On the Hook: Directors Liability for Corporate Tax Transgressions

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1 On the Hook: Directors Liability for Corporate Tax Transgressions Ryan Morris and Les Chaiet* Under some circumstances, directors may be held personally liable for certain tax liabilities of the corporations they serve. These statutory measures were largely instituted to deter corporations from preferring other creditors at the sake of the taxman. Since remedies against a corporation are generally limited to the corporation s assets, a corporation in financial distress has an incentive to borrow from the taxman by not remitting third party taxes (such as wage deductions) in order to satisfy other creditor claims. One way of deterring such behaviour is to influence the corporation s directing mind. This article will examine the scope of a director s liability for the tax liabilities of a corporation under certain federal and Ontario tax statutes (the Tax Statutes ) and will outline some strategies for reducing the risk of liability. Directors Defined The term director is not defined in the Tax Statutes. The general consensus emanating from the decisions rendered by the Canadian courts is that an individual, who has been properly elected and constituted as a director of a corporation, sufficiently falls within the scope of the director liability provisions of the Tax Statutes. 1 Even if an individual has not been properly elected or constituted as a director, an individual can still be considered a director in fact and be held personally liable for certain corporate tax debts. 2 However, Canadian courts have generally acknowledged that the de facto director doctrine should be applied with caution, particularly where it imposes liabilities. 3 This acknowledgement is based on the common law recognition that a director must consent (explicitly or implicitly) to be a director. De facto directors typically fall into one of the following three categories: (i) those who are duly elected but may lack some qualification under the relevant company law that disqualifies them from legally being directors; (ii) former directors whose term of office has expired but who have continued to act as directors; or (iii) those who simply assume the role of director without any pretence of legal qualification. 4 The de facto director test looks at whether an individual has influence to control and direct the management of a corporation. Mere possession of such authority is not demonstrative of whether an individual has, in fact, served as a de facto director. For example, the Tax Court of Canada has held that in the context of large public companies, extensive powers are often conferred on senior officers and yet such powers and responsibilities do not, in and of themselves, transform such officers into de facto directors. 5 In determining whether an officer or an employee is a de facto director, the courts have considered, among other factors, whether outsiders would assume the person was a director, whether representations were made by the person and whether the person participated in directorial acts, such as signing documents as a director and sitting on the board of directors. 6 Federal Tax Liability Income Tax Act Generally, under the director liability provisions in the Income Tax Act (Canada), 7 directors can personally be held liable for a corporation s failure to withhold and remit third-party taxes from certain payments, including payments of salary and dividend, interest and rental payments to non-residents. 8 In the case of a failure to withhold, directors may be liable to pay the amount that should have been withheld, and may be subject to a penalty of 10 percent (or 20 percent if the corporation s failure was made knowingly or under circumstances amounting to gross negligence) of the amount that should have been withheld, plus interest. 9 In the case of a failure to remit, directors are liable to pay the unremitted amount, and may be subject to a penalty of 10 percent (or 20 percent if the corporation s failure was made knowingly or under circumstances amounting to gross negligence) of the amount that should have been remitted, plus interest. 10 Before the CRA can assess directors for the tax liabilities of the corporation, the CRA must demonstrate its inability to recover the amounts directly from the corporation. To demonstrate its inability to recover the amounts directly from the corporation, the CRA must generally show that its execution against the Taxation Law May

2 corporation was returned unsatisfied, prove a claim against the corporation in dissolution or liquidation proceedings, or prove a claim against the corporation in bankruptcy proceedings. 11 It is possible for a person to be subject to director s liability for claims that arise after the person is no longer a director of the corporation. However, no action or proceeding can be brought against a director if it is commenced more than two years after the person last ceased to be a director of the corporation. 12 If there is more than one director of a corporation, the director who absorbs the liability of the claim is entitled to seek contribution from the other directors who were liable for the claim. 13 Each director may be assessed for the full amount of the corporation s tax liability, but a director who pays an amount towards this liability is entitled to the same preference in liquidation, dissolution, or bankruptcy proceedings against the corporation as would otherwise have been available to the Crown. 14 Another area of possible tax liability may arise in situations where the director is the legal representative responsible for liquidating a corporation. A director who distributes the property of a tax debtor without a clearance certifi cate may be personally liable for certain unpaid tax liabilities to the extent of the value of the property distributed. 15 Therefore, in certain circumstances, directors may wish to obtain a clearance certificate before overseeing the distribution of the assets of a corporation. In addition to civil liability, directors face possible criminal liability. Directors who directed, authorized, assented to, acquiesced in or participated in the commission of any corporate offence under the ITA will be considered a party to and guilty of the offence. 16 A director convicted of such an offence may be punished whether or not the corporation has been prosecuted or convicted. 17 A director who fails to file or to make a required tax return is guilty of an offence and may be liable to pay a fine between $1,000 and $25,000 and may face imprisonment for up to one year. 18 Directors may also be held liable for participating in such serious offences as making false or deceptive statements in corporate tax documents and tax evasion. 19 The penalty for such offences is a fine of between 50 percent and 200 percent of the amount of the tax that was evaded, or a fine and imprisonment for up to two years. 20 Canada Pension Plan and Employment Insurance Act Directors may also be held jointly and severally liable for the failure of a corporation to deduct and remit employee contributions under the Canada Pension Plan 21 and employee premiums under the Employment Insurance Act. 22 Similarly, directors may be held jointly and severally liable for the failure of a corporation to remit the employer contributions and premiums under such statutes. 23 The directors of a corporation are jointly and severally liable with the corporation to pay the required premium amounts under the CPP and EIA, plus any penalties and interest. The penalty for failing to make the proper remittance is 10 percent of the amount that the corporation should have remitted. 24 A 20 percent penalty applies for subsequent failures that were made knowingly or under circumstances amounting to gross negligence. A director acting as a liquidator of a corporation may be held personally liable for unpaid premiums and contributions if he/she fails to obtain a certifi cate confirming that all the premium amounts have been paid. 25 The EIA and CPP obligations come with the same limitation period and contribution protections as discussed above in the context of the ITA. 26 Excise Tax Act A director of a corporation is liable for the amount of net goods and services tax ( GST ) assessed under the Excise Tax Act 27 that the corporation has failed to remit. Where a corporation fails to remit an amount of net GST, the directors of the corporation at the time the corporation was required to remit the amount are jointly and severally liable, together with the corporation, to pay that amount and any interest thereon. 28 A director that participates in a corporation s failure to pay, collect, or remit GST is also guilty of an offence and may be subject to a fine not exceeding the aggregate of $1,000 and an amount equal to 20 percent of the amount of net GST that should have been paid, collected, or remitted, along with possible imprisonment for a term not exceeding six months. 29 The obligation imposed on directors is not limited to exercising the requisite standard of care in ensuring that GST was remitted. There is also an obligation 14 Taxation Law Volume 15, No. 3

3 to exercise the same standard of care in ensuring that GST is properly calculated. In the case of a failure to collect the proper amount of GST, the liability will be the amount that should have been collected, plus penalties and interest. 30 Due Diligence Defence A director is not liable for a failure to remit taxes under the above statutes 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. 31 The overarching question that tax courts ask in analyzing whether a director s conduct has been duly diligent is: what should the director have done that was not done? Robertson J.A. explained the level of conduct that would satisfy the statutory due diligence requirement in Soper v. The Queen, 32 a 1998 Federal Court of Appeal decision. Robertson J.A. set out an objective subjective test as the standard of care required by directors. The test takes into account subjective factors such as the personal knowledge and background of the director, as well as the company s organization, resources, customs and conduct. Generally, a director who is experienced in business and financial matters is likely to be held to a higher standard of care than a director with no business acumen or experience, whose presence on the board of directors reflects nothing more, for example, than a family connection. There is also an objective element that is embodied in the reasonably prudent person language. In assessing the objective reasonableness of the conduct of a director, the factors to be taken into account may include the size, nature and complexity of the business carried on by the corporation and its customs and practices. A basic criterion in the objective subjective test is that a director is required to be aware of the legal responsibilities and duties associated with the position and cannot plead ignorance of the rules. 33 For example, it has been stated that an unsophisticated businessperson in their first directorial position can still be held liable if they wait until a corporation s failure to remit before attempting to take action, as directors are required to prevent the failure to remit ahead of time. 34 However, courts will examine the equities of the case; where the directors were volunteers, lacked formal education, 35 or were challenged by language barriers, 36 courts have tended to relax the due diligence threshold. A director has a positive duty to obtain information or become aware of facts which might lead to the conclusion that there is, or could be, a potential problem with remittances. The typical situation in which a director is, or ought to have been, aware of the possibility of such a problem is where a corporation is in financial difficulty. 37 A director who is aware of a corporation s financial difficulty and who deliberately decides to finance the corporation s operations with unremitted source deductions will likely be unable to rely on the due diligence defence because the director is assuming the risk that the corporation will subsequently be able to make its remittances. 38 Therefore, it has often been held to be insufficient for directors simply to have carried on business, knowing that a failure to remit was likely or hoping that the corporation s fortunes would revive with an upturn in the economy or in its market position. However, the Federal Court of Appeal has recently stated that it is not reasonable to assume that directors can simply walk away from the business, abandon all that they have built up and leave employees and families in the cold; directors are entitled to pay employees, suppliers and other creditors in order to keep the business afloat. 39 In the absence of grounds for suspicion, it is not improper for a director to rely on company officials to honestly perform duties that have been properly delegated to them. It is the exigencies of business and the company s constitution that together determine whether it is appropriate to delegate a duty. The larger the business, for instance, the greater the need will be to delegate. Whether a director has exercised the requisite due diligence will, in part, depend on the level of control that the director has over the corporation s obligations. For example, it has been held that zero tolerance attaches itself to directors whose employment duties include the responsibility to administer remittance payments. 40 On the flip side, a director who has lost legal control over the company, for instance, on the appointment of a receiver-manager, would generally not be liable to the CRA for company debts that are incurred subsequently. Some cases have extended this principle to soft receivership situations where directors have lost de facto control over the company s finances. 41 The courts have generally placed a higher standard on inside directors compared to outside directors, particularly when outside directors reasonably relied on assurances from the inside directors that the Taxation Law May

4 corporation s tax remittance obligations were being met. It is not expected that an outside director directly inquire at the comptroller s office about withholdings and remittances. 42 This is not to suggest that a director can adopt an entirely passive approach but only that, unless there is reason for suspicion, it is permissible to rely on the day to day corporate managers to be responsible for tax remittances. For example, an outside director will generally be liable if he or she ignores what is transpiring within the corporation and his or her experience with the people who are responsible for its day-to-day affairs. It should be noted that the CRA s administrative policy, contrary to general case law, is not to distinguish between directors, be they passive, nominee, or outside directors. 43 Consequently, an outside director s lack of involvement in the affairs of the company may not absolve them from being assessed by the CRA. Under the ETA, factors that will be considered by the courts in determining whether directors meet the due diligence test include whether the director delegated the remittance of GST to a competent and trained bookkeeper, 44 whether the bookkeeper adopted a reliable system for GST remittances, 45 whether the director was heavily involved in the financial operations of the company, 46 whether the director made a conscious decision not to remit GST and to use those funds to pay other creditors in order to make the company function, 47 whether the director was a professional, 48 and whether there was reasonable reliance upon a third party charged with ensuring that all required tax is remitted. 49 Ontario Tax Liabilities Employer Health Tax Act Any director who directed, authorized, assented to, acquiesced in, or participated in an offence under the Employer Health Tax Act 50 is guilty of the offence whether or not the corporation has been prosecuted or convicted. 51 Offences include making false or deceptive statements on any return, statement or document, actively evading tax payments, deliberately altering or disposing of tax records or books, and omitting material facts on statements, records or books. Directors may generally be liable on conviction to a fine of not less than the greater of $500 and 25 percent of the amount of tax that should have been paid and/or imprisonment for a term of not more than two years. 52 Corporations Tax Act Any director who directed, authorized, assented to, acquiesced in, or participated in an offence under the Corporations Tax Act 53 is guilty of an offence whether or not the corporation has been prosecuted or convicted. 54 Offences include failing to deliver a return for a taxation year, making false or deceptive statements on returns, making false and deceptive entries or omissions to material records or books of account and generally any non-compliance with the CTA. A director may generally be liable on conviction to a fine of not less than the greater of $500 and 50 percent of the amount of tax that should have been paid and/or imprisonment for a term of not more than two years. 55 Retail Sales Tax Act Under the Retail Sales Tax Act, 56 directors are jointly and severally liable when a corporate vendor fails to collect or remit sales tax. 57 Any director who directed, authorized, assented to, acquiesced in or participated in an offence under the RSTA is guilty of an offence, whether or not the corporation has been prosecuted or convicted. 58 A director may be subject to a penalty equal to the amount of sales tax that the vendor failed to collect. 59 Where the vendor s failure to collect tax is attributable to neglect, carelessness, wilful default or fraud, the director may be subject to an additional penalty in an amount equal to the greater of $25 or 25 percent of the tax that the vendor failed to collect where a penalty has already been assessed against the vendor in respect of the failure to collect, and an amount equal to the greater of $25 or one and one-quarter times the amount of tax that the vendor failed to collect where no penalty has been assessed. 60 In the event a corporation winds up, a director who assumes the role of liquidator for such corporation becomes personally liable for the corporation s tax debts. Specifically, a person that distributes the property of a tax debtor without a clearance certificate is liable for the tax debt of the property distributed. 61 A director facing possible tax liability may rely on a due diligence defence 62 and is further protected by a two-year limitation period that prevents any assessment being made against the director more than 2 years after the person last ceased to be a director of the corporation. 63 Reducing the Risk of Director s Liability Directors should be proactive in ensuring compliance with tax statutes. Failure to be proactive in this regard might result in an unwanted surprise in the form of 16 Taxation Law Volume 15, No. 3

5 personal liability for the tax liabilities of a corporation. Appropriate delegation, risk management when the corporation is in financial crisis and active participation on the board of directors are all methods by which directors may reduce the risk of personal liability. Delegation In many instances, it may be sufficient for a director to delegate the tax remittance functions to managers, especially if the director is an outside director of a large corporation. However, it is imperative to ensure that the accounting function has been entrusted to someone who is knowledgeable, trained and aware of the relevant tax laws. Financial Crisis Some of the positive steps directors may take when they become aware of financial difficulty include attempting to increase the company s line of credit with its bank, coming to an arrangement with the bank that would enable the corporation to make remittances, setting up controls to account for remittances, asking for regular reports from the company s financial officers on the ongoing use of such controls, and obtaining confirmation at regular intervals that withholding and remittance has taken place. A director can also look to other means of relieving the financial crisis such as recovering outstanding amounts owing to the company or seeking new sources of capital. Ask Questions Directors should ask for reports on remittances from financial officers and ask questions during board meetings. Effective lines of communication between directors and the corporation s responsible employees should always be maintained. Conclusion Directors should be aware of the risks they face when assuming their directorial role and performing their directorial duties. One such risk is personal liability for certain tax liabilities of the corporations they serve. This potential liability arises under numerous federal and provincial tax statutes, and the penalties and punishment that attach to such liability can be extremely harsh. As such, directors should take proactive steps to become aware of the tax risks they face as directors and to adopt practices that will reduce such risks. * Ryan Morris, McMillan Binch LLP, (416) , ryan.morris@mcmillanbinch.com. Les Chaiet, Student- at-law, McMillan Binch LLP. The research assistance of Tina Chun, 2004 Summer Law Student, McMillan Binch LLP, is gratefully acknowledged. 1 Hay v. Canada, [2004] TCJ No. 29 (TCC) ( Hay ). 2 Canada v. Corsana, [1999] FCJ No. 401 (FCA). 3 Supra, note 1 at para Re Lo-Line Electric Motors Ltd., [1988] 2 All ER 692, as cited in Mosier v. The Queen, [2001] TCJ No. 692 (TCC) ( Mosier ). 5 Mosier, ibid. at para Hay, supra note 1 at para RSC 1985, c. 1 (5th Supp.), as amended ( the ITA ). 8 ITA, subsection 227.1(1). 9 ITA, subsection 227(8). 10 ITA, subsection 227(9). 11 ITA, subsection 227.1(2). The claim against an insolvent corporation must be proven within six months of the date of the liquidation, dissolution, assignment into bankruptcy or bankruptcy order. 12 ITA, subsection 227.1(4). 13 ITA, subsection 227.1(7). 14 ITA, subsection 227.1(6). 15 ITA, subsection 159(3). 16 ITA, section ITA, subsection 238(1). 19 ITA, subsection 239(1) RSC 1985, c. C-8 (the CPP ). 22 SC 1996, c. 23 (the EIA ). 23 CPP, section 8-9. Under the CPP, an employer s contribution is equal to the contribution that the employer should have deducted from its employees wages. EIA, section 68. Under the EIA, the employer premium is equal to 1.4 times the amount of the premium that the employer should have deducted from its employees wages. 24 CPP, subsection 21(7); EIA, subsection 82(9). 25 CPP, subsections 23(5), (5.1); EIA, subsections 86(4), 86(7). 26 CPP, subsection 21.1(2); EIA, subsection 83(2). 27 RSC, 1985, c. E-15 (the ETA ). 28, subsection 323(1). 29 ETA, subsections 329(1)-(2), s ETA subsection 280(1). 31 ITA, subsection 227.1(3); EIA, subsection 83(2); CPP, subsection 21.1(2); ETA, subsection 323(3). 32 [1998] 1 FC 124 (FCA) ( Soper ). 33 Black v. The Queen (1993), 93 DTC 1212 (TCC). A corollary of the rule is that directors cannot assume a Taxation Law May

6 subservient role and rely on that as a ground to escape fiduciary duties. 34 Grigg v. Canada (1998), 99 DTC 188 (TCC). 35 Facchini v. Canada (2004) DTC 3677 (TCC) Soper, supra note 30 at para Canada v. McKinnon, [2001] 2 FC 203 (FCA) ( McKinnon ). 40 Hamilton v. Canada, (2004) DTC 2860 (TCC). 41 Clarke v. Canada, (2000) DTC 6230 (FCTD) at paras Non-liability in these situations has been explained both on the ground that the charging provision assumed that the directors were freely able to choose whether the company remitted its payroll deductions and on the ground that the directors lacked the necessary control over the company s finances. See also McKinnon, supra note Soper, supra note 30 at para Information Circular No. 89-2R. 44 Lau v. Canada, [2002] TCJ No. 615 (TCC) Taillefer v. Canada, [2004] TCJ No. 96 (TCC) Ewachnick v. The Queen, [1997] TCJ No. 295 (TCC) RSO 1990, c. E.11 (the EHTA ). 51 EHTA, section EHTA, subsection 31(7). 53 RSO 1990, c. C.40 (the CTA ). 54 CTA, section CTA, subsection 76(5). 56 RSO 1990, c. R.31 (the RSTA ). 57 RSTA, subsection 43(1). 58 RSTA, section RSTA, subsection 20(3). 60 RSTA, subsection 20(4). 61 RSTA, subsection 22(6). 62 RSTA, subsection 43(3). 63 RSTA, subsection 43(5). 18 Taxation Law Volume 15, No. 3