544 (T.C.C.), at SSI

12. The Appellant submits that he was, at all times, an outside director of the Corporations who was not involved in day-to-day management and had little ability to control the Corporations or the boards of directors. Furthermore, the Appellant submits that he was powerless to influence the course taken by the Corporations and thus should not be responsible for their obligations to Revenue Canada.

13. The Appellant further submits that from May, 1991 he was a director of the Corporations in name only, in order to preserve his leverage under the agreement to have his shares bought. The Appellant had absolutely no influence over the board of directors and was completely powerless to have any influence over the affairs of the Corporations after this date. As a consequence, he should not be liable for the failure to remit amounts to Revenue Canada which became due some nine months later.

(iii) The Standard Where a Director Has Severed His Ties to the Corporation

14. Where a person has severed his connection with the corporation of which he is a director, such action relieves the person of vicarious liability for the corporation’s default in remitting deductions at source. This is particularly so where the person is banned from having influence on the corporation by virtue of the severance of the relationship:

In my opinion the general principle that ignorance of the law is no excuse ... can have no application here. In enacting subsection 227.1(3) Parliament established an exonerating standard of conduct the presence of which is to be determined in particular cases by the actual relevant facts and not by fixing to a taxpayer knowledge of a somewhat esoteric point of corporation law that in reality is probably not within the actual knowledge of a good number of legal practitioners. While at first blush subsection 227.1(3) suggests a requirement for positive assertion on the part of a taxpayer in order to bring himself within its ambit, this is not necessarily so in all situations. It may well be that a taxpayer would not take positive steps in some circumstances and still be correctly [regarded] as having “exercised” that degree of care, diligence and skill expected of a reasonably prudent person that creates the protection from liability afforded by the subsection. That obtains in respect of this appeal. I am satisfied that reasonable grounds existed for the appellant’s belief that he had severed his connection with the Company as director and secretary-treasurer and concomitantly his responsibility for it when he placed his resignation in the hands of the Company’s president and it was accepted by him. This relieves him of vicarious liability for the Company’s default in remitting the deductions at source and this is so a fortiori where, as here, the appellant was effectively barred from exercising influ- ence over the management of the company by the person in defacto control of its affairs after the resignation was submitted.

Cybulski v. Minister of National Revenue, supra, at 1535

Stevenson Estate v. R. (1996), 97 D.T.C. 863 (T.C.C.), at 865

15. The Appellant submits that his relationship with the Corporations was effectively severed when he agreed to sell his shares to the other shareholders and directors in May, 1991. While be had very limited influence over the management of the Corporations before that date, the Appellant had absolutely no influence after that date. He was powerless. While the Appellant did not tender resignations as a director of the Corporations, this was solely to retain some leverage in order to ensure that payments were made under the said Agreement. The purpose and effect of the Agreement was to sever the Appellant’s role in the Corporations and to bar him from participating at all in the business and financial affairs.

16. The Appellant submits that because the failures to remit occurred at least nine months after the agreement to be bought out of the Corporations, he should not be held liable under subsection 227.1(1). By the time that the defaults to Revenue Canada had occurred the Appellant’s relationship to the Corporation had been terminated for at least nine months. The severance of the Appellant’s relationship to the Corporations barred him from exercising any influence. Thus he exercised the degree of care, diligence and skill that a reasonably prudent person would have in comparable circumstances.

Submissions of the Respondent

Counsel for the Respondent points to the Appellant’s education and business experience. Also he was a major creditor of the Corporations. The Appellant did nothing to prevent the remittance failures. She referred to Tab 18 of Exhibit R-l which contains the details of the Appellant’s claim for an allowable business investment loss in 1991 resulting from the Appellant’s write-off of the $50,000 mentioned above. Counsel concedes this was probably prepared in March or April of 1992 but she refers to the statement in the claim that Discount was insolvent as of July 31, 1991. The Appellant must have been aware of the fact the Corporations were in financial difficulties because the payments under the Agreement were not forthcoming. She argues that the Appellant had a right to demand an audit under Section 1.04 in both Corporations’ Shareholders’ Agreements (Tabs I and 2 of Exhibit A-l) and further he had the rights provided in the Ontario Business Corporations Act as a shareholder to demand an audit. He should not simply have waited on the sidelines and let things deteriorate.

She refers to the decision of this Court in Byrt v. Minister of National Revenue (1991), 91 D.T.C. 923 (T.C.C.), in particular the following passage at pp. 930-931:

A director must be prudent. A director cannot ignore disturbing actions of a president of a corporation, even if the president also controls a majority of the shares of the company. The degree of prudence required by subsection 227.1(3) leaves no room for risk. In exercising the degree of care, diligence and skill to prevent a corporation’s failure to remit source deductions as Part VIII tax, the director must heed what is transpiring within the corporation and his experience with the people who are responsible for the day-to-day affairs of the corporation. Once a director knows something negative about the corporation’s affairs other directors do not know and he does not even attempt to inform the other directors, he is lacking a degree of care and diligence. He lacks skill, care and diligence when after querying the integrity and sincerity of a person, he does nothing to control the actions of that person. A prudent person, in such circumstances, would have become at least suspicious and the person’s degree of care and diligence ought to have increased substantially if he chooses to remain a director of the corporation. A director cannot be said to have done anything which is reasonable, proper, right or just when he permits irregularities to continue.

Analysis and Decision

In my opinion, for the following principal reasons, the Appellant has succeeded in establishing due diligence, namely:

1. Perhaps from the outset, i.e., the dates of incorporation of the Corporations, the Appellant was an outside director. In any event, he certainly must be considered as an outside director from and after the Agreement of May 21, 1991.

2. That Agreement of May 21, 1991 evidences the fact that the Appellant wanted to be out of the Corporations but, on the advice of his lawyer, he remained on as a shareholder and a director. It is clear from his testimony and that of Pollack that from and after the date of that Agreement he was no longer “a partner” in the Corporations. The provisions of the Agreement discussed above support this position.

3. From and after the Agreement the Appellant was essentially totally barred from receiving any financial information concerning the Corporations. His relations with the Corporations had been terminated and he was no longer involved in any way with the operations of the businesses.

4. Until May of 1991 the Appellant received and reviewed the written information supplied by Pollack and the bookkeeper with respect to sales, inventory and payables and there had been no problems with any payables including particularly amounts obliged to be remitted to Revenue Canada.

5. Defaults in making remittances occurred long after the May 21, 1991 Agreement, the earliest default occurring nine months thereafter.

6. The education and business experience of the Appellant militates against him in his due diligence defence but in my opinion that is offset by the other considerations discussed above.

7. I do not consider critical the failure to cause an audit of the Corporations to be made. Such a remedy is certainly an extreme measure and in any event it would take a very legalistic minded director to even know that the remedy existed.

8. The various court decisions referred to in the Appellant’s Memorandum of Law and Argument, in particular the decision in Cybulski in my opinion support the conclusion arrived at herein.

Consequently, for the above reasons, the appeal is allowed with costs and the assessment is vacated.

Appeal allowed.