Date: 20010223
Docket: 2000-164-IT-I
BETWEEN:
GUY RULTON,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
For the Appellant: The Appellant himself
Counsel for the Respondent: Micheal Ezri
____________________________________________________________________
Reasons for Judgment
(Delivered orally from the Bench at Toronto, Ontario, on January 22, 2001)
Mogan J.
[1] Some cases are determined by their facts because there is relatively little law involved. In other words, cases like this do not require me to interpret and apply some complex provision of the Income Tax Act. This case turns on its facts primarily because there is no suggestion from the Appellant that he had lost control of the company to a financial institution. The Appellant was a director of a company and there were source deductions not remitted. He was therefore assessed as a director.
[2] In the 1990s, the Appellant lived in or near Hillsburg, Ontario, a town with a population of about 2,000 people. There was a pub in Hillsburg operated under the name "Molody's Pub". In 1994-1995, Mr. Molody wished to sell his pub, and the landlord of the building where the pub was operated wanted the business to continue. The Appellant and a friend, David Lyver, who also lived in Hillsburg, decided that they would purchase the pub if they could finance it. They could not afford on their own to pay the purchase price. The landlord, however, was anxious that the business continue and so he called the Appellant and Mr. Lyver and offered to make a loan to help them purchase the pub. They decided to go ahead with the transaction.
[3] The Appellant and David Lyver took over the business on February 1, 1995. They changed the name of the business to "Extra Innings Sports Bar Inc." which as one can see has a sports connotation. The Appellant stated that there was an arena across the street and, in the winter, people playing hockey could come over to the pub after their games. Apparently there was also a park or baseball diamond nearby.
[4] The Appellant and Mr. Lyver were full-time delivery drivers with Pepsi Cola during the summer. Although it was a full-time job in the summer, they were either laid off or employed only part of the time during the winter. The Appellant and Mr. Lyver thought that owning and operating this pub would keep them occupied through the winter months and that they could hire someone in the summer when they hoped to continue as full-time employees of Pepsi Cola.
[5] At one point in his evidence, the Appellant said that he and Mr. Lyver had no big plans for the pub. They did not expect to make a family fortune out of it but they did expect to operate it as a business in the town where they lived. The actual operations were managed by the Appellant and Mr. Lyver from February 1 until late April or early May when they were called back by Pepsi Cola.
[6] They had employed Deanna Ellis (the wife of David Lyver) as a worker in the bar. She was like a senior employee/waitress and also assisted in the management because of her close connection with the two owners. Ms. Ellis prepared a document being a weekly and monthly journal which is entered as Exhibit R-1 and consists of four pages marked 10/15 to 13/15. The document is like a check list of things that any manager or responsible employee should do who is attempting to manage the sports bar. It is also a recital of the problems that already exist and have to be cured. It appears to me that it was prepared by somebody who had a pretty good understanding of what was going on and what had to be done in the sports bar.
[7] Ms. Ellis had to leave the sports bar at the end of May on maternity leave. Because the Appellant and his partner were fully occupied working more than 40 hours a week for Pepsi Cola, it was necessary to hire someone who could manage the bar in their absence and report to them. They hired Alisa Frost who had been a waitress for them and for the prior owner. She was in charge and, ultimately, they gave her signing authority to issue cheques to pay suppliers and other creditors of the bar. That employment continued from late May (when Ms. Ellis left) until December 1995 when the Appellant and his partner sold the business to Tony and Anita Welsh.
[8] Therefore, it can be seen that the Appellant and his partner operated this business for about 11 months from February 1 until the end of December 1995. They had incorporated the company bearing the name Extra Innings Sports Bar Inc. and the business was operated within the company. The Appellant and Mr. Lyver were the only directors of the company. When the business was sold to Tony and Anita Welsh, only the assets of the business were sold and not the corporate entity. The purchasers did not take on the liabilities of the corporation except for those liabilities that they chose to discharge. They did not want to take on the liability for the payroll. This appears in Exhibit R-3 which is a copy of the agreement of purchase and sale for the Extra Innings Sports Bar. It is a simple document drafted and signed on December 18, 1995 by the owners, David Lyver and Guy Rulton and by the purchasers, Anthony and Anita Welsh. It is a one-page agreement and it speaks for itself.
[9] At the time the business was sold, there were unremitted source deductions from the salary and payroll of employees which had accumulated but had not been paid to Revenue Canada. These amounts were in the aggregate of about $14,000 including federal and provincial tax, federal and provincial penalties and interest. On December 1, 1995, the Appellant and his partner paid $1,065 to reduce that liability. There were two subsequent payments in December 1995 and January 1996 of $800 each, which reduced the aggregate liability to approximately $11,380. Those payments are set out in Schedule "A" to the Reply to the Notice of Appeal.
[10] Because the remaining unremitted source deductions were not paid by the corporate entity, the Minister of National Revenue issued an assessment against the Appellant, requiring him to pay the shortfall under section 227.1 of the Income Tax Act which is the provision that creates director's liability for this kind of unpaid remittance. It is from that assessment that the Appellant has come to Court. The issue comes down to whether the Appellant has satisfied the due diligence test in subsection 227.1(3) of the Act.
[11] There is no claim in this appeal that the Appellant and Mr. Lyver lost control of the company as frequently happens when a bank steps in and overrides the decision of the directors to determine what cheques the bank will permit to be cashed. This is a common scenario in other cases involving director's liability. The only issue is whether the Appellant acted with due diligence in a manner that would satisfy subsection 227.1(3). The relevant words of subsection 227.1(1) are as follows:
227.1(1) Where a corporation has failed to deduct or withhold an amount, ... has failed to remit such an amount or has failed to pay an amount ... the directors of the corporation ... are jointly and severally liable ... to pay that amount and any interest or penalties relating thereto.
That is the charging section which imposes a liability on any director of a corporation which has failed to deduct or remit. Subsection 227.1(3) has been called the "due diligence test". It is the provision which permits a director in appropriate circumstances to escape the liability that would otherwise fall on him or her under subsection 227.1(1).
227.1(3) A director is not liable for a failure under subsection (1) where the director exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances.
The question is whether the Appellant, in the facts of this case, has exercised that degree of care, diligence and skill.
[12] In 1995, the Appellant was 27 years of age, a young man by any standard. He stated that he and his partner had no prior business experience and they had never owned or operated any kind of business. They had no bookkeeping experience and, indeed, they had to hire an outside party, Linda Cheyne, to do the payroll. Although this was not specifically brought out, I assume it was because neither the Appellant, nor Mr. Lyver, nor Ms. Ellis, knew how to complete the payroll with the appropriate source deductions for income tax, Canada Pension Plan contributions, Unemployment Insurance premiums and any other deductions that might be required by some statute to be taken at the source, commonly called "source deductions". Ms. Cheyne would complete the payroll from the information given to her by the manager, either the Appellant or his partner, or by Ms. Ellis up to the end of May, or by Ms. Frost from May onward.
[13] The Appellant knew that the business was in some difficulty from the start. Exhibit R-9 is a letter prepared by the Appellant and his partner addressed to a woman at Revenue Canada who was reviewing their possible liability. In cross-examining the Appellant, counsel for the Respondent brought to his attention a particular sentence on the first page of that letter which states: "The restaurant was barely scraping by after paying all outstanding bills". It is clear that the Appellant and his partner knew that their business was marginal from the start. According to his evidence, the real boom fell on him and his partner in the fall when Ms. Frost brought to his attention a bill from the hydro company for approximately $3,000 or $4,000. She told the Appellant that the hydro would be cut off if the bill was not paid within a short period of time. Apparently, this liability rang the bell in the minds of the Appellant and his partner that the business was not going well; that they had significant debts; and that they should look to sell it. Over the next couple of months, they arranged to sell the business to Tony and Anita Welsh who took over the business on December 24, 1995 in accordance with Exhibit R-3 which is the agreement of purchase and sale.
[14] It is interesting that the hydro bill could get as high as $3,000 or $4,000 with a threat to cut off power in so many days if it was not paid. For utilities like hydro, water and even telephone which is not a public utility but privately supplied in Canada, generally those utilities are not cut off without a series of warnings to the consumer. Therefore, when Alisa Frost brought this bill to the Appellant's attention in the early fall 1995, there must have been some period of time when the liability to hydro was building up, and there must have been some notices from hydro to the customer saying "please pay your account, etc.". If those notices were received, they apparently were not brought to the Appellant's attention because he said that the size of this bill and the threat to have the power cut off was a real surprise to him and his partner.
[15] He also said that he had placed too much trust in the employees at the sports bar, particularly the senior employee, Alisa Frost. He suggested that the employees were playing games with the owners in that certain food and alcoholic beverages were disappearing from the premises in a manner not consistent with the volume being consumed by paying customers. This is not an uncommon situation in a consumer-type business like a restaurant unless it is very tightly managed. This business was not tightly managed. I draw that conclusion from the agreement of purchase and sale (Exhibit R-3).
[16] The second paragraph of the agreement of purchase and sale with Mr. and Mrs. Welsh, in my view, tells a story itself. Although the sale price is never specifically identified in this agreement, it appears to have been $17,000 because the second paragraph of the agreement speaks of a deposit of $2,000 and a balance of $15,000, and then of the liability to the landlord of $17,000. That paragraph is so descriptive of the business and the way it was apparently run that I propose to set it out in full:
A deposit of $2,000.00 will be paid. The balance of $15,000.00 will be held by Mr. and Mrs. Welsh, to pay off monies owing to suppliers, rent, hydro and gas. Once all suppliers/creditors, other than salaries are paid, any balance will be reimbursed to Guy Rulton and David Lyver. The loan to the landlord of approximately $17,000.00 will still be held by Guy Rulton and David Lyver for a period of six months, or earlier date as agreed by all parties.
The owners, Guy Rulton and David Lyver, will be given a detailed statement and paid receipts of all monies paid to suppliers, gas and hydro.
[17] It is the evidence of the Appellant that he and Mr. Lyver received no cash as a result of this sale. Apparently, all of the purchase price paid by Mr. and Mrs. Welsh was money directed to creditors of the business, mainly suppliers, paying hydro and gas and rent. Therefore, the landlord and others who had to be paid in order to permit the business to continue operating were paid. It says something about the lack of tight management that it would come as a surprise to the Appellant in the fall of 1995 when the big hydro bill was brought to his attention.
[18] The liability under the statute is a liability for a failure to remit. The exculpatory clause in subsection 227.1(3) permits a director to escape that liability if he has used care, diligence, and skill to prevent the failure. Counsel for the Respondent has referred me to the decision of the Federal Court of Appeal in Soper v. The Queen, 97 DTC 5407. That decision has been cited in many cases. It has become a leading case where the issue is whether the liability is affixed to an inside or outside director and what kind of care an inside or outside director has to demonstrate to escape the liability. Robertson J.A. delivering judgment for the Court, set out the history of section 227.1 which is the usual story of the ease with which a company can operate by paying its most insistent suppliers while not paying Revenue Canada on a monthly basis because the Minister of National Revenue is not a supplier. Under the law, when salaries and wages are paid in a particular month, the taxes withheld at source must be remitted to Revenue Canada by the 15th of the following month. And so there is a holding period when the money has been withheld by the employer but, under the statute, is conceived as being held in trust even though most employers do not actually set aside that amount. Robertson J.A. refers to this at page 5412 of his reasons when he states:
... The withholding of source deductions is a notional concept which does not materialize until the obligation to remit actually arises. In respect of amounts which are notionally withheld from an employee's salary pursuant to subsection 153(1), the regulations under the Act prescribe that remittances must take place within fifteen days of the end of the month in which the withholding occurred. ...
[19] That is the way the law works. It is consistent also with the monthly journal (Exhibit R-1) which was prepared by Ms. Ellis on behalf of the Appellant. On the fourth page of that exhibit, she refers to something that has to be done. Item #3 states:
On the 15th of each month, Revenue Canada received from Linda Cheyne for source deductions remittance. Payment is made through the bank before 3:00 p.m. Amount = $Various (usually around $1,500).
This checklist (Exhibit R-1) shows that as early as February, March, April, and May, when Ms. Ellis was helping the Appellant and his partner run the business and she prepared this monthly journal, she knew about source deductions. She knew that she would get the payroll from Linda Cheyne, and that the amount had to be paid by the 15th of the month and in the bank by 3:00 p.m. Also, item #4 on this list states:
On the 15th of each month, Revenue Canada outstanding account payments on source deductions, remittance. Payment by mail with cheque (mail one week before 15th). Amount = $800.00.
When the Appellant was questioned on this, he did not remember having that brought to his attention but he did acknowledge that it must have meant that there was an outstanding liability for source deductions as early as the spring of 1995, and that the liability was being discharged by sending Revenue Canada $800 a month for the arrears until the arrears were paid off.
[20] There is not only the law imposing the 15-day remittance relief period, from October 1 to October 15 for September source deductions. It is reinforced by Robertson J.A. in Soper. It is also demonstrated that the Appellant and his partner either knew about it or, if they did not know about it, their most senior employee knew about it in preparing the monthly journal in the spring of 1995.
[21] There is no evidence that there were any internal controls in the way this business was operated. Sometimes in cases like this, the evidence that does not come out says as much about the business as the evidence that does. For example, was there a cash register? Was there more than one cash register? Was there one for the bar and one for the restaurant? Was there a cash register tape? Did anybody, either the Appellant or his partner, or the wife of Mr. Lyver, Deanna Ellis, take off the cash register tape and compare it with the amount in the till, the vouchers, the credit cards? Was there any check being done to make sure that the sales recorded matched the revenue coming in? That is a kind of elementary verification of what goes on in most businesses. Apparently, there were very loose controls or no controls at all in this case.
[22] Similarly, on the consumption part, did the supplies purchased (particularly alcohol where there has to be a more serious verification for Ontario Government purposes) match with the sales being recorded, or was there a big gap indicating, perhaps, theft of inventory within the organization. There is no evidence on the Appellant's part that that kind of verification was being made with respect to inventory. There is no question that the Appellant and his partner were inside directors. They were the only directors. They purchased the business to operate themselves and they only stepped out of actual operation when they took up employment with Pepsi Cola in late April or early May. So they fall clearly in the category of "inside directors".
[23] One of the passages which impresses me in Soper is the statement by the Court in paragraph 33 (page 5417) about the "subjective and objective test". It is subjective in the sense that one has to accept a director with the skills he actually brings to the job. In other words, if a person like the Appellant and his partner come unskilled in business to take over an operation like this, one cannot expect the same skill from them as one would from a bank manager or a person who has a masters in business administration. On the subjective side, one has to take the taxpayer as one finds him or her. But there is an objective test as well which falls within subsection 227.1(3) where it speaks of the degree of care, diligence, and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances. And so whatever the director does has to be measured against the objective standard of what a reasonably prudent person would have done in these circumstances. Robertson J.A. states at page 5417:
... it is difficult to deny that inside directors, meaning those involved in the day-to-day management of the company and who influence the conduct of its business affairs, will have the most difficulty in establishing the due diligence defence. For such individuals, it will be a challenge to argue convincingly that, despite their daily roll in corporate management, they lacked business acumen to the extent that that factor should overtake the assumption that they did not know, or ought to have known, of both remittance requirements and any problem in this regard. In short, inside directors will face a significant hurdle when arguing that the subjective element of the standard of care should predominate over its objective aspect.
[24] This is the Appellant's problem. He is a young man with virtually no business experience on the subjective side, but that cannot predominate over the objective element of what a reasonably prudent person would have done. The business innocence or the business ignorance, depending on how one phrases that, of the Appellant does not excuse him from taking on a business like this with so little experience and then simply throwing up his hands and saying, "Well, I didn't know anything about business". Most people crawl before they walk and then they walk before they run. In my view, it is not prudent for people like the Appellant and his partner, young men in their 20s, to purchase a business like this, even in a small town, and then allow it to operate with so few controls that it can be out of control in a matter of weeks. They can have liabilities they do not even recognize such as the $800 payment each month to make up arrears of source deductions. In less than a year, they lose the business to a buyer when all of the proceeds of sale are consumed paying off suppliers. Even then, all of the creditors are not paid because the biggest creditor with the biggest clout is the Minister of National Revenue coming back to claim source deductions.
[25] The duty is, in subsection 227.1(3), to prevent the failure. It is not a remedial thing. It is not what someone does after the Minister has failed to receive the remittances. It is what steps were taken to prevent the failure. As I see this business, and I am relying on the believable evidence of the Appellant, there were very few controls, hardly any controls exercised that would keep it in check. I will turn to one more passage in Soper where Robertson J.A. stated at page 5418:
In my view, the positive duty to act arises when a director obtains information, or becomes aware of facts, which might lead one to conclude that there is, or could reasonably be, a potential problem with remittances. Put differently, it is indeed incumbent upon an outside director to take positive steps if he or she knew, or ought to have known, that the corporation could be experiencing a remittance problem. ...
[26] Of course, the Appellant and his partner were inside directors and not outside directors; and so the burden is even greater on them. They certainly knew, or ought to have known, from the monthly journal prepared by Ms. Ellis that the remittance problem from the start. Although the Appellant stated in evidence and I certainly believed him, "I didn't even know what a source deduction was when I took over this business", he had an obligation to learn soon. He had an obligation to become aware of what a source deduction was and to ensure that it was remitted in a timely manner to prevent a default.
[27] It is an elementary fact that if an employee is paid a gross salary of $200 a week and the source deductions are $70, the employee receives take-home pay of $130 but the other $70 is not the property of the employer. The $70 taken out of the employee's pay has to be set aside and remitted to Revenue Canada by the 15th of the following month. When an inside director permits the $70 to be swallowed up and used in the day-to-day operations of the business, to pay suppliers and pay rent and other obligations, that is the very risk which section 227.1 was planted in the Income Tax Act to avoid.
[28] I found the Appellant to be highly believable. There is no doubt in my mind that he is an honest person. There is no question that he and his partner made an honest endeavour and there was no attempt to rip off any person or to cheat the government or defraud the Minister of National Revenue. There was nothing of that kind. They were, from what I can determine on the evidence "babes in the woods" swimming in a very deep sea with limited swimming experience. They took the risks. The law is there. They were the only directors. They had an obligation. In my view, the Appellant did not discharge the due diligence test in subsection 227.1(3). Therefore, with some regret to his honest endeavours as a businessman, the appeal is dismissed. The Appellant is liable for the unremitted source deductions.
Signed at Ottawa, Canada, this 23rd day of February, 2001.
"M.A. Mogan"
J.T.C.C.