Paul E Gagné v. Minister of National Revenue, [1978] CTC 2458, [1978] DTC 1336

Guy Tremblay [TRANSLATION]:—The evidence in this case was heard at Quebec City, Quebec, on May. 2, 1977, and the oral pleadings on May 13, 1977.

1. General Point at Issue

The Board must decide whether additional expenses at the 20% rate should be allowed in respect of additional gross income of over $70,000 for the years 1968 to 1972 inclusive, since all vouchers were destroyed by a flood.

The Board must also decide whether the penalties of 25% imposed by the respondent in respect of each of the years in question because of fraud or gross negligence should be upheld.

2. Burden of Proof

If this appeal is to be allowed, the appellant must show:

(a) that the assessments are in error, and thus the respondent is not entitled to claim either the taxes or the penalties;

(b) that if the assessments are justified with respect to the taxes, he must refute the respondent’s evidence—if there is evidence— showing that he committed gross negligence in filing his own tax return for the years 1968 to 1972 inclusive.

Moreover, if the respondent is to succeed in having the penalties upheld, he has the burden of showing that the appellant committed fraud or gross negligence by making a misrepresentation when filing his own tax returns for the years in question.

The appellant’s obligation, described in paragraph (a) above, derives from the judgment of the Supreme Court of Canada in RW S Johnston v MNR,. [1948] CTC 195; 3 DTC 1182.

•i. .

The respondent’s and the appellant’s respective obligations, described in paragraph (b) above, derive from subsections 56(2) of. the old Act, 163(2) and (3) of the new Act and 62(3) of the Income Tax Application Rules, 1971.

3. Facts Alleged

3.1. Facts Alleged by the Appellant

Subparagraphs (a) to (k) of paragraph (5) of the notice of appeal clearly express the facts as seen by the appellant.

5. The reasons in Support of each of the appeals are as follows:

(a) each year the taxpayer made his tax returns to the best of his knowledge and in accordance with the vouchers available to him:

(b) the basement of the taxpayer’s residence was flooded and, as a result, he completely lost many other items, including the documents in support of his tax returns, the whole as stated in a claim and payment by the Town of Beauport in the amount of $3,000.00 filed herewith;

(c) unable to submit vouchers attesting to these expenses, the taxpayer provided explanations and a sample of the market for painters, which shows quite clearly that it is impossible to obtain a profit margin of eighty per cent (80%) on a contract;

(d) the Minister, for his part, proceeded to draw up a capital reconciliation and, in so doing, established the appellant’s capital at a figure approximately $41,104.00 above the latter’s real capital, as attested by a copy of the said reconciliation appended hereto;

(e) the profit margin in the painting contractor business is between ten and twenty per cent of the contracts granted;

(f) the taxpayer provided a list of persons with whom he contracted during the years in question but, because of the lack of vouchers, is unable to specify what particular amounts belong to each person;

(g) the taxpayer operated by ‘subcontracting a contract he had just received, and although he received the total amount after performing the contract he had to reimburse the subcontractors immediately, so that he kept only the profit margin between the contract and the subcontract:

(h) the Department’s decision to disallow the expense is arbitrary, unreasonable and inconsistent with accepted practice in this type of business;

(i) the Minister added the amounts of bank deposits without considering expenses or whether the amounts which he indicated under the heading “gross income’’ were in fact that;

(j) there can be no question of penalties in a special situation, and the Minister has the burden of proof where they are concerned;

(k) the taxpayer has the right to a reserve under s. 23(2) of the transitional provisions.

3.2. Facts Alleged by the Respondent

Paragraph 3 of the reply to the notice of appeal also clearly summarizes the facts as seen by the respondent.

3. The respondent based his assessments of the appellant in respect of the taxation years 1968 to 1972 inclusive on, inter alia, the following presumptions of fact:

(a) during the period in question, Mr Paul E Gagné worked as a house painter under the business name ‘Les Entreprises de Peinture Provinciale Enr”

(b) during the said period, the appellant reported the following sums as income:

1968	$4,490.80
1969	$4,492.12
1970	$5,415.95
1971	$5,932.00
1972	$6,099.07

(c) after the appellant’s business was audited by the Special Investigations Section of the Department of National Revenue, Departmental employees discovered the following income had not been reported:

1968	$ 7,905.84
1969	$ 6,708.45
1970	$15,007.42
1971	$24,962.35
1972	$15,715.19

(d) the said amounts of additional income were admitted by the appellant in his notices of objection;

(e) following the addition of this supplementary income, the taxpayer claimed additional sums as expenses for each of the fiscal years in question;

(f) notwithstanding the appellant’s failure to produce vouchers in support of the said expenses, the Minister allowed the taxpayer additional amounts of expenses equivalent to twenty per cent of the additional income for each of the years.

4.1. Facts Proven

4.1. The appellant, who is 63 years of age, has been working as a painter for over 40 years. However, although he still takes contracts and hires men to perform those contracts, he himself has not actually worked as a painter for about ten years. His state of health prevents him from doing so. He has had four heart attacks.

4.2. During the years in question and in 1973, the appellant had his business office in his basement, where he also kept several boxes of invoices and vouchers concerning contracts performed, purchases, sales and so on.

4.3. In July 1973 over a foot of water entered the basement as a result of a backup in the drainage system. The appellant’s son stated that the water was “up to our knees’’. All the documents in the, boxes and in the bottom drawers of the desk were soaked and unusable for all practical purposes.

4.4. The boxes and their contents were thrown out.

4.5. The counterfoil of a cheque for $3,000 issued by the Town of Beauport for damages caused by the backup and a receipt to this effect signed by the appellant were produced as Exhibit A-1.

4.6. It appears from the testimony of the appellant that during the years in question his bookkeeping system was not very organized, though almost all the vouchers were kept. As an exception to this general rule, the appellant cited certain purchases of paints or automobile expenses for which he did not request any vouchers, or lost the ones he was given. The appellant was the only person who handled the bookkeeping, made deposits and so on.

4.7. The existing vouchers were filed by subject matter. The appellant’s son, who moved the boxes, said that they were marked “contracts”’, “accounts receivable” and so on.

4.8. The appellant maintained in his testimony that, because it was difficult to find painters during the summer months, he often hired students to paint. He made no deductions from their wages nor did he give them a T4 form at the end of the school year.

In 1970 and 1971 the appellant had up to 22 employees. The minimum number of employees was 6. He sometimes paid them directly in cash. He hired a few temporary workers when necessary. The appellant stated that his business has dropped by 50% since the respondent’s investigation into his firm and the audits of his suppliers and subcontractors.

4.9. The appellant stated that the profit margin in contracts for painting buildings varied between 4 and 20%. Sometimes losses are also incurred. He remembered losing $2,000 in one contract with the Department of National Defence. He was also obliged to absorb wage increases which occurred between the times of tendering for a contract and performing it. Furthermore, it may cost up to $200 to prepare a tender (plan, quantity, estimated cost and so on). According to the appellant, it may sometimes be necessary to submit as many as 20 tenders to obtain one contract. Tenders are normally submitted for contracts of $1,000 and more. When cross-examined, the appellant was confronted with a list of customers and admitted that tenders are submitted almost exclusively for public and semi-public bodies. Most of the customers during the period at issue were private individuals. The appellant also stated that he sometimes had to entrust the contracts he obtained to subcontractors for almost the same price as that of the contract. However, he did not provide any details concern- ing these subcontractors through which they could even be clearly identified. The vouchers might perhaps have helped him if they had not been destroyed.

4.10. The appellant stated that if he had earned the net income that the Department of National Revenue claimed he did, his lifestyle would have been quite different. He has never been to Florida. He purchased his first automobile in 1963, his second in 1970, and in 1977 he still has this second automobile bought in 1970.

4.11. The chief expenses in a painting contract are labour and materials (paint, brushes and thinner).

4.12. The appellant contends that approximately 95% of the materials were purchased from Sico. However, with the aid of the figures taken from the purchases made from Sico in 1971 and 1972, the respondent showed that in fact the purchases for that year constituted only 75% of all those reported in the tax return.

4.13. Mr Belanger, a witness for the respondent, testified that the appellant’s bank deposits and his reported gross income were different (1969: $2,000; 1970: $4,100.25) from the total amounts of the contracts listed in a book which the respondent took from the appellant’s home. On this point, the appellant answered that he listed all contracts and tenders in the said book. However, he did not. obtain every contract for which he tendered. On this point, Mr Belanger testified that the total amount listed in the book was less than the bank deposits. On re-examination, Mr Gagne said that the deposits were not necessarily all income within the meaning of the Income Tax Act. Furthermore, the expenses were not deducted from this income.

4.14. After the appellant’s accountant referred to a capital reconciliation prepared by the respondent following the audit, counsel for the respondent objected to the filing of this exhibit which had, moreover, been filed with the notice of appeal. The Board had allowed the document (Exhibit A-3) to be filed subject to the decision it would make regarding the objection.

Counsel for the respondent objected first because the document in question had not been a basis for the notice of reassessment. Furthermore, the document was allegedly given by Mr Bélanger “to the taxpayer on the express condition that he should not use it against the Department”. This document, which was given “without prejudice”, was probably only to have been used for “internal” audit work.

In his testimony, Mr Bélanger stated first that the document in question had not been used as a basis for the assessment, and also that when the document was given to Mr Guévremont, he told the latter that his capital reconciliation was only in summary form. At that time Mr Belanger did not state that he had told Mr Guévremont that he was giving him the document without prejudice. Moreover, Mr Guévremont denied this statement by counsel.

The valid evidence before the Board is that Exhibit A-3 did not serve as a basis for the assessment and that it was summarily prepared for an internal audit. Moreover, these figures were taken from the audit, and therefore in accordance with certain principles of accounting. Nevertheless, Exhibit A-3 has a certain value in that it represents the real situation. Therefore, after authorizing it to be filed “under reservation’’, the Board now allows it to be used. However, as these figures were prepared in a summary fashion, the Board will use them “with reservation, and thus they will not be used as a basis for the judgment but in order to “audit” the Board’s conclusions.

In view of the above decision, the Board also authorizes document A-4, which the accountant based on document A-3, to be used for the same purposes in order to show that the amount assessed is exaggerated.

4.15. Both witnesses for the respondent, Mr Fernand Mathieu and Mr Raymond Bélanger, stated that the assessment at issue was based not on the capital difference accounting procedure but on the appellant’s income and expenditure for the years in question, determined from an analysis of contracts, bank deposits, figures produced by the appellant and a list of accounts receivable.

4.16. Mr Belanger testified that the latter, “operational” method made it possible to assess the increase in gross income, shown below and also in paragraph 3(c) of the reply to the notice of appeal:

The assessment issued on May 9, 1975 was based on the above figures for additional income. Further to discussions with the taxpayer, the Department allowed expenses of 20% on the additional gross income.

4.17. According to Mr Bélanger, the appellant possessed a very sketchy bookkeeping system: the method for recording income was incomplete and that for expenses non-existent.

4.18. Pursuant to the various analyses of documents, as described in paragraph 4.15, the auditor established for each of the years in question a list of 116 customers of the appellant (14 in 1968, 18 in 1969, 20 in 1970, 40 in 1971 and 14 in 1972). According to the witness for the respondent, these customers had paid the appellant amounts which the latter had not included in his income. Furthermore, there were disparities between the ledger and the reported gross income for the years:

The total of all these amounts gave the figure for additional gross income which appears in the first column of paragraph 4.16.

4.19. In his notice of objection, the appellant began as follows: “We object not to the amount of gross income but to the amount of net income assessed.”

4.20. It was against the disallowed expenses that the appellant objected and subsequently appealed. He considered that the appropriate expenses showing the net income as stated below should be deducted from the added net income:

The 1972 gross income includes $4,530.65 in accounts receivable as of December 31, 1972.

4.21. As can be seen from the tax returns, the appellant’s reported gross and net income for the years in question are as follows:

On average, therefore, the net income constitutes 15% of the gross income.

4.22. Mr Bélanger, the witness for the respondent, said that there was a disparity of $13,455 with respect to the wages paid by the appellant for which no T4 was issued.

4.23. The same witness for the respondent also stated that over 90% of the volume of income was controlled by third parties.

4.24. Pursuant to the notices of reassessment issued on May 9, 1975 for the years in question, the appellant filed notices of objection on July 29, 1975.

4.25. Pursuant to this notice of objection, the respondent allowed 20% of the added income as expenses and issued a second notice of reassessment on October 15, 1976.

4.26. The appellant filed his notice of appeal to the Board on October 26, 1976.

5. Particular Points at Issue

5.1. The Board must decide whether it must take into consideration the loss of documents due to the flood in 1973, should the appellant’s evidence prove to be inadequate.

5.2. The Board must also decide whether the appellant has discharged the burden of proof concerning

(a) the $70,000 of gross income added by the respondent to the income already reported by the appellant in respect of the years 1968 to 1972 inclusive;

(b) the additional expenses at the 20% rate already allowed by the respondent on the added gross income.

5.3. Finally, the Board must decide whether the respondent has discharged the burden of proof with respect to’ the penalties of 25%, amounting in total to approximately $2,300, which he imposed for fraud or gross negligence on the basis of subsections 56(2) of the old Act and 163(2) of the new Act.

6. Comments

6.1. The Documents Destroyed

From the facts reported in paragraphs 4.2 to 4.7, it appears to the Board that, following the backup in the drainage system which occurred in July 1973, some documents in the basement of the appellant’s residence had to be thrown out as they could not be salvaged. What was the nature of these documents? According to the evidence, they were contracts, purchase and sales invoices; and accounts receivable—in short, vouchers concerning the appellant’s business for the years prior to the flood. One thing is certain: if the respondent had been able to lay his hands on all these documents, his auditing work would doubtless have been facilitated. Furthermore, the existence of these vouchers would have enabled the appellant to provide the appropriate explanations.

The Board is even convinced that the parties in the case at bar would not have appeared before it if these vouchers had not been destroyed.

The Board accordingly concludes that the appellant could not produce the best evidence because of the absence of the documents in question, and that the Board will have to take this into account.

6.2. Gross Income

The question is whether the evidence submitted by the appellant makes it possible to cancel or reduce the amount of $70,000 added to the appellant’s gross income for the years in question.

6.2.1. The first problem in deciding on this point is to determine whether the admission made by the appellant in his notice of objection binds the Board. “We object not to the amount of gross income but to the amount of net income assessed’’, the objecting party said.

Moreover, in paragraph (i) of his notice of appeal, the appellant relied on the following argument:

the Minister added the amounts of bank deposits without considering expenses or whether the amounts which he indicated under the heading “gross income’’ were in fact that.

If I am not mistaken, therefore, the appellant limited his appeal to the inclusion of the net income in the amounts explained in paragraphs 4.13 and 4.18. These amounts break down as follows:

The Board considers that an admission made in the notice of objection may not be considered if the evidence before it contradicts the admission. In any event, a contrary decision preventing evidence from being submitted could be reversed by the Federal Court, which on appeal from a decision by the Board hears a case de novo.

6.2.2. Furthermore, in his notice of appeal the appellant objects to the inclusion of $4,530.65 in his net income for 1972. This sum represents accounts receivable, and the appellant relies on subsection 23(2) of the transitional provisions. With respect to this last item of the accounts receivable, it was not shown that this sum of $4,530.65 came from another year than 1972. Subsection 23(2) of the transitional provisions reads as follows:

23. (2) Valuation of work in progress.—Where a taxpayer has not elected under paragraph 34(1 )(d) of the amended Act in respect of his income from a business that is a profession for his 1972 taxation year, work in progress in respect of the business at the commencement of the 1972 fiscal period of the business shall be valued at the same amount at which it was valued at the end of the 1971 fiscal period of the business for the purpose of computing his income from that business for the 1971 taxation year.

This section applies to accounts receivable from work in progress and not to accounts receivable from work completed. The evidence did not show the nature of the accounts receivable in question. The appellant had the burden of showing the nature of the said accounts. Furthermore, subsection 23(2) applies only to members of professions and not to commercial businesses. Thus, this sum of $4,530.65 must be confirmed as part of the appellant’s gross income for 1972.

6.2.3. The amounts of $2,000 (1969) and $4,100.25 (1970), which represent the difference between bank deposits and gross income, were included by the respondent in the appellant’s gross income. The evidence provided by the appellant (paragraph 4.18) was not very convincing. He did say that everything deposited does not necessarily constitute income within the meaning of the Income Tax Act. That is indeed true. However, the Board would have liked a few specific cases, such as indemnities or gifts received, to be cited to illustrate the point. The possession of vouchers, which were destroyed by the flood, would have probably helped the appellant in his testimony on this point. The Board is left with a doubt in favour of the appellant. However, although this doubt is not strong, it is sufficient to grant a decrease of $500 in 1969 and $1,000 in 1970, which reduces gross income accordingly.

6.2:4. Moreover, the Board wonders how the respondent could have known that the payments from the 116 customers, a list of whom was given to the appellant, had not already been included in reported income. Legally speaking, however, the assessment is presumed accurate until proof to the contrary, and as the appellant admitted this list of customers and the income pertaining to it (he even gave the net income corresponding to the payments received by each customer, as explained in paragraph 4.20), the Board has no choice but to affirm the inclusion of these moneys in the appellant’s gross income.

6.3. Net Income

Once the additional net income has been established, the Board must decide whether all appropriate expenses have been deducted from it in order to obtain the real net income. The respondent allowed as expenses 20% of the additional gross income. The question is whether the evidence showed that amounts should be deducted in addition to this 20%.

Before answering this principle question, others must be considered. If the appellant failed to declare income, had he necessarily failed to deduct all expenses? If at the inquiry before the Board the appellant did not have all his vouchers (because they were destroyed in the flood in 1973), did he not have all those vouchers for expenses when he filed his tax returns for each of the years from 1968 to 1972? What could have prevented the appellant from claiming them all?

We should examine the appellant’s evidence to see what answers it provides to all these questions.

The evidence submitted by the appellant can be summarized as follows: I cannot have earned as much net income as the Department says, otherwise I would be richer than I am, or I would have led a less frugal life than I did. Furthermore, in order to have the net income stated by the Department, my firm would have had to bring me over 25% profit, which is economically impossible. The Board does not underestimate such arguments a priori. According to the appellant and his accountant, profits on the various contracts (paragraph 4.9) could range between 4 and 20%. This evidence was not refuted, but the Board would have preferred to have more substantial evidence supported by other people to the same effect or otherwise. The principal expense was for labour and, according to the evidence submitted (paragraph 4.1), it is true that the appellant’s state of health prevented him from doing manual work. Consequently, he hired more people, thereby increasing costs. However, because of the weakness of the evidence, the Board does not feel limited to this 20% net profit.

It can be seen from paragraph 4.21 that on average the appellant reported 15% net profit in his tax returns. The Board has computed the average net income for each of the five years in question from the taxed net income (reported net income plus the 20% allowed by the respondent) divided by the total gross income (reported income plus the income added by the respondent). The result is the following table:

The general average for taxed net income is 33.7%. Moreover, by considering the decreases in gross income of $500 in 1969 and $1,000 in 1970, as decided in paragraph 6.2.3, by including for the same years $1,500 and $3,100.25 in the appellant’s estimated net income (which he had not included), and finally by adding $4,530.65 to the 1972 net income, as decided in paragraph 6.2.2, the Board will arrive at the adjusted general average of the net profit estimated by the appellant:

The general average of the estimated net income thus adjusted is therefore 23.18%.

Whereas. gross income for 1969 must be reduced by $500, and that for 1970 by $1,000, pursuant to the decision of paragraph 6.2.3;

Whereas the sum of $4,530.65 must be upheld as part of gross income for 1972;

In view of the appellant’s evidence and its weaknesses, which were due inter alia to the lack of vouchers, and also to the appellant’s memory lapses;

In view of the lack of vouchers because they were destroyed as a result of the flood;

Whereas the assessment was issued in accordance with the “operational” method of accounting (as opposed to the “capital difference” method);

The Board rather arbitrarily sets the net income as follows:

6.4. Fraud and Gross Negligence

It can be seen from the evidence that during the years in question the appellant alone was responsible for bookkeeping, making bank deposits and filing his tax returns. According to the appellant himself, the bookkeeping system was not complete, although it contained all the vouchers.

In fact, the appellant has only himself to blame if there was negligence in filing his tax returns.

However, what surprises the Board are the substantial amounts added to the income as a result of the audit, as can be clearly appreciated from the table in paragraph 4.16. Furthermore, these amounts were not disputed. The evidence focused on expenses in order to arrive at net income. The fact that most of the appellant’s individual income entries are not themselves substantial increases the negligence further. The substantial amounts forgotten lend weight to the Board’s finding that the negligence is not merely ordinary but gross.

However, the Board considers that the sum of $4,530.65 representing accounts receivable, which was omitted in 1972, should be deducted from this gross negligence. At the time of filing the first statement, in 1972, it was easy to forget to include accounts receivable as income pursuant to the new Act, which came into effect as from 1972.

7. Conclusion

The Board allows the appeal in part and refers the matter back to the respondent for reassessment in accordance with the reasons and figures given above.

Appeal allowed in part.