O’connor v. R., [1997] 2 CTC 2075

Rip T.CJ.:

Martin O’Connor (“O’Connor”) and Open Sky Inc. (“Open Sky”) have each appealed (Informal Procedure) assessments of tax levied against them by the Minister of National Revenue (“Minister”). O’Connor appealed from an assessment for 1990 on the basis that Open Sky did not confer a benefit on him, pursuant to subsection 15(1) of the Income Tax Act (“Act”), in that year and that the appellant should be entitled to deduct expenses incurred in earning income from property: paragraph 18(l)(a) of the Act [1] Open Sky has appealed from assessments for 1990 and 1991 on the basis that it did not fail to report income of $18,590 in 1990 and $1,070 in 1991 in accordance with subsection 9(1) of the Act, it is entitled to deduct expenses in 1990 and 1991 for use of property on which it carried on its business in those years, pursuant to paragraph 18(1)(a) of the Act, and that it did not knowingly or under circumstances mounting to gross negligence made a false statement or omission in the said years pursuant to subsection 163(2) of the Act. The company’s fiscal year ends on July 31st. The facts in each of the appeals are related and, accordingly, the appeals were heard on common evidence. Mr. James Court, C.M.A., the accountant for both of the appellants acted as their agent in these appeals and also testified on their behalf.

O’Connor is president and sole shareholder of Open Sky and was employed by that corporation in operating its business of selling and installing satellite dishes and related systems. In 1988 O’Connor suffered a burst aorta and his doctor told him that the tension in supervising all aspects of the business was not good for him. O’Connor said he removed himself from the immediate day to day aspects of the business to an “overview” of the business. He said that he no longer handles customers sales, accounts payable, accounts receivable and other administrative matters nor does he install equipment. “I had people working for me ... who (were) honest and reliable”. O’Connor said he reviewed ongoing technology and other matters of technological nature.

One of the employees was Shirley Nordal “whose primary function was to do bookkeeping and send out invoices for me”. She and Lynn Oltar, another employee, dealt with customers. Open Sky had two to four employees at any one time.

When a sale occurs, O’Connor explained, documents are “usually drawn up as to what the deal is” and describes the equipment purchased and the price. Once a dish is installed, payment is made, usually by cheque or by cash. He could not advise as to what portion of sales were paid by cash and by cheque. Cash payments were put into a “cash box”, together with the related sales invoice. O’Connor indicated that Open Sky would usually make invoices on cash sales, usually with the names of the purchasers. A copy of the invoice was given to the customer. He stated that the company always “operated near survivability” and was on a cash basis with suppliers. The company generally kept $1,000 to $2,000 in cash on its premises. The company did not have a cash register.

Cheques were deposited to the bank by O’Connor or Ms. Nordal, but not necessarily to the company’s account. The company has a regular bank account but O’Connor revealed that there is never money in the account for more than several days. One of the reasons the company does not keep money in the bank account is that “we do not want the money seized” in the event there is difficulty with Revenue Canada concerning source deductions. Cash receipts are not deposited to the company’s bank account. O’Connor explained that if a customer gave him a cheque for the purchase of a satellite system, he would cash the cheque through his personal account, withdraw an equal amount from his personal account and then use it to pay for the supplies. He said it was “quite rare” for him to pay an expense from his personal account, Those expenses that he did pay from his personal account, he stated, were for the purchase of computer software which sold at a lower price to an individual than to a corporation.

O’Connor acknowledged that he had full access to the cash box. He said he did not live high and rarely took money out of the cash box. When he did take cash out of the box “Shirley knew about it and would record it”. O’Connor stated that the company never issued cheques to him. His “main people were scrupulously honest” and when any of them took money from the cash box it would be to buy what was necessary for the company and they would put receipts into the box to cover the amount withdrawn.

O’Connor acknowledged the company had no system to balance funds. For example, there was — and is — no petty cash voucher system. He said that the system works well with the regular people but falls down when new or dishonest people are employed by the company.

Open Sky carried on its business from O’Connor’s home and in 1990 took up approximately 80 per cent of O’Connor’s home. O’Connor owned his home. Open Sky paid all mortgage payments, utilities and taxes for the house. There were two mortgages on the property. Annual payments on the first mortgage was $4,151 a year, and for the second mortgage, $4,845 a year.

The monthly mortgage payments to the first mortgagee were paid by cash. Payments to the second mortgagee were made by post-dated cheques on O’Connor’s personal account. To make the monthly payments on the second mortgage, O’Connor would take the required amount out of the cash box and deposit that amount into his personal account.

O’Connor testified that Ms. Nordal “would apportion payment” of the mortgages in the books of the company. O’Connor stated that he did not “really know” how Ms. Nordal knew when he took money out of the cash box, if he had not told her. He explained she should know “off the top of her head” that there were two mortgage payments to be made each month and he withdrew money for that purpose. If he took money out of the cash box for personal reasons, O’Connor added, “generally” he would tell her he withdrew money from the box. He added that the accountant, Mr. Court, would check Ms. Nordal’s work and, unless Mr. Court indicated otherwise, he, that is, O’Connor, would not look over Ms. Nordal’s shoulders. O’Connor volunteered that he is “not into” financial statements. He said he “hardly looks at the year end statement. When you are hardly making money ... (there is) ... nothing to look forward to ...”.

O’Connor suspects that sales of $19,660 ($18,590 in 1990 and $1,078 in 1991) realized by Open Sky in the course of its business were not entered into its books of account because a salesman, Don Garwood, with whom he did not have a “satisfactory relationship”, did not submit invoices of his sales to Ms. Nordal. O’Connor explained that Garwood worked for Open Sky between April and September 1990. In April 1991 the Royal Canadian Mounted Police (“RCMP”) seized documents and records in the possession of Open Sky. (I shall deal with this later.) Amongst these documents were invoices O’Connor said were prepared by Don Garwood. Revenue Canada subsequently received the records from the RCMP. When he first met with officials of Revenue Canada, O’Connor was informed that the company failed to report over $30,000 income. He said Revenue Canada officials indicated that “income came to the company and was not included in our income”. He said he took the Revenue Canada information and went through the accounts and “actually found the stuff was not reported”. Most of the unreported income originated with sales by Garwood. O’Connor could not say why Garwood did not bring these sales invoices to Ms. Nordal’s attention. O’Connor stated that “he does not understand why (the invoices) were missing”. O’Connor explained that the normal practice, once a transaction was completed, was for a salesmen to bring a copy of the invoice and the cash received to Ms. Nordal. In reviewing the documentation, he discovered that some deposits made by Garwood’s customers prior to the installation of equipment were brought to Ms. Nordal and were included in the company’s books of account. The Minister originally added approximately $49,500 to the Open Sky’s income for 1990 and 1991. On a review of the seized documents, O’Connor was able to trace sales of approximately $30,000 for which invoices were issued and the aggregate amounts of unreported income for 1990 and 1991 was reduced by reassessments to $19,660.

Counsel for the respondent produced to O’Connor a schedule prepared by Revenue Canada auditors indicating sales of $19,660 that had no corresponding journal entries. These sales represent the amounts that O’Connor was not able to trace in the company’s books. O’Connor indicated that these sales represented transactions to people he did not know. However, counsel showed O’Connor a cheque made by one Barry Shatzeman payable to cash that was endorsed by O’Connor.

Also shown to O’Connor were calculations of commissions due on sales, purportedly prepared by Garwood. O’Connor said that “he assumes that the business kept track of commissions to his employees ... but was not sure”.

With respect to mortgage payments, O’Connor stated that “whoever is supposed to be paying” pays the monthly mortgage payments. He later said Open Sky “made these payments”. He also testified that payments were made to the mortgagees but he could not say by whom. “At the time it did not seem to make a difference”. He said that when he takes money out of petty cash there is no indication how he intends to use the money. He said there was no way to distinguish withdrawals for personal or business purposes. There was no paper trail.

O’Connor testified that for the past eight years he spent most of the time “from about November or January to April, May or June” in Mexico.

Mr. Court explained how Ms. Nordal attempted to record the various transactions in the books of Open Sky. All available vouchers and documents were recorded by Ms. Nordal in a Cash Receipt (or sales) Journal and a Cash Disbursement (or expense) Journal. He said she records all transactions that she is given. She records cheques and cash sales through the Cash Receipts Journal and all expenses in the Cash Disbursement Journal. Cash transactions were recorded in the cash column; cheque transactions were recorded in the bank column. At the end of the year she provided Court with the books of account. He reviews them and prepares a trial balance and tries to make sure the accounts are reasonable. He acknowledged the cash account is not usually balanced. He explained “we review the costs to see where the disbursements were”. He said that in 1990 and 1991 there seemed to be unreported sales. Cash sales were recorded but there were no corresponding invoices. He explained “we went through to recap the records” and make an analysis. Court made adjustments to O’Connor’s living expenses and monthly payments of mortgage interest and utilities. O’Connor’s shareholder loan account was adjusted to reflect the mortgage payments and then to reflect notional payments of rent. However, the adjustments did not find their way into the tax return. He explained that in 1990, “when we recapped the records, all balanced”. “Cash was not out of whack ...”. However, Court stated, “it did not go further ... not all mortgage payments were charged ...” In fact, mortgage payments for only three months were charged against the appellant’s shareholder loan account. Court said that cash was not in a large overdraft and “we made a wrong assumption”.

Court could not explain why all invoices were not sent to Ms. Nordal to be recorded. He believes a file of invoices seized by the RCMP was “stuffed in a drawer ... and they never got to Shirley...”.

With respect to the unreported transactions, Court insisted that part of the sales were recorded: there were two transactions in which deposits of $500 and $100 were recorded but the final balances, once the sales took place, were not “tracked down”. Court indicated that after his review of the unreported sales, the only sales that could not be traced — several were traced — were sales by Garwood. For 1990, only six invoices were not recorded and in 1991, only one invoice was missing, he said.

O’Connor financed Open Sky’s business in part by cash advances, according to Court. His drawings from the company have always been against his shareholder loan account. He also stated that O’Connor did not charge the company rent for use of his home. Court did not prepare a formal statement of rental income and rental expenses. The amount of mortgage and other payments by the company during the year equalled the expenses O’Connor incurred in maintaining the property. Hence there was a “saw off” and the transactions were ignored in tax returns. In other words, as I understand it, the company paid a notional rent equal to 80 per cent of the annual mortgage payments, utilities and taxes on the property. This was a practice that was adopted in each of the years before 1990 and in subsequent years. Court testified that if the missing sales in the amount of $19,660 had been recorded, O’Connor would have been charged for mortgage payments, utilities and taxes of $9,600 and contemporaneously, his loan account would have been adjusted for the mortgage payments, utilities and taxes on the property in an amount aggregating $9,600. The amount of the $9,600 paid by the company would have been treated as rent. Court complained that Revenue Canada did not permit him to make such an adjustment in 1990 because it had not been claimed in the financial Statements.

Court took the position that the amount of $19,660 was not included in the company’s income from sale due to a clerical error. The clerical error was caused by a salesman who did not turn in his sales invoices. He stated that unreported sales should be offset by unreported expenses, expenses that were incurred on a cash basis. During his argument, Court indicated that he routinely made adjusting entries for cash drawings and “offset” the drawings from rent in the year. It was only due to an “accident or oversight” in 1990 that the appellants got into this “unfortunate mess”. In his view it is reasonable to allow the company to deduct a rental expense from its income. Adjustments should not be prohibited to correct an accounting error. Accordingly, Court submitted O’Connor did not benefit by the amount of $9,600 which the company paid on account of property it used and that amount should be deducted from the $19,660 Revenue Canada added to his income in 1990 as an appropriation pursuant to subsection 15(1) of the Act. Any penalties assessed should also be reduced on the basis that the company be permitted to deduct the amount of $9,600. Court explained that O’Connor incurred no benefit since the company ought to have paid him the rent.

Earlier in my reasons, I referred to the RCMP seizing the books and records of Open Sky. Robert Campbell Bingham was, at the time of trial, a sergeant with the Commercial Fraud Section of the RCMP. He participated in the seizure. He testified on behalf of the respondent. He stated that in 1989 the RCMP received information that Open Sky and other dealers were selling satellite chips and decoding equipment to permit viewers to descramble satellite television signals on their receivers. Together with a Mr. Courtland, an officer of the film security video office of the motion picture industry, Bingham approached Open Sky to purchase a decoding chip. Prior to attending at the premises of Open Sky, Courtland telephoned Open Sky and was told that they sold this material on a cash basis only. Courtland and Bingham attended on Open Sky on November 21, 1989. Courtland posed as a traveller from Vancouver who wanted a decoder chip installed in a video unit. Courtland delivered the unit to Open Sky’s premises and was given a receipt for the video unit. The cost was $200. Courtland was told cash was the only acceptable means of payment and, on collecting the unit a day or so later, paid with four $50 bills. Courtland was purportedly given a receipt for the payment of the $200 but neither his name or the price paid is indicated on the receipt. Bingham believes that Courtland dealt with O’Connor personally.

On April 11, 1991 the RCMP, acting on a search warrant, entered the premises of Open Sky and seized its books and records. Bingham personally executed the warrant. Charges were laid against O’Connor and Open Sky. By an agreement entered into between the Crown and the defendants, the defendants pleaded guilty and they were fined $2,000 on two counts. All the illegal equipment was destroyed or turned over to the RCMP. On August 13, 1993 Bingham supervised the return of the records of Open Sky to a Mr. Leo Zabor, an employee of Open Sky who was present when the documents were first seized. Bingham said the only items not returned to Open Sky were those items that were ordered destroyed by the judge. These included computer chips. Bingham prepared a folder of invoices for the Department of National Revenue. He testified when a review was made of sale transactions by Open Sky for 1989, the sale made to Courtland in the amount of $200 was not recorded in Open Sky’s books.

Bingham stated that in a meeting he had with Court in 1993, some pages of the synoptic for 1989 were missing and Court had agreed to supply the missing documents. At a second meeting, O’Connor stated that he had incurred expenses for the chips and software and he should get credit for the expenses. Bingham told O’Connor that “chipping” is relatively inexpensive and the software that O’Connor stated he purchased could be downloaded for free. Bingham stated O’Connor got very upset when he could not substantiate the cash expenses. Bingham characterized the company as having “poor internal control”.

Analysis

Open Sky did not maintain records that reflected its sales. At best, Open Sky operated on a hit and miss strategy. Most sales were probably recorded and some sales were not. What was recorded, or should have been recorded, it seems, depended on what Ms. Nordal was told or what she knew or ought to have known, according to O’Connor. Cash went into and out of the cash box without any record of a deposit or withdrawal. O’Connor tried to lay the responsibility on Ms. Nordal, who he indicated, was an honest and competent employee.

O’Connor tried to paint himself as an owner of a business enterprise who, because of ill health and absence from the premises for long periods, was not aware of what was taking place. Or, perhaps, what was taking place, was beyond his control. I believe O’Connor has a false impression of the facts. It was he who set up the business and determined how it was to be carried on and how in reality it was carried on. For example, the practices of Open Sky encouraging cash sales, disregarding what was going in and out of the cash box and insufficiently supervising employees such as Garwood were put in place by O’Connor and were never discouraged. There was no effort to put a system of controls in place.

As far as I can surmise, Ms. Nordal did as good a job as she could have done, given the circumstances as they were described to me. She did not testify and I infer from her absence that her evidence would have been unfavourable to the appellants. [2] Court indicated he did not believe her presence would add anything.

I stated at trial that Open Sky’s means of recording its business affairs was “an accident waiting to happen” and in 1990 the accident occurred. I do not accept Court’s submissions that the amount of $19,660 was omitted due to a clerical error and that the mortgage payments paid by Open Sky ought to be adjusted to reflect the payments as rent paid to O’Connor.

The amount of $19,660 was not included in Open Sky’s income because Open Sky had no system, however elementary, to reasonably insure that its sales would be included in income. The omission was not due to any clerical error. Bingham’s conclusion that Open Sky had “poor internal control” is an understatement.

At the end of each year Court prepared a financial statement of Open Sky’s business operations. In preparing the statement, Court would attempt to balance various corporate accounts by making adjusting entries to the accounts. From what I gathered from the evidence, the absence of actual corporate records required Court, at times, to make arbitrary decisions on how the accounts ought to be adjusted. That Revenue Canada may have accepted these adjustments in other years is no reason Revenue Canada must agree to accept the adjustment in 1990. The appellants should not look to success in these appeals by saying Revenue Canada is not fair. The appellants should look at themselves. The fact of the matter is that Open Sky failed to report income in the amount of $19,660 and the omission was not due to a clerical error or simple carelessness.

I am not convinced, on the evidence before me, that the amount of $19,660 of unreported income be adjusted to $10,060 to reflect the payment of a “notional” rent of $9,600 by Open Sky to O’Connor.

It appears that the books of accounts of Open Sky so lacked for information that it was only after the end of a financial period that real decisions were taken as to how accounts were to be adjusted for that year. O’Connor said that “whoever” was to make the mortgage payments made the payments. He was not sure who made the payments, although he later said Open Sky made the payments. In 1990, mortgage payments for only three months had been charged against O’Connor’s loan account. It was Court who considered the payments as a rent and adjusted the relevant accounts when preparing the statement for 1990.

Nowhere in the records of Open Sky and O’Connor is there provision for rent. O’Connor and Open Sky never took the correct formal steps to provide for rent. In Friedberg v. R., (sub nom. Friedberg v. Canada) [1992] 1 C.T.C. 1, (sub nom. R. v. Friedberg) 92 D.T.C. 6031, Linden J.A. stated, at p. 6032:

... If a taxpayer fails to take the correct formal steps, however, tax may have to be paid. If this were not so, Revenue Canada and the courts would be engaged in endless excercises to determine the true intentions behind certain transactions. ...

The penalties assessed against Open Sky pursuant to subsection 163(2) of the Act should stand. Open Sky

... knowingly, or under circumstances amounting to gross negligence in the carrying out of any duty or obligation imposed by or under [the Act], has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return, ... in respect of a taxation year ...

The omission from income by Open Sky in the amounts of $18,590 in 1990 and $1,070 in 1991 were not inadvertent nor were they a mere clerical error. The fact that only seven invoices were missing does not help the appellants. As my colleague Sarchuk T.C.C.J. said in 412237 Ontario Limited v. R., (sub nom. 412237 Ontario Ltd. v. Canada) [1994] 1 C.T.C. 2177, 94 D.T.C. 1022, at page 2185 (D.T.C. 1026):

... discrepancies do not have to be large to constitute gross negligence. ...

This was not the first time Open Sky omitted to include sales in computing its income. Bingham recalled the sale of $200 to Courtland that Open Sky did not include in its income in 1989. The omissions from income of sales in 1990 were part of a pattern that began as late as 1989. It was only in 1991 that the RCMP seized Open Sky’s documents and Revenue Canada audited its affairs. The omissions were the result of gross negligence, if not the knowledge, of Open Sky. The financial records of Open Sky were sloppy and O’Connor knew this. The company had no internal control of its finances and O’Connor knew this too. His attitude was that this was no great concern to him. He was “not into” maintaining financial records. When, therefore, sales are omitted in computing income in these circumstances, it is not due to clerical errors or mere carelessness; it is due to gross negligence, at the least.

The amount of $19,660 paid by Open Sky during the 1990 calendar year on O’Connor’s behalf was a benefit conferred on O’Connor by Open Sky and is to be included in computing his income for 1990: subsection 15(1). As I stated earlier in these reasons, I do not find that the amount of $19,660 ought to be reduced by the amount of $9,600 as notional rent paid by Open Sky to O’Connor in 1990, as argued by his agent. O’Connor was aware of the lack of proper bookkeeping by Open Sky. I am not satisfied that the amount of $19,660 was not used by O’Connor for his own benefit and advantage. This is not a situation similar to that in Chopp v. R. [1995] 2 C.T.C. 2946, 95 D.T.C. 527 (T.C.C.), for example.

The sources of these appeals were the lack of proper bookkeeping and proper controls by Open Sky. Associate Chief Judge Christie made the following comments in Kay v. R., (sub nom. Kay v. Canada) [1995] 1 C.T.C. 2310 (headnote only), 95 D.T.C. 1 (T.C.C.), at page 2:

It may be appropriate to say something about taxpayers keeping records and books of account. Under subsection 230(1) of the Income Tax Act every person carrying on business and every person who is required to pay taxes shall keep records and books of account in such form and containing such information as will enable the taxes payable under the Act to be determined. Failure to comply with the subsection will not, of itself, result in the dismissal of an appeal against a reassessment of liability to income tax. But it could interfere with an appellant’s ability to discharge the burden of proof on him of showing that, on a balance of probability, the reassessment is in error. This was recently dealt with by the Federal Court of Appeal in Sidhu v. M.N.R., [1993] 2 C.T.C. 278, 93 D.T.C. 5453. Mahoney, J.A. in delivering the judgment of the Court said at page 281 (D.T.C. 5454-5):

The requirement of s. 230(1) may fairly be characterized as absolute ... The failure to record transactions will inevitably handicap a taxpayer seeking to discharge the burden of proving that they took place but the responsibility of the trial judge in such circumstances is to decide, on a balance of probabilities having regard to all the evidence and its credibility, whether any, all or none took place. The proper approach was demonstrated by Strayer, J., in Schwartz v. Her Majesty the Queen, [1987] 2 C.T.C. 12, 87 D.T.C 5274 at page 14 (D.T.C. 5275).

The law places the onus on the taxpayer in such cases to prove wrong the Minister’s reassessment on the basis that the taxpayer is in a better position to prove what actually happened, if he chooses and is able to do SO. ...

To the foregoing I might add that if on an appeal to this Court the circumstances are such that because of failure to keep records of business transactions or to keep reasonably comprehensible records the onus on the appellant cannot be discharged then, I think, the appellant can only be regarded as the author of his own misfortune.

The appeals will be dismissed.

Appeal dismissed.