Marchcroft Farms Limited v. Her Majesty the Queen, [1994] 1 CTC 2420, 94 DTC 1245

Archambault, J.T.C.C.:—The only issue raised by the appeal of the appellant is the penalty under subsection 163(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") in connection with undisclosed income of $264,300. The appellant did not contest that this sum had to be included in its income for the 1987 taxation year.

Facts

The appellant commenced business in 1984. During the relevant taxation year, its sole shareholder, director and officer was Ms. Dez Rayzak, a human resource consultant. As president of the appellant, Ms. Rayzak was primarily concerned with building the business of the company and marketing its services. The appellant operated a horse riding school and boarding. The value of all its assets in the 1987 taxation year was $346,349. The appellant’s capital came from its sole shareholder ($35,854 in 1987) and Quantetics Corporation ("Quantetics") ($307,750 in 1987) a corporation owned by her husband. Ms. Rayzak was also responsible for bookkeeping including getting all the information to the appellant's accountants, Touche Ross. Ms. Rayzak was not involved in the business of Quantetics.

The latter corporation was involved in carrying out research and development programs during 1986 and 1987. Quantetics hired the appellant to provide services in connection with a research and development project for dressage horse performance and breading. A statement of account of $256,000 dated January 31, 1987, bearing the letterhead of the appellant describes the following services:

Project management, experimental design, data collection and assembly, assessment of data, specification and measurement of conformational and performance characteristics, analysis of judging standards, attendance at dressage competitions to obtain large sample set of horses.

This invoice shows that Ms. Rayzak performed 580 hours at $125 an hour and that C. Whitham performed 530 hours at $100 per hour between February 1986 to January 1987. Another statement of account rendered by the appellant for $8,300 on May 8, 1986, shows that Ms. Rayzak rendered consulting services during 20 days at the rate of $300 per day and C. Whitham nine days at $250 a day. The aggregate of these two invoices represents the sum of $264,300 which the respondent included in the income of the appellant and in respect of which a penalty under subsection 163(2) of the Act was assessed. The amount of $264,300 represents more than 54 per cent of the appellant’s gross income for the 1987 taxation year. The net income for accounting purposes, as determined by the appellant was $19,351 while, for tax purposes, it was $16,125. Ms. Rayzak remembers having drafted the May 8, 1986 invoice, but does not know who would have prepared the statement of January 31, 1987. She does, however, remember having kept records of her time for the services she performed for this contract. The evidence indicates that the May 1986 invoice was paid in cash or by cheque, while the $256,000 was paid by an offset against a debt of $293,000 owing by the appellant to Quantetics. Nothing was reported by the appellant until it received a letter from the respondent indicating its intention of assessing a penalty. Then, the appellant filed an amended tax return on July 19, 1989, declaring the sum of $256,000. The fee of $8,300 was not included. The company computes its income on an accrual basis for both accounting and tax purposes.

Ms. Rayzak stated that she did not have much knowledge of accounting principles and relied on her husband who was more knowledgeable and on the services of Touche Ross as her accountants in the preparation of the financial statements and the tax returns for the company. She did not, however, think that she had provided a copy of the two invoices to her accountants.

Ms. Rayzak testified that she signed the tax return and reviewed the financial statements attached thereto. She never raised the issue of the unreported income with her accountants and stated that she was not aware of the unreported income when she signed them. The 1987 tax return was filed late on May 13, 1988, more than a year after the year end and almost six months after the financial statements had been finalized.

The respondent's position

Under subsection 163(2) of the Act, the respondent must show that the taxpayer either knowingly or under circumstances amounting to gross negligence in the carrying out of its duty made a false statement in its return. A taxpayer must act as a reasonable person and has the duty to review and to question its accountants before signing and filing a tax return. A taxpayer cannot hide behind its accountants for the failure to disclose 54 per cent of its gross income. Counsel for the respondent stressed that it is the corporation who is the taxpayer being assessed the penalty and not its shareholder, Ms. Rayzak.

The appellant's position

The respondent did not discharge its onus of showing that the appellant knowingly or under circumstances amounting to gross negligence made a false return. The appellant insisted that it did not know that the January 31, 1987 invoice for $256,000 had been prepared and that a book entry settin off the fees against the loan receivable had been executed by Quantetics. Had the appellant received cash, it would have reported the income. Ms. Rayzak was not a sophisticated bookkeeper and relied mainly on her husband and the appellant’s accountants in the preparation of the company's financial statements and tax returns. It was not clear to a lay person whether such an amount should have been reported as declared income. Counsel for the appellant also alleges that if the company had hired a controller, this error would not have occurred. However, there are no obligations to have a controller under the Act. This was not a breach of duty.

Analysis

The issue is whether or not the appellant made a false return knowingly or under circumstances amounting to gross negligence. It is quite clear from the evidence I heard that the appellant did not knowingly make a false return. I believe Ms. Rayzak when she states that she was not aware of the unreported income when she signed the tax return. However, the amount of fees earned by the company was very substantial. It represented more than 54 per cent of the appellant’s gross income for the 1987 taxation year. Its taxable income was only $16,125. The company billed more than 1100 hours between February 1986 and January 1987 in addition to 29 days of consulting services. Although Ms. Rayzak may not have remembered seeing the invoice of January 31, 1987 for $256,000 and she did not have a great knowledge of accounting principles, she should have known that the fees were missing given the substantial services provided to Quantetics. Furthermore, she remembered preparing the statement of May 8, 1986 for $8,300 and not only was the amount not included in the return when it was filed but it was not included in the amended return when the Minister indicated that it would issue an assessment for a penalty.

Counsel for the respondent cited several cases dealing with the assessment of penalties. I will only cite a few of them which in my view support the conclusion that I have come to. In Carson v. M.N.R. (1963), 34 Tax A.B.C. 105, 63 D.T.C. 997-15, Mr. Roland St-Onge, then a member of the Tax Appeal Board, made the following comment at page 107 (D.T.C. 997-17) with respect to a taxpayer who had reported an income of $12,096 and forgotten income of $10,511:

One cannot believe that the taxpayer ignored the existence of that big profit, and his omission amounts easily to gross negligence in the carrying out of his duties and in preparing his income tax return.

As already alleged and proved, the chartered accountants did not audit the accounts. That means they had to rely entirely on the information given by the appellant. If there is any omission, only the appellant must bear the responsibility for it.

On the argument that the unreported income was due to a fault of the spouse of the taxpayer, Mr. St-Onge made the following comment at page 109 (D.T.C. 997-18):

Mrs. Carson's alleged errors could not be used to excuse the appellant, who signed and certified as accurate a tax return in which the errors did not involve a few hundred dollars but amounted to almost half his income for the taxation year 1960.

The case of Click v. M.N.R., [1971] Tax A.B.C. 460, 71 D.T.C. 333, is interesting because it deals with the issue of a dividend paid by means of an entry in the company's books. This bears resemblance to the fact of the fee of $256,000 paid by way of an offset against a loan owing by the appellant to Quantetics. Mr. Fordham, Q.C., also a member of the Appeal Board stated at page 461 (D.T.C. 333):

Be all this as it may, $6,000, no matter in what way it was credited to the appellant's account, is rather a lot of money not to remember when completing one’s income tax return. In fact it was nearly as much as the appellant's total other earnings for the year and was thus a sum that the appellant should have found difficult to forget or overlook.

In Shimizu v. M.N.R., [1972] C.T.C. 2019, 72 D.T.C. 1020 (T.A.B.), the appellant's defense was that she had provided her bookkeeper with all the information necessary to enable him to prepare correct returns. Furthermore, she had only limited education and very little business experience and therefore could not be expected to check and query the returns prepared by her bookkeeper. The unreported income amounted to 50 to 79 per cent of the total income of the business. Mr. Roland St-Onge stated at pages 2021-21 (D.T.C. 1021):

No matter how limited the appellant’s business experience may have been, her suspicions concerning the extent of her income should have been aroused by the fact that the initial equity in the business of only $2,000 had increased to $30,000 after only three years in business.

In this appeal, the appellant received fees of $264,300 when its total assets were $346,349. This big jump in its assets is difficult to forget at the time of filing its tax return more than a year after its year end.

Finally, in Howell v. M.N.R., [1981] C.T.C. 2241, 81 D.T.C. 230, Mr. Delmer E. Taylor of the Tax Review Board, now a judge of this Court made the following comments at page 2245 (D.T.C. 234) with respect to the argument that an inexperienced taxpayer may rely on tax experts:

I am in agreement with counsel for the respondent—there is a bottom limit to the responsibility which must be accepted by even the most inexperienced or trusting taxpayer. That bottom limit is not simply to read the last relevant line of the return (a balance owing or a refund). It must demonstrate a reasonable effort on his part in the circumstances and within his own framework of comprehension and competence to understand the component elements of that final result. . . . A review of his income tax return, which is warranted by the certificate thereon, would have been adequate for him to discover the omission before filing the return since, in my view, this was within his comprehension and competence.

Given that the invoices indicated that substantial services were rendered in 1986 and 1987 to Quantetics, it is difficult to understand how such a large fee could have been omitted from the tax return. It should be stressed that Ms. Rayzak was the person responsible for the bookkeeping and was therefore in a position to know that the invoices were missing. She had prepared one invoice herself and, although she did not remember sending the big one, she had spent personally at least 580 hours and 20 days in rendering the services to Quantetics. For these reasons, I conclude that the false statement of income contained in the tax return for the 1987 taxation year was due to circumstances amounting to gross negligence of the appellant.

This appeal will therefore be dismissed with costs.

Appeal dismissed.