Hildebrandt v. R., [1997] 3 C.T.C. 2936, 98 D.T.C. 1013

Mogan T.C.J.:

1 According to the opening statements in the Appellant's Notice of Appeal and in the Respondent's Reply, the taxation years under appeal are 1990, 1991 and 1992. As I understand the substance of the pleadings, however, the only issue before this Court concerns the 1990 and 1991 taxation years. Specifically, the question is whether the Minister of National Revenue can justify certain penalties assessed under subsection 163(2) of the Income Tax Act for the 1990 and 1991 taxation years. There are no material facts alleged in the Notice of Appeal other than a bald statement that the penalties are not justified. Certain basic facts are pleaded in the Respondent's Reply. Subsection 163(3) of the Act states:

• 163(3) Where, in any appeal under this Act, any penalty assessed by the Minister under this section is in issue, the burden of establishing the facts justifying the assessment of the penalty is on the Minister.

2 The Appellant's income tax returns for 1990, 1991 and 1992 (Exhibits R-1, R-2 and R-3) reported farm losses of $12,500, $10,000 and $7,500, respectively. Each return contained a statement of farming revenues and expenses which may be summarized as follows:

1990	1991	1992
Total Farm Revenues	$514,994	$379,593	$340,161
Total Farm Expenses*	584,432	438,386	342,200
Farm Income (Loss)	(69,438)	(58,793)	(2,039)
Livestock Inventory Adjustment
(prior year)	(25,538)	(82,476)	(131,269)
Livestock Inventory Adjustment
(current year)	82,476	131,269	125,808
Net Farm Income (Loss)	(12,500)	(10,000)	(7,500)

Notes:

• * including capital cost allowance

Other Source Income	45,431	38,265	24,755
Farm Losses	(12,500)	(10,000)	(7,500)
Total Income (per income tax return)	32,931	28,265	17,255

3 By Notices of Reassessment dated November 1, 1993, the Minister increased the Appellant's reported income for 1990 and 1991 and decreased it for 1992 by the following amounts:

1990	1991	1992
Income Reported	$32,931	$28,265	$17,255
Increase (Decrease)	16,434	82,917	(2,434)
Revised Income per Reassessment Nov. 1/93	49,365	111,182	14,821

1990
Total Income per reassessment Nov. 1/93
Cattle Inventory (current year)
previous addition	$82,476
revised amount	72,631
Less	(9,845)
Other deductions
Total income per reassessment Aug. 5/94
1991
Total Income per reassessment Nov. 1/93
Cattle Inventory (current year)
previous addition	$131,269
revised amount	25,938
Less	(105,331)
Other additions
Total income per reassessment Aug. 5/94
1992
Total Income per reassessment Nov. 1/93
Cattle Inventory (current year)
previous addition	$125,808
revised amount	20,477
Less	(105,331)
Other additions
Total income per reassessment Aug. 5/94

• 163(2) 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 a penalty of...

...“Gross negligence” must be taken to involve greater neglect than simply a failure to use reasonable care. It must involve a high degree of negligence tantamount to intentional acting, an indifference as to whether the law is complied with or not....

4 Kathryn Willis testified as a witness for the Respondent. She is a business auditor for Revenue Canada. She described Revenue Canada's general screening process for individual income tax returns. The Appellant's returns for 1990 and 1991 were selected on the basis of random screening. On a relative basis, his interest expenses seemed high and his grain sales seemed low. Ms. Willis attempted to contact the Appellant to get his books and records through a letter (Exhibit R-2F) to his accountants dated September 12, 1992. A record book would show all revenues and expenses. The Appellant had no record book. What he had was two boxes of documents which were simply vouchers and some sheets of paper. On a sheet of paper, the Appellant had one total amount for revenues and one total amount for expenses. The Appellant had substantial grain and cattle sales but they were not recorded in an orderly fashion.

5 Ms. Willis tried to start her audit in the fall of 1992 by performing a rough source and application of funds. She took the sources of revenue and attempted to determine where the expenses were made. Her source and application method produced a negative result, and so she decided to prepare a statement of net worth for the period 1989-1991. On February 16, 1993, she wrote to the Appellant (copy to his accountants) enclosing a copy of her net worth statement. See Exhibit R-2D. She received no response to her letter but there were some telephone discussions. Her memos to file (Exhibit R-17) show how difficult it was to arrange a meeting with the Appellant or his accountants. Ms. Willis wrote a second letter (Exhibit R-2C) again enclosing her net worth statement and stating that penalties under subsection 163(2) would be assessed. The first reassessments were issued on November 1, 1993 using the net worth statement to increase the Appellant's income for 1990 and 1991 and to assess penalties under subsection 163(2).

6 Ms. Willis identified Schedule “B” to the Respondent's Reply herein as her final net worth statement. The Appellant (through his accountants) had requested adjustments to certain bank balances in the original net worth statement and to the amounts specified under section 28 of the Act. Messrs. Burroughs, Weber & Partners, a firm of chartered accounts in Swift Current, Saskatchewan, prepared and filed the Appellant's income tax returns for 1990, 1991 and 1992. In a letter dated January 26, 1994 (Exhibit R-3D) from Messrs. Burroughs, Weber & Partners to Ms. Willis, Mr. A.E. Downs (a member of that firm) stated in part:

1990	— Adjustments to figures on net worth working papers
	Statement of personal assets — Exhibit “A”
Bank accounts	1989	1990
Royal 8202699	$90,891.18	$92,000.20
	Statements of business liabilities — Exhibit “D”
Other loans and mortgages	1989	1990
ACS	$29,375.00	$26,675.00

7 As a result of adjustments proposed, we would request adjustments to the inventory adjustment on the farm statement as follows: Ms. Willis acted upon the requests in Exhibit R-3D. She adjusted the balances of the Royal Bank account no. 8202699 directly on her net worth statement. See Schedule “B” to the Reply. She adjusted the amounts with respect to inventory on the Notices of Reassessment which were issued on August 5, 1994. Those amounts were specified under subsection 28(1) of the Income Tax Act and were not part of the net worth determination. See the above summary of those reassessments. It is the adjustments to those amounts specified with respect to inventory which had the effect of reducing the Appellant's total income for 1990 and 1991 from the high levels which were assessed for tax on November 1, 1993 to the lower levels reported by the Appellant in his income tax returns.

8 It is logical to question the Minister's ability to justify penalties under subsection 163(2) for 1990 and 1991 when the reassessments of August 5, 1994 which levied those penalties also reduced the Appellant's total income for 1990 and 1991 to the same amounts as the Appellant had reported for those years. In my opinion, however, there are three important factors which weigh against the Appellant: (i) the magnitude of his farming operation; (ii) the absence of adequate books and records to determine the profit or loss of that farming operation; and (iii) the Appellant's acceptance of the Respondent's net worth statement to determine his income for 1990 and 1991.

9 As noted above, the Appellant's farming operation was substantial. His was not a few cows and a few chickens on a few acres of land. In 1990, his total farm revenues and total farm expenses each exceeded $500,000. That is a business operation of some magnitude. Subsection 230(1) of the Income Tax Act states in part:

• 230(1) Every person carrying on business and every person who is required, by or pursuant to this Act, to pay or collect taxes or other amounts shall keep records and books of account (including an annual inventory kept in prescribed manner) at his place of business or residence in Canada ... in such form and containing such information as will enable the taxes payable under this Act... to be determined.

10 Subsection 230(1) establishes a standard of care with respect to books and records for every person carrying on a business. The Appellant's farming operation was a substantial business. Prima facie, the Appellant was negligent concerning the statutory standard of care in subsection 230(1).

11 The revised net worth statement (hereinafter referred to as the “NWS”) which Ms. Willis used in the reassessments of August 5, 1994 to determine the Appellant's income for 1990 and 1991 is Schedule “B” to the Respondent's Reply to the Notice of Appeal herein. Although the NWS speaks for itself, I will attempt to describe its methodology. The Appellant's assets and liabilities are recorded as at the 31st day of December in two or more consecutive years. By subtracting the liabilities from the assets, the net worth on each year end date is determined. By comparing the net worth at the end of one year with the net worth at the end of the subsequent year, one can observe if there was an increase in net worth during the subsequent year. An apparent increase in net worth is adjusted downward to recognize non-taxable amounts received in the subsequent year (e.g. a gift or inheritance), and adjusted upward to recognize the cost of personal expenses (e.g. food and clothing) in the subsequent year. After taking into account all relevant adjustments, a change in adjusted net worth from the end of one year to the end of the subsequent year can be computed. If that change in adjusted net worth is a positive amount (i.e. if the adjusted net worth at the end of the subsequent year exceeds the adjusted net worth at the end of the immediately preceding year), Revenue Canada would assume that such positive amount (i.e. the excess) was the taxpayer's income for the subsequent year.

12 For obvious reasons, a statement of net worth is not the best way to measure annual income. The method is inherently imprecise. In Clayholt v. Minister of National Revenue (1990), 90 D.T.C. 1543 (T.C.C.), at 1545, I cited some earlier cases in which the net worth method of assessing was referred to as “makeshift” and a “last ditch attempt”. Notwithstanding its shortcomings, the net worth method of measuring annual income has been accepted by the courts in many income tax appeals. The Appellant and his accountants seem to have accepted the NWS herein without batting an eye. Nowhere in the correspondence before me are there any howls of protest from the Appellant or his accountants against the use of Ms. Willis' NWS as a method of measuring income. There is no claim that the Appellant's documents would provide a better method of measuring his income. The only form of protest is a bland request in the accountants' letter (Exhibit R-3D) that certain bank balances be adjusted on the NWS and that the Appellant be permitted to change his specified amount under paragraph 28(1)(b) of the Income Tax Act.

13 The Appellant's acceptance of the NWS is a real admission on his part as to the inadequacies of his own books and records. In my view, he has admitted that he was negligent with respect to the statutory standard of care imposed by subsection 230(1) of the Act set out above.

14 In order to justify the penalties, the Respondent must prove that there was gross negligence in the making of a false statement in the Appellant's income tax returns. One test for such gross negligence is to compare the amount of income reported by the Appellant in a particular year with the amount of income as determined for that same year by the NWS. In this appeal, the only two years are 1990 and 1991. The Appellant has accepted the NWS as a method of measuring his income. An amount specified by the Appellant under paragraph 28(1)(b) in response to the NWS is not part of the NWS although the NWS itself may rely (for the purpose of valuing inventory) on such amount as the Appellant specified in his income tax return. The Appellant's reported income and his income as determined by the NWS and their relationship are set out in the following table:

1990	1991
Income Reported	$32,931	$28,265
Income per Net Worth
Statement	49,365	111,182
Increase	16,434	82,917
Increase as percent of Reported Income	49.9%	293%
Reported Income as percent of Net Worth	66.7%	25.4%
Statement

15 Under the Income Tax Act, a person carrying on a farming business is permitted in paragraph 28(1)(b) to specify an amount with respect to the fair market value of inventory. That amount becomes a positive element in the computation of farming income for one year but that same amount becomes a negative element under paragraph 28(1)(f) in the computation of farming income for the subsequent year. When filing his income tax returns for 1990 and 1991, the Appellant had used paragraph 28(1)(b) to specify the following amounts with respect to the fair market value of livestock inventory: $82,476 for 1990 and $131,269 for 1991. See Exhibits R-1 and R-2. Those same amounts were used to value livestock inventory in the NWS. See Exhibit R-2D.

16 When the Appellant saw the results and effect of the NWS, he asked Ms. Willis to amend his specified amounts with respect to the fair market value of livestock inventory relying on paragraph 28(1)(b). See Exhibit R-3D. For 1990, he amended his specified amount from $82,476 to $72,631 so that the decrease ($9,845) plus other deductions of $6,590 would offset the increase of $16,434 resulting from the NWS. And for 1991, he amended his specified amount from $131,269 to $25,938 so that the decrease ($105,331) would offset the increase of $82,917 resulting from the NWS plus other income of $22,413. It is the impact of the amended amounts (specified under paragraph 28(1)(b) of the Act) with respect to livestock inventory upon the income determined by the NWS which brings the Appellant's total income for 1990 and 1991 back to the lower amounts which he reported.

17 The measurement of income by the net worth method is a simplistic determination of profit or loss without regard to any of the special adjustments required by generally accepted accounting principles or permitted by the Income Tax Act. For example, a net worth determination of annual income would not take into account a reserve under paragraph 20(1)(m) of the Act for the future delivery of goods or services; nor would it reflect in consecutive years an amount specified by a farmer under paragraph 28(1)(b), even though it may use such specified amount in the valuation of inventory for the year in which the amount was specified. Therefore, when the net worth method is accepted as a measure of the Appellant's income, and the question under subsection 163(2) is whether a false statement was made in his income tax return under circumstances amounting to gross negligence, the Appellant cannot escape from the amount of income he reported in a particular year and the amount of income determined by the net worth method for that year. In colloquial language, he is stuck with both amounts.

18 The Appellant's decision, after reviewing his higher levels of income as determined by the net worth method, to specify amended amounts under paragraph 28(1)(b) had the effect of bringing his income, as finally assessed for tax, down to the levels he reported in his returns for 1990 and 1991.

19 In my view, however, he may still be liable for a penalty under subsection 163(2) if the gap between what he reported and what was determined to be his income by the net worth method is significant. The fact that the Appellant is able to reach out to the Income Tax Act and exercise his right under paragraph 28(1)(b) to specify certain amended amounts for 1990 and 1991 which reduce his income for those years from the higher levels determined by the net worth method does not mean that he did not make false statements in his income tax returns for 1990 and 1991; or that such false statements were not made under circumstances amounting to gross negligence.

20 By accepting the NWS, the Appellant admits that he reported only2/3of his 1990 income and only1/4of his 1991 income. Having regard to the difference between the amounts of income which the Appellant reported for 1990 and 1991 and the amounts of income determined in the NWS for 1990 and 1991, I find that the Appellant made a false statement in each of his income tax returns for 1990 and 1991. Having regard to the magnitude of that difference in relative terms, and the Appellant's inadequate books and records, I find that the Appellant's false statements were made under circumstances amounting to gross negligence in the words used by Strayer J. in Venne: “an indifference as to whether the law is complied with or not”.

21 Counsel for the Appellant relied on the decision of this Court in Glass v. R. (1994), 94 D.T.C. 1091 (T.C.C.). Mr. Glass operated a cattle and grain farm on 5,000 acres of land in Saskatchewan. In 1980, he retained Farm Business Consultants (“FBC”) to do his accounting and tax returns. Mr. Glass and his wife maintained orderly books and records. In 1983, he incorporated D Co. as a family corporation and transferred significant farm property including cattle to D Co. which paid Mr. Glass $75,000 per annum in rental income. In 1988, he failed to report $10,000 of the rent paid to him by D. Co. In 1989, D Co. received $124,000 from the sale of cattle which Mrs. Glass then transferred to the personal bank account of Mr. Glass in order to earn more interest. The $124,000 amount was not included in the income of Mr. Glass or D Co. for any year. The omissions of the $10,000 and the $124,000 from income were discovered by an auditor from Revenue Canada in June 1991. Mr. Glass did not deny the omissions from income and cooperated with the Revenue Canada auditor. Penalties were assessed under subsection 163(2). When allowing the appeal of Mr. Glass, McArthur J. stated at pages 1093 and 1094:

Part of the responsibility for the omissions was placed on a former employee of F.B.C. who is deceased who may have had failing health while preparing the Appellant's statements and returns in 1989. In addition to the two omissions, interest expense of $17,448 and $17,532 for 1988 and 1989 taxation years, respectively, was not claimed. The interest expense and adjustment in 1988 more than offset the unreported $10,000 rental income for that year.

On the evidence, the Appellant had retained and relied on F.B.C. to do the preparation statements and income tax returns for many years.... He, through his wife Darlene, kept accurate records that were presented quarterly to the consultants. A record of the $124,450 income was clearly presented. The substantial interest expense was also available and not used as a deduction.

The evidence is not sufficiently convincing to conclude that the Appellant had the state of mind or mens rea required to apply subsection 163(2). While there was certainly a degree of negligence by the Appellant in dealing with his tax returns, he is given the benefit of the doubt and I find there was no gross negligence that would attract penalties.

22 I am not certain that I would have reached the same conclusion as the trial judge in Glass. In any event, the facts in these appeals (Hildebrandt) are quite different because (i) the Appellant did not maintain an orderly record of revenues and expenses; and (ii) the Appellant cooperated with the Revenue Canada auditor (Ms. Willis) only until he was told that there was a significant discrepancy between his reported income and his income as determined by the NWS. According to the evidence of Ms. Willis in cross-examination, the cooperation of the Appellant ceased when he learned of that discrepancy.

23 Counsel for the Appellant also relied on the decision of this Court in Fortis v. Minister of National Revenue (1986), 86 D.T.C. 1795 (T.C.C.). The decision in Fortis is easily distinguished because, in that case, the two individual taxpayers disputed the net worth statement on the basis that they had received funds from loans or gambling. Mr. Hildebrandt, the Appellant herein, did not dispute the NWS. In Kerr v. R. (1989), 89 D.T.C. 5348 (Fed. T.D.), Martin J. stated at page 5354:

...In order to support a penalty under subsection 163(2) it is not necessary, in my view, to establish precisely the exact quantum of unreported income. It is sufficient that the Minister establishes that there has been gross negligence or circumstances amounting to gross negligence in making a false statement in an income tax return.

24 The pleadings do not raise any issue with respect to the computation of the penalties under subsection 163(2). In the absence of such issue, I assume that the Appellant's “understatement of income” is $16,434 for 1990 and $82,917 for 1991; and that all of the “understatement of income” for each year is attributable to a false statement in the Appellant's return of income for each respective year. The appeals are dismissed, with costs.