Richard Alan Beer v. Her Majesty the Queen, [1996] 3 CTC 2628 (Informal Procedure)

Rowe D.J.T.C.C.: — The appellant appeals from an assessment of income tax, dated October 20, 1995, issued against him in a Notice of Assessment (03876) as a consequence of failure by YCO Enterprises Inc.

(YCO) to remit to the Receiver General federal income tax withheld from wages paid to its employees, as well as penalties and interest, during a period, commencing in 1991 until January 31, 1993, at all times during which the appellant was a director of said corporation.

The sole issue is whether or not the appellant exercised the degree of care, diligence and skill to prevent the failure of YCO to remit the amount that a reasonably prudent person would have exercised in comparable circumstances.

The appellant testified he is a businessman residing in West Vancouver, British Columbia. A book of documents, with tabs 1-8, inclusive, was filed as Exhibit A-1. He stated that he is the President of a hotel company in Powell River, British Columbia which has 60 employees. He emigrated to Canada 30 years ago at age 23 and started his own business. Over the next three decades he started five different businesses, built them up and then sold them. In each case he was a director and principal of the corporation operating the business. The enterprises would begin in a modest manner and then grow over the next few years. One company that he started grew to have 100 employees and another had 240. As a consequence, he was very familiar with the requirements to remit income tax from employee deductions. Further, he has long been aware of the liability imposed on a director of a corporation by virtue of section 227.1 of the Income Tax Act (the “Act”).

The appellant stated that, in 1987, he sold a company that manufactured and sold brass hardware and started a seafood processing business. He rented premises in an empty warehouse and began operating under the name Sir Richard Seafoods. Within two years, the business was grossing $1 million and another company was purchased and merged with the seafood business which was then relocated to the nearby municipality of Delta. The previous space, together with improvements and equipment, was sold to a corporation, YCO for the sum of $45,000, with $15,000 paid by the purchaser as down payment. The principal shareholder in YCO was Yvette Konnemund. YCO defaulted in the balance of the purchase price and, in 1991, Yvette Konnemund contacted the appellant with a view to determining if he was interested in re-purchasing the business. He met with her and decided to purchase 75 per cent of the issued shares in YCO for the sum of $140,000 on terms as set out, inter alia, in the agreement dated February 6, 1991 found at Tab 1 of Exhibit A-1. Attached to said agreement, as Schedule A, was a document titled “Consulting Agreement” dated March 18, 1991 in which Mrs. Konnemund agreed to function as a consultant to YCO and to use her experience as a Chef to maintain quality of the product.

At this point, the appellant and his wife were directors of YCO and, even though Mrs. Konnemund still owned 25 per cent of the shares, she was not a director. Although a manager was in charge of the business, the appellant stated he spent between one and one and one-half hours per day at the YCO premises. There were five employees working in the business. On April 2, 1991, Mrs. Konnemund departed for Germany — which came as a surprise to the appellant - and she remained there for two months. On May 7, 1991, YCO lost a major customer which had been purchasing product amounting to 30 per cent of total sales. This event had an immediate effect on the cash flow of the company because the turn-around time had been less than 30 days from the order to production, shipping, invoicing, payment by the customer, and then deposit to the YCO bank account.

Prior to this occurrence, there had been no arrears in any remittance of employee deductions to Revenue Canada. The appellant stated that he realized YCO required a line of credit and he approached two banks. He was confident there would not be a problem in obtaining financing as YCO had unencumbered assets of more than $170,000. He prepared a complete proposal, with all of the necessary financial information about YCO, including cash flow charts and went to see the banks. Both institutions wanted more information which he provided within one week. Three weeks later neither bank had made a commitment to lend money to YCO. He surmised that the banks were concerned that if YCO had lost its largest customer — Safeway — that it might lose others and the survival of YCO would be threatened. In the eyes of the bank loan officers, YCO was a “restaurant account” which placed it into a high-risk category. This was not correct as the company was in the business of manufacturing gourmet bakery products such as quiches, meat pies and related items for sale in large retail stores. The appellant explained that he went to a leasing company with the idea that YCO could sell its assets to the leasing business and then lease them back, which would free up some operating capital. However, he could not put this deal together and by the first week of June, 1991, he realized that he would have to sell YCO. There were no arrears in remittances to Revenue Canada at this point.

On June 3, 1991, he wrote to his lawyer - Tab 2 of Exhibit A-1 - asking him to assist in the process of finding a buyer for the YCO business. Within one week, Mr. Wong, a lawyer with a large immigration practice, was introducing prospects to the appellant. The appellant thought that YCO was worth between $200,000 and $250,000. About the first part of July, 1991, YCO suppliers put it on a C.O.D. basis and the first failure to remit employee income tax deductions to Revenue Canada occurred about July 15, 1991. The appellant stated that he felt this shortfall could be made up in the near future either from a loan coming through or from a sale of the company. The amount owed at that point was about $1,000 as YCO only had five or six employees. At the most, he believed YCO would be sold within two months. However, the rules at the time required immigrant investors to purchase a business worth at least $300,000 in order to qualify for landed immigrant status and the top asking price of YCO was only $250,000.

By the late summer of 1991, the appellant had cut back every expense possible, reduced some staff to part-time and did not do regular maintenance. Some business brokers contacted him and indicated they would try and find a buyer for YCO. In the spring of 1992, the business was listed for sale with a broker and complete financial information was supplied to assist in facilitating a sale. At this time, about $12,000 to $14,000 was owing to Revenue Canada. A broker brought around some interested parties and in August, 1992, an offer was received for $100,000 with a down payment of $40,000 which he refused. He was still not overly concerned about the debt to Revenue Canada for remittance of employee income tax deductions as the amount owing was about $18,000 and the company still had $170,000 in saleable assets. Near the end of 1992, an offer for $165,000 on a “subject-to” basis was received but the conditions could not be removed and the sale did not proceed. Another prospect, although interested, did not make a formal offer. Then, Mr. Mike Alameddine offered to buy the assets of YCO for the sum of $125,000 and the appellant and Mrs. Konnemund - the holder of 25 per cent of the shares

— agreed to sell. An agreement — Tab 4 of Exhibit A-1 — as amended was signed by the parties and the price was reduced to $103,750 on the basis that. Mrs. Konnemund would be a 25 per cent shareholder in the new corporation which would take over the assets of YCO and use them in the course of operating the business.

The appellant and his lawyer met with Mr. Alameddine and his lawyer and in the course of discussion it was made clear that Revenue Canada had to be paid the amount outstanding for employee income tax deductions which had not been remitted since July, 1991. It was decided that the funds necessary to clear off this debt would be retained by another solicitor to be held in trust until the sale of YCO assets had been concluded. Mrs. Konnemund was fully aware of the debt to Revenue Canada and it was the largest unpaid bill of YCO. The agreement was amended in handwriting at page 2 to reflect the arrangement whereby a third solicitor would receive funds which would not be released without the written consent of both vendors — i.e. the appellant and Mrs. Konnemund. In that way, the appellant stated that Revenue Canada would be paid in full before any other money would be released.

On February 7, 1993 he wrote a letter to Mr. Alameddine — Tab 5 of Exhibit A-1 — in an effort to reiterate that Revenue Canada had to be paid in full and that sufficient funds be retained for that purpose and that he would request an audit from Revenue Canada to verify the amount owing including penalties and interest. He arranged for an audit and the closing of the sale was to take place on February 18, 1993 but it was delayed about 10 days. Mr. Alameddine had put down a $12,000 deposit with the broker. The appellant was in arrears in payments to Mrs. Konnemund pursuant to his agreement of February 6, 1991 and when he failed to make the balloon payment called for, she sued him for the balance owing in the sum of $56,000. He defended the claim on the grounds of misrepresentation and Mrs. Konnemund’s counsel issued a motion seeking summary judgment. Mr. Beer stated he met with his lawyers and decided not to continue defending the action as the sale of the assets of YCO would pay off the debt to Revenue Canada as well as his debt to Mrs. Konnemund. The settlement took the form of him transferring all of his shares in YCO to Mrs. Konnemund — Tab 7 of Exhibit A-l — and he then resigned as a director - Tab 8 of Exhibit A-1. He was convinced that the deal with Mr. Alameddine would close in the manner intended and that Revenue Canada would be paid in full.

Revenue Canada completed the audit on March 15, 1993 and he participated in the process and assisted as required. During that audit, the auditor told him that the transaction with Mr. Alameddine had not been concluded and that Mrs Konnemund had sold YCO to another party. The appellant stated that he told the auditor that Revenue Canada should have put a lien against the assets in order to secure payment. His wife had resigned as a director of YCO in 1991 and, after his resignation on February 25, 1993, Mrs. Konnemund was the sole director. Even though a major customer had been lost in 1991 when Mrs. Konnemund was out of the country he attempted to find more business and felt that YCO was a viable enterprise with $170,000 in unencumbered assets and five employees. He did not have any personal funds to inject into YCO as his other business was not doing well and Revenue Canada was accepting payments of small amounts and was not applying much pressure to be paid in full.

In cross-examination, the appellant stated that for the first three months he was involved in YCO that an individual was responsible for handling the payroll but after that he assumed that responsibility. There was no system in place to set aside employee deductions of income tax into a separate account. In February, 1992, his automobile was broken into and his briefcase, containing the chequebook for YCO, was stolen. Until it could be replaced, he wrote cheques to YCO from his company, Sir Richard Seafoods, to pay for certain product it was distributing and also issued some pay cheques to YCO employees for a short term. The loss of the Safeway account, amounting to 30 per cent of the gross, resulted in negative cash flow almost immediately. He agreed that the amendment to the agreement at Tab 4 of Exhibit A-l did not specifically refer to the indebtedness to Revenue Canada. He still does not know whether Mrs. Konnemund sold the assets of YCO or her shares but Revenue Canada was not paid by her.

Counsel for the appellant stated that the amount owing was not in issue nor any other component giving rise to liability under the relevant provision of the Act except the appellant, having regard to the circumstances, exercised the standard of care, diligence and skill as a reasonably prudent person. Counsel submitted that the appellant had a plan of action to obtain new financing and the company was in good shape at the time, with Revenue Canada being the largest creditor. Then, a buyer was found and a method put in place to pay Revenue Canada in full but the sale went awry and Mrs. Konnemund failed to live up to her clear obligation to pay the outstanding amount of the remittances to the Receiver General.

Counsel for the respondent submitted that actions taken after the failure to remit cannot constitute due diligence and that the appellant is liable as assessed.

Since the only issue is whether or not the appellant can be granted absolution under subsection 227.1(3) of the Act, the relevant provision reads as follows:

A director is not liable for a failure under subsection (1) where he exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.

It should be noted that there is no requirement in the Act that the funds deducted from employees for income tax must be held in a separate account by the employer, it must also be pointed out that the relevant provision in place during the period at issue in this appeal was subsection 227(4) of the Act which reads:

Every person who deducts or withholds any amount under this Act shall be deemed to hold the amount so deducted or withheld in trust for Her Majesty.

In Robitaille v. R. (sub nom. Robitaille v. Canada), [1990] 1 C.T.C. 121, 90 D.T.C. 6059 (F.C.T.D.) dealt with the issue of director’s liability and, at pages 125-26 (D.T.C. 6062) stated:

Although, when dealing with “the degree of care, diligence and skill” to be exercised by “a reasonably prudent person” in “comparable circumstances”, each case must necessarily depend on its particular facts, it appears that the Tax Court in its more recent decisions might have been more lenient towards directors than the previous cases, which seemed to insist on a somewhat higher duty, the duty presumably being an absolute one for the director to take positive action, since he or she must, in all cases, regardless of the situation, prove affirmatively that, both before and after the occurrence, there was on his or her part an exercise of care, skill and diligence in the performance of the duties normally incumbent upon a director. The argument is based on the common law principle that no distinction is to be made between directors whether they are active or purely nominal directors. Although that burden would, in the vast majority of cases, fall upon any director seeking to escape liability under subsection 227.1(1) by qualifying as an exemption under 227.1(3), I cannot accept that it is an inflexible rule of universal application regardless of the facts of any case. There exists, as was decided by Chief Judge Couture, of the Tax Court of Canada in the reported case of Fancy & Fancy v. Minister of National Revenue (supra), certain exceptional situations where a distinction can and should be made. Be that as it may, the “circumstances” referred to in subsection

(3) must be those which, either directly or indirectly, would have an effect on the actions or on the inaction of the person sought to be held liable under subsection (1). The fact that the Bank, to the knowledge of and with the consent of the Defendant, from October 1982, effectively assumed sole control over all disbursements of the corporation, constitutes a very important circumstance.

Furthermore, where the effective control of the corporation has been taken over by a bank such as in the case under appeal, without the bank being requested or invited to do so by the directors, and where the decisions as to what cheques will or will not be issued without consultation with the Board of Directors, are exclusively those of the bank, then from that time the actions of the corporation regarding the payment or withholding of monies are essentially those of the bank and I would be prepared to hold that, even without considering section 227.1(3), there would be no liability on the directors under section 227.1(1) because the latter obviously contemplates that the corporation is freely acting through its Board of Directors. The exercise of freedom of choice on the part of the director is essential in order to establish personal liability.

The term “diligence”, which is now codified, provides a higher objective standard than that imposed by the common law on directors generally. Although the test is to a large extent an objective one, the question remains, however, what a reasonably prudent person would do in the circumstances in which a director finds himself. These circumstances include subjective elements such as, degree of education, business knowledge and general ability of the director.

The Plaintiff was not ignorant of corporate affairs as she had a small corporation of her own of which she was president and manager. It is probable, therefore, that she was aware at least of some of the general duties of a director.

In the case of Short v. Minister of National Revenue, [1991] 1 C.T.C. 2464, 91 D.T.C. 67, the Honourable Judge Rip, Tax Court of Canada dealt with the appeal of a director of a company that, as in the within appeal, paid its employees their net pay and the difference between that amount and the gross pay was the sum that had to be remitted to the Receiver General for source deductions. There, as in the situation facing the appellant and controlling mind of YCO, the company did not have money on hand to pay the gross wages to its employees and was relying on money coming in later to make up the difference. At pages 2469-70 (D.T.C. 71) of his judgment Rip J.T.C.C. stated:

During 1986 the Company was attempting to pay its creditors by obtaining work. The bank, counsel says, was “helping to get the Company on its feet” by extending a line of credit. Post-dated cheques were issued to pay off indebtedness. The Company could do nothing to prevent the failure because it had no money with which to pay.

The Company operated by means of future progress payments from contracts being paid on time to permit the Company to make timely remissions of source deductions to the Receiver General. Counsel stated the only reason the Company could not remit the amount of source deductions was that it “didn’t have money to pay” since it was operating on a bank loan.

According to his counsel, Short had only two alternatives. Short could have tried to overcome the Company’s difficulties by paying creditors or he could have closed the business with the result no creditor would get paid. A reasonably prudent person in comparable circumstances would have tried to overcome the Company’s difficulties and cause the corporation to continue in business, he argued.

While one sympathizes with the appellant’s misfortune, it is quite clear that he did nothing to prevent the failure by the Company. The Company’s practice was to pay its employees their net salaries and rely on future receipts to remit amounts that ought to have been deducted from wages. The Company was playing with fire; there was always a reasonable probability that sooner or later anticipated revenue may not be received and no money would be available to remit. Short knew that the Company was in violation of section 153 since the Company’s practice was not to deduct or withhold amounts as required. The Company would simply pay net wages out of money available to it, hoping to have money available from its operation to remit when required. There was no system to operate within the Company that was tried and tested and had been shown not likely to fail: Merson v. Minister of National Revenue, 89 D.T.C. 22. When anticipated progress payments failed to be made the Company had to rely on bank loans to pay its creditors.

Short did make arrangements with the bank for the Receiver General to be paid as and when required, as well as arrears, out of the Company’s line of credit. But whether the Receiver General would continue to receive payments depended on the financial well-being of the Company and willingness of the bank. The failure of the Company to remit was not due to the bank cancelling its line of credit but was due to the Company not having sufficient funds to pay gross wages to its employees from which it could deduct and withhold taxes and other statutory payments. I accept O’Brien’s evidence that Short advised him that he was soon to receive $30,000 from the Department of Public Works and would pay his debt to the respondent. However, it appears he applied the $30,000 to paying suppliers to the detriment of the respondent. The facts in Fancy v. Minister of National Revenue, 88 D.T.C. 1641, are not similar to the appeal at bar.

For Short to have complied with subsection 227.1(3) need not have entailed the cessation of the Company’s operations. However, as Taylor T.C.J. stated in Clark v. Minister of National Revenue, 90 D.T.C. 1094 at page 1099 “...to continue an operation under circumstances which leaves little or no hope of making up that month’s default, and runs the risk of additional liability, would...leave the director personally liable....” I appreciate Short wished to cause the Company to honour debts and may have believed that to continue the Company in business would assist this. But the fact is that each week the Company continued to operate, its indebtedness to the Receiver General increased. There was no scintilla of evidence that the Company’s business during the summer and fall of 1986 was viable. To continue to operate such a business in the circumstances was not reasonable.

Turning again to the within appeal, I wish to make it clear that I find the evidence of the appellant to be credible and it is obvious that, at all times, both before and after the default occurred, he attempted to save the company and when it appeared the company had to be sold and a buyer was found he tried to ensure that the debt to Revenue Canada would be paid in full. However, it is the standard taken to prevent the failure that is relevant. The non- remittance on or about July 15, 1991 was a deliberate choice made by the appellant. YCO was short of money and continued to be in that position while the appellant attempted to obtain additional business or some method of raising operating capital. Each pay period thereafter the deductions for income tax were made only in a notional sense and the employees received their net pay. The amount that should have been withheld and then remitted to the Receiver General did not exist. The choice not to remit the amount due and owing for such income tax deductions was repeated over and over and in so doing the appellant ran the risk that the valiant rescue efforts might not bear fruit and that the debt to Revenue Canada would remain outstanding. He gambled and he lost. In hindsight, had the deal with Mr. Alameddine not fallen through and had Mrs. Konnemund honoured her legal obligation to pay the outstanding amount owed by YCO, which she controlled totally after February, 1993, then this litigation would not have been necessary. That is not the same thing as having met the due diligence requirements at the time of the initial and subsequent defaults. Nor would the assessment against the appellant have been necessary had Revenue Canada taken some action to secure the sale or disposition of the YCO assets until payment of outstanding remittances had been made. To allow continuous default over a period of 18 months is not, in my view, responsible. It should not be necessary for a director to have to attend personally at a Revenue Canada office and deliver up an engraved invitation to execute a seizure on corporate assets to satisfy a debt owing under the Income Tax Act. However, the point is whether the appellant exercised the care, diligence and skill to prevent the failure to remit that one could expect from a reasonably prudent person under the circumstances. One must be careful to consider what circumstances are relevant. It is not enough to empathize with the financial troubles of YCO and to applaud the efforts of the appellant to keep it operating. When funds deducted from employees for income tax are not remitted, as a result of a deliberate omission, it is extremely difficult in my view to envisage a situation where a director could escape liability under the saving provision. Of course, there will be circumstances where flood, fire, robbery, loss of records, computer meltdown and other horrible events would prevent remittances from being made for a short period of time but, barring such scenarios, there cannot ever be any justification for withholding employees’ income tax and not remitting it to the Receiver General or, having made such a deliberate choice, to continue the default.

The business community has to get this message. When money is deducted from an employee for income tax, it is no longer the money of the employer. It was the earned money of the employee and then, in a nanosecond, a goodly portion of it was taken, in compliance with the Act, from the employee and now is held in trust for Her Majesty. Once that fact is accepted then plans, schemes, wishes, hopes and dreams can still be relied on to save a business enterprise but funds withheld from an employee for income tax cannot be used until a White Knight or the Cavalry ride over the hill.

The assesment was properly issued and the appeal is dismissed.

Appeal dismissed.