Henning v. K., [1998] 4 CTC 2692

Lamarre T.C.J.:

The appellant is appealing from an assessment dated June 12, 1996 in the amount of $9,215.85, which was made pursuant to section 227.1 of the Income Tax Act (the "Ac").

Facts

The appellant is a lawyer by profession and has had a general commercial and estate law practice in Edmonton for 46 years. As such, he has sat on the boards of many corporations.

In the summer of 1992, the appellant was approached by a friend and client, Bernie Budney, whom he had known since 1980, to assist him in the acquisition of certain garage and tire shop assets. At the same time, Budney requested the appellant to participate in a business corporation known as Affordable Tire & Auto Repair Ltd. (“Affordable”).

Affordable was incorporated under the Business Corporations Act (Alberta) (the “BCAA”) on December 9, 1992. The Articles of Incorporation were prepared by Douglas C. Hodgson, an articling student then working for the appellant’s law firm, and the law firm’s address was given as Affordable’s registered office. At the time of incorporation, there was only one director, Mrs. Janet Lennox, who was Budney’s spouse.

According to Budney, he asked the appellant to help him' finance the operation of Affordable. Apparently, the appellant agreed, provided Budney was able to secure title to the tire shop premises so that Affordable would be in a position to grant the Alberta Treasury Branch (“ATB”) a second mortgage on these assets to secure a line of credit that the appellant, in turn, would guarantee. If these conditions were fulfilled, the appellant asked that Affordable be reorganized to include the appellant’s participation as a shareholder and director of Affordable.

In consideration of the appellant’s guarantee and management assistance, the appellant’s corporation, Femco Financial Corporation Ltd. (“Femco”) was to receive a management fee of $2,500 per month.

On April 27, 1993, ATB agreed to grant Affordable an operating line of credit of $75,000 upon certain conditions, one of which was that the appellant and one of the corporations he controlled guarantee the loan. Some legal documents were also required. ATB’s offer was signed by Budney and the appellant. Then, on April 30, 1993, Articles of Amendment were signed by the appellant as president of Affordable; they modified the structure of the share capital. As well, a Notice of Change of Directors, appointing the appellant and Budney as directors of Affordable, was signed by the appellant, as president, on the same date. These documents were filed with the Registrar of Corporations on July 27, 1993.

On July 19, 1993, Douglas Hodgson had sent a memorandum to the appellant together with certain documents to be executed by him in anticipation that the line of credit would be granted. These documents included a share subscription by the appellant and the Notice of Change of Directors.

On December 20, 1993, a letter dealing with the proposed reorganization of Affordable was sent to Affordable by John Whitmore of the appellant’s office. Enclosed were certain documents to be executed and returned by Budney in order to prepare the 1993 annual return to be filed with the Registrar of Corporations. These documents included the resolution by which the shareholders appointed the appellant and Budney as additional directors.

According to the appellant, although the notice of his appointment as a director of Affordable was filed, he was not in fact appointed as a director since the conditions precedent to such an appointment were never satisfied. Budney’s testimony was to the same effect. He said that since he was not able to fulfil the conditions on which the appellant agreed to act as a director, the appellant never was a director or shareholder of Affordable.

Affordable never did get the line of credit from ATB. According to Budney, this can be explained by his failure to transfer additional assets to Affordable and by Affordable’s failure to clear up certain pre-existing liabilities. Consequently, the appellant was never called upon to guarantee a line of credit for Affordable.

Budney testified that Affordable operated its business without the operating credit. He said that it had already started its operations in early 1993. The appellant was not involved in the business’s activities. He was not invited to a single directors’ meeting. Budney negotiated with ATB and with other creditors on his own. They had no other contact with each other after the failure to obtain the operating credit. Neither the appellant nor his corporation, Femco, received a management fee from Affordable.

On June 14, 1994, the appellant signed the 1993 annual return, which was then filed with the Registrar of Corporations. The appellant is referred to in this return as a 50 percent shareholder. In his examination-in-chief, the appellant testified that in June 1994, he had not seen Budney for a while and figured that Budney did not need him anymore. When the appellant was presented with the 1993 annual return, one year had elapsed and Affordable was still not in a position to grant a second mortgage. The appellant, therefore, asked his clerk to get him out of the company. The following appears in a separate note relating to a conversation between the appellant and an employee of his firm: “will sign organizational material. However, wants to get out of this company”. In cross-examination, the appellant said that he signed the 1993 return as solicitor only so that the company would not be struck off. He acknowledged, however, that when he signed the 1993 return in June 1994, he would still have honoured his commitment, if Budney had showed up with a clear title to the business.

On August 24, 1994, the Alberta Treasury (Tax and Revenue Administration) wrote the appellant to advise him that Affordable had failed to file a return for the taxation year ended December 9, 1993, as required by the Alberta Corporate [Income] Tax Act, and that, as a director, he might be subject to prosecution if the return were not filed. In a letter to Revenue Canada dated July 25, 1995, the appellant said that he was unaware that he was mentioned as a director until he received the notice from the Alberta Treasury on August 24, 1994. He said that he promptly instructed his firm’s corporate department to file a notice revoking his appointment as a director.

The appellant tendered his resignation as director of Affordable on October 4, 1994 and the Notice of Change of Directors was filed with the Registrar of Corporations on November 4, 1994.

Affordable did not default on its employees’ source deduction payments to Revenue Canada except for September 1994, which was the company’s final month of operation. Budney testified that he had to shut down the business due to the harsh financial conditions. The total outstanding amount, including penalties and interest, at the date of assessment was $9,215.85, which is the amount at issue.

Appellant’s Argument

The appellant first submits that he was not at any time, in fact or in law, a director of Affordable. According to the appellant, he was never elected or appointed as a director. Only the voting by shareholders can elect or appoint directors, and Budney testified that he was the voting shareholder and that he never appointed the appellant as a director. Furthermore, even if the appellant had been elected or appointed by Budney, the appellant submits that he was not elected or appointed as required by subsection 100(5) of the BCAA and is therefore deemed not to have been elected or appointed as a director pursuant to subsection 100(6) of the BCAA. Subsections 100(5) and 100(6) of the BCAA read as follows:

100(5) A person who is elected or appointed a director is not a director unless

(a) he was present at the meeting when he was elected appointed and did not refuse to act as a director, or

or

(b) if he was not present at the meeting when he was elected or appointed,

(i) he consented to act as a director in writing before his election or appointment or within 10 days after it, or

(ii) he has acted as a director pursuant to the election or appointment.

(6) For the purpose of subsection (5), a person who is elected or appointed as a director and refuses under subsection (5)(a) or fails to consent or act under sub- section (5)(b) shall be deemed not to have been elected or appointed as a director.

According to the appellant, he agreed to become a director of Affordable only if certain conditions precedent were met. Since none of the conditions were met, the appellant was not required to be a director. Furthermore, at all material times, the appellant acted only in his capacity as solicitor for Affordable.

The appellant further submits, in the alternative, that if he were to be considered a director of Affordable, he exercised the degree of care, diligence and skill to prevent Affordable’s failure to remit source deductions that a reasonably prudent person would have exercised in comparable circumstances. As a result, he should not be held personally liable pursuant to subsection 227.1(3) of the Act.

Respondent’s Argument

It is the Respondent’s position that the appellant was aware that he was a director from the time he became one, as per the documentation filed in evidence, and up until the time when he resigned his directorship. It is also the respondent’s position that the appellant, being a senior practitioner in the City of Edmonton, was well aware of the duties of a director of a corporation. He had executed documents identifying himself as both a director and shareholder of Affordable and was fully aware of what he was doing. Accordingly, the appellant should be jointly liable for any failure by Affordable.

Analysis

With regard to the appellant’s first argument, I am of the view that the appellant was elected and appointed a director of Affordable as of April 29, 1993, as is specifically set out in the Notice of Change of Directors filed with the Registrar of Corporations on July 27, 1993. The appellant has not convinced me that when he signed that document as president of Affordable, he did so only in his capacity as solicitor for Affordable. Indeed he instructed a lawyer from his office to prepare all documents necessary for the reorganization of Affordable (see letter dated December 20, 1993, Exhibit A-1, Tab 5).

Even if it were true that none of these documents were executed, I am far from convinced that the appellant did not act as a director of Affordable from the moment he agreed to file all the documents with the Corporate Registry identifying himself as a director of Affordable, as required by ATB. Although the appellant said that he did not participate in the negotiations with ATB, he did participate indirectly by agreeing to comply with ATB’s requirements, including that of being identified as a director of Affordable.

Furthermore, I do not see why the appellant would have agreed on June 14, 1994 to sign the 1993 annual return, which indicated that he held 50 percent of the shares in Affordable and that a Notice of Change of Directors had been filed. By that time, Affordable had been operating its business for almost a year and a half. Even though the appellant was aware that Affordable was operating without a line of credit, he indicated that if all the conditions required by ATB were met, he would have honoured his commitment to Budney.

Finally, the appellant did not start the resignation process until the Alberta Treasury informed him in August 1994 that he could be held liable for Affordable’s failure to file a tax return. I find it hard to believe that the appellant was unaware that he was identified as a director of Affordable in the Corporate Registry. I find, rather, that he did consider himself a director of Affordable before he resigned, although there is one indication from June 1994 that he wanted to get out of the company (see the conversation record dated June 14, 1994 -- Exhibit A-l, Tab 8 -- where the appellant stated that while he would sign the organizational material, he wanted to “get out of this company”).

I therefore conclude on the appellant’s first argument that he has not shown, on a balance of probabilities, that he did not act as a director pursuant to his election or appointment. I accordingly believe that he was a director of Affordable within the meaning of the BCAA from April 29, 1993 until his resignation on October, 4 1994.

The appellant’s second argument is that he had already resigned when the obligation to remit the source deductions for the month of September 1994 arose. He further submits than in any case, 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 obligation to withhold is found in subsection 153(1) of the Act which reads in part as follows:

153. (1) Withholding. - Every person paying at any time in a taxation year

(a) salary or wages or other remuneration,

shall deduct or withhold therefrom such amount as is determined in accordance with prescribed rules and shall, at such time as is prescribed, remit that amount to the Receiver General on account of the payee’s tax for the year under this Part or Part XI.3 ...

The amount so withheld is deemed to be held in trust for Her Majesty the Queen by the employer pursuant to subsection 227(4), which reads as follows:

227. (4) Money held in trust. - Every person who deducts or withholds an amount under this Act shall be deemed to hold the amount so deducted or withheld in trust, separate and apart from the person’s own moneys, for Her Majesty and for payment to Her Majesty in the manner and at the time provided under this Act, and Her Majesty has a lien and charge on the property and assets of the person whether or not the person has kept the amount separate and apart or is in receivership, bankruptcy or liquidation or has made an assignment.

The time limit for remitting amounts deducted or withheld at source is set out in section 108 of the Income Tax Regulations. Subsection 108(1), which is applicable here, reads as follows:

108. Remittances to Receiver General. -

(1) Subject to subsections (1.1) and (1.11), amounts deducted or withheld under subsection 153(1) of the Act shall be remitted to the Receiver General on or before the 15th day of the month following the month in which the amounts were deducted or withheld.

A payer is liable to a penalty under subsection 227(8) of the Act for a failure to deduct or withhold:

227. (8) Penalty. - Subject to subsection (8.5), every person who in a calendar year has failed to deduct or withhold any amount as required by subsection 153(1) or section 215 is liable to a penalty of

(a) 10% of the amount that should have been deducted or withheld; or

(b) where at the time of the failure a penalty under this subsection was payable by the person in respect of an amount that should have been deducted or withheld during the year and the failure was made know- ingly or under circumstances amounting to gross negligence, 20% of

that amount-

The payer’s liability for a failure to remit is found in subsection 227(9.4), which reads as follows:

227. (9.4) Liability to pay amount not remitted. - A person who has failed to remit as and when required by this Act or a regulation an amount deducted or withheld from a payment to another person as required by this Act or a regulation is liable to pay as tax under this Act on behalf of the other person the amount so deducted or withheld.

Interest will also be charged in such a case pursuant to subsection 227(9.2), which reads as follows:

227. (9.2) Interest on amounts deducted or withheld but not remitted. -- Where a person has failed to remit as and when required by this Act or a regulation an amount deducted or withheld as required by this Act or a regulation, the person shall pay to the Receiver General interest on the amount at the prescribed rate computed from the day on which the person was so required to remit the amount to the day of remittance of the amount to the Receiver General.

If there is a failure to deduct or withhold, the Minister may assess the payer pursuant to subsection 227(10), and if there is a failure to remit, the Minister may assess the payer pursuant to subsection 227(10.1).

Furthermore, the liability of directors for a failure to deduct, withhold or remit is provided for in section 227.1, which reads in part as follows:

227.1 (1) Liability of directors for failure to deduct. - 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) Idem. - A director is not liable for a failure under subsection (1) 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.

There is one proposition that the liability to remit tax withheld crystal- lyzes as soon as the tax is deducted even though a period of time is given during which the tax can be forwarded. This proposition can be found in an article by Edwin G. Kroft, “The Liability of Directors for unpaid Canadian Taxes”, in the Report of Proceedings of the Thirty-seventh Tax Conference, 1985 Conference Report (Toronto: Canadian Tax Foundation, 1986) 30:1 at 30:20 and 30:21. According to Mr. Kroft, “section 227.1 is intended to shift the allocation of the loss to persons who occasioned the loss or could have prevented it from occurring”. Thus, a failure to remit or pay can occur at any time during the period in which the payment or remittance might be made.

However, there is another proposition that under a criminal prosecution, an offence for failing to remit employee source deductions can be committed only after the 15-day period has elapsed and that the payer cannot, therefore, be in default before the sixteenth day (see R. v. Sakellis (1970), 70 D.T.C. 6202 (Ont. C.A.). It is therefore arguable that a director who ceases to hold office before the final date should not be liable under subsection 227.1(1) on the grounds that he is not a director at the time that the remittance is required to be made, (see E.P. Moskowitz, “Directors’ Liability Under Income Tax Legislation and Other Related Statutes,” (1990) 38 Can. Tax J. 537 at 553 - 554).

In my opinion, this last proposition should stand. If, as was held in Sakellis, the payer is not in default before the sixteenth day, I do not see why a heavier burden should be imposed on a director. Furthermore, the Act as drafted creates two separate obligations: the obligation to deduct or withhold and the obligation to remit. Under subsection 227(9.4), the liability to pay an amount not remitted arises only at the time the remittance is required by the Act or a regulation (which in the instant case is pursuant to subsection 108 of the Income Tax Regulations, on or before the 15th day of the month following the month in which the amounts were deducted or withheld). Interest on amounts deducted or withheld but not remitted as and when required by the Act or a regulation is computed from the day on which the person was so required to remit the amount to the day of remittance of the amount to the Receiver General. I doubt that any interest would be charged to the payer if the payment to the Receiver General were made after the amounts were deducted at source but before the 15th day of the following month. It makes more sense that the payer, and the director where the payer is a corporation, will be held liable for a failure to remit upon the expiration of the 15-day period and that interest on the amount in question will be computed from that point in time. Accordingly, if someone resigns a directorship after the time the amounts were deducted at source but before the deadline for remittance, I am of the view that this person should not be held jointly and severally liable together with the payer corporation for the amounts that it failed to remit. As soon as the director resigns, he no longer has any power to prevent the corporation’s failure to remit.

My conclusion on the appellant’s second argument disposes of the case in his favour. However, I will also analyse his third argument. Did the appellant show, on a balance of probabilities, that he exercised the appropriate degree of care, diligence and skill to prevent the failure?

The Federal Court of Appeal reviewed the tests to be applied when such a due diligence defence is raised in Soper v. R. (1997), 97 D.T.C. 5407 (Fed. C.A.). They can be summarized as follows:

1. The standard of care set out in subsection 227.1 must take into account subjective elements such as 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, more is expected of individuals with superior qualifications or experienced business persons.

2. However, the standard of care is not purely subjective. It is not enough for a director to say that he or she did his or her best. It is equally clear that honesty is not enough.

3. 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”. (See Soper, supra, pages 5416-5417).

Furthermore, inside directors, namely those who are involved in the day-to- day management of the company and influence the conduct of its business affairs, will have the most difficulty establishing the due diligence defence.

For outside directors, a positive duty to act arises where they obtain information, or become aware of facts, which might lead one to conclude that there 1s, or could reasonably be, a potential problem with remittances.

In the present case, the evidence did not reveal that, based on the financial information or documentation available to the appellant, he ought to have known that there was a problem or a potential problem with remittances. Source deductions and remittances were regularly made by an outside company that was managing Affordable’s payroll. This outside company was processing the payroll and Budney was signing cheques every month for the total amounts due. There were no real reasons for the appellant to be aware of potential problems with remittances. Besides, Budney said in his testimony that it was only in September that he learned he would no longer be able to pursue the business which was in fact shut down at the end of September 1994. All that time, the appellant had little contact with Budney, who did not tell the appellant about all his financial problems. Budney had been operating the business without the line of credit since early 1993. The appellant did not have to guarantee any loan to Affordable.

I find that the appellant was acting as an outside director, that taking all the circumstances into account, there was no reason for him to be alerted to any potential problem with remittances, and that consequently he did not have a positive duty to act before the date of his resignation on October 4, 1994.

I therefore conclude that the appellant is not personally liable for the amounts owing by Affordable. The appeal is allowed, with costs.

Appeal allowed.