Friday, 4 May 2012

Due Diligence Defence: Objective Standard

The following article was published in the December 2011 edition of the Canadian Tax Highlights. It is republished here with permission.  I thought of this article after conversing with a director who is facing a director liability assessment from Canada Revenue Agency.  This director has forgone a salary  for years all in the hopes of keeping the corporation functional but as can be seen from what I wrote in December 2011 the courts take a harsh view on the director who uses the Crown monies to keep a corporation afloat in the hopes that matters can be rectified subsequently.

Due Diligence Defence: Objective Standard

The federal and provincial tax and other statutes administered by the CRA and its provincial counterparts contain provisions that impose personal liability on a director of a corporation that fails to remit source deductions or GST, HST, or PST held in trust. Those statutes also allow the director to escape personal liability if she can show that she carried out her duties with due diligence to ensure that remittances would be made to the tax authorities. For years, uncertainty surrounded the nature of the standard of care: is the director's personal knowledge and background relevant (a subjective test)? Or is she held to the same standard as every other director (an objective test)?

In 1997, the jurisprudence on the issue was inconsistent. In Soper (97 DTC 5407), a decision since considered 186 times, the FCA attempted to establish a standard for the determination of whether a director had acted with due diligence to ensure that source deductions withheld under subsection 153(1) would be remitted. The taxpayer accepted a directorship of a company that he knew was experiencing financial difficulty, but failed to inquire about whether the tax remittances were being made. Because the taxpayer was an experienced businessman, he was found not to have carried out his duty with due diligence.

The FCA said that the standard of care was "objective subjective," and looked to section 122(1)(b) of the Canada Business Corporations Act (CBCA), whose language was adopted in ITA subsection 227.1(3).

Rather than treating directors as a homogeneous group of professionals whose conduct is governed by a single, unchanging standard, that provision embraces a subjective element which takes into account the personal knowledge and background of the director, as well as his or her corporate circumstances in the form of, inter alia, the company's organization, resources, customs and conduct. Thus, for example, more is expected of individuals with superior qualifications (e.g. experienced business-persons).

The standard of care set out in subsection 227.1(3) . . . is, therefore, not purely objective. Nor is it purely subjective. It is not enough for a director to say he or she did his or her best, for that is an invocation of the purely subjective standard. Equally clear is that honesty is not enough. However, the standard is not a professional one. Nor is it the negligence law standard that governs these cases. Rather, the Act contains both objective elements--embodied in the reasonable person language--and subjective elements--inherent in individual considerations like "skill" and the idea of "comparable circumstances." Accordingly, the standard can be properly described as "objective subjective."

In Peoples Department Stores Inc. (2004 SCC 68), the SCC considered the CBCA section 122(1)(b) standard of care for a director and said that the Soper characterization of the standard as "objective subjective" could lead to confusion. "We prefer to describe it as an objective standard. To say that the standard is objective makes it clear that the factual aspects of the circumstances surrounding the actions of the director or officer are important in the case of the s. 122(1)(b) duty of care, as opposed to the subjective motivation of the director or officer, which is the central focus of the statutory fiduciary duty of s. 122(1)(a) of the CBCA." Subsequent TCC decisions were divided between adherence to the different standards of care described by the FCA in Soper and by the SCC in Peoples (the latter decision did not deal directly with tax legislation).

Most recently in 2011, the FCA dealt with the issue again in Buckingham (2011 FCA 142). The TCC (2010 TCC 247) had concluded that up to February 2003 the director took reasonable business measures to address the corporation's financial difficulties and to avoid failures to remit taxes, including work on a proposed equity issue, attempts to secure a line of credit, reductions in expenditures, and an attempt to merge with another company. Thereafter, however, the director focused on curing defaults in remittances rather than undertaking efforts to avoid further failures to remit. The FCA cited Worrell ([2001] 1 CTC 79 (FCA)), which said that the due diligence defence is not available if the director's efforts are aimed at remedying defaults after they have occurred: a director's duty is to prevent the failure to remit, not to condone it in the hope that matters can be rectified subsequently. The FCA further emphasized that the interpretation of ITA and ETA defences should not encourage remittance failures by allowing a due diligence defence to a director who finances corporate activities with Crown monies in the expectation that the failures can eventually be cured.

The FCA agreed "with the trial judge that the 'objective subjective' standard set out in Soper has been replaced by the objective standard laid down by the [SCC] in Peoples Department Stores" because of the reference to a "reasonably prudent person." The similarity of language in the CBCA, the ITA, and the ETA "is not a mere coincidence, but rather a further indication that the standard of care, diligence and skill required by all these provisions is similar. Similar legislative language dealing with similar matters should be given a similar interpretation unless the legislative context indicates otherwise." Thus, the common-law principle that a director's management is to be judged according to her personal skills, knowledge, abilities, and capacities is set aside: the factual aspects of the circumstances surrounding the director's actions are stressed, not her subjective motivations.

The TCC has since followed the FCA's Buckingham decision in Boles (2011 TCC 288) and Heaney (2011 TCC 429). In Boles, a de jure director did not realize that his verbal resignation as a director was insufficient. He had not been active in the company for more than two years when he received an assessment under the ETA's directors' liability provision. The taxpayer unsuccessfully raised the due diligence defence. The TCC cited the FCA in Buckingham and said that a director must exercise reasonable care, diligence, and skill and take appropriate steps "to prevent the failure" to remit and not to cure it thereafter. The court further said (quoting Buckingham) that the defence was not available to "inactive directors chosen for show or who fail to discharge their duties . . . by leaving decisions to the active directors. [Thus] a director must carry out the duties of that function on an active basis and [cannot rely] on his or her own inaction."

In Heaney, the appellants were directors of a corporation, DSL, which ran into financial difficulty due to the economic times and unforeseeable technical problems stemming from a contract with Bell. The facts were similar to those in Buckingham. At a certain point, DSL elected to delay making its remittances to the CRA; the directors saw this as a temporary measure because they fully expected to find new financing that would allow DSL to meet its obligations to the CRA. But throughout 2001 the directors were unsuccessful in their search for new partnerships, investors, and other ways to recapitalize the company. Before that time, they took positive actions to cover remittances--ceasing to advertise, changing product offerings, reducing customer hours, and focusing on receivables. The directors were not allowed the due diligence defence in the later period when their focus was on finding financing to remedy DSL's remittance failures. The TCC emphasized that the use of an objective standard did not imply that the director's particular circumstances were to be ignored; quoting Buckingham, the court said that "[t]hese circumstances must be taken into account, but must be considered against an objective 'reasonably prudent person' standard."

The three 2011 decisions indicate that a director who focuses on remedying past-due remittances rather than on preventing failures to remit cannot rely on the due diligence defence. Moreover, the FCA has recognized that stricter standards now apply to directors and that, as the SCC stressed in Peoples, "the emergence of stricter standards puts pressure on corporations to improve the quality of board decisions."

Sunita Doobay
TaxChambers, Toronto

Canadian Tax Highlights
Volume 19, Number 12, December 2011
©2011, Canadian Tax Foundation

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