Peter Fortis, Two-O-Five Northway Restaurant and Tavern Ltd., George Pappas v. Minister of National Revenue, [1986] 2 CTC 2378, 86 DTC 1795

Rip, T.C.J.:—Peter Fortis ("Fortis") and George Pappas ("Pappas") appeal their income tax reassessments for 1978,1979 and 1980; Two-O-Five Northway Restaurant and Tavern Ltd. ("corporation") appeals income tax reassessments assessed for its 1978, 1979, 1980 and 1981 taxation years. The Minister of National Revenue, Taxation, the respondent, reassessed Messrs. Fortis and Pappas on a net worth basis whereby he determined each individual's income for the year in issue and increased each individual’s reported income, as follows:

During the years in issue the individual appellants and Greg Papikiriagis each owned 337, per cent of the issued and outstanding shares in the capital stock of the corporation. The respondent reassessed each of the three shareholders of the corporation and added to their incomes for 1978, 1979 and 1980 the aggregate amounts of $28,572.40, $21,570.81 and $27,235.13 respectively. The respondent then assumed these amounts represented unreported income to the corporation, whose year end is March 31, and he added the amounts of $7,143.10, $26,822, $23,011.89 and $20,501.35 to the corporation’s reported incomes for the 1978, 1979, 1980 and 1981 taxation years respectively. At all relevant times the corporation carried on the business of a restaurant.

Penalties were also assessed against the appellants pursuant to subsection 163(2) of the Income Tax Act ("Act").

The appeals were heard together on common evidence.

At the opening of the trial the agent for the appellants advised that the only issue before the Court in respect of Mr. Fortis' appeal was whether the increase in his net worth was due to gambling during the years under appeal and in respect of Mr. Pappas’ appeal, whether he received loans aggregating $14,000 from friends and thus his net worth for 1979 should be reduced by liabilities of $14,000. It was agreed by counsel for the Minister and the corporation's agent that if the net worths of the individual appellants are decreased by the Court, the income of the corporation would be reduced accordingly. The appellants’ agent stated that his clients did not agree to increases in their incomes as reassessed, but the only independent evidence they had to refute the respondent's increase in the net worth of each of Mr. Fortis and Mr. Pappas was that a portion of the increases in the net worths was due to gambling gains by Mr. Fortis and loans made to Mr. Pappas.

In 1969, Mr. Pappas purchased a house in Belleville; the mortgage on the house was approximately $31,000. Sometime after the purchase he made an arrangement with the Royal Bank of Canada to borrow $38,000, of which $31,000 was to be applied to pay off the mortgage and the balance would be deposited with the bank. The loan was payable on demand but Mr. Pappas was to pay the bank each month the sum of $1,000 on account of interest and principal, if any. Mr. Pappas testified that in 1978 interest rates were increasing and rather than be indebted to the bank he borrowed money from two friends. Mr. Pappas stated that Dennis Papadatos, a cook at the corporation's restaurant, loaned him $7,000 in 1979. The loan was made by several cash advances of between $300 and $500 from February, 1979 on, every three or four weeks. When the loan totalled $7,000, no further advances were made and a "receipt" was prepared. No promissory note was prepared at the time because "we trust each other”. The purported receipt, written on printed stationery, read as follows:

Mr. Pappas advised that by agreement the principal amount of the loan from Mr. Papadatos and unpaid interest was to be repaid once the restaurant owned by the corporation was sold.

Mr. Pappas stated that a record of the advances was maintained by him but was thrown out after the assessments were issued.

Mr. Pappas explained that when he received cash from Mr. Papadatos he kept the money at home until the end of the month when he would make a payment to the Royal Bank. In 1979 Mr. Pappas repaid the bank in a lump sum of $18,000; the sources of these funds were a $10,000 loan from his brother-in-law, $5,000 from his wife and $3,000 transferred from a bank account.

In the meantime, Mr. Pappas testified, he borrowed $7,000 from Mr. John Bernard Meagher in small cash amounts over a period of time. A “receipt” similar to that signed by Mr. Papadatos was signed by Mr. Meagher; the latter note was payable on demand and no provision was made for interest. Mr. Papadatos testified he had records of the loan available at the time the assessments were being prepared but since “nobody asked” for them, he did not show the records to anyone. The loans from Mr. Meagher were repaid during 1982 to 1986; Mr. Pappas obtained a receipt from Mr. Meagher for each payment made to him.

In examination-in-chief Mr. Papadatos acknowledged he loaned Mr. Pappas $7,000; he testified he advanced various amounts in 1979. He stated the source of the funds was his salary from the corporation. Mr. Pappas had testified Mr. Papadatos" salary from the corporation in 1978 was approximately $5,000. Mr. Papadatos testified his living costs were low since he lived with a cousin and paid only $25 a month for rent during 1978 to 1980. His only expenses, he said, were for food and rent, although sometimes he gambled.

During cross-examination Mr. Papadatos’ income tax return for 1979 was produced. He reported his income from salary to be $6,354 and his return indicates he claimed an Ontario tax credit based on rental payments during the year of $1,200. He testified that he also kept records of amounts advanced to Mr. Pappas but threw them away. He also acknowledged in cross-examination that of the $7,000 he loaned to Mr. Pappas, $3,000 was borrowed from a cousin in Peterborough and $4,000 was his own funds.

Mr. Meagher, a conductor with Canadian National, has known Mr. Pappas for about ten years and considers him a good friend. He testified he loaned Mr. Pappas $7,000 in “late 1978 or early 1979"". He stated the loan was made in a lump sum, and that Mr. Pappas repaid the loan without interest in small amounts over a period of time.

During the course of the cross-examination of Mr. Pappas counsel for the respondent questioned him about deposits made to an account at the Toronto-Dominion Bank in Belleville. Mr. Pappas first said he could not remember making a deposit slip in his name on October 10, 1979 and later identified a deposit slip dated June 3, 1980 for the same account as a deposit to his wife"s account. On July 22, 1980 an amount of $1,200 in cash was deposited to this account; the deposit slip contained a signature purporting to be that of Mr. Pappas. Mr. Pappas said the source of the $1,200 was from gambling; this was the first occasion in which gambling was given as a source of funds to Mr. Pappas. Mr. B. Tenbult, an employee of the Toronto- Dominion Bank, identified the account as Mr. Pappas’.

Mr. Fortis’ evidence was that in the years under appeal he gambled regularly, two nights a week after work, and his winnings exceeded his losses by approximately $5,000 per year. He did not maintain a record of his gains and losses. He played poker since the early 1960s and during 1978, 1979 and 1980 he played with the same group of players at their homes. He testified he won enough money from gambling to pay his living expenses; his pay cheques were deposited to his bank and withdrawals would be made as money was required. He confirmed the difficulty the restaurant had with the jamming of the cash register tape and said that on several occasions he threw out tapes.

Mr. George Poulos testified he played cards with Mr. Fortis once or twice a week during the years under appeal. He claims Mr. Fortis won "more than me and I win". Mr. Poulos has no records of his gambling activities.

Mr. Pappas described the operations of the restaurant during the years under appeal. He is the chief cook during the day and was responsible for the purchase of food, wine and liquor. The other shareholders were cooks during the evening. Each shareholder's wife also worked at the restaurant.

During calendar years 1979 and 1980 the cash register used by the restaurant broke down frequently and required repairs. When the cash register was out of order bills were retained and the sales were recorded when the register was repaired. Mr. Pappas said he did not know how the cash register actually functioned, but he was aware that numbers on the tape would jump several times on the same date. Daily reports were made from the tape. The tapes and food bills were stored in the basement. Mr. Pappas stated that sometimes dishwashers would clean the basement and throw out old tapes and bills. He explained that the restaurant did not keep a full day's tape because "nobody told us to"; for the same reason cancelled cheques were not retained.

Apparently only two tapes were available at trial, one tape was produced by the appellant to show errors made by the machine: 17 items are set out on the tape; the date on the tape reads 2 March, 1991, amounts vary from zero to $1,382.65, most of the amounts being zero, two of the amounts being $962.21, one nine cents and another 15 cents. Mr. Pappas and his brother, and sometimes Mr. Fortis, would open and close the cash register and clear the tape daily, although several other employees had access to the register.

Mr. Nick Dykstra, an auditor with the respondent, testified for the respondent. Mr. Dykstra audited the tax returns of the three appellants. Mr. Dykstra examined the daily cash reports and records of the restaurant, reconciled bank deposits and reconciled annual sales to those reported in the income tax returns, as filed. He noted the only sales recorded by the restaurant were from daily summary tapes. He reviewed the restaurant's sales for the years in appeal and found that after adjustments made by the corporation's accountants, sales were constant from year to year. He could not verify cash register tapes because they did not exist; he stated he was told by the shareholders they did not know they had to keep the cash register tapes so they threw them out. He said source documents had been destroyed and he could not verify if the reported sales were correct.

Mr. Dykstra then analyzed the corporation's payments to its shareholders and their wives. He interviewed the shareholders to determine how the restaurant carried on its business and the hours they worked. On checking the basement of the restaurant he found a box containing bills, invoices from suppliers, cancelled cheques, statements and two rolls of cash register tapes which were different in size from summary tapes. He found one of the cash register tapes corresponded with a summary tape, but the end of the tape did not correspond to the prior day; the beginning of the tape for September 13, 1980 did not correspond to the end of the tape for September 12, 1980; the tape for December 30, 1979 did not correspond to the end of December 29, 1979 or December 31, 1979. In addition, the tape jumped from number to number, for example the tape would read “59, 60, 100”. This problem existed in summary tapes from January, 1978 on.

Mr. Dykstra then prepared a net worth statement for each shareholder and found discrepancies from reported income aggregating $25,000 to $30,000. He said he discussed the statements with the shareholders. Mr. Pappas told him he had borrowed money from Messrs. Papadatos and Meagher in December, 1979. In an interview with Mr. Papadatos, he was told the loan was advanced in 1978 on four separate occasions: $2,000 was advanced in each of March, June and September and $4,000 in November. Mr. Papadatos informed Mr. Dykstra, according to Mr. Dykstra, that the source of the funds for the loan was his salary; in a later interview Mr. Dykstra said Mr. Papadatos told him that he borrowed $7,000 from a relative in Peterborough and he was not sure when he loaned money to Mr. Pappas, whether it was 1978 or 1979; he also said the first advance he gave to Mr. Pappas was $3,000 in cash and later on he gave him $4,000 in cash. On verifying the bank account of Mr. Pappas, Mr. Dykstra could not confirm loans of $14,000, made in December, 1979 being deposited to Mr. Pappas’ bank account. Mr. Dykstra said that Mr. Pappas made numerous cash deposits to the bank account in various denominations of $20, $50 and $100 bills.

Mr. Dykstra also confirmed that Mr. Fortis deposited his salary from the corporation to the bank, and in 1980, for example, withdrawals were made to repay loans, to make car payments, a cheque in the amount of $5,900 was issued on the account to a casino in Atlantic City.

Mr. Pappas’ agent argues that because Mr. Pappas borrowed $14,000 from two friends in 1979, any statement setting out the net worth of Mr. Pappas at the end of the year must provide for liabilities of $14,000. The Minister's statement of net worth ignored these liabilities and, as a result, the net worth determined by the Minister is excessive by at least $14,000. There is not, in my view, any evidence that on the balance of probability shows the Minister erred in assessing Mr. Pappas for the years under appeal. There is no evidence loans aggregating $14,000 were made in 1979. Firstly, the evidence of Mr. Pappas and Mr. Papadatos in respect of the latter's loan of $7,000 is not convincing: according to Mr. Pappas the loan was made during the course of 1979, from February on; Mr. Papadatos originally testified the source of the funds for the loan was his salary; on cross-examination he admitted he borrowed $3,000. Further, Mr. Papadatos testified that during 1978 and 1979 he paid a monthly rent of $25, but on filing his income tax return for 1979 he claimed annual rental payments of $1,200. That the records of advances of the loans were destroyed by both Mr. Pappas and Mr. Papadatos is simply not believable. The “receipt" of December 4, 1979, to Mr. Papadatos, signed by Mr. Papadatos, means nothing and signifies nothing. Secondly, I accept Mr. Meagher's evidence that he loaned Mr. Pappas $7,000; however Mr. Meagher could not remember in what year he made the loan to Mr. Pappas. I note that notwithstanding the friendship between Mr. Meagher and Mr. Pappas, Mr. Pappas obtained a receipt each time he repaid Mr. Meagher.

In an appeal against an assessment for tax assessed on a “net worth" basis the onus lies on the appellant and he must establish affirmatively that his taxable income was not that for each of the years for which he is being assessed. Mr. Pappas either must establish his income or prove that even on a proper and complete "net worth" basis the assessments were wrong. See Chernenkoff v. M.N.R., [1949] C.T.C. 369 at 375; 4 D.T.C. 680 at 683. If one accepts that loans were made in 1979 — or in any other year — to Mr. Pappas by both Mr. Papadatos and Mr. Meagher, the liabilities in the net worth statement would have to be increased to the extent of unpaid balance of the loan at the end of the year. Mr. Pappas would then have to satisfy the Court the funds he borrowed are reflected in the list of assets described in the net worth statement prepared by the Minister; this he did not do. There is no provision for cash in the net worth statements for any of the years under appeal; the balances in two of Mr. Pappas’ bank accounts show very modest annual increases during the years under appeal, and the balances in the other accounts show reductions in the years after 1977. The advances were made in cash. It is reasonable to infer that Mr. Pappas’ assets would have increased in direct proportion to the loan advances, and the amounts of unreported income would not be different from that determined by the Minister. Mr. Pappas did not prove otherwise. He also did not establish his income for any year.

Mr. Fortis' agent conceded that his client did not satisfy the onus placed on him to prove the assessments he appealed from were not correct.

I am of the view that the corporation did not satisfy the onus placed on it either. The principal witness for the corporation was Mr. Pappas. Mr. Pappas had been in the restaurant business in Canada for over ten years prior to the years under appeal. His explanation why the cash register tapes and cancelled cheques were thrown out is not convincing, especially when coupled with his evidence that he destroyed records of the loans. In any event the corporation did not establish its income for any year under appeal or demonstrate any error in the Minister's calculation of income.

The appellants were also assessed penalties in accordance with subsection 163(2) of the Act, which for the 1980 and 1981 taxation years read as follows:

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

(a) 25% of the amount, if any, by which

(i) the amount, if any, by which

(A) the tax for the year that would be payable by him under this Act

exceeds

(B) the amount that would be deemed by subsection 120(2) to have been paid on account of his tax for the year

if his taxable income for the year were computed by adding to the taxable income reported by him in his return for the year that portion of his understatement of income for the year that is reasonably attributable to the false statement or omission

exceeds

(ii) the amount, if any, by which

(A) the tax for the year that would have been payable by him under this Act

exceeds

(B) the amount that would have been deemed by subsection 120(2) to have been paid on account of his tax for the year

had his tax payable for the year been assessed on the basis of the information provided in his return for the year, and

(b) 25% of the amount, if any, by which

(i) the amount that would be deemed by subsection 122.2(1) to be paid for the year by him or his spouse, as the case may be, if that amount were calculated by reference to the information provided in the form

exceeds

(ii) the amount that is deemed by subsection 122.2(1) to be paid for the year by him or his spouse, as the case may be.

With respect to the 1978 and 1979 taxation years paragraph 163(2)(a) read as follows:

163. (2) . . .

(a) 25% of the amount, if any, by which

(i) the tax for the year that would be payable by him under this Act if his taxable income for the year were computed by adding to the taxable income reported by him in his return for the year that portion of his understatement of income for the year that is reasonably attributable to the false statement or omission

exceeds

(ii) the tax for the year that would have been payable by him under this Act had his tax payable for the year been assessed on the basis of the information provided in his return for the year, and . . .

In order for a penalty to be assessed pursuant to subsection 163(2) there must be:

(a) a liability for tax;

(b) a false statement or omission in a return filed as required by or under the Act or a regulation;

(c) knowledge or gross negligence by the person in the making of a false statement or omission;

(d) an understatement of income for a year, as defined by subsection 163(2.1), that is reasonably attributable to the false statement or omission.

Subsection 163(3) provides that:

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.

The Minister must therefore prove each of the four above elements in order to successfully defend his assessments of penalties against the appellants.

In assessing a penalty under subsection 163(2) the Minister has to determine the amount of income the taxpayer failed to report and establish the circumstances surrounding the unreported income. The Minister must show a taxpayer has failed to report income so the Court can determine whether any particular penalty was in an amount authorized by subsection 163(2). See Elchuk v. M.N.R., [1970] C.T.C. 326 at 329; 70 D.T.C. 6235 at 6237.

Where a penalty is assessed under subsection 163(2) as a result of a net worth assessment it is frequently difficult for the Minister to establish facts justifying the assessment of the penalty. What is frequently described as a net worth assessment is a result of the Minister's estimate of the taxpayer's income based upon the best available evidence. See Dezura v. M.N.R., [1947] C.T.C. 375 at 377-80; 3 D.T.C. 1101 at 1102-4, per Thorson, P., Commercial Hotel Limited v. M.N.R., [1948] C.T.C. 7 at 8-9; 3 D.T.C. 1119 at 1119-20, per O’Connor, J. and Graham v. M.N.R., [1959] C.T.C. 514 at 519; 59 D.T.C. 1271 at 1274, per Dumoulin, J.

A taxpayer who disagrees with a net worth assessment may appeal the assessment but, notwithstanding the assessed tax may have been calculated on estimated income, the taxpayer still has the onus of demolishing the basic fact on which the taxation rested. See Johnston v. M.N.R., [1948] S.C.R. 486; [1948] C.T.C. 195 and Chernenkoff v. M.N.R., (supra). If the taxpayer fails in his onus to rebut the net worth assessment, the assessment remains in force. This is the result of the appellants’ appeals from assessments of tax.

The question then raised is whether the Court may accept without any other evidence, the income determined by the Minister in making a net worth assessment as an indication of a taxpayer’s understatement of income for the year for the purposes of subsection 163(2). In her submissions the appellants were grossly negligent in not reporting all their incomes, counsel for the respondent referred the Court to the decisions of Sam v. The Queen, [1974] C.T.C. 634; 74 D.T.C. 6493 (F.C.C.), Gadway v. M.N.R., [1984] C.T.C. 2648; 84 D.T.C. 1559 (T.C.C.), and Coscarella v. M.N.R., [1984] C.T.C. 3067; 85 D.T.C. 3 (T.C.C.), where the amounts of income calculated by the Minister were used in determining the penalty. Mr. Justice Kerr found that the Minister satisfied the burden of establishing the facts justifying the assessment of penalties against Mr. Sam, although his reasons for judgment do not discuss the evidence. Cardin, T.C.J. found sufficient evidence existed to support the penalties in Gadway (supra) and Coscarella (supra).

Subsection 163(3) imposes on the Minister the onus of establishing the facts justifying the assessment of the penalty under subsections 163(1) or (2). The onus on the Minister in respect of the penalty should be no different from the onus placed on a taxpayer who appeals from an assessment of tax. Consequently when a taxpayer appeals an assessment of the penalty, the Minister must establish on a balance of probabilities the facts justifying the assessment. A fact which must be established is the understatement of an income for the year since the amount of additional tax on which the penalty is calculated can only be determined once the understatement of income for the year is known.

Mr. Justice Rand described the onus of a taxpayer in an appeal from a taxation on income in Johnston v. M.N.R., (supra), at 489 (C.T.C. 202):

. . . since the taxation is on the basis of certain facts and certain provisions of law either those facts or the application of the law is challenged. Every such fact found or assumed by the assessor or the Minister must then be accepted as it was dealt with by those persons ... the onus was [the taxpayer's] to demolish the basic fact on which the taxation rested.

In an appeal from an assessment of a penalty under subsections 163(1) and (2), however, any fact found or assumed by the assessor or the Minister cannot be accepted as it was dealt with by those persons since as a result of the coming into force of subsection 163(3) the Minister has statutory burden of establishing the facts justifying the assessment of the penalty. The Minister now cannot rely on assumptions pleaded in his reply to the notice of appeal to establish any fact justifying the assessment of the penalty. Neither Johnston nor M.N.R. v. Pillsbury Holdings Limited, [1964] C.T.C. 294; 64 D.T.C. 5184 is of assistance to the Minister in respect of a penalty assessed under subsections 163(1) and (2).

To permit the Minister to use his own arbitrary determination of understatement of income for the year based on a net worth assessment places the onus on the taxpayer to demolish the fact on which the penalty rested: this, as already stated, is contrary to subsection 163(3) of the Act. In The Queen v. W. Taylor, [1984] C.T.C. 436; 84 D.T.C. 6459, Mr. Justice Rouleau held, at 440 (D.T.C. 6463), that a finding under subsections 163(2) and (3) could not have been intended by Parliament to eliminate the duty imposed on the taxpayer under section 152 to prove the assessment of tax was wrong. Similarly, Parliament could not have intended that the facts relied on or assumed by the Minister in making an assessment under section 152 to eliminate the duty imposed on the Minister under subsection 163(3); otherwise subsection 163(3) would be rendered impotent.

The amount of the understatement of income for the year must be known prior to the penalty being assessed and the Minister must establish to the Court the precise quantum of the understatement of income for the year. As stated earlier, the Court cannot determine whether the penalty was in an amount authorized by subsection 163(2) unless the Minister first shows the taxpayer failed to report income and what that unreported income was. (Elchuk v. M.N.R., supra.)

It is not inconceivable, therefore, that the Minister may reassess tax pursuant to subsection 152(4) of the Act by adding to income reported by the taxpayer an amount the Minister estimates the taxpayer understated in his return of income, but may not succeed in assessing a penalty in respect of the same amount. See The Queen v. W. Taylor, (supra).

Once the Minister establishes the amount of understatement of income the taxpayer failed to report for the year, he may establish a false statement or omission was made by the taxpayer in his return with his knowledge or under circumstances amounting to gross negligence.

In the case at bar, the Minister assessed each individual appellant on a net worth basis and taxed the corporate appellant on the basis that the increases in income of the individual appellants and another shareholder of the corporation over that reported in their income tax returns represented unreported income to the corporation, their employer and sole source of income. No appellant succeeded in destroying the facts on which his assessments rested.

No evidence was led by the Minister to establish any fact justifying the assessment of penalties. The unreported income determined by Mr. Dykstra for each appellant was only an estimate, at best. Mr. Fortis' claim that the increase in his net worth was due to gambling winnings was corroborated; the extent of his actual winnings is unknown. Some of the additional income assessed Mr. Fortis may represent gambling winnings. Mr. Pappas was able to establish that he borrowed money from Mr. Meagher, at least, but could not establish the dates of the loan. It is clear that the statements of net worth for Mr. Pappas did not take into account the liability of Mr. Meagher either in 1978 or 1979; the Minister did not prove that the liability would not reduce the net worth of Mr. Pappas for the particular year. The production by the Minister of the net worth statements he prepared in making the assessments is only proof of the existence of the statements; for purposes of subsection 163(3) their contents must be established and this the Minister has failed to do.

The corporation's income was increased to the extent of the unreported income determined for its shareholders; because the Minister did not establish the amount of understated income of the shareholders, it must follow the penalties assessed against the corporation must fall. I fully appreciate that if the corporation had maintained proper records and books of account the Minister may have determined with certainty the amounts of understatement of income and assess penalties, but because it was derelict in its duty to maintain records and books of account the corporation's understated income can only be estimated, and so it escapes from the penalty under subsection 163(2).* [1]

The appeals will be allowed only for the purpose of deleting the penalties from the assessments appealed from; the appellants shall be entitled to one-half of their party and party costs, if any.

Appeals allowed in part.