Date: 20001030
Docket: 1999-3477(IT)I
BETWEEN:
VINCE CIRILLO,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Agent for the Appellant: Richard Adelman
Counsel for the Respondent: Sherry
Darvish
____________________________________________________________________
REASONS FOR JUDGMENT
(Delivered orally from the Bench at
Toronto, Ontario, on September 5, 2000)
Mogan J.T.C.C.
[1] This is an appeal with respect to
the 1993, 1994 and 1995 taxation years. In each of those years,
the Minister of National Revenue added to the reported income of
the Appellant certain amounts which have been identified as
shareholder benefits under subsection 15(2) of the Income Tax
Act. The shareholder benefits are in the form of interest on
a debt under section 80.4 of the Act and an automobile
stand-by charge under section 6 of the Act. The
Appellant has appealed against those assessments contesting
mainly the shareholder benefit provision. His Notice of Appeal
did not specifically challenge the automobile stand-by
charge but that question arose in a peripheral matter and will
have to be dealt with. The Appellant has elected the informal
procedure.
[2] Exhibit A-1 is a purchase
and sale agreement dated May 6, 1991 in which the Appellant
along with Michele Miceli and Frank Talarico agreed to
buy all the shares of a company identified as Pane Vittoria
Bakery Limited for a price of $500,000. The vendors were four
particular individuals whose identity is not relevant to this
appeal but, to the extent that I have to refer to them, I will
simply call them "the four vending shareholders". The
only important term of that purchase agreement for the purpose of
this appeal is paragraph 1 which describes the purchase price as
being paid by a $30,000 deposit and $100,000 to be secured by a
chattel mortgage on certain assets. The balance of the purchase
price was to be paid by cash or certified cheque on closing and
it appears that the closing actually occurred on or about October
28, 1991.
[3] The Appellant and his original two
partners paid a significant amount of money to acquire the shares
of Pane Vittoria Bakery Limited. As soon as they acquired those
shares, they determined that they did not want to carry on the
bakery business within the corporation they had just purchased.
Apparently, there was a problem with regard to the Workers'
Compensation Board and Pane Vittoria. It was not referred to in
any detail but I accept the business judgment of the Appellant
and his two colleagues that they were going to form their own
company to carry on the bakery business. They incorporated a
company called 961533 Ontario Limited ("533") and
immediately after the closing of the purchase from the four
vending shareholders, the remaining assets of Pane Vittoria (the
"operating assets") were transferred to 533.
[4] The issue in this case is whether
there was a shareholder loan from 533 to the Appellant and his
fellow shareholders of 533. That leads to the question of how the
transactions were recorded when the shares of Pane Vittoria were
purchased from the four vending shareholders; and the operating
assets were later transferred from Pane Vittoria to 533. Exhibit
A-4 is a copy of the hand-written journal entries made by
the accountant for 533 after the Appellant and his two partners
acquired all the shares of that company. That document is
approximately five pages long with the first three pages showing
the closing journal entries as at June 30, 1992 and the last two
pages showing the closing journal entries as at June 30,
1993. It appears that at all relevant times the fiscal period of
both 533 and Pane Vittoria was June 30. The journal entries as
photocopied and entered as Exhibit A-4 are not complete because
the debit side of the entries is recorded but in many cases, the
credit entries either have been totally or partially eliminated
in the photocopying. Indeed, I notice that on a couple of the
pages even the debit entries have been perhaps not completely
recorded. Exhibit A-5 is a printed copy of the first
journal entry for June 30, 1992 and the first journal entry for
June 30, 1993. Those entries had to be typed because the journal
entries in Exhibit A-4 are not included in their entirety in the
photocopying. The parties are in agreement that the printed
journal entries in Exhibit A-5 are an exact replica of the
journal entries as they existed in the original version of
Exhibit A-4.
[5] I will set out the journal entries
made in Exhibit A-5 as of June 30, 1992. It does not state what
the purpose is, but it shows a number of debit and credit entries
which, of course, both add up to $500,000 as follows:
|
|
Debit
|
Credit
|
|
Truck
|
$24,071
|
|
|
Equipment
|
11,565
|
|
|
Sign
|
355
|
|
|
Inventory
|
32,186
|
|
|
Lawyers fees
|
4,761
|
|
|
Corporate costs
|
1,132
|
|
|
Goodwill
|
425,927
|
|
|
Mortgage Payable
|
|
132,186
|
|
Capital
|
|
150
|
|
Shareholder
|
_______
|
367,663
|
|
|
$500,000
|
$500,000
|
The above exhibit was commented on by the agent for the
Appellant and both witnesses for the Respondent. Relying on that
evidence, I have to conclude that the entries are accurate from
an accounting point of view in the sense that they balance. That,
however, is an amalgamation of two different concepts.
[6] What really happened in the
transaction was that the Appellant and his partners purchased
shares for $500,000. There was a provision in paragraph 1(b) of
Exhibit A-1 which provided for an inventory
adjustment. The inventory adjustment (inventory valuation) which
was performed on the closing date caused an adjustment to be made
in the vendors' favour of $32,186. Therefore, the purchase
price was increased from $500,000 to $532,186 and, in accordance
with the agreement, that inventory adjustment was added to the
sum of $100,000 and secured as payable to the four vending
shareholders by the chattel mortgage on certain assets.
[7] Exhibit A-1 (the purchase
agreement) is not complete because there is a reference to the
assets in Schedule C which schedule is not included in the
exhibit. Therefore, I cannot determine what the precise assets
were which were intended to be charged with the chattel mortgage.
By inference from all the surrounding circumstances in this case,
I conclude that the balance of $132,186 was to be secured by a
chattel mortgage on all of the business assets of Pane Vittoria
because those would be the logical assets to secure the residue
of the purchase price. There is no evidence that there would be
any other assets by which the price might be secured.
[8] I turn to the second part of the
transaction which is the decision made by the Appellant and his
partners to transfer the operating assets out of Pane Vittoria
and into their operating company, 533. That was the primary
purpose of the first journal entry at June 30, 1992 because it
shows the transfer of business assets having a value of
approximately $74,000, being all of the assets, excluding
goodwill. I have concluded that the person who did that journal
entry performed it in error because two very separate
transactions are mixed up. That person started out by recording
on the books of 533 the purchase of the operating assets from
Pane Vittoria, all the assets listed ahead of the item
"goodwill". At that point, if the person doing the
journal entry had stopped, he or she would have then made a
credit entry of $74,000 as an inter-company loan being the
amount owing by 533 to Pane Vittoria. That might very well have
been the end of the transaction. But that is not the way the
journal entry reads. For some reason, the person has mixed up the
purchase of the assets by 533 from Pane Vittoria with the
purchase of the shares by the Appellant and his two partners from
the vending shareholders. Also, that person seems to have felt
compelled to make the aggregate amount of the journal entry add
up to $500,000. Therefore, that person put in what I would call a
"plugged" amount and identified it as goodwill of
$425,927 to ensure that the total would be $500,000.
[9] On the credit side, there was some
truly imaginative and erroneous bookkeeping. For example, the
first credit entry is a mortgage payable for $132,186. That is
obviously the chattel mortgage contemplated by paragraph 1(b) of
the purchase and sale agreement. Exhibit R-1 is the chattel
mortgage from Pane Vittoria to the four vending shareholders
dated October 28, 1991, in the amount of $132,186. The first
credit entry is mortgage payable and it is clearly targeting the
chattel mortgage given by Pane Vittoria to the vending
shareholders to secure the amount owing for their shares and
securing it on the assets of Pane Vittoria. The person doing the
journal entry probably concluded that, because the operating
assets of Pane Vittoria were being transferred into 533 and
because those assets were charged with the mortgage, the
liability for the mortgage should also be transferred into 533.
That explains, in my view, why the first credit entry is
$132,186. To show the confusion in the mind of the person making
the journal entry, by that time (around June 1992), he knew that
the additional $32,186 was the inventory adjustment running in
favour of the vending shareholders. If he was going to record the
transaction as being the total purchase price, he should have
been aiming at a target amount of $532,186 instead of the
$500,000 established in the original agreement. That is just a
further indication of how ill-thought-out this
journal entry was. I do think the person making the entries was
justified in thinking that since 533 was taking over the assets
of Pane Vittoria and those assets were charged with a mortgage,
then 533 should assume the liability. That is the first credit
item in the journal entry.
[10] The journal entry shows capital of
$150, whatever that means. There is other evidence to indicate
that the paid-up capital of 533 was only $3 for three
shares. I do not know whether the word "capital" in the
mind of the person, the bookkeeper, making up the journal entry
was intended to convey paid-up capital but for whatever
reason, it is there. I might add that there was not entered in
evidence by either party at any time in this hearing a financial
statement of 533. I never saw the balance sheet for the
corporation for the years under appeal, and so I do not know
whether the paid-up capital in the mind of the person who
made the journal entry was either $3 or $150. That is one of many
things I would like to have seen had I had an opportunity to look
at the balance sheet of 533.
[11] The person making this journal entry
has to find another credit entry to make the journal entry
balance. The third credit entry is recorded as a shareholder
advance to the company in the amount of $367,663 even though, as
far as I know, the Appellant and his colleagues never advanced
that amount to the company. On the other hand, if they had not
agreed that the goodwill was worth approximately $426,000
($500,000 less $74,000), both items may be a bit fanciful.
[12] One year later, apparently the same
person was doing the bookkeeping for the company because on the
second part of Exhibit A-5 there is another journal entry
at June 30, 1993. The purpose of that journal entry is stated as
follows: "To record goodwill wrongly posted at the
beginning". This journal entry is very simple. It debits the
shareholder loan account $425,928 and credits goodwill with
$425,928. The effect of that, of course, satisfies the purpose as
stated by the bookkeeper and it eliminates the goodwill. Also in
the shareholder loan/shareholder advance account, it reverses the
balance from being a credit balance in favour of the shareholders
to being a debit balance of about $58,000 in favour of the
company. On the basis of the second journal entry at June 30,
1993, apart from any transactions in the intervening 12 months,
the shareholders account would have gone in the books of the
company from a credit balance of $367,663 which of course is in
the shareholders' favour, to a debit balance of $58,000
indicating the shareholders have an obligation to their company
in that amount.
[13] It is difficult to speculate what was
in the mind of the person making the journal entry but the price
paid for the shares in the range of $500,000 indicates to me that
there must have been a significant amount of goodwill in the
business. That price is so much higher than the apparent book
value of the operating assets as they came across from Pane
Vittoria to 533 that the goodwill must have been worth about
$400,000. I am not in a position to know but, when a group of
individuals agrees to buy the shares of a corporation for
$500,000 when the underlying book value of the assets of the
corporation is significantly less than $500,000, the goodwill of
the corporation's business may very well represent at least
part of the purchase price. In a share purchase transaction as
opposed to an asset transaction, the goodwill is usually an
unrecorded item. That was the result in this case after the
correcting journal entries were made on June 30, 1993. The
goodwill was eliminated but I question whether the debit charge
should have been all against the shareholder loan account.
[14] Having regard to the two journal
entries in Exhibit A-5, if the correction at June 30,
1993 had been made a minute or two after the journal entry of
June 30, 1992, the goodwill would have disappeared; there would
have been a $58,000 debit entry for loan to shareholders; and the
credit entry would have been almost exactly $132,000. That would
have explained the chattel mortgage taken on by 533 but it still
would not have made a lot of sense because there was no evidence
that the shareholders had borrowed $58,000 at that time from 533.
What happened in the assessments under appeal flows from these
two journal entries which I have taken some time to describe.
[15] I return now to Exhibit R-1 which
is the first page of the chattel mortgage. It shows Pane Vittoria
as the mortgagor and the four vending shareholders as the
mortgagees. The chattel mortgage is in the amount of $132,186,
with interest at 10% per annum and provides for monthly payments
of $1,385.82 over a five-year period and amortized over 15 years.
Exhibit R-2 is a ledger sheet from 533 entitled
"mortgage payable" and it shows monthly payments in the
precise amount of $1,385.82 as prescribed in the chattel
mortgage. It shows monthly payments being made throughout the
calendar years 1992, 1993, 1994, 1995 and the first 10 months of
1996 which would bring the monthly payments up to the
five-year term because the chattel mortgage was given in
October 1991. Apparently, all payments on that chattel mortgage
were made by 533. I conclude that 533 did assume the burden of
the mortgage when it took over the operating assets from Pane
Vittoria which were the assets underlying and providing security
to the chattel mortgage.
[16] In argument, the agent for the
Appellant asked the question: Did the Appellant transfer a debt
to the corporation? I think that the Appellant alone did not
transfer any debt to the corporation, but I do conclude that the
Appellant and his two founding shareholders in 533 caused 533 to
assume part of their obligation to the four vending shareholders.
533 made all the payments on that chattel mortgage of
$132,186.
[17] Was there an accounting error in the
journal entries and, if so, is the Appellant responsible for the
accounting error? Whether a shareholder of a corporation is
responsible for a bookkeeping error depends upon the
circumstances of the error. In a decision that I rendered in
Chopp v. The Queen, 95 DTC 527, I found that a bookkeeping
error had been made without the knowledge or intention of the
dominant shareholder. I was able to make that decision because I
heard extensive evidence from four significant witnesses: the
dominant shareholder; his daughter who was an amateur bookkeeper;
the outside chartered accountant who did an actual audit of the
corporation because of its size and the corporations it did
business with; and the internal chartered accountant who was
hired by the corporation after the bookkeeping error was
discovered and the dominant shareholder realized that he had to
have more competent bookkeeping. It was proven to me in
Chopp that the error was made innocently without knowledge
and was corrected as soon as it was discovered.
[18] I would be the first person to
acknowledge that a shareholder is not necessarily bound by the
bookkeeping errors of someone who keeps the books of his
corporation. If the recording of the chattel mortgage on the
books of 533 was an accounting error, and if that error had been
corrected along the way, I would be able to find that the
Appellant, who is a baker and not a bookkeeper, was not bound by
the error. I assume from the Appellant's evidence that he
never looked at the financial statements. He may not feel
comfortable trying to understand a financial statement of a
corporation. If the corporation had reneged on this chattel
mortgage and thrown it back in the laps of the shareholders, and
if the shareholders had corrected the bookkeeping error when it
came to their attention, I could have granted relief.
[19] When the Appellant's agent asked if
the Appellant was bound by the accountant's errors, I have no
hesitation in stating that a shareholder is not bound by the
errors of his accountant or bookkeeper, per se, but
shareholders are bound by the conduct of the corporation they
control. When the conduct of the corporation shows that month
after month, year after year, over a period exceeding four years
the corporation keeps grinding out payments on a mortgage as if
it were the mortgagor, then I say that the shareholder is bound
not by the error of his bookkeeper but by what his corporation in
fact did month by month and year by year in the way that it
processed its business and discharged obligations, whether they
are the particular obligations of the corporation itself or the
obligations of a shareholder. If a shareholder's obligation
is discharged over a long period of time by his corporation
making regular monthly payments, any objective third party could
easily conclude that the corporation had taken over the
shareholder's obligation.
[20] On the main issue, if I decide against
the Appellant, there were two other arguments put forward. Should
the whole amount of the debt be added from the beginning or
should the shareholder benefit be computed month by month as the
payments are made? If there was any evidence that during the term
of this chattel mortgage, which was five years or 60 months, the
shareholders had realized that their corporation was paying off
their debt, and they had terminated the payments by the
corporation and taken over the debt payments themselves, then I
would have no difficulty in concluding that the shareholder
benefit ought to be measured only month by month as the
corporation made each payment for the benefit of its
shareholders. But when there is no indication that the
transaction was detected or the error, if it was an error, was
adjusted during the course of the indebtedness, then I think it
is reasonable to conclude that there was an implicit arrangement
between the shareholders of 533 and 533 itself that 533 would
indeed take on this debt as of October 1991 and pay it off. That
is what happened.
[21] On the measurement of the quantum of
the shareholder benefit, I conclude that it is reasonable to
measure the benefit as if the debt had been assumed around
October, November or December 1991. The benefit being the face
value of the debt or some lesser amount, was conferred at that
time. Any advances made by the Appellant to the corporation at
any time during the years under appeal ought to be construed as
repayments by the shareholder to reduce what otherwise would be
the shareholder benefit under subsection 15(2). Therefore, any
payments made by the Appellant to 533 ought to reduce the
shareholder benefit otherwise assessed against him. I conclude
from the evidence of the auditor and the appeals assessor who
testified, and from looking at Exhibits A-8 and R-5,
that the advances made by the Appellant to 533 were in fact
regarded as a reduction of the amount otherwise included in his
income as a shareholder benefit.
[22] Another collateral item was whether the
right portion of the shareholder benefit has been allocated to
the particular taxpayer, Mr. Cirillo. On that matter, I rely
on the evidence of the field assessor, Mr. Nefsky, who said
that he had traced the shareholder register of the corporation
and, in March 1993, the Appellant and Mr. Miceli had bought
out the one-third interest of the third shareholder,
Mr. Talarico. Therefore, as of March 1993, the Appellant and
Mr. Miceli had become 50/50 shareholders. And then in July
1994, the Appellant purchased the half interest of
Mr. Miceli and, later in 1994, the Appellant sold a
one-half interest in 533 to two other persons.
[23] On June 30, 1993, the Appellant was a
50/50 shareholder of 533. Therefore, I hold that the allocation
of the shareholder benefit to the Appellant on a 50/50 basis was
an appropriate one for 1993 and 1994 and 1995 because, when he
bought out Miceli in July 1994, he then sold to the other two.
50/50 is not an unreasonable allocation with regard to the
Appellant.
[24] The last item is an automobile
stand-by charge which was not directly pleaded in this case
but comes up by way of Exhibit A-7 which is the
schedule prepared by the appeals assessor to explain how the
amounts were computed for assessment purposes. Also Exhibit
A-8 is a schedule prepared by the appeals assessor showing
the adjustments made from the audit at the appeals level. In a
nutshell, it turns out that for 1993, the automobile
stand-by charge was taxed twice. It crept into the
shareholder loan account as appears in Exhibit A-8 through
an item identified on June 30, 1993 as "adjusting
entry cars" and it appears specifically as a
separate item for 1993 in Exhibit A-7 as $6,143. Therefore,
I allow the appeal for 1993 for the purpose of eliminating from
the Appellant's income the sum of $6,143 as that item appears
in Exhibit A-7. I am not persuaded that there is any
similar relief available for 1994 and 1995 because as I look at
Exhibit A-8, which is the reconciliation of the shareholder
loan account prepared by the appeals auditor, there is no other
item identified as "cars" like the one for June 30,
1993. Because there was no submission from the agent for the
Appellant or counsel for the Respondent, I have concluded from
the evidence before me that it is only 1993 in which the
Appellant has been double taxed on automobile. On that basis, the
appeal for 1993 is allowed only for the purpose of eliminating an
amount of $6,143 as an automobile stand-by charge. The
appeals for 1994 and 1995 are dismissed.
Signed at Ottawa, Canada, this 30th day of October, 2000.
J.T.C.C.
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