Dussault J.T.C.C.: - These appeals are from four different assessments, the notices of which, for the appellant’s 1989 taxation year, are number A186999 dated December 7, 1990, and number B200744 dated March 10, 1993, and for the appellant’s 1990 taxation year, numbers B136493 and Bl36497 dated June 17, 1991.
Issue
As stated in section 10 of the Reply to the Notice of Appeal, the only issue 1s “to determine whether the cost mark-up provided for in the Appellant’s franchise contract with its Franchisees in Canada is a payment to which section 212(l)d) of the Income Tax Act, applies”.
The assumptions of fact made by the Minister of National Revenue (the “Minister”) in issuing these assessments, as stated in paragraphs a) to h) of section 9 of the Reply to the Notice of Appeal, are as follows:
a) prior to 1989, Entré Computer (the franchisor) entered into a written franchise agreement (the original franchise agreement) with its Franchisees in Canada;
b) section IV)A)3) of the original franchise agreement provided as follows:
IV. FEES
A. In consideration of the franchise granted herein, Franchisee shall pay to Franchisor the following fees:
(...)
3. A continuing monthly royalty fee during the term of this Agreement in an amount equal to eight percent (8 per cent) of Franchisee’s gross sales, as defined herein, of all products and services related to the franchised business.
c) effective April 1, 1989, the Franchisor and Canadian Franchisees amended the original franchise agreement;
d) section E of the recitals portion of the amended franchise agreement reads as follows:
RECITALS
(...)
E. The parties, in general, wish this revised commercial relationship between them to reflect three principal elements:
(i) Continued ability by Franchisee to use the Proprietary Marks (as defined in the Franchise Agreement) in connection with Franchisee’s Entré Computer Center at the Center Location, as currently provided by the Franchise Agreement;
(ii) An opportunity on the part of Franchisee to purchase personal computer hardware and software products (herein called “Product”) as carried by Entré or its parent company, Intelligent Electronics, Inc. at Product Cost (as defined in this Amendment) plus a percentage markup, which percentage mark-up shall be deemed a license fee for use of the Proprietary Marks, plus outbound freight or transportation costs; and
(iii) An opportunity on the part of Franchisee to obtain such services as Entré from time to time may offer, on an a la carte or fee-for-service basis.
e) section 2)a) of the amendment portion of the amending franchise agreement provided as follows:
AMENDMENT
NOW THEREFORE, for good and valuable consideration, the receipt of which is acknowledged, the parties agree to amend and modify the Franchise Agreement as follows:
(...)
2. “Cost-Plus” Agreement
a. Deletion of Royalty
Section IV.A.3 of the Franchise Agreement, which provides for the payment of Royalty, is deleted from the Franchise Agreement.
f) section 2)c) of the amendment portion of the amending franchise agreement also added section IV)F) to the original agreement and reads as follows:
c. Addition of Provisions Describing “Cost-Plus”
Section IV of the Franchise Agreement is amended to add the following new Paragraphs F. through J.:
F. Product Purchases — To Be Invoiced at Product Cost Plus Mark-Up Plus Freight Costs.
Franchisee’s purchases of Product from Entré, or from Entré’s parent company IE, as the case may be, will be invoiced to Franchisee on the following basis: (i) The Product invoice will reflect the Product Cost (as hereinbelow defined) of the Product(s) being invoiced; to which will be added (ii) a percentage mark-up applied to the Product Cost (the “License Fee Mark- Up” or “Mark-Up”), determined in accordance with Entré’s Mark-Up Schedule and the policies and procedures pertaining thereto, as such may be established and published from time to time, which Mark-Up shall be deemed and considered a license fee charged for the license granted by the Franchise Agreement to Franchisee to use the Proprietary Marks in connection with Franchisee’s operation of an Entré Computer Center at the Center Location. In addition to being responsible for paying the Product Cost and the Mark- Up, Franchisee will also be responsible for paying the costs of shipping the Product to Franchisee’s Centre Location or other designated delivery point, the cost of insuring the Product while in transit and other outgoing transportation-related costs (herein collectively called “Freight Costs”).
g) the tax levied by the assessments represents 10 per cent of the cost mark-up received by the Appellant (which is a non resident of Canada) in 1989 and 1990 from two of its Canadian Franchisees namely from 592351 Ontario Limited (also known as the “Cal Jones” franchise situated at 155 University Avenue in Toronto) and from Renaissance Investments Ltd. (also known as the “Renaissance” franchise situated at 118 Eglington Avenue West in Toronto);
h) the above mentioned mark-up is a rent, royalty or similar payment for the use of or for the right to use in Canada any property, invention, trade name, patent, trade mark, design or model, plan, secret, formula, process or other thing whatever.
The appellant claims that the mark-up 1s essentially part of the purchase price despite the deeming clause in the amendment to the original franchise agreement, so that paragraph 212( 1 )(d) of the Income Tax Act (the “Act”) would be inapplicable to the payments made by its Canadian franchisees.
The respondent contends that the mark-up is precisely what it is called in the amendment, namely a “license fee” so that the payments made were subject to the Part XIII tax on non-resident persons as provided for in paragraph 212(1)(d) of the Act.
Summary of Evidence
By agreement, counsel for both parties filed a book of evidence containing the original franchise agreement and the amendment as well as various memoranda and letters by officers and employees of the appellant, Entré Computer Centers Inc. (“Entré”), and its parent company, Intelligent Electronics Inc. (“IE”), concerning the mark-up system implemented by Entré and its franchisees after IE gained control of Entré in December 1988.
Two witnesses testified on behalf of the appellant, Mr. Edward Meltzer, former treasurer of Entré and subsequently treasurer of IE, and Mr. Alex Mile, who in the years in issue operated with his wife an Entré franchised computer store in Toronto.
Mr. Meltzer first testified on Entré operations before the takeover by IE. Prior to the takeover, Entré, a United States public company with its headquarters in northern Virginia, had sold some 200 franchises for computer products retail stores, 10 of which were in Canada. Typically, franchises granted by Entré would be start-up operations and the franchisee would have had no previous experience. Entré would provide initial training for the franchisee and his staff regarding the operation of the store, supply technical support with respect to the equipment and hire a field sales team to help the franchisee with various aspects of his operations.
The original franchise agreement provided that the following fees were payable by the franchisee to Entre:
— An Initial Franchise Fee of $30,000 US.
— A Store Design and Implementation Package Fee of $10,000 US. This fee was payable to ensure that all Entré’s franchised stores had a uniform design so as to create a national image.
— An Ongoing Royalty of 8 per cent of gross sales exclusive of sales tax. This fee was charged on all goods and services sold by the franchisee whether or not they had been obtained from Entré. The royalty would also apply to services and training designed and provided by the franchisee for its own customers. Mr. Meltzer stated that about 15 per cent of the franchisee’s sales were of products obtained from other suppliers as there was no restriction or limitation in that regard. He also said that the 8 per cent royalty was meant to cover all the services rendered by Entré to its franchisee by way of training and technical support as well as advice provided by the members of the field team who were constantly visiting franchisees.
- An Advertising Fee of one per cent of gross sales to maintain a national advertising fund to promote Entré’s name. In fact, two separate funds were maintained one for the United States and one for Canada.
Mr. Meltzer testified that near the time of the takeover by IE in December 1988 the franchisees were generally dissatisfied with the agreement in that they felt then that they had learned about the computer retail business and that they no longer wanted to pay for services they no longer needed. They wanted only a reliable supplier. In essence, they wanted to replace the 8 per cent royalty that covered all the services rendered by Entré with a system consisting of a specific fee for each service whereby they would pay on an “à la carte” basis and only for what they wanted. Moreover, they felt that they should not have been obligated to pay a royalty on sales of goods supplied to them by third parties or on services, such as consulting, they themselves designed and provided for their own customers.
At the time of the takeover IE was located in Pennsylvania. It operated as a distributor of computer products to stores called Today’s Computers Business Centers (“TCBC”). Essentially, IE was in the same business as Entré. But, unlike Entré, it was not providing any services for the TCBC stores and there was no royalty payable to IE on the stores’ sales. IE was buying products in large quantities, obtaining discounts that individual dealers could not get. It was reselling those products to the stores strictly on a straight sale basis at cost plus a mark-up.
After the takeover of Entré by IE in December 1988, the operations of the two companies were consolidated in Pennsylvania. In January 1989, at the annual convention of Entré’s franchisees, Mr. Richard D. Sanford, then Chairman of the Board and Chief Executive Officer of IE announced, without going into details, that he intended to abandon Entré’s royalty system and replace it by a cost-plus or a mark-up system and that a task force comprising employees of both companies as well as representatives of the franchisees would be formed to work out the details of implementation.
Mr. Meltzer as well as Mr. Alex Mile, who was acting as a representative of the Canadian franchisees, were members of the task force. Many issues had to be dealt with in order to finalize the change. One issue was whether the new fee based on the purchase of products would be a flat fee, i.e. one set at the same rate for everybody, or a sliding scale fee, i.e. one based on volume and decreasing as volume increased, as it in fact turned out to be. Moreover, the appropriate percentage had to be determined. Another concern had to do with the value of Entré’s name and whether or not the advertising fund was to be maintained to finance national advertising. Mr. Meltzer said that the franchisees were really divided on that issue.
Another issue was the credit that Entré had provided for its franchisees but that IE had not provided for the TCBC dealers. Other questions discussed included the proper treatment of freight costs in the new cost-plus or mark-up system, the continuation of technical services, training and marketing programs, and the fees that would be payable for same.
After lengthy discussions, the implementation of the new system or program was announced on April 10, 1989 and was to apply retroactively to April 1, 1989. It was patterned on the system IE already had with the TCBC dealers but included certain aspects of the agreement between Entré and its franchisees. The “best of both worlds”, as commented by Mr. Bill Alvis, President of the Reseller Division of IE, in making the announcement.
The main features of the new system were the following:
- The eight per cent royalty on gross sales was eliminated.
- The one per cent advertising fee was eliminated.
- Training and other support services were retained but the franchisees had to pay only for those they chose to take advantage of on an “à la carte” basis.
— The price charged to franchisees for products depended on the volume purchased on a monthly basis with a mark-up over cost (exclusive of freight cost to the franchisees), varying from a high of 8.7 per cent to a low of 4.95 per cent with 12 different brackets. Franchisees were also responsible for freight costs.
The new system was designed to be on average 20 per cent less costly to Entré’s dealers than the royalty system had been. It would entail an average mark-up of 7.4 per cent while the royalty system was estimated to have been the equivalent of an average mark-up of 9.32 per cent when one takes into account not only the 8 per cent royalty but also the handling fee formerly charged to franchisees as well as the 1 per cent advertising fee.
The Entré dealers could choose to operate under the royalty system or change to the new cost-plus system. All of them, including the Canadian franchisees, made the change.
Before implementation, much thought had been given to the pricing scheme. According to Mr. Meltzer, counsel for Entré, Mr. Peter Johnsen, was concerned with the application of the Robinson Patman Act, which is an American legislation prohibiting discriminatory pricing practices in sales of commodities unless they can be justified by a cost differential for different purchasers. Violation of this anti-trust legislation could entail not only criminal proceedings but also civil liability as it provides for a private right of action for treble damages. As the legislation apparently applies only to sales of goods and not to licence fees or royalties, Mr. Johnsen urged as one potential line of defence that the mark-up be deemed a licence fee in the amendment to the agreement between Entré and its franchisees. According to Mr. Meltzer, this is the reason why the original franchise agreement was amended the way it was. The same concern also led Mr. Johnsen to suggest that in order to strengthen the defence against potential liability, the cost of the product and the mark-up should be stated as two separate amounts on invoices and that the mark-up should be referred to on the invoices and other company documents as a licence fee. The important thing here was that the mark-up would not be seen as part of product cost. It is clear from Mr. Meltzer’s testimony and various documents entered in evidence that the Robinson Patman exposure had not been taken lightly.
Canadian tax considerations with respect to the new system were dealt with by Ms. Vicki Thomas, then tax manager of Entré. Besides the question of whether to set up a Canadian subsidiary or simply a branch operation in Canada, options which were both finally discarded, she addressed the issue concerning the application of customs duties (referred to as “customs fees”) and the federal sales tax to the new mark-up. She concluded that the fees and the tax could not be avoided on the total price charged including the mark- up, referred to as “the selling price”, unless, as she said, “IE goes back to the concept of a license fee”. As she said in her memorandum this in turn would create another problem because such a fee would then be viewed as a royalty subject to the 10 per cent withholding tax. Ms. Thomas also clearly stated her view that the new cost-plus arrangement would not be subject to the Canadian 10 per cent withholding tax.
Mr. Alex Mile testified that he was quite satisfied with the change because at that time he felt that he understood the retail computer business well and that the training was no longer necessary. He commented on the change in the following manner:
A. Well it had a tremendous impact, because all of a sudden we were able to get products from Intelligent Electronics at a much less price on the grid. Secondly, if we sourced from somewhere else for the products, we wouldn’t have to pay any royalty on it. Thirdly, when we sold our services to our customers, like the service contracts and so on, we didn’t have to pay any royalty on it. And fourthly, we, they were not as insistent on using the name Entre. When it was just Entre Computer Center, they were very insistent on using the name and we had been for about a year or two (2) years starting to use another name and we were using a name called Renaissance Canex.
Moreover, according to him, the value of the Entré name was negligible in Canada and the advertising fund in Canada, kept separate from the United States fund, was not very big and was not really being used. Beginning in 1988, Mr. Mile had even carried on his business under two names, Renaissance Canex and Entré Computer Center. This was done in order to create an image distinct from that of being only a franchisee which was not very highly regarded in the business community. In the summer of 1989, Mr. Mile even stopped using the Entré name altogether because nobody at IE cared about that, unlike Entré who had been insisting on its use during the previous years. According to him, even with the mark-up, the prices were usually cheaper than those offered by other companies. However, if these companies had better prices he would buy from them. As he said, he began to look at IE as just “another distributor”, “another source of product”.
It is clear from Mr. Mile’s testimony that he was not concerned with the legal aspects of the changes made to the original agreement. He was not given a chance to comment on those changes and did not seek independent legal advice before signing the amendment. He was simply told not to withhold tax because royalties were no longer due to Entré.
Appellant's Submissions
Counsel for the appellant submits first that, leaving aside the characterisation made in the amendment, the mark-up on cost paid by the Canadian franchisees to the appellant is in essence part of the purchase price of products bought from the appellant and not a royalty or a similar payment made for the use of a trade name or other right or property as those payments were defined by the Federal Court of Appeal in Saint John Shipbuilding & Dry Dock Co. Ltd. Second, he submits that the Court should look at what has actually taken place between the parties, at the commercial reality of their relationship and decide whether or not the mark-up is a “license fee” not according to the characterisation given in the deeming clause of the amendment to the franchise agreement, but on the basis of the true nature of the payments as disclosed by the evidence. Counsel for the appellant stresses that the Court should look at the substance of the transaction and not at the label given to it by the parties. In that sense, he contends that he is not seeking a restructuring of the transaction but merely a different characterisation than that given by the deeming clause. In support of his arguments counsel for the appellant relied on numerous decisions and notably on the judgment of the House of Lords in Wesleyan and General Assurance Society? on the decision of the Supreme Court of Canada in Bronfman Trust, on the decisions of the Federal Court of Appeal in Friedberg^ Urichuk, Hudson Bay Mining and Smelting Co. Ltd. and Brault-Clément Inc.^ as well as on the decisions of the Tax Court of Canada in Farm Business Consultants^ and Continental Bank of Canada.
Finally, counsel for the appellant argues that the evidence submitted, both oral and documentary, is strong and meets the degree of proof required by the Tax Court of Canada in its decisions in Pallan^ and Privitera' for situations where one is seeking to repudiate the terms of an agreement.
Respondent's Submissions
Counsel for the respondent submits that when there is no ambiguity in a contract, there is no valid purpose to going beyond what the parties have agreed upon. He insists that the appellant cannot take contrary positions in the United States and in Canada. As the intention was that the mark-up be considered a “license fee” in the United States, consistency would require that the legal form relied on in the United States also prevail in Canada. He contends that the appellant cannot now invoke the commercial reality and ask the Court to rewrite the contract by removing words from it. Several decisions were referred to, particularly the judgment of the Supreme Court of Canada in Stubart Investments Limited^ the decision of the Federal Court of Appeal in Gurd’s Products Company Limited as well as the decision of the Tax Court of Canada in Continental Bank of Canada (supra).
However, counsel also stresses the fact that the original franchise agreement was still in place despite the amendment and that rights and obligations under that agreement such as, for example, a non-competition clause went beyond those that would normally be found in a straight sale contract.
Analysis
The amendment to the original franchise agreement had the effect of replacing the 8 per cent royalty and the 1 per cent advertising fee, both computed on gross sales by a system whereby franchisees would pay for products at cost plus a variable mark-up, depending on the volume purchased in a given month, as well as freight costs. In particular, the change was effected by inserting the following clause in the franchise agreement:
F. Product Purchases - To Be Invoiced at Product Cost Plus Mark- Up Plus Freight Costs.
Franchisee’s purchases of Product from Entré, or from Entré’s parent company IE, as the case may be, will be invoiced to Franchisee on the following basis: (i) The Product invoice will reflect the Product Cost (as hereinbelow defined) of the Product(s) being invoiced; to which will be added
(ii) a percentage mark-up applied to the Product Cost (the “License Fee Mark- Up” or “Mark-Up”), determined in accordance with Entré’s Mark-Up Schedule and the policies and procedures pertaining thereto, as such may be established and published from time to time, which Mark-Up shall be deemed and considered a license fee charged for the license granted by the Franchise Agreement to Franchisee to use the Proprietary Marks in connection with Franchisee’s operation of an Entré Computer Center at the Center Location. In addition to being responsible for paying the Product Cost and the Mark-Up, Franchisee will also be responsible for paying the costs of shipping the Product to Franchisee’s Center Location or other designated delivery point, the cost of insuring the Product while in transit and other outgoing transportation-related costs (herein collectively called “Freight Costs’’). ^
Proprietary Marks are defined in the original franchise agreement as covering certain trademarks, logos, emblems, and indicia of origin including, but not limited to, the mark “Entré Computer Center” and such other trade names, service marks and trademarks as may be designated by the franchisor for use in connection with the system.
There is little doubt that what is contemplated above all is the purchase of a product at product cost plus a percentage mark-up and that both components are reflected on the product invoice. The franchisee is also responsible for paying freight costs including shipping costs and the cost of insuring the product while in transit, which is an indication he is to assume the risks of ownership from the moment of shipping. The transaction is essentially a sale and the payment of the amount stated on the invoice is the price paid to become owner of the product. The payment does not exhibit any of the characteristics usually found in a payment of rent, royalty or similar payment for the use of or the right to use property. There is simply no link, other than the one established in the deeming provision, between the applicable mark-up and the actual use of or right to use Entré Proprietary Marks. The mark-up is simply dependent upon the volume of products purchased.
Under the original franchise agreement all franchisees had the same basic rights for which they had already paid numerous fees among which were the initial franchise fee and the implementation fee. Under the amended agreement their rights to use Entré’s Proprietary Marks, as defined, remained essentially unchanged, but it was agreed that Entré or IE would no longer provide services except on an “à la carte basis” and for specific fees to be determined by Entré or IE. The 8 per cent royalty on gross sales was abandoned as was the I per cent advertising fee. The advertising fund was relinquished. The evidence clearly points to the fact that after the takeover by IE, the Entre name was not important anymore. One wonders what value, if any, it would have had in Canada before the takeover. The evidence surely indicates that it had none thereafter. What was important for the franchisees before was the fact that Entré was providing many services. The need for such services seems to have lessened as time went by, for at least a good number of franchisees. Under the new system, these services were not abandoned altogether but were to be provided only for those requiring them and for specific fees to be determined by the franchisor. Above all, the amendment to the agreement, by focusing on the purchase of products instead of on royalties for services, moves away from what can be viewed as a classic franchising or licensing system into one that is more akin to a distributor-dealer system in which the basic transaction is precisely the sale of a product for a set price based on the level of monthly purchases. In my view, this is the commercial reality of the transaction. The truc nature of the mark-up is that it is a component and an integral part of the purchase price of a product purchased at a given time. The documentary evidence as well as the testimony Of Mr. Meltzer and Mr. Mile support that conclusion.
This being said, the effect of the deeming provision must be ascertained. For purposes of clarity it will be recalled that it 1s couched in the following terms:
...which Mark-Up shall be deemed and considered a license fee charged for the license granted by the Franchise Agreement to Franchisee to use the Proprietary Marks in connection with Franchisee’s operation of an Entré Computer Center at the Center Location.
There is uncontradicted evidence as to why this deeming clause was inserted into the amendment to the franchise agreement: it was in order to develop a potential line of defence against possible liability under the Robinson Patman Act. In fact, the intention was to give the mark-up the colour or appearance of a licence fee by so naming it. There is simply no evidence that after the takeover IE wanted Entré’s franchisees to pay for a licence to use Entré’s Proprietary Marks.
Much has been said on the subject of form versus substance. I do not think it would serve any useful purpose to restate the law in that respect. Higher courts have laid down the principle that substance should be given precedence over form in appropriate circumstances. That is not to say that form never matters. It does in many cases particularly when a transaction is cast in such a way as to require that formal steps be taken. However, without indulging in semantics, there is a difference between the form of a transaction and mere nomenclature or labelling. In the judgment of the House of Lords in Wesleyan and General Assurance Society (supra) Viscount Simon specifically addressed the point in the following manner:
It may be well to repeat two propositions which are well established in the application of the law relating to Income Tax. First, the name given to a transaction by the parties concerned does not necessarily decide the nature of the transaction. To call a payment a loan if it is really an annuity does not assist the taxpayer, any more than to call an item a capital payment would prevent it from being regarded as an income payment if that is its true nature. The question always is what is the real character of the payment, not what the parties call it.
Secondly, a transaction which, on its true construction, is a of a kind that would escape tax, is not taxable on the ground that the same result could be brought about by a transaction in another form which would attract tax.
Obviously, we are concerned here with Viscount Simon’s first proposition. “Mere use of the words” or “mere nomenclature” had already been rejected years before in the Duke of Westminster’s case. That principle has been expressed in numerous ways in more recent decisions.
Although deeming provisions are often found in statutes and particularly so in tax statutes their use in private agreements is less customary. In Verrette?® Beetz J. of the Supreme Court of Canada explained in the following terms, the meaning of such a provision in the context of a statute:
A deeming provision is a statutory fiction; as a rule it implicitly admits that a thing is not what it is deemed to be but decrees that for some particular purpose it shall be taken as if it were that thing although it is not or there is doubt as to whether it is. A deeming provision artificially imports into a word or an expression an additional meaning which they would not otherwise convey beside the normal meaning which they retain where they are used;...
In Sutherland? Dickson J. of the same court commented on the purpose of a deeming clause by saying:
The purpose of any “deeming” clause is to impose a meaning, to cause something to be taken to be different from that which it might have been in the absence of the clause.
I do not think a deeming provision has a different purpose when used in the context of a private agreement, although the element of artificiality is somewhat enhanced. It is clear that third parties are not bound by such a provision which seems to me to be a very unsophisticated attempt at disguising the true nature of a transaction.
In the instant case, the evidence discloses no rational way in which the variable mark-up, dependent strictly on monthly purchases by a given franchisee, could be linked to the licence granted to use the franchisor’s Proprietary Marks tn connection with the franchisee’s operation. On the one hand, as franchisees were free to buy from any other distributor, their actual purchases from Entré did not bear any relation to their actual use of those marks. For example, a small franchisee could buy all his products from Entré, paying a high mark-up, while a large franchised operation might buy only a fraction of its products from Entré but in a volume such that a smaller mark-up would be applicable. On the other hand, if the so-called licence fee was simply, as stated, for the licence to use those Proprietary Marks, one wonders why they would have varied with different franchisees and from month to month. I simply fail to see any commercial purpose other than the one explained with respect to the Robinson Patman Act for labelling the mark-up as a licence fee in the circumstances at bar. The use of the deeming provision must be considered to be an attempt to distort the reality of the relationship between the parties and should not, as such, be given any legal effect, just as it should not in the circumstances attract any adverse tax consequences.
Conclusion
On the evidence presented at trial, I am of the view that the mark- up over cost is part of the price of the products purchased from Entré by its Canadian franchisees and as such is not covered by paragraph 212(1)(d) of the Act.
The appeals are allowed and the assessments are vacated, the whole with costs to the appellant.
Appeal allowed.
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