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Director Liability in Context of a “Carousel Scheme”: The Cherniak Case

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Although section 323 of the Excise Tax Act imposes joint and several liability onto the corporate director for a corporation’s failure to remit GST/HST, this liability is negated if 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.”  In order to establish this due diligence defence, a director has to meet a fairly high threshold according to current jurisprudence.  The recent decision of Cherniak (2015 TCC 53), suggests that this defence will be very difficult to meet where the corporation assessed was involved in “artificial” transactions.

On the facts of the case, the Appellant was the sole director of a corporation, GMC Distribution Ltd. (“GMC”), which was alleged by CRA to be part of a so-called “carousel scheme” where “GST is drawn out of the system on the basis of fictitious export sales of zero-rated supplies that allow the exporter-seller to receive large refunds in connection with tax that was never remitted in the first instance”.  Specifically, GMC purportedly purchased computer parts from a supplier, and sold them with a 0.25% mark-up to other companies for eventual export.  The parts were said to be eventually purchased using funds from an off-shore bank account, while the proceeds of the sales also ended up in an off-shore account (presumably, completing the carousel). 

CRA assessed GMC for over $3.5 million in net tax arrears, plus interest and penalty, primarily arising out of denied ITCs claimed with respect to GMC's purchases.  The appeal of that assessment was eventually dismissed by the TCC after some procedural quarrels and the Appellant was assessed under the s. 323 ETA director’s liability provisions.  In his defence, the Appellant argued that (1) the underlying assessment was wrong because GMC was legitimately entitled to ITCs in respect of its purchases; and (2) he exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in comparable circumstances pursuant to section 323(3) of the ETA such that director’s liability is negated.

The TCC found that the Appellant’s testimony was neither reliable nor credible, such that the Appellant left the impression that he was deliberately trying to mask his complicity in the carousel scheme.  It held that GMC’s purchase and sale transactions were both fictitious, such that it was not entitled to ITCs in respect of its purchases, yet it still had to remit GST that it had collected on the artificial sales pursuant to section 222 of the ETA

With respect to the due diligence defence, the TCC disagreed with the Appellant that blame should be restricted solely to another individual involved in the scheme.  It applied the objective standard of due diligence in denying the Appellant’s defence.  Not only was the Appellant not duly diligent, but he was considered an “active participant” in the scheme.

Certainly, in the context of an allegedly fraudulent scheme, where evidence suggests that the Appellant was anything more than a dupe, it is highly unlikely that the Appellant will have any hope of establishing a due diligence defence.  If the facts of the case were different such that the Appellant was duped and under the impression that the transactions were legitimate, the Appellant may have had an argument that the underlying assessment was wrong based on the recent decisions by the TCC and FCA in Salaison Lévesque (2014 TCC 36; 2014 CAF 296).  In particular it could have been argued that he was entitled to ITCs despite the supplier’s commission of fraud; although, the fact that no supply appears to have been made at all, would likely still have been fatal.

This case also serves as a rare example of where the application of the objective standard in the context of a due diligence defence might have actually assisted the Appellant (as he was a Certified Management Accountant, which might have implied that he would have had a higher subjective standard to live up to in respect of tax obligations).  Nevertheless, in the context of the evidence as outlined in the decision, the Appellant clearly did not have a legal leg to stand on.  

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Guest Wednesday, 13 November 2019

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