Tax Court of Canada Judgments

Date: 19981001

Dockets: 97-3790-IT-I; 97-3791-IT-I

BETWEEN:

ALECA FRASER, GERALD FRASER,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent,

Reasons for Judgment

Beaubier, J.T.C.C.

[1] These appeals pursuant to the Informal Procedure were heard together on common evidence by consent of the parties at Halifax, Nova Scotia on September 24 and 25, 1998. Both Appellants testified. They are now separated. They have a son aged 12. They called their lay accountant, Marian Scriven, to testify. The Respondent called the auditor on the file, Joann Burke.

[2] The Appellants were reassessed for their 1992, 1993 and 1994 taxation years on the basis that they had received unreported income from a milk route of approximately 500 customers that they operated in their registered partnership, GEF Enterprises, in the Halifax and Sackville areas in those years. Penalties were also assessed. They appealed. Paragraphs 4, 5, 6 and 7 and Schedule A of the Reply to Gerald Fraser's Notice of Appeal summarize the assessments and appeals. They read:

4. As a result of an audit, the 1992, 1993 and 1994 Income Tax Returns were reassessed by way of Notices of Reassessment dated July 2, 1996 to include additional net business income of $10,914.03, $12,325.70 and $10,452.61 respectively, and to assess penalties under subsection 163(2) of the Income Tax Act on unreported income in each year. Net business income for the three years was increased for disallowed expenses and unreported business income as indicated on Appendix A to this reply.

5. The Appellant filed valid Notices of Objection to the assessments for the 1992, 1993, 1994 taxation years. As no information was supplied which would explain why the Appellant disagreed with the calculation of gross income or why he felt that expenses were unreasonably disallowed, the Minister of National Revenue (herinafter the "Minister') confirmed the assessments by way of Notice of Confirmation dated September 29, 1997.

6. In so assessing the Appellant for the 1992, 1993 and 1994 taxation years, the Minister made the following assumptions of fact:

a) the Appellant owned a 50% interest in G.E.F. Enterprises, a partnership operating a milk and dairy products delivery business. The other partner in the business was the Appellant's spouse, Aleca Fraser;

b) the Appellant was actively involved in the delivery of milk and other products in the years audited;

c) books and records maintained by the partnership included a disbursements journal, an accounts payable listing, expense vouchers, sales contracts and invoices for equipment purchases, duplicate deposit slips, a deposits journal, cancelled cheques, and bank statements. The accounting records were not based on a double entry bookkeeping system;

d) records were not maintained to enable the production of a balance sheet;

e) gross sales shown on the profit and loss statements that were filed with the Income Tax Returns for the years under appeal were calculated from total deposits to the bank account with adjustments for cash expenditures and client cheques that were returned because there was insufficient funds in the client's account (NSF cheques);

f) there was very little inventory at the end of each year under Appeal and no records were kept of inventories;

g) records of year end accounts receivable were not maintained;

h) gross sales and net business income of the partnership and allocation of net income to each partner as filed with the Tax Returns are summarized on Appendix 'A' attached to this reply;

i) income reported by the Appellant was insufficient for family living expenses;

j) the Appellant failed to deposit all revenues or failed to record all cash withdrawals and/or payments made in cash;

k) the Appellant failed to adjust sales determined by the deposit method for holdbacks receivable;

l) the records of the business could not be relied upon to readily determine the Income Tax liability of partners in the 1992, 1993 1994 taxation years;

m) it was reasonable to conclude, given the type of the business and the records maintained by Baxter Foods Ltd. that the gross profits were more reliably determined by applying the known gross profit percentage to the known purchases of the business from Baxter Foods Ltd. for each year in question;

n) the changes to the partnership's income and business expenses as a result of the audit for the years in question appear on Appendix 'A' attached to this reply;

o) the Appellant's representative submitted an analysis of 1992 sales and cost of sales to determine gross profit which, when adjusted for holdbacks receivable, verifies unreported income determined by the auditor.

p) insurance expenses claimed included amounts paid as premiums for a life insurance policy and an income disability insurance policy which were considered personal expenses;

q) vehicle expenses were reduced by amounts considered to be capital items;

ISSUES TO BE DECIDED

7. The issues to be decided is whether or not the Appellant's reported net incomes for the 1992, 1993, and 1994 taxation years were understated and whether or not penalties under subsection 163(2) of the Act were properly assessed.

Appendix 'A'

			G E F ENTERPRISES
AS REPORTED		1992		1993		1994
Sales		254,133.68		240,750.67		260,117.65
Purchases		220,481.26		211,013.39		221,784.76
Gross Profit		33,652.42		29,737.28		38,332.89
Expenses:
Bus. Equip & rental		608.74		4,846.60		4,835.77
Fees, Tax, License		109.00		35.00		376.02
Office		4,975.81		800.83		972.09
Supplies & Materials		239.05		116.72		68.15
Maint. & Repairs		8.86		2.34		562.13
Auto/Truck		9,586.48		9,962.22		12,135.89
Travel Expenses		839.55		970.54		1,115.62
Interest & Bk Chgs		1,826.39		2,286.63		1,784.18
Insurance		1,355.80		1,377.60		1,689.60
Miscellaneous		6,378.75		672.25		767.07
Salaries		3,000.00		8,000.00		10,500.00
GST		121.14		58.79
CCA		0.00		1,801.00		1,399.05
Total Expenses		29,049.57		30,930.52		36,205.57
Partnership Net Income		4,602.85		-1,193.24		2,127.32
Partnership Share:	Aleca	Gerald	Aleca	Gerald	Aleca	Gerald
	2,301.42	2,301.43	-596.62	-596.62	1,063.66	1,063.66
Salary		3,000.00		6,000.00		8,000.00
Net Bus. Income	2301.42	5,301.43	-596.62	5,403.38	1,063.66	9,063.66
AUDIT ADJUSTMENTS
-unreported income		20,472.25		23,273.80		18,111.74
-disallowed
insurance expense		1,355.80		1,377.60		1,389.60
-disallowed vehicle exp.						1,657.74
Deduct:
-increases CCA						-253.85
Total Adjustments		21,828.05		24,651.40		20,905.23
Partner's Share	Aleca	Gerald	Aleca	Gerald	Aleca	Gerald
of adjustments	10,914.03	10,914.02	12,325.70	12,325.70	10,452.61	10,452.62

[3] The "salaries" described in Appendix "A" are partnership draws which Revenue Canada has not reassessed to divide equally. No partnership agreement is in evidence.

[4] This case is about a milkman and his route. Appendix "A" does not describe the way that the Frasers dealt with their money. It describes the way their accountant dealt with what the Frasers did. For example, in 1992 the Frasers drew $400 to $430 per week from the cash flow of the business and recorded it in a ledger as "salary". Their accountant, Mrs. Scriven, then took the ledger at the year end, along with whatever records and receipts they had, and prepared a financial statement with the headings described in Appendix "A". She did not describe approximately $21,000 as partnership draw. Rather, and using Appendix "A's" headings, she broke them down as follows:

Bus. Equip & rental $608.74

Fees, Tax, License 109.00

Office (not including "rent") 175.81

Supplies & Materials 239.05

Maint. & Repairs 8.86

Travel Expenses 839.55

Interest & Bk Chgs. 1,826.39

Insurance 1,355.80

Miscellaneous 6,378.75

Salaries 3,000.00

GST 121.14

Partnership Net Income 4,602.85

Total: $19,265.94

In 1992 the Frasers also paid out about $450.00 per month to a service station for gasoline and paid out "bridge tokens" which were shown in their ledger. (Exhibit A-1). Roughly speaking, these ledgered disbursements appear to have amounted to over $5,000.00. But Auto/Truck disbursements are recorded by Mrs. Scriven at $9,586.48. It appears that the discrepancy between the "salary" draws and the $19,265.94 itemized from Appendix "A" is in the $9,586.48.

[5] Mr. Fraser is not employed as a milkman by Baxter Foods Ltd. ("Baxters"). As a result, Baxters does not have to comply with employment laws for holiday pay, withholdings, holidays and other benefits. Therefore, he is in business. The business is the partnership G.E.F. Enterprises, which is a partnership of Mr. and Mrs. Fraser. It is a marginal business. Revenue Canada expects records such as invoices; records of discounts given here and there daily from the milk truck; records of doubtful or bad debts; cross-checking records of inventory picked up, delivered or sold, and returned by Mr. Fraser for storage for the next day; and all of the other records of a major operating, sophisticated, paper worked business. But this is an operation off the truck and out of the pocket. It is essentially a cash operation by a milkman. The Appellants did not and do not know anything sophisticated about bookkeeping and proper invoices and other records and duplicates which would impose further costs which cannot be afforded by this mom and pop operation. In order to assess the Frasers, Revenue Canada arrived at a figure for gross margin expected and worked out some kind of a volume figure based upon records they obtained from Baxters to arrive at the "Total Adjustments" in Appendix "A". Baxters' records are in four week units ending each April; the Appellants' year end is December 31. Therefore, Revenue Canada adjusted Baxters' records

[6] The Appellants both testified that they reported all of their incomes. They have operated this "milk distribution" business for 17 years. They both have grade 12 education. Mr. Fraser operates the milk route. During the years in question, on Mondays and Thursdays he started from Baxters (their supplier) at 5:00 a.m. on the Sackville route and delivered until 2:00 p.m. On Tuesdays and Fridays he started the Halifax route and continued delivering on that until 7:30 or 8:00 p.m. He delivered milk to homes at retail. He also delivered to three large customers – a school (Gertrude Parker Elementary, with 300 students), a restaurant (Copper Penny Tavern) and a service station (Kearney Lake Petrocan). The school did its buy orders through Baxters at "cost", the service station was a charge account "wholesale", and the restaurant was a cash customer and received the same "wholesale" discounts as the service station. The restaurant stopped buying products from G.E.F. Enterprises in 1993. The school account was operated entirely through Baxters.

[7] Revenue Canada called the three large customers "wholesales"; the rest were "retail". Mr. Fraser thought the mark-up was "retail" at 27.5% and "wholesale" at 22.5% per litre of milk. Other products such as orange juice, creamers and whipped cream were minor in volume and were also subject to a percentage. He also delivered cooking oil to the restaurant. Every four weeks Baxters paid G.E.F. Enterprises a rebate which was deposited with the other cheques. Both Mr. Fraser and Revenue Canada gave global percentages of mark-up for the products. In contrast, Marian Scriven, the Fraser's lay accountant, described the actual numbers respecting a four litre container of milk purchased from Baxters and sold by the Frasers in January, 1992. They are:

Purchase price $4.42

Retail selling price 5.36

Wholesale selling price 5.08

Baxter four week rebate per litre

- "Retail" .0425

- "Wholesale" .02

None of these figures work out to either party's global percentages and none allow for the school figures. The Frasers did not record school sales as either income or expense in any of their ledgers or records. Rather, the income or expense of the school sales were adjusted entirely in Baxters' statements. Mrs. Scriven also described some accounting discrepancies that she saw including a Baxter 1991 bill of $1,535.57 for 1,066.5 litres that the Appellants paid in 1992. Revenue Canada's auditor, Joann Burke stated that she allowed for this when she completed her calculations. However, no one explained why the 1991 bill appears to work out to about $1.50 per litre.

[8] Mrs. Scriven also testified respecting the Frasers' personal use of products. She had asked them about it when she prepared the statements originally and they said that they paid for the products they used personally. Mrs. Scriven understood this to mean that they deposited their payment with the cash receipts. The Frasers meant that they had paid Baxters. The Court finds that this was an innocent misrepresentation of the accounting for payment by the Frasers. It is an example that describes their accounting limitations in this whole matter. Mr. and Mrs. Fraser are honest. But Mr. Fraser has no sense of accounting at all. Mrs. Fraser's accounting knowledge is limited to assembling columns of figures.

[9] The auditor testified that Revenue Canada's determination of unreported income was based upon a calculation of gross retail margins of 27.5 on milk products and 25% for by-products. Revenue Canada used Baxters' product volume records for its calculation. Since there were no records by the Frasers respecting receivables, bad debts, pre-paid tickets or inventory, nothing was allowed for them. In 1994 Revenue Canada adjusted the gross margin for by-products to 28%.

[10] Revenue Canada's checking calculations for the purpose of the assessment were based upon the Appellants' income tax returns and income tax refunds which indicated:

For 1992	– after vehicle payments and groceries, but not including their mortgage interest, and home insurance	- $222.00
For 1993	– after personal expenses, groceries and mortgage reductions, but not including vehicle insurance, gas, clothing or entertainment	+$3,000.00
For 1994	– calculated the same as 1993	+$104.00

Thus, based upon their reported incomes, Revenue Canada felt that the Frasers had no funds left for any "life-style". Revenue Canada calls this check a "source and application of funds" check.

[11] Frasers admitted that they had almost no "life-style". From their testimony in Court, their appearance, their dress, and their demeanour, the Court accepts the fact that the Frasers had no "life-style". It is quite apparent that the Frasers struggled just to get by from day to day. But Mrs. Fraser had an inheritance from her mother which enabled them to buy a home. She also had some modest interest income in 1994.

[12] Both the Appellants were credible. Mr. Fraser is not an aggressive or astute businessman. He is a hard worker. He picked up the milk, did the deliveries, collected, solicited new accounts, and did the bank deposits. He kept a day to day charge book of customer accounts but he did not check it against the ledger. Nor did Mrs. Fraser. Mr. Fraser did not check the goods he picked up from Baxters against its invoices or record. There is no evidence that Mrs. Fraser did either. They used the accounting system Mrs. Scriven told them to. It was not satisfactory to Revenue Canada.

[13] Their milk truck is a second-hand, 1983 postal truck that Mr. Fraser bought in 1992 for $6,500. The business sales, by dollar volume, was 5 to 10% to the three large customers and the rest was to households. The sales accounts were 30% tickets, 5 to 10% cash, and the rest were charged on a weekly, bi-weekly or monthly basis, not including the school account which went through Baxters. The periodicity of the charge accounts was based on Mr. Fraser's reluctance to let charges amount to more than $50.00 outstanding on any one account.

[14] For the most part, Mrs. Fraser kept the records. The records reported what they deposited in the bank, what they withdrew from cash collected by Mr. Fraser and what they paid out – roughly, cash flow. Mrs. Scriven checked these figures, prepared an annual statement and income tax returns and the income tax returns were filed. Mrs. Scriven, who was called by the Appellants, stated that there are some minor initial adjustments to the figures recorded and reported. They are as follows:

	1992	1993	1994
1. Write-offs for cash customers who skipped and did not pay	$300.00	$300.00	$300.00
No reassessment is necessary for this adjustment because the amounts were never dealt with as receivables, if Revenue Canada's basis of reassessment is found to be incorrect.
2. Personal use of milk, orange juice and products
Add	$1,040.00	$1,040.00	$1,040.00
3. N.S.F. cheques	$1,337.81	$1,646.76	$1,182.03
Mrs. Fraser recorded these in the ledger as they were deposited, then removed them on being N.S.F.'d and then recorded them when they were collected. Thus, there is no reason to adjust the records respecting N.S.F. cheques.

4. Discounts of $10 to $20 per week	$520.00 to $1,040.00	$520.00 to $1,040.00	$520.00 to $1,040.00
These are miscellaneous discounts which Mr. Fraser admitted he gave on non-milk products to various customers and charities from time to time.

[15] Mrs. Scriven testified as to her experience with other milk distributors in the Halifax area. She did statements and prepared income tax returns for them during the years in question. She stated that their profit margins are similar to the Appellants'. She also stated that she has had business experience with Mrs. Fraser and that her experience is that Mrs. Fraser is an honest woman. Finally, Mrs. Scriven testified that all of the wives of the milk distributors she has worked for held jobs to make ends meet. Mrs. Fraser also had outside income during 1992, 1993 and 1994.

[16] The Frasers' car is ten years old and is subject to a chattel mortgage. Their house was purchased with Mrs. Fraser's inheritance from her mother's estate in 1992. It is subject to a mortgage and required a new roof in 1993. Their only vacation was in 1988 when they won a trip to the Bahamas. Each year they have borrowed to buy their R.R.S.P.'s consisting of $1,000.00 and $1,500.00 each.

[17] The Appellants' evidence refuted the assumptions. Their income was sufficient for their modest family living expenses. With the exception of the school volume and monies, the records of the business were sufficient to determine the income tax liability of the Appellants in 1992, 1993 and 1994. The Appellants' evidence and the numbers given by Mrs. Scriven for 1992 refute the global mark-up figures that Revenue Canada thinks are correct. The Appellants' evidence also refutes Revenue Canada's premise that all of the Appellants' expenses are in the Appellants' income tax returns; the school costs were not recorded by the Appellants' income tax returns.

[18] It became necessary for the auditor to testify and give evidence to support the assumptions. She did not give detailed factual evidence of the Appellants' volume of purchases from Baxters or of how Revenue Canada's mark-up percentages were calculated so that Revenue Canada's estimates could be checked. The estimates are just that. They are not accounting figures.

[19] The school account for 300 children is not in the Fraser records. Mr. Fraser testified respecting the school figures on a per litre basis. He picked up school milk from Baxters at a charge of 43 ¢ per litre. The school gave him a chit at 30 ¢ per litre. Baxters charged Mr. Fraser with a second cost of 24 ¢ per litre and then credited him with payment of 30 ¢ per litre. There is a discrepancy between Frasers' credits through Baxters and Revenue Canada's calculations based upon gross global mark-ups. Per litre, the possible numbers are:

	Fraser's Credits	Revenue Canada's
Pick-up charge	24 ¢	43 ¢
Retail price	30 ¢	52.025 ¢ (27.5%)
Net	6 ¢	9 ¢

But Mr. Fraser described a duplicate expenses or cost entry with Baxters for picking up the school milk – first at 43 ¢ and then, upon delivery of the chit, 24 ¢ . All of this was sworn factual evidence which could be checked.

[20] Thus, there a number of sources of errors for Revenue Canada's figures which were not reconciled by Revenue Canada's evidence or estimates. Respecting the school, they include possible duplication of the volumes of the school milk as to both purchases and sales; possible duplicates of expenses of purchases; a possible profit calculation of 9 ¢ rather than 6 ¢ per litre, or a possible discrepancy of profit consisting of 52.025 ¢ per litre less 24 ¢ ; a possible failure to remove a second profit or volume figure; and a factor of 27.5% which is wrong. Some of these errors could be compounded. Moreover, Baxters' volume figures could also be wrong. Revenue Canada's assumptions are based on their calculation of volume of product multiplied by Revenue Canada's mark-ups. Revenue Canada did not recalculate the expense of product costs. In both, the school figures could be wrong or omitted. Whatever the possible error in Baxters' figures, the Frasers' figures accepted it. But Revenue Canada did not estimate the cost of volume and subtract it from its estimate of the gross income from sales of that volume. The school deliveries were about 5% of the Frasers' total and could have been close to 10%. In essence, this accounts for the discrepancy. It was not resolved by Revenue Canada's evidence.

[21] The Court accepts the Appellants' testimony that they reported all of their income with the exceptions admitted to by their counsel and the admissions of Mrs. Scriven and Mr. Fraser. The assessments of the Appellants are referred to the Minister of National Revenue for reconsideration and reassessments on the basis that their reported incomes should be adjusted by the following amounts:

	1992	1993	1994
ADD
Personal Use of Products
Mr. Fraser	$520.00	$520.00	$520.00
Mrs. Fraser	520.00	520.00	520.00
Insurance Expenses	($1,355.80)	($1,377.60)	($1,389.60)
Mr. Fraser ½	677.90	688.80	694.80
Mrs. Fraser ½	677.90	688.80	694.80
Vehicle Expense			(1,667.74)
Mr. Fraser ½			833.87
Mrs. Fraser ½			833.87
DEDUCT
CCA			(-$253.84)
Mr. Fraser ½			-$126.92
Mrs. Fraser ½			-$126.92

[22] The appeal of the assessment of penalties is allowed. The Court saw both Appellants' testify. Neither is a sophisticated business person. They discussed the personal use items with Mrs. Scriven and they were deducted as the result of an honest misunderstanding. It is easy to consider life insurance as a business expense, since it often is a legitimate business expense and it might very well have been considered to be a form of business interruption insurance. Similarly, at least part of the vehicle expenses may have been in the ledgers which Mrs. Scriven accepted without question.

[23] The Appellants have succeeded in reducing the aggregate of amounts in issue by more than one-half. The hearing lasted one and one-half days. Appellants' counsel prepared for the hearing and the Appellants' cases were fact filled. Each Appellant is awarded separate party and party costs which are calculated as follows:

	Mr. Fraser	Mrs. Fraser
Preparing for hearing	$200.00	$200.00
Conduct of hearing 1 ½ days	900.00	900.00
Total	$1,100.00	$1,100.00

Signed at Ottawa, Canada this 1^st day of October 1998.

"D.W. Beaubier"

J.T.C.C.