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Docket: 2001-3832(IT)G |
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BETWEEN: |
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LENESTER SALES LTD., |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
____________________________________________________________________
Appeal heard on common evidence with the appeal of Sushi Sales Limited
(2001-3852(IT)G) on July 21, 22, and 23, 2003, at Toronto, Ontario
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By: The Honourable D.G.H. Bowman, Associate Chief Justice |
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Appearances: |
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Counsel for the Appellant: |
Clifford L. Rand and Susan Thomson |
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Counsel for the Respondent: |
Peter M. Kremer, Q.C. and Carole Benoit |
____________________________________________________________________
JUDGMENT
The appeal from the assessment made under the Income Tax Act for the 1997 taxation year is allowed with costs and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the appellant was not controlled by Giant Tiger Stores Limited, was not associated with Giant Tiger Stores Limited or any other corporation with which Giant Tiger Stores had a franchise arrangement, and was therefore not required to allocate any portion of its business limit to any other corporation for the purpose of determining its small business deduction under section 125 of the Income Tax Act.
Signed at Ottawa, Canada, this 31st day of July, 2003.
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"D.G.H. Bowman" |
A.C.J.
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Docket: 2001-3852(IT)G |
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BETWEEN: |
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SUSHI SALES LIMITED, |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
____________________________________________________________________
Appeal heard on common evidence with the appeal of Lenester Sales Ltd. (2001-3852(IT)G) on July 21, 22, and 23, 2003, at Toronto, Ontario
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By: The Honourable D.G.H. Bowman, Associate Chief Justice |
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Appearances: |
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Counsel for the Appellant: |
Clifford L. Rand and Susan Thomson |
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Counsel for the Respondent: |
Peter M. Kremer, Q.C. and Carole Benoit |
____________________________________________________________________
JUDGMENT
The appeal from the assessment made under the Income Tax Act for the 1997 taxation year is allowed with costs and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the appellant was not controlled by Giant Tiger Stores Limited, was not associated with Giant Tiger Stores Limited or any other corporation with which Giant Tiger Stores had a franchise arrangement, and was therefore not required to allocate any portion of its business limit to any other corporation for the purpose of determining its small business deduction under section 125 of the Income Tax Act.
Signed at Ottawa, Canada, this 31st day of July, 2003.
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"D.G.H. Bowman" |
A.C.J.
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Citation: 2003TCC531 |
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Date: 20030731 |
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Docket: 2001-3832(IT)G |
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BETWEEN: |
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LENESTER SALES LTD., |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent, |
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AND BETWEEN: |
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Docket: 2001-3852(IT)G |
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SUSHI SALES LIMITED, |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
REASONS FOR JUDGMENT
Bowman A.J.C.
[1] These appeals are from assessments for the appellants' 1997 taxation years. They were heard together on common evidence.
[2] Lenester Sales Ltd. ("Lenester") operated a Giant Tiger store in Pembroke, Ontario, under a franchise and license from Giant Tiger Stores Limited ("GTS") a Canadian corporation founded by Gordon Reid with its head office in Ottawa. Lenester is now wholly owned by Russell Bennett Kerr but in 1997, 501 of its shares were owned by Mr. Kerr and 499 by GTS.
[3] Sushi Sales Limited ("Sushi") operated a Giant Tiger store in Campbellford, Ontario. In 1984, 501 of the shares of Sushi were owned by Mr. Havelock Bingley and 499 by GTS. In 1997, Mr. Bingley's 501 shares were owned by 176485 Canada Limited, a company whose shares were owned by Mr. Bingley and his wife Mabel.
[4] The question in these appeals is whether the appellants, who are both Canadian-controlled private corporations ("CCPCs") are each entitled to the full small business deduction under section 125 of the Income Tax Act. In 1997, section 125 permitted a CCPC to deduct from the tax otherwise payable by it 16 percent of the least of a number of figures, one of which was its business limit for the year. It is not suggested that Lenester or Sushi did not carry on active businesses in Canada.
[5] Business limit is defined in subsection 125(2) as $200,000 except where a corporation is associated with another corporation, in which case it is nil unless the associated corporation files an agreement allocating the $200,000 among it and the other companies with which it is associated or, failing such an agreement, the Minister of National Revenue makes the allocation.
[6] In 1997, GTS had franchise arrangements with between 80 to 90 corporations similar to those it had with Lenester and Sushi. The Crown's position is that Lenester and Sushi were each associated with GTS and therefore with each other and indeed with the other 80 or 90 corporations with which GTS had franchise arrangements. The reason for this is that corporations associated with the same corporation are deemed to be associated with each other.
[7] The basis for the contention that GTS and the appellants are associated is that GTS "... controlled directly or indirectly in any manner whatever ..." the appellants within the meaning of paragraph 256(1)(a) of the Income Tax Act.
[8] Subsection 256(5.1) reads:
For the purposes of this Act, where the expression "controlled, directly or indirectly in any manner whatever," is used, a corporation shall be considered to be so controlled by another corporation, person or group of persons (in this subsection referred to as the "controller") at any time where, at that time, the controller has any direct or indirect influence that, if exercised, would result in control in fact of the corporation, except that, where the corporation and the controller are dealing with each other at arm's length and the influence is derived from a franchise, licence, lease, distribution, supply or management agreement or other similar agreement or arrangement, the main purpose of which is to govern the relationship between the corporation and the controller regarding the manner in which a business carried on by the corporation is to be conducted, the corporation shall not be considered to be controlled, directly or indirectly in any manner whatever, by the controller by reason only of that agreement or arrangement.
[9] The facts are not particularly in dispute. GTS prior to, during and after the year in question carried on the business of franchising the discount department store business to independent operators who would operate the stores.
[10] The arrangements were essentially as follows: GTS would lease retail premises and then sublease them to the franchisees, such as the appellants, or, if it owned the store it would lease it to the franchisee.
[11] GTS would carefully select the people who were to operate the franchises. For example, both Mr. Kerr and Mr. Bingley had had many years of experience managing Woolco or Woolworth department stores throughout Canada. There was a period of training, which could run from six months to a couple of years, in which they operated a store owned or leased by GTS. Mr. Greg Farrell, the vice-president (finance) of GTS, testified that there was a great deal more supervision and control of the operation by GTS during the training period than after the franchise took over.
[12] After the training period Mr. Kerr and Mr. Bingley were offered a franchise to run the stores at Pembroke or Campbellford, respectively. The pattern in this case was, I understand, typical of that in the case of the other franchisees. The arrangement entailed a number of aspects:
(a) the individual, such as Mr. Kerr and Mr. Bingley, would acquire from GTS for a nominal consideration 501 of the 1,000 shares of the existing operating company (Lenester or Sushi). GTS retained 499 shares. A shareholders' agreement was entered into between GTS, the individual (referred to as the "executive" in the Lenester agreement or the "manager" in the Sushi agreement) and the company (Lenester or Sushi). Mr. Arnell Goldberg, a solicitor also signed as escrow agent.
[13] A few of the provisions of the shareholders' agreement should be noted. The executive was to be hired by the company as an employee and was to devote his full time to his employment with the company. His remuneration was to be determined from time to time by the board of directors.
[14] There were to be two directors, one a nominee of GTS and one a nominee of the executive. The shareholders agreed to vote their shares to effect this result. There were to be no casting votes.
[15] There was a typical shotgun clause permitting one shareholder to offer to sell his (or its) shares to the other one who had to either accept or make the same offer to sell to the other.
[16] In the Sushi agreement the shotgun clause is slightly different, but its effect is the same. Moreover, in the Sushi agreement it is provided that in the event that there is a disagreement between the directors or the shareholders relating to the conduct of the company either shareholder can call a general meeting to pass a resolution winding up the company.
(b) The second part of the arrangement is the franchise whereby GTS grants a franchise to the franchisee (Lenester or Sushi). Sections III and IV of the Lenester franchise agreement read:
SECTION III - GRANT OF FRANCHISE
3.1 Subject to the terms and conditions set forth in this Agreement, Franchisor hereby grants to Franchisee, Franchisee hereby accepting, the right and license to operate a Franchised Store, utilizing the System as well as the Trade Marks, at the Premise, as well as the right to indicate to the public that the business carried on thereat is being operated as part of the System.
32. Franchisee acknowledges and agrees that the right and license granted to it herein are non-exclusive and are granted for use only at the Franchised Store at the Premises, and such grant shall not in any way hinder or prevent Franchisor from granting additional rights and licenses as it, in its sole discretion may determine, to any person, firm, partnership, corporation or other entity (including Franchisor itself) for the use of the Trade Marks and/or the System elsewhere than at the Premises.
3.3 Subject to the provisions of paragraph 9.1.13 hereof, Franchisee shall not, except with the prior written consent of Franchisor, use or permit the use of any other trade mark, trade name or commercial symbol in connection with the Franchised Store, nor use or permit the use of the System or the Trade Marks, or any information contained in the Manual, except in connection with the Franchised Store.
SECTION IV - TERM AND RENEWAL
4.1 The term of this Agreement, unless sooner terminated in accordance with the terms and conditions hereof, shall be for a period of one (1) year commencing on the date of execution hereof.
4.2 This Agreement shall be renewed each year for a period of one (1) year unless either party has delivered to the other three (3) months prior written notice of its intention not to renew this Agreement.
The term of the Sushi franchise was 10 years, renewable for a further 10 years.
[17] There is nothing unusual about the franchise agreements. They certainly impose serious limitations on the way this business is conducted. This, however, is typical of all franchise agreements. One requirement in the Sushi agreement is that the business be operated in accordance with an operations manual. The manual was not put in evidence but I understand it is lengthy and detailed.
(c) The third aspect of the arrangement is the lease from GTS to the franchisee companies. There is nothing unusual about the leases here.
(d) One final aspect upon which counsel for the respondent placed some emphasis is the banking and financial arrangements.
[18] Every day or bi-weekly the cash receipts for the business would be deposited in Lenester or Sushi bank accounts in Pembroke or Campbellford, as the case may be. Once a week they would be transferred to the company's bank account in the Canadian Imperial Bank of Commerce ("CIBC") in Ottawa. The amounts in all of the franchisees' accounts at the CIBC in Ottawa are notionally "pooled" along with the account of GTS and interest paid on this amount. Where the particular franchisee's account was in a deficit position it was charged interest.
[19] The purchasing function was also performed by GTS. Inventory was either shipped from the GTS warehouse or purchased from suppliers who billed and were paid by GTS. GTS charged no mark-up on goods it supplied from its warehouse or on goods shipped directly by the supplier to the franchisee's store.
[20] The respondent contends that GTS controlled the franchisees because of the wording in the first half of subsection 256(5.1) and that the appellants are not saved by the "franchise exception" in the second half of that subsection.
[21] Counsel for the respondent accepts that the franchise agreements are within the franchise exception but contends that the shareholders' agreement and the financial and banking arrangements do not fall under the wording of the exception in subsection 256(5.1). The appellants contend that they do not fall under the first part of subsection (5.1) and that even if they did, they are within the exception in the second part.
[22] Before dealing with subsection (5.1), let us consider just what we have here. We have a successful franchising operation run by GTS that enables small business persons like Mr. Kerr and Mr. Bingley and their wives to engage in business operations that they could never have engaged in by themselves. By entering into such arrangement with GTS they obtain numerous advantages:
(a) They are required to put up only nominal capital;
(b) They have the advantage of stepping into an existing and successful commercial retailing operation;
(c) They can use well-known trademarks;
(d) They have the economic benefits of the purchasing, supply and distribution system of a large organization; and
(e) They integrate with the financial, banking and accounting system of a large organization which handles their financial, banking and income tax affairs competently and efficiently.
[23] They give up, of course, a measure of independence but it is a part of a mutually advantageous business relationship and it enables them to survive in competition with huge organizations like Wal-Mart. The franchisor, GTS, requires that the franchisee adhere to certain practices and procedures. This is necessary to protect its goodwill, its trademarks and its reputation. It is also necessary to protect the other franchisees because if a customer has a bad experience with one franchised outlet he or she may well regard all the other stores in the same light.
[24] Nonetheless, it appears from the evidence that the operators of the franchisees, such as Mr. Kerr or Mr. Bingley enjoyed substantial autonomy in the way they ran the business. This is hardly surprising, given the extensive experience each of them had in merchandising before joining the GTS organization.
[25] I would be remiss if I did not mention the great contribution made by the wives of Mr. Kerr and Mr. Bingley, Susan and Mabel. They worked with their husbands in the stores and helped build them into successful operations.
[26] This strikes me as a perfectly ordinary franchise operation, with the necessary and usual conditions and restrictions imposed by the franchisor, but not inordinately so.
[27] My conclusion is confirmed by the evidence of John Sotos. Mr. Sotos is a lawyer with extensive experience in franchising. He has published widely in the field. He examined the GTS franchise operations and interviewed not only the Kerrs and Bingleys but also the operators of several other franchises as well as officers of GTS. I found Mr. Sotos an impressive and knowledgeable expert witness and I have no hesitation in accepting his report in its entirety. To illustrate how typical the GTS arrangement is of franchising as it is done in Canada, I am reproducing a portion of Mr. Sotos' report that deals with such franchises:
Product franchising and business format franchising can each be conducted by three different methods: unit franchising, area development franchising and sub-franchising (often called "master franchising"). The current Giant Tiger franchise network is an example of unit franchising. In unit franchising the franchisor licenses the franchisee to establish and operate the franchise business at a single defined location (or for a mobile franchise, along a defined route). The parties enter into a "unit franchise agreement" and (usually) one or more ancillary contracts (examples: sublease, equipment/sign leases, supply agreement, security agreement, owners' personal guarantees, directors'/officers' confidentiality/non-compete agreements), all of which together define the parties' obligations regarding the establishment and operation of the franchisee's business.
There are many variations of unit franchising. One of these, commonly called "joint venture franchising", involves the franchisor taking an equity interest in its franchisee. A corporation, limited partnership or other suitable investment vehicle is created to hold the franchise and the franchisor then grants unit franchise rights to the joint venture franchise vehicle in the usual manner. The franchisor holds an equity interest in the franchise vehicle. A separate shareholder, partnership or other joint venture agreement is entered into to define the parties' respective rights and obligations regarding ownership and control of the joint venture franchisee. The Lenester and Sushi franchises under review are typical examples of joint venture unit franchises.
There are many reasons why a franchisor may want to use joint venture unit franchising. For example, a franchisor may choose to use the technique in order to assist undercapitalised individuals (perhaps recently-graduated professionals such as pharmacists, or perhaps managers of franchisor-owned outlets who have proven to be exceptional retailers) to get into business for themselves, since these individuals are either necessary as franchisees (the regulated professionals) or highly desirable as franchisee (the proven managers). Sometimes the joint venture franchisee will buy out the franchisor's interest in the franchise business over time from the franchisee's share of profits, but that is not a necessary feature of a joint venture franchise.
[28] In his report Mr. Sotos described the controls that the franchisor typically exercised over the franchise. These controls are necessitated by both practical and economic exigencies and by legal necessity. After discussing the controls exercised in the GTS franchises he concluded as follows:
4) The Giant Tiger Franchise Operation
The 1995 Lenester Franchise Agreement and Sublease, and the 1982 Sushi Franchise Agreement and Sublease, contain most of the controls discussed in the foregoing section of this report (those relating to site selection and build-out are of course absent since the franchise stores were already in existence when the agreements were entered into). Those agreements do not contain any controls that go beyond those I have listed. As well, it appears from each of my franchisee interviews that GTS not only does not impose controls outside those in its written contracts, in practice it does not enforce all of the controls which are in its written contracts. Each of the franchisee shareholders I interviewed said that he, and not GTS, made all of the day-to-day business decisions concerning his outlets. Therefore it is my opinion that:
(a) the controls imposed by GTS on Lenester and Sushi through the Franchise Agreement and Sublease are typical of a business format unit franchise;
(b) with a few exceptions (discussed below), the Lenester and the Sushi Franchise Agreements and Subleases are typical of the types of franchise agreement and sublease customarily used by a franchisor engaged in unit franchising; and
(c) again with the same exceptions, the relationships and business arrangements between GTS and the Appellants (as reflected in the Lenester and Sushi Franchise Agreements, Subleases and Shareholders Agreements, and in the information which I obtained during my interviews with Messrs. Kerr, Havelock and the GTS managers), are typical of those enjoyed by the parties to a joint venture unit franchise.
As you requested, I will discuss those few aspects of the Appellants' franchises that are somewhat out of the ordinary.
[29] The aspects of the arrangements that he considers somewhat out of the ordinary are:
(a) the unusual fairness to the franchisee;
(b) the nominal initial franchise fee paid to GTS; and
(c) the one-year initial term in the Lenester agreement (albeit renewable).
His view was that these are not standard but they are not unusual. I do not see in them a reason for dismissing the appeals. For example, the low initial fee paid to GTS simply reflects the corporate policy of GTS not to make money on the initial fee, as some franchisors do, but on the service fees payable during the carrying on of the operation. This has the advantage of permitting people like Mr. Kerr and Mr. Bingley without a large amount of capital to become franchisees in the GTS organization without a large initial capital outlay.
[30] Do the controls exercised by GTS over the operations of the franchisees amount to de facto control as contemplated by subsection 256(5.1)? Certainly GTS did not have de jure control since it did not have over 50 percent of the votes and could not elect the board of directors.[1]
[31] I can see nothing in these arrangements, including the documents and the shareholders' agreements, the leases and the franchise agreements that could result in control in fact of either Lenester or Sushi. The banking, financial and accounting arrangements do not give control to GTS. The classic statement on the meaning of de facto control of a corporation is found in Silicon Graphics Ltd. v. R.:[2]
66 The case law suggests that in determining whether de facto control exists it is necessary to examine external agreements (Duha Printers, supra, at 825); shareholder resolutions (Caouette v. Canada (Minister of National Revenue),[1996] T.C.J. No. 1568 (T.C.C.), para. 10); and whether any party can change the board of directors or whether any shareholders' agreement gives any party the ability to influence the composition of the board of directors (International Mercantile Factors Ltd. v. R, (1990), 90 D.T.C. 6390 (Fed T.D.) at 6399, aff'd (1994), 94 D.T.C. 6365 (F.C.A.); and Multiview Inc. v. R, 97 D.T.C. 1489 (T.C.C.) at 1492-93).
67 It is therefore my view that in order for there to be a finding of de facto control, a person or group of persons must have the clear right and ability to effect a significant change in the board of directors or the powers of the board of directors or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors.
[32] Applying that test obviously GTS had no such right.
[33] Even applying the somewhat broader interpretation suggested in some cases, such as Société Fonçière D'Investissement Inc. v. R.[3] and Transport M.L. Couture Inc. v. R.,[4] it is clear that GTS had no direct or indirect influence that would result in control in fact of Lenester or Sushi.
[34] Even if I am wrong in this conclusion, I think the GTS arrangement is precisely the sort of thing that the franchise exception in the second part of subsection 256(5.1) is aimed at. Parliament obviously recognized that franchisors frequently exercise significant control over the way franchisees run their operations. To refuse to apply the exception in this case would be to write the exception substantially out of the Act. Counsel argues that the banking and financing arrangements as well as the shareholders' agreements are outside of the exception. I do not accept this. The financial arrangements are an essential part of the overall arrangements as are the shareholders' agreements. They are all part of the extremely broad range of contractual and financial arrangements between franchisors and franchisees contemplated by subsection 256(5.1). Why the CCRA wishes to whittle away at this extremely beneficial exception to the rule in subsection (5.1) for franchise arrangements that form so important a part of the way business is done in Canada and that enable small entrepreneurs to compete with big and aggressive multinationals is, I must confess, utterly beyond me. Their purpose is to govern the relation between GTS and the franchisee as to the manner in which the business is to be conducted.
[35] I am also of the view that the franchisees and GTS were at arm's length. They had separate interests and there was certainly no single or controlling mind. Nor can it be said that they "acted in concert" in a way that deprives the relationship of its arm's length nature. To say that every time two independent business persons in pursuit of their own business interests work together to achieve a mutually beneficial commercial objective means that they are "acting in concert" and are, therefore, not at arm's length would mean that no business relationships would ever be at arm's length.
[36] Counsel for the respondent pointed out what might be an anomaly. He noted that if a franchisor controlled a franchisee in such a way that the first part of subsection 256 (5.1) applied it would follow that they would necessarily not be at arm's length and therefore the exception in the second part could never apply. He suggests that therefore the phrase "dealing at arm's length" is to be interpreted as implicitly being qualified by the word "otherwise" if it is to make any sense. I tend to agree with him but it is not necessary to reach a definitive conclusion on that point in this case.
[37] The appeals are allowed with costs and the assessments for the appellants' 1997 taxation years are referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that neither appellant was controlled by Giant Tiger Stores Limited, was not associated with Giant Tiger Stores Limited or any other corporation with which Giant Tiger Stores had a franchise arrangement, and was therefore not required to allocate any portion of their respective business limits to any other corporation for the purpose of determining their small business deduction under section 125 of the Income Tax Act.
Signed at Ottawa, Canada, this 31st day of July, 2003.
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"D.G.H. Bowman" |
A.C.J.
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CITATION: |
2003TCC531 |
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COURT FILE NO.: |
2001-3832(IT)G and 2001-3852(IT)G |
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STYLE OF CAUSE: |
Lenester Sales Ltd. and Sushi Sales Limited and Her Majesty the Queen |
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PLACE OF HEARING: |
Toronto, Ontario |
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DATE OF HEARING: |
July 21, 22 and 23, 2003 |
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REASONS FOR JUDGMENT BY: |
The Honourable D.G.H. Bowman Associate Chief Justice |
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DATE OF JUDGMENT: |
July 31, 2003 |
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APPEARANCES: |
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Counsel for the Appellant: |
Clifford L. Rand and Susan Thomson |
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Counsel for the Respondent: |
Peter M. Kremer, Q.C. and Carole Benoit |
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COUNSEL OF RECORD: |
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For the Appellant: |
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Name: |
Clifford L. Rand |
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Firm: |
Wildeboer Rand Thomson Apps & Dellelce, LLP |
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For the Respondent: |
Morris Rosenberg Deputy Attorney General of Canada Ottawa, Canada |