Citation: 2013 TCC 139
Date: 20130503
Docket: 2011-5(IT)G
BETWEEN:
ANDRÉ DROUIN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
[OFFICIAL ENGLISH
TRANSLATION]
REASONS FOR JUDGMENT
Bédard J.
[1]
This is an appeal from
a reassessment, notice of which is dated August 27, 2009, for the 2008
taxation year (the reassessment), whereby the Canada Revenue Agency (the CRA)
denied $85,875.33 in deductions that the appellant had claimed as capital cost
allowance, eligible capital property and interest in respect of the purchase of
a franchise authorizing him to market computer software.
Background
[2]
Prospector Networks
International Inc. (PIN) was a company based in Barbados. The appellant submits
that PIN carried on a business that developed software for business markets in North America and elsewhere (“the software”).
[3]
The software consists
of the following:
(i)
Solutions Prospector: a
software package designed to help salespeople identify prospective clients;
(ii)
Mail it Safe:
software designed to secure and track e-mail to help lawyers, health care
professionals, public agencies and others who regularly send and receive
confidential information;
(iii)
CashOnTime: a software
package designed to help financial officers and collection agents track
accounts receivable and payments.
[4]
PIN granted licences
(in 2003 and 2004) and franchises (from 2005 to 2008) that, according to the
appellant, allowed the licensees and franchisees (collectively, “the
franchisees”) to use and market the software and any products derived from the
software.
[5]
According to the
appellant, PIN also offered to market the software on the franchisees' behalf
under contracts of mandate with PIN's subsidiaries and associated businesses.
[6]
The appellant is a
software engineer.
[7]
In 2007, the appellant
bought a franchise and signed an agency agreement with a subsidiary of PIN.
Under the terms of this mandate, the subsidiary undertook to operate the
appellant's franchise. I should immediately note that the respondent submits
that this agency agreement is a sham. The appellant bought the franchise on the
advice of his financial planner.
[8]
The purchase price of
the franchise in 2007 was $200,000: $10,000 for the franchise rights and
$190,000 for the Solutions Prospector and Mail it Safe software. The
appellant gave the franchisor a five-year full recourse promissory note bearing
interest at a rate of 7.5% per annum. The respondent submits that this
promissory note is a sham.
[9]
The contracts signed in
2007 (i.e., the franchise agreement and the agency agreement) were replaced
with new contracts in 2008. The cost of the franchise was raised by $30,000 in
2008. When he bought his franchise in 2008, the appellant gave the franchisor a
ten-year full recourse promissory note bearing interest at the rate of 4% per
annum. The respondent submits that the 2008 agency agreement and promissory
note, too, are shams.
[10]
Any dealings that the
appellant had with PIN, the agent or any of PIN's affiliated companies were at
arm's length.
[11]
The respondent's
position: The CRA's
position is that the appellant bought the franchise solely for the purpose of
obtaining tax deductions. This position is based on the following arguments.
(A) Argument I – There
was no business
[12]
First, the CRA submits
that the deductions were not made for the purpose of gaining or producing
income, because at no time during the relevant period did the appellant intend
to carry on a business or in fact carry on a business, nor for that matter did
Network Prospector or MarketX Services Inc. intend to carry on a business or in
fact carry on a business on behalf of the appellant. See the Reply to the
Notice of Appeal (the Reply) at subparagraph 26(l). See also the Reply at
paragraphs 28, 29 and 36 to 38. See also the Reply at
subparagraphs 25(o), (p) and (r), where the CRA alleges that the appellant
never intended to draw income from his business.
(B) Argument II – The
sham
[13]
Second, the CRA submits
that the full recourse promissory note and the agency agreement constituted [translation] "shams" (see the
Reply at subparagraphs 26(l), (m), (p), (x), (y), (z), (aa) and (bb) and
at paragraphs 32 and 34).
(C) Argument III – The
unreasonable price
[14]
Finally, the CRA
submits that the [translation] "fair
market value of the franchise and the rights attached to it was nil" (see
the Reply, subparagraph 25(s)). The CRA further submits that [translation] "the fair market value
of a franchise of Prospector International Networks Inc. was very low, if not
nil" (see the Reply, subparagraph 26(cc)).
Issue
[15]
The issue in this case
is the following: Was the appellant carrying on a business in the year 2008?
This issue also raises the following questions:
(a)
Did the full recourse
promissory note and the agency and management agreement constitute shams?
(b)
Did the appellant pay a
reasonable price for his franchise?
Procedural history
[16]
On December 21,
2010, the appellant filed in this Court an appeal against the reassessment; the
CRA filed its Reply on March 14, 2011.
[17]
After two case
management conferences held on May 19 and September 6, 2011, the
Court set a tight, expedited schedule requiring the parties to disclose a
considerable volume of documents and to hold examinations for discovery.
[18]
On September 14,
2011, the Court rendered a confidentiality order in respect of the exhibits
filed by the appellant (see Drouin v. The Queen, 2011 TCC 425,
2012 DTC 1020).
[19]
On October 21,
2011, the CRA filed a [translation] "Motion
to Amend the Reply to the Notice of Appeal" alleging that the appellant's
franchise was a [translation] "tax
shelter" and that the software that he marketed constituted [translation] "computer tax shelter
property", such that the deductions claimed by the appellant were
prohibited under the applicable provisions. On November 10, 2011, the
Court dismissed the motion (see Drouin c. The Queen, 2011 CCI 519,
2012 DTC 1012).
[20]
The hearing lasted a
total of 30 days, from January 23, 2012, to May 10, 2012. The
appellant filed approximately 785 exhibits, totalling around
13,000 pages. The respondent filed 161 exhibits.
[21]
During the hearing, the
Court rendered a decision dismissing inter alia an objection by the appellant
to the testimonies of five other franchisees and two financial planners whom
the CRA wanted to call as similar fact witnesses:
[translation]
[44]
It is appropriate to reproduce paragraphs 22 to 24 of the written
submissions of the respondent, which read as follows:
[translation]
22.
The respondent submits that the testimonies of the franchisees and the
financial planners are entirely relevant according to the criteria of the
Supreme Court because these people were involved in transactions identical to
those involving the appellant and thus will give evidence that may increase the
likelihood that the contracts signed by the appellant and the promissory note
allegedly given to him are in fact shams.
23.
The testimonies of the franchisees and the financial planners will also
increase the likelihood that representations were made to the Prospector
franchise buyers to the effect that buying a franchise would give them a tax
benefit in excess of the amount paid by them.
24.
The testimonies of the franchisees and the financial planners will also
increase the likelihood that no businesses were actually carried on through
Prospector franchises.
(Drouin
c. La Reine, 2012 CCI 94 [not translated], para. 44)
[22]
In that same judgment,
the Court also ruled on the qualifications of the expert witnesses that each of
the parties planned to call after a motion on February 9 and 13, 2012. The
Court thus accepted Jean‑François Ouellet (Mr. Ouellet) as an expert
in management and in innovation marketing. However, the Court refused to accept
Denys Goulet as an expert in appraisal, deeming his report to be of no
probative value because his opinion was inextricably based on the opinions of
an unidentified person who had not been presented to the Court as an expert.
Proceedings
[23]
At the trial, the
appellant presented an overview of the history of PIN from its beginnings to
the present day through the testimonies of Thomas L. Jones (Mr. Jones),
Michel Vincent (Mr. Vincent), Claude Duhamel (Mr. Duhamel), Paul‑André Mathieu (Mr. Mathieu)
and Stéphane Teasdale (Mr. Teasdale).
[24]
The testimonies of
Mr. Jones and Mr. Duhamel reveal that PIN is the successor to
Stratsite Inc. (Stratsite), an information technology company founded in 1998
by two young entrepreneurs, Mr. Jones and Carl Phoenix (Mr. Phoenix).
Stratsite was initially involved in providing Web site development, PowerPoint
presentation and electronic communications services for companies in the
financial sector. Stratsite's clients included Valeurs mobilières Internat, a brokerage
firm where Mr. Duhamel worked as a stockbroker. Mr. Duhamel had
clients who wanted to invest in new high-tech companies. Being satisfied with
Stratsite's work, he decided to approach Mr. Jones and Mr. Phoenix to
learn more about their future projects. One of the projects that Mr. Jones
and Mr. Phoenix discussed with him was C‑Local, an electronic data
bank, similar to the Yellow Pages, that incorporated advanced search engines.
However, this project required considerable financing. Mr. Duhamel managed
to raise several million dollars in financing from various investors, which
allowed Stratsite to go forward with the development of C‑Local.
[25]
Near the end of 2000
and in early 2001, when the technology bubble burst, C‑Local's Web site
was online and accessible to the general public, but the product was not being
marketed. The financing needed to roll out C‑Local was impossible to come
by, and an initial public offering had to be cancelled. The company was soon
short of funds and had to reduce its staff considerably.
Solutions Prospector
[26]
In spite of everything,
Stratsite managed to finalize the tracking and notification system it had been
working on. In 2002, Stratsite decided to breathe new life into the company by
focusing on this tracking system. Building on their Web site design know-how,
their database and the tracking system, Mr. Jones and his associate
created a new computer program: Solutions Prospector. This software was
designed to allow users to send an e-mail to a select list of recipients, inviting
them to visit a Web site. The software would then track what action the
recipients took, if any, after receiving the invitation.
[27]
Mr. Duhamel
testified that when he was seeking funds for Stratsite, he was referred to
Andrew Murray (Mr. Murray), a businessman residing in Barbados who knew
people with access to capital around the world. According to Mr. Duhamel,
Mr. Murray had expressed an interest in Stratsite and had joined with him
in preparing the financing plan and the following business plan with him.
Canaventure, a company owned by Mr. Murray and incorporated in the British
Virgin Islands, would ask Stratsite to develop Solutions Prospector on its
behalf. Canaventure, which would hold the intellectual property rights for the
software to be developed, would sell investors marketing licences for the
products developed by Stratsite, and the licensees would in turn ask Stratsite
to market the software on their behalf. The money paid to Canaventure would be
given to Stratsite to finance the software's development.
[28]
Licences were initially
priced at $75,000 each. To maintain a stable cash flow for Canaventure and
Stratsite, the licences had to be paid partly in cash and partly by means of a
limited recourse promissory note. Mr. Duhamel explained that structuring
the licences in this way had the added advantage of significantly reducing
their risks by allowing them to claim a capital cost allowance on their
licences while still receiving royalties.
[29]
In 2002, only a handful
of licences were sold. In 2003, the initial price of $75,000 was increased to
$100,000, and the initial 30% down payment had to be paid in instalments over
two years. The balance, paid by a limited recourse promissory note, was due
10 years later. Interest was paid out of the income earned. According to
Mr. Duhamel, they sold approximately 140 licences in 2003 and 250 in
2004, under the same terms.
[30]
In 2003, Canaventure
began using the business name Prospector International and then officially
changed its corporate name to PIN. On August 1, 2003, PIN incorporated
Prospector Network Inc. (Network) to take over Stratsite's activities, and
Stratsite was wound up. Mr. Duhamel explained that from then on, Network
played two distinct roles: first, developing software for PIN; and second, marketing
this software for the licensees. According to Mr. Duhamel, a third
company, Prospector USA, wholly owned by Network, was incorporated in the
United States to facilitate marketing efforts in that country.
[31]
Development of
Solutions Prospector was completed in November 2003. The company's
business activities also began to pick up in 2003. For example, Network tried
to do business with resellers of modified products, that is, businesses that
were already selling information technology products and could distribute
Solutions Prospector through their own networks. The attempt failed:
Mr. Duhamel and Mr. Jones explained that the resellers refused to
distribute Solutions Prospector because it was still unproven on the market.
Network opened offices in Miami and Montréal to try to sell the software. A
business plan identifying target markets was drawn up, and numerous
presentations, personalized proposals and competitive analyses of competing
products were done. Network made efforts to identify clients, efforts which
included using Solutions Prospector. A few paying or prospective clients were
using Solutions Prospector. Twelve of them were designated as [translation] "strategic accounts",
that is, well-known businesses that, if encouraged to use Solutions Prospector,
could foster market uptake and thus increase sales. Network offered these
businesses free or discounted user rights. In addition, to target more niche
clients, Network launched two derivative programs based on Solutions
Prospector: "Prospector Finance" and "Prospector Trade Show".
Licensees were informed of new releases and upcoming projects through updates.
[32]
Despite all this,
Network's efforts did not translate into sales. Mr. Jones and
Mr. Duhamel attribute these disappointing results to the laborious nature
of designing and developing microsites that meet high standards of
professionalism. Clients also expected Network to provide the databases, which
are very expensive, while Prospector's business model assumed that clients
would provide their own lists.
Mail it Safe
[33]
In April 2005, new
software was announced. Prospect Mail, later renamed Mail it Safe, is
described as a productivity and security tool. Basically, it allows senders to
know when their messages have been read, how long the messages were looked at,
and whether the attachments were downloaded. It also gives senders' messages
added security by using encrypted networks on the Mail it Safe
central server and by offering additional options, such as password protection.
Initially, Mail it Safe could only be used via the Web as a module of
Solutions Prospector, but it was later adapted to make it compatible with
Outlook, and eventually with Lotus and BlackBerry, which increased the client
base. Mail it Safe is offered either under a perpetual licence or
through the purchase of a limited-time right known as "SaaS"
(software as a service). Mr. Vincent described the difference between the
two arrangements in the following terms (see Examination of Mr. Vincent,
Transcript, January 25, 2012, Question 340):
[translation]
Generally,
an SaaS solution is hosted. That means that the hardware isn't at the client's
offices but is taken care of by the solution provider. So, for example, with
Mail it Safe, the clients who are in SaaS mode use the solution via a
server hosted by us, actually, by our partner, who has the specialized
infrastructure. As to why we offer two modes, it's because it leaves us—it's a
question of business flexibility. There are businesses that don't want to do
what in industry jargon is called "capex", capital expenditures, and
that prefer to have an operating expense in the budget. Because under their
internal procurement approval procedures, it's easier to justify incurring an
operational expense than a capital expense. In other businesses, it's the
opposite. So we give ourselves the flexibility to align with the clients'
interests.
What's
more, there are businesses where technology is almost like a religion. There
are some that think one thing is the best in the world and another thing is
worthless, while others say the opposite. Everyone has their own beliefs. So
there are businesses that say there's no way we can have the information from
the applications we use be hosted outside our infrastructure. So these
companies object to the SaaS mode because they can't accept having their data
stored elsewhere. Other business will tell you the opposite. They don't want
anything to do with managing that in house because they don't have the
resources in place.
[34]
In 2005 and 2006,
Network devoted considerable effort and money to marketing
Mail it Safe. Marketing consultants were hired to develop
Mail it Safe's market image. Specific sectors were identified: legal
services, financial services and health services. Network also decided to close
the Miami office and open offices with sales teams in New York, Chicago, Los
Angeles and Boston. It hired additional staff through the Montréal office. A “virtual
office” was set up in London for about six months, and there were plans to
open an office in Paris, according to Mr. Duhamel. There were also
discussions with a Mexican associate, according to Mr. Duhamel.
[35]
A significant amount of
documentation was prepared for prospective clients: presentations, brochures,
guides, user manuals, webinars and technical documents. Network created a Web
site for Mail it Safe. It did strategic planning and trained in-house
salespeople using reports, presentations and analytical documents. It also
attended a number of trade fairs, including the LegalTech Trade Show in New
York, and took part in various events attended by its target clientele. It also
conducted a survey of selected members of its clientele to better understand
clients' perceptions of the software.
[36]
Network also entered
into agreements with certain organizations, including the Greater Montréal Real
Estate Board, the Corporation de services du Barreau du Québec and the New York
County Bar Association. It donated 250 user licences to the Blythedale
Children's Hospital, where the software was used. There were negotiations with
Pitney Bowes and the Massachusetts Vietnam Veteran Association towards entering
into a business agreement. Network also made IBM its technical associate,
meaning that IBM took care of the security reports for Mail it Safe.
Moreover, like Microsoft and BlackBerry, IBM allowed its logo to be used for
advertising purposes.
[37]
Network also tried to
find resellers that could sell Mail it Safe to their clients.
According to Mr. Duhamel, this solution could have led to sales but would
have had the added advantage of raising the product's profile with a view to a
possible acquisition by a major company. According to Mr. Duhamel, there
were talks with Cablevision, Openface, Reach Everywhere, Merrill and BBDO, but
nothing came of them.
[38]
In 2005, Revenu Québec,
which viewed the licensing system more as an investment than a business,
threatened to disallow the capital cost allowances claimed. In response,
Network and PIN offered the licensees the opportunity to convert the licences
into franchises. According to Mr. Duhamel, approximately
40 licensees, or 20% of them, refused to convert their licences. Two
hundred new franchises were sold in 2005. In addition, Mr. Duhamel
explained that a special agreement, consisting primarily of a partial interest
holiday, was concluded with 14 franchisees who had already invested in
another of its business projects that had not turned out well.
[39]
Mr. Duhamel
explained that under the terms of the 2005 franchise agreements, the
franchisees acquired [translation] "an
operating franchise" giving them [translation]
"the non-exclusive right to distribute, within the territory and to
authorized clients, . . . Solutions Prospector and MISTM
software for a term of 25 years beginning January 15, 2005". Under
the contract, each of the franchisees was assigned a specific territory and had
access to a data bank on the businesses located in that territory (see also the
Solution Prospector and Mail it Safe franchise agreement between
Prospector International Network Inc. and Annie Fortin dated December 30,
2005, Exhibit A‑55 (1‑97), Volume 27, page 10893, at
page 10897, paragraphs 2.1 and 3).
[40]
Another clause in that
contract stipulated that if 75% of the franchisees agreed at a special meeting
to sell their franchises to a third party, a franchisee could be required to
sell its franchise, on condition that the sale be made under the same terms as
for all the franchises.
[41]
In response to a
question from the franchisees regarding the number of franchises that PIN
intended to grant, Mr. Duhamel answered that PIN had capped the number of
franchisees at 1,500 and had divided the United States into
1,500 territories accordingly, by postal code. According to
Mr. Duhamel, each territory was supposed to have between 10,000 and 20,000
potential clients entered in the Dun & Bradstreet data bank for businesses
and professionals. According to Mr. Duhamel, the franchisees were told
several times how the territories were divided up.
[42]
Furthermore, the price
of a franchise was raised to $160,000 (including $10,000 in franchise fees to
take into account the launch of Mail it Safe), with an interest rate
of 7% per annum. The term of the promissory note was four years.
[43]
New franchises were
sold in 2006 under similar terms.
[44]
According to
Mr. Duhamel, the money from the franchisees was used for development and
marketing. Moreover, the evidence showed that Network was in regular contact
with franchisees, usually by e-mail, but sometimes by regular mail. Most often,
these contacts took the form of updates. There were also annual and special
meetings, well attended by franchisees, during which presentations on the
business situation and development were given. A [translation] "franchisees' manual" with periodic
updates was sent to franchisees by mail and e-mail. A [translation] "VIP night" was organized to mark the
launch of Mail it Safe, an intranet site was made available to
franchisees, and franchisees were invited to refer people they knew to Network.
The 2006 appraisal by Wise, Blackman
[45]
Mr. Duhamel
explained that well after the technology bubble had burst, some financial
groups renewed their interest in Mail it Safe and started
negotiations. According to Mr. Duhamel, Mr. Murray considered the
possibility of taking the company public. Mr. Duhamel also explained that
it had become important to have a valuation of the company done (see
Examination of Mr. Duhamel regarding the announcement to franchisees that
the company might be taken public, Transcript, February 2, 2012, Questions
519‑531; Update (in a bundle), Exhibit A‑23.1.16.5,
Volume 18, page 7852, at pages 7862-7865,) (announcement to
franchisees that the company might be taken public).
[46]
In addition, according
to Mr. Duhamel, the franchisees started asking whether the franchisor and
the agent had the financial capacity to continue developing and marketing the
products (Examination of Mr. Duhamel, Transcript, February 2,
2012, Questions 293, 299 and 302.)
[47]
To answer these
questions, PIN hired renowned appraiser Richard M. Wise, FCA, FCBV, FASA,
MCBA, of the firm Wise, Blackman LLP, which merged with MNP LLP on June 1,
2011 (Examination of Mr. Duhamel, Transcript, February 6, 2012,
Question 88; Valuation of the business of Prospector International Network
Inc. as at Sept. 30, 2006, by Wise, Blackman LLP, Exhibit A‑21.1,
Volume 16, page 6939).
[48]
In its report (the 2006
valuation), Wise Blackman concluded as follows:
[TRANSLATION]
In
our opinion, according to the information and documents that we have reviewed
and the explanations that were given to us, and subject to the assumptions and
restrictions herein, the fair market value of the business on or about the
valuation date was from $147,000,000 to $164,000,000 (rounded).
[49]
The franchisees were
notified of the conclusions of the 2006 valuation (Mail it Safe 2006
Overview and Forecast for 2007, Exhibit A-22.1.27, Volume 17,
page 7298, at page 7301; PIN – Update – July 2009,
Exhibit A‑22.1.36, Volume 17, page 7419, at
page 7421).
[50]
Despite all efforts,
sales of Mail it Safe were weak. Mr. Jones and Mr. Duhamel
attributed the failure of Mail it Safe to the managers of potential
client's information technology departments, who failed to understand the added
value of the tracking function and tended to take a lot of time to ensure that
Mail it Safe was compliant with their own networks, such that sales
became a very long process. Mr. Ouellet, whom I recognized as an expert,
explained that the market had a poor awareness of the problem of the lack of
security in electronic communications and was therefore less inclined to invest
substantial amounts of money in security (Examination of Mr. Ouellet,
Transcript, March 1, 2012, Question 47). Furthermore, according to
Mr. Jones and Mr. Duhamel, given the disputes with the tax
authorities, Network had to devote more resources to legal fees and liaison
activities with franchisees. Finally, according to Mr. Jones, and
especially according to Mr. Duhamel, the tax dispute negated the benefits
of the partnerships that Network had entered into.
[51]
Mr. Duhamel and
Mr. Jones testified that Network took a number of steps to deal with these
disappointing sales, including creating a [translation]
"strategic sales committee", conducting surveys and seeking
new partnerships. It also changed its human resources policy and required its
salespeople to prepare reports when they lost potential sales. The price of
Mail it Safe was changed, and new brochures and presentations were
developed. In reaction to comments from certain clients, Network added a [translation] "secure Reply"
function to Mail it Safe.
[52]
Mr. Duhamel stated
that in 2007, since results were still minimal, Network changed its business
plan. He testified that Network decided to close its offices in the United
States and focus its efforts on Quebec, a territory that had not been assigned
to franchisees, in order to create a virtual storefront that could then be used
to gain sales in the United States. Network was able to recruit two key
employees: Mohammed Yacoub (Mr. Yacoub), the former president of a company
with 1,200 employees and a turnover of $120 million; and Michel
Lamontagne, a member of the ethics board of the Autorité des marchés financiers
(AMF) and chairman of the board of the Régie de l'assurance maladie du Québec.
Mr. Yacoub commissioned market studies targeting larger businesses.
Intensive negotiations were held with IBM's Montréal office with a view to
turning a technical partnership into a reseller partnership and to encouraging
the use and adoption of Mail it Safe. IBM took steps in this
direction with Royal Bank, Bombardier and Desjardins. Network also entered into
an agreement with the Ordre des conseillers en ressources humaines et en
relations industrielles du Québec and continued to create new software.
[53]
According to
Mr. Duhamel, in 2007, Network nevertheless continued its sales efforts in
the United States, but from its Montréal office.
[54]
Network made several
sales in Quebec in 2007.
[55]
Mr. Duhamel
explained that in August 2007, Mr. Yacoub offered to take over the
development and marketing business. According to Mr. Duhamel,
Mr. Yacoub, however, wanted to operate that business through a separate
company because he wanted to steer clear of trouble with the tax authorities.
MIS International (MIS) was created for this purpose in December 2007.
Mr. Yacoub and Mr. Lamontagne became chief executive officer and
chairman of the board of MIS, respectively. PIN, which held 70% of the company's
shares, tasked him with developing products and creating a virtual storefront
for the franchisees (Examination of Mr. Duhamel, Transcript, February 29,
2012, Questions 575 and 577).
[56]
According to
Mr. Duhamel, the franchisees were informed of the planned creation of MIS
at the annual general meeting in November 2007.
[57]
To develop the
software, MIS took charge of the technology team and the software's
intellectual property. The relationship between MIS and PIN was governed by a
series of contracts, some of which were filed in evidence (Exhibits A‑132,
A‑133, A‑134 and A‑135). Under the terms of these contracts,
PIN transferred the intellectual property to MIS for a royalty equal to 12% of
the sales. The contracts also included clauses to ensure that PIN would be able
to meet its obligations to the franchisees (see clause 2.1 of the contract
entitled "Intellectual Property Licence Agreement", Exhibit A-134).
[58]
The following emerged
from the credible testimony of Mr. Vincent. In fall 2007,
Mr. Vincent was appointed vice-president of sales of MIS and was
instructed [translation] "to
design and rethink the marketing strategy for the Mail it Safe
solution". He came up with a new business strategy and restructured the
sales team. In addition to capitalizing on its existing partnerships, MIS
established new technology partnerships with Microsoft, the seller of Outlook,
and RIM, the seller of BlackBerry. Mr. Vincent also implemented a [translation] "government strategy"
aimed at having the product adopted by public and parapublic agencies that
often deal with confidential data and communications. Significant resources
were also devoted to training staff and preparing presentations. Some client
prospecting was done by telephone. Mr. Vincent's efforts bore fruit, and
Mail it Safe started to acquire some prestigious clients, including
Revenu Québec. The proceeds from these sales were not shared with the
franchisees, whose territories did not include Canada, but were used, according
to Mr. Duhamel, to develop a virtual storefront for the international
marketing of Mail it Safe in the franchisees' territories.
[59]
Although MIS focused
most of its efforts on Quebec and made most of its sales there, there were also
some meetings and presentations in the United States, Toronto and abroad, even
though no offices had been opened there. The contracts between PIN and MIS were
amended in 2009 to make it clear that MIS's marketing rights were limited to
Canada.
[60]
The following also
emerged from Mr. Duhamel's testimony. In late 2007, further discussions
were held with Revenu Québec, this time regarding the promissory notes. Revenu
Québec rejected the capital cost allowance claimed for the franchises acquired
with limited recourse promissory notes. To rectify this problem, PIN proposed
to the franchisees that the notes be converted into full recourse promissory
notes. This meant that franchisees would promise to pay the amounts due upon
maturity and would no longer be able to simply give back their franchises. The
franchisees' initial reaction to this proposal was mixed, but in the end, after
the meeting on November 27, 2007, about two thirds of the franchisees
acquired new franchises with full recourse promissory notes.
[61]
The main features of
the 2007 contract are similar to those of the 2005 and 2006 contracts, with the
exception of some significant differences regarding the price and the payment
terms: the promissory note became a full recourse promissory note, the interest
rate was reduced to 7.5%, and the term was extended to five years.
Mr. Duhamel stated that the amount of the principal was raised to $200,000
to account for the improvements made to Mail it Safe and for the new
partnerships.
[62]
Mr. Duhamel
explained that the territories were precisely defined: each franchisee would be
given 20,000 businesses selected from the database according to a unique
combination of postal codes and SICs (Standard Industrial Classification
numbers). Mr. Duhamel also explained that territories in Florida and
France, as well as Zurich, were expressly excluded from the assigned
territories because they had been sold by PIN in 2005 and 2006. Canada was not
expressly excluded, but as Mr. Duhamel stated, it was clear that Canada
was reserved for the virtual storefront. According to Mr. Duhamel,
approximately 1,100 new franchises were sold in 2007, including those
assigned to new franchisees (such as the appellant) and those assigned to
franchisees as a replacement for others.
[63]
Mr. Teasdale, a
lawyer who specializes in franchise law, explained that PIN hired him in 2008
to analyze the contracts and propose changes that would, on the one hand,
better [translation] "reflect
the business and operational reality" and, on the other hand, put the
contract [translation] "on
the cutting edge of what is being done in contracting in many industries".
The 2008 version of the contract, prepared by Mr. Teasdale, included
numerous changes and clarifications:
(1)
the preamble was changed considerably;
(2)
an express definition of [translation] "franchised business"
was added (section 1.1.3);
(3)
a manual was expressly provided for
(section 1.1.4);
(4)
a 10-year time limit was added to the renewal
terms, as 10 years was considered to be [translation]
"pretty much the industry standard";
(5)
clarifications were added to explain how the
exclusive lists work, and to provide for [translation]
"a mechanism whereby if a franchisee sold to a client on someone
else's list, compensation would have to be paid" (section 6.2);
(6)
[translation]
"additional services provided by Prospector, the franchisor" were
spelled out (section 9);
(7)
clarifications regarding the level of personal
participation required of a franchisee were added (section 10);
(8)
financing terms were largely moved into an
appendix, since the financing terms can vary and it is [translation] "easier to deal with an appendix than to
deal with a contract each time" (section 12 and appendix);
(9)
the franchisee's right to his or her own agent
was expressly confirmed, subject to the franchisor's approval
(section 13);
(10)
model clauses were added, as were an arbitration
clause and a clause stating that the applicable law would be Quebec law
(sections 16-17).
(Examination
of Mr. Teasdale, Transcript, January 26, 2012, Questions 408,
409, 413 and 414; Prospector World E & T Network International
franchise agreement (comparative version), Exhibit A‑36,
Volume 26, page 10179.)
Furthermore, the franchise price was increased to
$230,000, the interest rate on the promissory note was reduced to 4%, and the
term was extended to 10 years. As suggested by Mr. Teasdale, who felt
the expression "Prospector" was confusing, the expression [translation] "Prospector World
franchisee" was replaced with [translation]
"E&T Network International franchisee" ("E&T"
stands for "Encryption and Tracking").
[64]
According to
Mr. Duhamel, the list of possible exclusive clients for each franchisee
was reduced to 10,000 more carefully selected businesses. Self-employed workers
were removed from the list, for example. Also, Canada was expressly excluded
from the definition of the franchisees' [translation]
"territory".
[65]
As regards the mandate,
MarketX Services Inc. (MarketX) became the agent. According to
Mr. Duhamel, the law firm Fraser Milner Casgrain recommended that the
agent should be a company other than Network, so as to maintain [translation] "a certain distance
between the franchisor and the agent" (see court reporter's notes,
March 21, 2012, paras. 79 to 81). The evidence showed that MarketX
was never incorporated. It was not until March 2009 that Mr. Bernier
(who had bought Prospector) realized that MarketX had not yet been created. I
also note that under a resolution dated March 25, 2009, filed in evidence
as Exhibit A‑80, PIN assumed all of the rights and obligations of
MarketX. It also emerged from Mr. Duhamel's testimony that he learned that
MarketX did not exist around the same time that Mr. Bernier did. The
evidence on this point shows that the appellant did not find out that MarketX
did not exist until April 30, 2009 (that is, at the meeting of
franchisees). The appellant explained that at the time, he had assumed that
Network was still his agent under the 2007 agency agreement because MarketX was
supposed to replace Network. The appellant also testified that Network had been
his agent until March 26, 2010, when the franchisees' association replaced
Network.
[66]
I reiterate that in the
2008 contracts, as compared against the 2007 contracts, the franchise purchase
price was increased to $230,000, the interest rate of the promissory note was
reduced from 7.5% to 4%, and the term was extended from 5 years to
10 years. Mr. Duhamel explained that the term was extended in
response to pressure from the franchisees and their financial advisers, who
were unhappy with the sales of Mail it Safe (Examination of
Mr. Duhamel, Transcript, February 6, 2012, Questions 220, 222,
231, 244, 253, 283 and 285). Finally, the combined effect of the 2008 agency
agreement and the 2008 franchise agreement increased the royalties payable to
franchisees from 6% in 2007 to 12%.
[67]
The following also
emerged from Mr. Vincent's testimony. Although MIS succeeded in selling
Mail it Safe to credible clients, sales revenues were never as high
as hoped because the sales cycle was longer than expected and clients were not
prepared to spend considerable sums of money to make electronic communications
more secure because they could not measure the benefits in dollar terms.
Mr. Vincent stated the following about Mail it Safe and its
potential: [translation] "We have a good thing in
Mail it Safe, but it's not clear that it can be turned into a viable
business" (Examination of Mr. Vincent, Transcript, January 26,
2012, Questions 39 to 41).
CashOnTime
[68]
The decision was, therefore,
made in 2008 to develop a new business solution that was based on the tracking
technology but [translation] "would
allow us to quantify the benefits and calculate a quick return on investment"
(see Examination of Mr. Vincent, Transcript, January 25, 2012, Questions
351 and 516; MIS International Inc. – Management Meeting, August 26, 2008,
Exhibit A‑22.1.29, Volume 17, page 7314, at
page 7326). MIS, inspired by Mr. Mathieu's idea of using
Mail it Safe to send invoices to his clients and reduce collection
time, created CashOnTime (see Examination of Mr. Mathieu, Transcript,
February 28, 2012, Questions 578 to 581; Examination of
Mr. Duhamel, Transcript, February 6, 2012, Questions 177 and 184).
According to Mr. Vincent, this program used the tracking technology to
automate invoicing and track accounts receivable effectively. A team of
specialists was hired in mid-2008 to create the program as quickly as possible.
Like Mail it Safe, CashOnTime is offered under one of two
arrangements: a perpetual licence or a limited-time right (software as a
service).
[69]
Mr. Ouellet
testified that CashOnTime is definitely much easier to sell than
Mail it Safe because it meets an easily measured need, although
because of the nature of software as a service, this takes time:
[translation]
JUDGE: . . .
[44] Q. In
that sense, CashOnTime is easier to sell.
A. In
that sense, CashOnTime, in fact, the large part . . . there are
two, to answer the question directly, two components of CashOnTime that make it
perhaps more difficult. There is a component that really stands out, in my
mind, and as I was starting to tell you yesterday, the reason why I personally,
if I were to invest in this business, would be very interested in CashOnTime,
it's because it meets a need that is, I think, not difficult to promote, to
stimulate. It's based on something that is . . .
[45] Q. That
is easily measured.
A. That
is measurable, that can be defined, you see, in terms of the return on
investment from the standpoint of the buyer, the client, that is.
But
the trade-off, again, is that it's "Software as a Service". If I had
a business with accounts receivable, I'm not sure that I would want to send
that information out onto the Web to be held by someone I know but I don't
know, being vulnerable to that business being hacked by malicious individuals
who then have access to my data, which are pretty secret and important for my
business. So "Software as a Service" makes that more complicated.
The
other dimension that's probably just as important is that, again, if you are an
SME that has always had some kind of paper record with your accounts in it,
moving from that to a computerized notice system, from "Don't forget
collect X from Y," well, that's something that isn't compatible with their
current way of doing things. It's less critical than in the case of the SAX
than for the SaaS dimension of that product. But that can explain why it takes
a lot more time anyway.
In
the case of Mail it Safe, in the case of Prospector, well, in fact,
what slows things down, the main factor slowing things down, once again, is
this incompatibility with. . . with the current way of doing things.
And the main factor speeding things up, usually, is the perceived relative
advantage.
In
the case of CashOnTime, you can see the advantage. In the case of
Mail it Safe, you can see it, but it's less obvious because it's not
just a more roundabout way than exiting and going. . . There's more
hands-on work involved in sending an e-mail by Mail it Safe, but the
relative advantage is hard to see because there hasn't really been a scandal. I
think that was already raised, when I was here at the beginning.
[46] Q. Disaster.
A. There
wasn't any. . . That's it. There's nothing that makes. . .
It's a bit like fire insurance, if you've never experienced. . .
Everyone has fire insurance, but every time I pay for it, I ask myself why I
have it. Because nobody in my circle or close to them has had a fire, you know,
but as long as you haven't experienced it. But when it happens to you, however,
then it becomes essential. I didn't have any insurance for my hot tub because I
told myself, at the cottage, no one can steal a hot tub; it's always full.
Well, son of a gun! One weekend, I get there, and guess what had disappeared?
My hot tub. I bought a new one, and it's been insured ever since. But I had to
get robbed before taking out the insurance, the rider. Who steals a hot tub? So
there you go! So there's that.
And as for Prospector, well, there, the relative
benefit or advantage is less obvious. So there are even more disadvantages than
advantages from the consumer's point of view, probably. I've gone a bit off
topic.
Examination
of Mr. Ouellet, Transcript, March 1, 2012, Questions 44 to 46.
[70]
In the end, four [translation] "sectors" were
targeted for marketing CashOnTime: the manufacturing sector, the distribution
sector, the transportation sector and the professional services sector. The
sales efforts for CashOnTime began in 2008, when the program was still "vapourware"
(Examination of Mr. Vincent, Transcript, January 25, 2012,
Questions 526 and 537 to 539; Exhibit A‑22.1.30,
Volume 17, page 7347; and Exhibit A‑22.1.31,
Volume 17, page 7358). The first sale was made on October 31,
2008, to Client B (Exhibit A‑31, Volume 25 (confidential),
page 9993). Again, a vast array of presentations, brochures and Web sites,
in English and French, was prepared. Mr. Vincent made adjustments to the
sales team, took charge of training the salespeople and used the services of
external consultants that specialize in presenting software. He prepared a [translation] "sales manual"
and kept it up to date. According to Mr. Vincent, the sales cycle lasted
from 6 to 12 weeks, sometimes longer.
[71]
Twelve sales of
CashOnTime were made from 2008 to 2011. In addition, from 2009 to 2011, there
were four new sales of Mail it Safe.
[72]
In December 2008,
Mr. Yacoub, on behalf of MIS, sent the franchisees an update announcing
the creation of Mail it Safe (MIS update by Mr. Yacoub,
December 10, 2008, Appellant's Undertaking, Appendix 60.B,
Exhibit A‑109, page 11508, at page 11509).
[73]
On February 16,
2009, Mr. Yacoub and Mr. Vincent sent the franchisees notice of a
general meeting to be held on April 30, 2009. At the annual general
meeting, the CashOnTime software was unveiled, and the franchisees were given
financial statements detailing the various expenses incurred over the years.
There was also some discussion of the marketing efforts for
Mail it Safe and of the decision to focus on CashOnTime. Finally, the
franchisees were told that MarketX had not been incorporated and that Network
would continue to act as agent (Examination of Mr. Vincent, Transcript,
January 25, 2012, Questions 262 to 267 and 643; Examination of
Mr. Duhamel, Transcript, February 6, 2012, Question 318;
Examination of the Appellant on January 30, 2012, Questions 264, 265, 371
and 372; Examination of Mr. Duhamel, Transcript, February 6, 2012,
Questions 15, 357, 362 and 363).
[74]
The franchisees
received the minutes of the meeting in July 2009. The minutes state: [translation] "The current objective
is to create a virtual storefront for the CashOnTime service by the end of 2009
by having MIS enter into contracts with major Canadian businesses"
(Examination of Mr. Duhamel, Transcript, February 7, 2012,
Questions 289 to 296; PIN – Update, July 2009, Exhibit A‑22.1.36,
Volume 17, page 7419).
[75]
According to
Mr. Duhamel, Mr. Murray's interest and participation in Prospector
and MIS waned after 2007 because of his wife's illness. Mr. Duhamel
discussed this situation with Richard Lange, a long-time family friend, who in
2007 introduced him to Marc Bernier (Mr. Bernier), a senior manager.
Mr. Duhamel told Mr. Bernier all about Mr. Murray's lack of
interest and the difficulties they were having in marketing the software.
Mr. Bernier told him that he wanted to buy PIN. In March 2009,
following discussions between Mr. Duhamel and Mr. Bernier, and
several months after having external experts conduct an audit first,
Mr. Bernier bought PIN. Mr. Duhamel stepped down as Network's
president and became a consultant.
[76]
According to
Mr. Duhamel, Mr. Bernier chose not to go ahead with the incorporation
of MarketX, and on March 15, 2009, PIN adopted a resolution whereby it
assumed all the obligations entered into by MarketX (see Examination of
Mr. Duhamel, Transcript, March 21, 2012, Question 85;
resolutions of Prospector International Networks Inc. of March 15, 2009,
regarding MarketX Services Inc., Exhibit A‑80, Volume 29,
page 11139).
[77]
According to Kevin
Klein (Mr. Klein), a South African lawyer living in Cyprus,
Mr. Bernier asked him in June 2009 to review PIN's contracts.
Mr. Klein testified that he had a lot of experience in franchising, having
been a member of the board of directors of the Franchise Association of South
Africa, which belongs to the International Franchise Association (Examination
of Mr. Klein, Transcript, April 3, 2012, pages 57, 58 and 139).
[78]
Mr. Klein
explained that he was also asked to improve the contracts governing the
relationship between MIS and PIN, a task which was completed on
December 14, 2009, with the signing of the following clarification
agreements:
(1)
Clarification to the
Option to Acquire Certain Intellectual Property Rights (Exhibit A‑136,
Volume 33)
(2)
Clarification to the
Assignment of Intellectual Property (Exhibit A‑137, Volume 33)
(3)
Clarification to the Intellectual
Property Licence Agreement (Exhibit A‑138, Volume 33).
[79]
Mr. Klein also
testified that he found [translation] "confusion
over roles" and that he thought it necessary to clarify that MIS's role
had always been to develop and market the software in Canada alone, whereas PIN's
role was to market the software abroad through its network of franchisees
(Examination of Mr. Klein, Transcript, April 3, 2012, pages 65
to 68).
[80]
Accordingly,
Mr. Klein proposed changes to clear up some issues, particularly the
following:
(1)
The marketing rights that MIS granted to PIN in
countries other than Canada were exclusive, in that MIS could not sell
abroad. These changes were designed to [translation]
"counteract a possible irregularity apparently stemming from the
interpretation, be it accurate or not, or from the previous agreement, that MIS
had a joint right, which could compete with the franchisees and their rights"
(page 73).
Examination
of Mr. Klein, Transcript,
April 3, 2012, pages 73, 75, 76, 80 to 82 and 87.
(2)
The marketing rights that MIS granted to PIN in
countries other than Canada were transferable, [translation] "which they had to be so that the network
of franchisees could take advantage of them" (page 73). These changes
reflected the fact that [translation]
"in the case of a business operated by franchise, franchisees come and go".
Examination
of Mr. Klein, Transcript,
April 3, 2012, pages 73, 75, 77, 82, 83 and 87.
(3)
The marketing rights that MIS granted to PIN covered
[translation] "everything
that had been developed by MIS", so [translation]
"that it would be clear that the franchisees expected everything that had
been developed by MIS . . . . In the world of IT, software isn't
set in stone. It evolves. You'll have to take advantage of changes and version
upgrades, and the intention was that everything that was produced would benefit
the franchisees".
Examination
of Mr. Klein, Transcript,
April 3, 2012, pages 70 and 71.
(4)
The contracts between PIN and MIS did not
derogate from the franchisees' rights, since the changes expressly
recognized that PIN and MIS [translation]
"did not at any time intend to withdraw or restrict the rights of
Prospector franchisees or licence holders". As Mr. Klein explained, [translation]
"the reason for this was that we wanted to emphasize the fact that we
wanted to maintain the franchisor-franchisee relationship, that we wanted the
franchisees to be able to turn a profit on their investment".
Examination
of Mr. Klein, Transcript,
April 3, 2012, pages 74 and 78 to 80.
Clarification
to the Assignment of Intellectual Property entered into by Prospector
International Networks Inc., Prospector Network Inc. and Mail it Safe International Inc., December 14, 2009,
Exhibit A‑137, Volume 33, page 12015
The CRA search
[81]
In October 2009, the
CRA carried out a vast search at the offices of Network, MIS and
Mr. Duhamel, among others.
[82]
According to
Mr. Klein and Mr. Duhamel, the search threw the files and records of
Network and MIS into disarray; two servers were corrupted while under the CRA's
control, which caused a significant number of files to be lost. The CRA also
seized some cheques, and Mr. Klein had to travel to Montréal to get them
back (Examination of Mr. Duhamel, Transcript, February 27, 2012,
Questions 176 and 182; Examination of Mr. Klein, Transcript,
April 3, 2012, pages 89 and 90).
[83]
The search was very
upsetting for the employees and senior management. On December 11, 2009,
Mr. Yacoub resigned, and Mr. Klein was appointed director in his
place. On December 14, 2009, Mr. Vincent became the interim head of
operations at MIS (Examination of Mr. Vincent, Transcript,
January 25, 2012, Question 233. See also the Examination of
Mr. Vincent, Transcript, January 26, 2012, Question 100; Examination
of Mr. Klein, Transcript, April 3, 2012, pages 63, 64 and 100;
Examination of Mr. Vincent, Transcript, January 26, 2012,
Question 97).
The Association period (2009–2010)
The 2010 reorganization
[84]
After the search,
Mr. Bernier decided to reorganize the business to give it [translation] "a fresh start"
with a view to [translation] "maximizing
business potential" on a global scale. The firms Gowlings and Raymond
Chabot Grant Thornton recommended a new structure, which was implemented in
March 2010 (Examination of Mr. Vincent, Transcript, January 25,
2012, Questions 233 and 241 to 246; Examination of Mr. Vincent,
Transcript, January 26, 2012, Question 100).
[85]
Under the new
structure, the intellectual property rights were held by Luxemburg-based
companies, namely CashOnTime S.A.R.L. and Mail it Safe (Examination
of Mr. Vincent, Transcript, January 25, 2012, Questions 248, 249
and 253; Examination of Mr. Vincent, Transcript, January 26, 2012,
Questions 11 and 25).
[86]
Marketing was done by
subsidiaries or associates in the countries where the business activities took
place: CashOnTime Inc. (Delaware), CashOnTime Ltd. (England), CashOnTime Inc.
(Quebec) and Courriel Sécuritaire Inc. (Examination of Mr. Vincent,
Transcript, January 25, 2012, Questions 249 and 254; Examination of
Mr. Vincent, Transcript, January 26, 2012, Questions 11, 12, 19,
25 and 26).
[87]
Separate structures
were created for Mail it Safe and CashOnTime, on the one hand,
because each type of software was aimed at a distinct market, and on the other,
because this made it easier to sell one or the other separately to a potential
buyer (Examination of Mr. Vincent, Transcript, January 25, 2012,
Questions 250 to 252).
[88]
Espeo Inc. carried on
with the development of the software. Espeo is a distinct company belonging to
Mr. Vincent (Examination of Mr. Vincent, Transcript, January 26,
2012, Questions 12, 13 and 26).
[89]
After the
reorganization, the organization chart for the Prospector group of companies
looked like this:
Organization
chart downloaded from the intranet site of Prospector International Networks
Inc., Exhibit A‑42, Volume 26, page 10306.
Organization
chart prepared by Mr. Vincent, Exhibit A‑35, Volume 26,
page 10177.
The intranet
[90]
The Association des
franchisés Network Prospector (the Association) was founded on March 26,
2010, to [translation] "find
sellers and buyers and to market the latest solutions . . . that
have been developed". The Association was established at Mr. Bernier's
request, and PIN saw to its financing through another company, Gestion Viso
Inc. The Association was a non-share capital corporation incorporated under
Part II of the Companies Act, RSQ, c. C‑38. Its founders
consisted of Mr. Duhamel and a number of financial planners. PIN played no
part in the Association's management (Examination of Mr. Duhamel,
Transcript, February 6, 2012, Question 406; Examination of
Mr. Duhamel, Transcript, February 27, 2012, Questions 87, 88,
91, 95 and 96; Examination of Mr. Duhamel, Transcript, March 21,
2012, Question 125).
[91]
Starting in
April 2010, the franchisees were notified of the Association's creation
and the fact that it would be replacing Network, and membership applications
began arriving in May 2010 (Examination of Mr. Duhamel, Transcript,
February 7, 2012, Questions 85 and 86; Examination of
Mr. Duhamel, Transcript, April 3, 2012, pages 164 and 166;
letter from Mr. Bobby Doyon dated May 18, 2010, regarding membership
in the Association, Exhibit A‑111, Volume 31, page 11563).
[92]
Since the Association
was a non-profit corporation, it could not carry on business activities.
Consequently, it tried to enter into agreements with resellers who could take
care of the marketing for the franchisees. It thus entered into a contract with
Onix to do marketing in the United States, beginning in New York City
(Examination of Mr. Jones, Transcript, January 24, 2012, Questions
415 et seq.; Examination of Mr. Jones, Transcript, January 25,
2012, Question 107 (back in 2010); Examination of the Appellant,
Transcript, January 30, 2012, Questions 488 to 491; Examination of
Mr. Duhamel, Transcript, February 7, 2012, Questions 47, 48, 57, 69,
70, 71, 73, 83, 87, 88 and 90; Examination of Mr. Duhamel, Transcript,
February 27, 2012, Questions 93 and 107; Examination of
Mr. Duhamel, Transcript, April 3, 2012, pages 167 and 173;
Authorized Reseller (VAR) Agreement between Association Franchise Prospector
and Onix Service Inc., May 15, 2011 (Appellant's Undertakings,
Appendix 58), Exhibit A‑44, Volume 27, page 10652; [translation] "List of potential
clients currently being prospected by Onix Services Inc." (Appellant's
Undertakings, Appendix 66), Exhibit A‑45, Volume 27,
pages 10653 to 10658).
[93]
Onix was founded by
Jeff Dana, one of Network's salespeople in Miami at the time Solutions
Prospector was being marketed. He made a presentation to the Association in
March 2011 to explain a marketing strategy for Mail it Safe and
CashOnTime ("Onix Go to Market Strategy", March 28, 2011,
Exhibit A‑141, Volume 33, page 12026; Examination of
Mr. Duhamel, Transcript, April 3, 2012, page 161).
[94]
The franchisees were
notified of the agreement with Onix by mass e-mail on April 15, 2011, and
the final contract was signed on May 5, 2011 (Examination of
Mr. Duhamel, Transcript, April 3, 2012, pages 158 and 159;
contract between Association Franchise Prospector and Onix Services Inc.,
May 15, 2011 (Appellant's Undertakings, Appendix 58), Exhibit A‑44,
Volume 27, page 10652; e‑mail from the Association des
Franchisés Network Prospector to the appellant regarding [translation] "News from the agent",
April 15, 2011, Exhibit A‑139, Volume 33,
page 12020).
[95]
The Association
instructed Mr. Jones to assist Jeff Dana in his consulting work. More
specifically, he helped the Association to prepare [translation] "a business plan on the distribution and
sale of these products, particularly in New York. He also took part in efforts
already under way to recruit salespeople (Examination of Mr. Jones,
Transcript, January 23, 2012, Questions 414 to 427).
The 2010 general meeting
[96]
The 2010 annual general
meeting was held on June 15, 2010, at the Sofitel Hotel in Montréal
(Examination of Dr. Ngô, Transcript, March 14, 2012,
Question 548).
[97]
The incorporation of
the Association was announced at that meeting, and the franchisees were invited
to join it online by visiting the "Franchise Information Centre" Web
site. The franchisees were also given an update on the tax dispute, after which
there was discussion of the marketing efforts and of the market study that had
been prepared by "D". There was also a presentation on the latest
version of CashOnTime, which, in the opinion of the appellant, who attended the
meeting, [translation] "had
been improved . . . to target large companies" (Examination of
Mr. Vincent, Transcript, January 25, 2012, Questions 629, 646
and 648; Examination of the Appellant, Transcript, January 30, 2012,
Questions 388, 392 to 395, 726 and 727; Examination of Dr. Ngô,
Transcript, March 14, 2012, Question 550; Examination of
Mr. Duhamel, Transcript, April 3, 2012, page 162).
[98]
The franchisees'
committee, the formation of which had also been announced at the 2010 general
meeting, consisted of seven franchisees and was responsible for following up on
all general information regarding the marketing efforts and the disputes with
the tax authorities (Examination of the Appellant, Transcript, January 30,
2012, Questions 396 to 410 and 420).
The new contracts
[99]
In 2010,
Mr. Teasdale was asked to revise the franchise agreements again.
Mr. Teasdale explained that he was instructed to [translation] "once again change the contract to reflect
the reality of what was going on between the franchisor and the franchisees"
(Examination of Mr. Teasdale, Transcript, January 26, 2012,
Questions 427 and 449).
[100]
The 2010 revisions were
much broader in scope than the 2008 revisions, and the final contract was much
more detailed than the previous ones. For example, appendices were added
regarding franchisee territories, the list of trade marks, the software
concerned and prices (Examination of Mr. Teasdale, Transcript,
January 26, 2012, Questions 434 and 444; Contract entitled PIN
Franchise 2010 Version Franchise Agreement (comparative version),
Exhibit A‑37, Volume 26, page 10222).
[101]
The new contract also
added clauses regarding user licence contracts and the "Franchise Information Centre (FIC)", an intranet site hosting the operations manual and other
communications between the franchisor and franchisees. In addition, the new
contract contained [translation] "rather
substantial additions regarding additional obligations or services that would
be provided by the franchisor, particularly in terms of promotion and
advertising and the assistance that the franchisor would give the franchisees"
(Examination of Mr. Teasdale, Transcript, January 26, 2012,
Question 444).
[102]
The
1,500 territories in the United States were redefined (Examination of
Mr. Duhamel, Transcript, February 6, 2012, Questions 606 and
607; Examination of Mr. Duhamel, Transcript, February 7, 2012,
Question 11).
[103]
The new contracts were
announced at the 2010 annual general meeting, and the franchisees were invited
to approve them online through the FIC Web site. The vast majority of
franchisees agreed to the proposed new contracts (Examination of the Appellant,
Transcript, January 30, 2012, Questions 485 and 486; Examination of
Mr. Duhamel, Transcript, February 7, 2012, Questions 3, 4 and
105).
Changes to the promissory
notes
[104]
According to
Mr. Duhamel, because of the disappointing sales and the increasingly
bitter dispute between the tax authorities and the franchisees, and after
discussions with Mr. Duhamel and the financial planners, PIN agreed to
make significant changes to the terms of the promissory notes, including the
following:
(1)
the interest rate was
reduced to 1.75%, retroactively to 2007;
(2)
the annual payments
were set at $3,500, retroactively to 2007;
(3)
any amount paid in a
given year (that is, a period of 12 consecutive months from the date the
promissory note was signed) that exceeded the interest and the amount of the
principal (in this case, $1,500) due would constitute an advance payment of
interest and capital that the franchisees could apply against interest and
capital in a subsequent year.
As a result of these changes, each franchisee had to
pay $3,500 in 2010 and 2011, including $1,500 in capital and $2,000 in
interest. After 2011, they would owe nothing before the maturity date, when a
final lump-sum payment became due (Examination of Mr. Duhamel, Transcript,
February 7, 2012, Questions 12, 29 to 33; see also the Examination of
the Appellant, Transcript, January 30, 2012, Question 516;
Examination of the Appellant, Transcript, January 31, 2012,
Questions 107, 109 and 110; Examination of Mr. Duhamel, Transcript,
February 27, 2012, Questions 124, 133 and 139 et seq.).
The appellant's testimony
A. The appellant's background
[105]
The appellant is an
engineer and a member in good standing of the Ordre des ingénieurs du Québec.
After completing a university degree in electrical engineering with a
specialization in automation in 1991, he founded his own consulting business.
He went on to develop software for a company called Softec. Later, he worked
for Noranda, where he worked primarily in mining automation. In 2000, he
accepted a position at Nortel, where he worked to ensure that all equipment was
ISO 9001 compliant. In 2001, Nortel laid him off. After his layoff, he
worked for CAE checking software provided by the United States Navy. In
2002–2003, he founded a business that marketed an anti-moss agent to farmers.
He wound up that business in 2005.
B. The purchase of the franchise
[106] The following also emerges from the
appellant's testimony.
(a)
He first heard of
Prospector from Claude Legault (Mr. Legault), his financial planner since
the mid-1990s. Mr. Legault looked after his investments, such as his RRSP
and his life insurance policy. The appellant trusted him and still does
business with him.
(b)
He met with
Mr. Legault each year. At their 2005 meeting, Mr. Legault introduced
him to the Mail it Safe software and proposed buying a franchise. The
appellant declined the offer, feeling that he did not have the necessary funds,
and made RRSP contributions instead.
(c)
At their 2006 meeting,
Mr. Legault again proposed buying a Prospector franchise. Once again, the
appellant opted instead to contribute to his RRSPs.
(d)
In 2007, at their
annual meeting, Mr. Legault proposed for a third time that the appellant
buy a Prospector franchise. This time, Mr. Legault explained that the
Mail it Safe software had gained important clients, including Revenu
Québec, the Barreau du Québec and its New York counterpart. In addition,
Mr. Legault explained that 2007 would likely be the last year that such
franchises would be offered.
(e)
Mr. Legault gave
him two brochures at this meeting:
(1)
[translation] "Franchise Prospector
WorldTM: 2007 Edition" (Exhibit A‑3.1,
Volume 1, page 59);
(2)
[translation] "Mail it Safe:
2006 Launch and 2007 Vision" (Exhibit A‑3.2, Volume 1,
page 101).
The brochure [translation] "Franchise Prospector WorldTM:
2007 Edition" was 41 pages long, approximately 6 pages of which
(mostly in an appendix) discussed the tax implications. The rest of the
brochure dealt with the history of PIN and Network; the partnership with IBM;
the software being marketed (Solutions Prospector and Mail it Safe);
the nature of the franchise (that is, the exclusive marketing rights in a given
territory, the terms of payment and the payment of royalties); the marketing
strategy; the 2006 valuation by Wise, Blackman; a copy of the contracts; and a
summary of the contracts. The brochure [translation]
"Mail it Safe: 2006 Launch and 2007 Vision"
discussed the adaptation of Mail it Safe to various platforms (Lotus
Notes, BlackBerry and Mail it Safe Freedom); Network's participation
in trade fairs targeting the legal market; the partnerships with organizations such
as the Corporation de services du Barreau du Québec, the Greater Montréal Real
Estate Board, IBM and the New York County Lawyers' Association; the valuation
by Wise, Blackman; the vision for 2007; the research and development
activities; and the franchisee recommendation program. There was no mention of
the tax implications of the franchises.
(f)
The appellant did not
give an immediate answer to Mr. Legault's suggestion. He went home and,
after thinking it over, contacted Mr. Legault to ask him for additional
information. Mr. Legault sent him the documentation, including the
contracts. The appellant explained that he read everything in full before
making a decision.
(g)
The appellant accepted
Mr. Legault's proposal and opted to buy one single Prospector franchise in
2007 instead of contributing to his RRSPs: [translation]
"I put all my eggs in one basket" (Examination of the
Appellant, Transcript, January 30, 2012, Questions 82 and 108.) He
explained his reasons for buying the franchise in the following words:
[translation]
[109] Q.
And why did you opt to invest in Prospector?
A.
Well, it was a long-term investment with the expectation of getting a lot of
sales and getting dividends.
[110] Q.
You said to be able to get dividends.
A.
Yes.
. . .
[112] Q.
What were the benefits you hoped to get from this investment?
A.
Well, the benefits. . . Well, there was a tax component, an
investment, like all the investments I had made since the beginning. There was
that component. The second part, well, it was mostly to give me income in the
long term; it was really a long-term investment for. . . I had an
expectation that the. . . knowing the information technology field
and the possibilities of Mail it Safe, I really saw a potential for
sales.
JUDGE:
[113] Q.
So, to sum up, your investment was both a long-term investment that you
hoped. . . or you still hope, I don't know, will pay you dividends,
and evidently, there was a tax benefit attached to this product.
A.
Exactly.
MICHAEL
H. LUBETSKY:
[114] Q.
At the time, what was your assessment of Mail it Safe?
A.
Well, it was an innovative product that was really in terms. . .
computer security that was really a necessity. I still believe it's a truly
necessary product because now, as Mr. John demonstrated, when you send an e-mail,
well, it travels all over the place in the world before it gets to the
recipient. To date, I think. . . we haven't heard of a major scandal
in that respect, but it's just a matter of time because now that there are
doctors and lawyers sending information to their clients, if the information
ends up, so to speak, in the wrong hands, well, the information could be
disclosed, and there could be consequences.
(Examination
of the Appellant, Transcript, January 30, 2012, Questions 109, 110 and 112
to 114)
. . .
GUY
DU PONT:
[420] Q.
So, my colleague asked you whether this—I don't remember the exact words, but
more or less—that this investment, this franchise purchase was much more than
any other investment you had made before? Is that correct?
A.
Yes.
[421] Q.
And could you explain to the Court why you agreed to such an investment that
was bigger than all the investments you had made up till now?
A.
The main reason, it's really because I had. . . according to the
presentation I was given on Mail-it-Safe, I really saw significant
income-earning potential in terms of the long-term performance. It's really a
long-term investment.
(Examination
of the Appellant, Transcript, January 31, 2012, Questions 420 and
421)
(h)
The purchase of the
franchise was a long-term investment. The appellant added that he did not
expect to make a profit in the short term. His testimony on this point is worth
quoting:
[translation]
[380] Q.
Is that why you weren't worried about the slow pace of the marketing?
MICHEL
LAMARRE: Leading the witness, Your Honour.
GUY
DU PONT: Maybe. This time at least I'll withdraw. He's right.
[381] Q.
Is that a factor you considered?
A.
When I bought the franchise, yes.
[382] Q.
And in your assessment of the product's performance, is that a factor you
considered? There's no objection.
A.
O.K., yes, in effect, it's a. . . I knew that it was a company, that
it was a start‑up, and that the return on investment could be long term.
(Examination
of the Appellant, Transcript, January 31, 2012, Questions 380 to 382)
(i)
Mr. Legault had
explained to him that he could [translation]
"delegate the marketing to an agent with a team of salespeople
already set up in the United States and in Montréal" (Examination of the
Appellant, Transcript, January 30, 2012, Question 63; Examination of
the Appellant, Transcript, January 31, 2012, Questions 220 and 228).
(j)
On December 21,
2007, he signed the following four documents and then gave them to
Mr. Legault:
(1)
a franchise agreement
(the 2007 franchise agreement), whereby he acquired the right to market
Solutions Prospector, Mail it Safe and their derivative products in a
designated territory ([translation] "Contract
of Sale of a Prospector World Franchise", Exhibit A‑1.1.1,
Volume 1, page 1);
(2)
an agency and
management agreement (the 2007 agency agreement), whereby he gave Network a
mandate to operate his franchise for 94% of the gross revenue (section 3.1
of the [translation] "Agency
and Management Agreement", Exhibit A‑1.1.3, Volume 1,
page 16);
(3)
a promissory note (the
2007 promissory note), whereby he undertook to pay PIN $200,000 by no later
than December 15, 2012, with lump-sum interest at a rate of 7.5% per annum
paid annually in advance (promissory note, Exhibit A‑1.1.2,
Volume 1, page 15);
(4)
a cheque for $15,000 to
the order of PIN for the first interest payment (cheque dated December 21,
2007, Exhibit A‑2.1, Volume 1, page 54).
(k)
The 2007 franchise
agreement and the 2007 agency agreement were countersigned by Mr. Duhamel
on behalf of Network on December 28, 2007 (Examination of the Appellant,
Transcript, January 30, 2012, Questions 157 et seq.).
(l)
When the 2007
promissory note was signed, the appellant understood that he had to pay the
amount due upon maturity. He added that nobody told him otherwise. His
testimony on this point is worth quoting:
[translation]
[163] Q.
When you signed the contract, how much money did you expect to pay Prospector
International before the note's maturity date? How much money did you expect to
pay before 2012?
A.
The amount of the promissory note, which was $200,000. But yes, I intended to
pay, but I hoped to have sales to justify. . . to finance that
investment.
[164] Q.
And what suggestions or representations did Mr. Legault or anybody else
make to you to indicate that this. . . to indicate that you did not
have to pay this amount?
A.
No representations were made to me in that regard. I had really . . . I had a debt at that time, when I signed this
contract for $200,000.
(Examination
of the Appellant, Transcript, January 30, 2012, Questions 163 and
164; Examination of the Appellant, Transcript, January 31, 2012, Question 422)
(m)
He financed the initial
payment of $15,000 with a short-term loan that he later repaid with the tax
refund he received a few months later (Examination of the Appellant,
Transcript, January 30, 2012, Questions 170 to 176; Undertaking Number 3,
contract of loan dated January 29, 2008, Exhibit I‑24).
(n)
In November or
December 2008, Mr. Legault sent him the new contracts. He then called
Mr. Legault for an explanation of the changes, and Mr. Legault told
him, among other things, that the term of the note had been extended to
10 years to better reflect the life span of the product, and that this
meant the balance due had been increased to $230,000. Mr. Legault also
explained to him that [translation] "updating
contracts on a regular basis was a normal practice with franchises"
(Examination of the Appellant, Transcript, January 30, 2012,
Questions 235 to 237 and 744; Examination of the Appellant, Transcript,
January 31, 2012, Questions 233 to 251; Examination of the Appellant,
Transcript, March 21, 2012, Questions 6 to 10; Undertaking 60 E,
letter from Mr. Legault dated November 25, 2008, Exhibit I‑30).
(o)
The appellant was
satisfied with Mr. Legault's explanations, and on December 19, 2008,
he agreed to the changes and signed a new franchise agreement (the 2008
franchise agreement), the new agency and management agreement (the 2008 agency
agreement) and a new promissory note (the 2008 promissory note) (Examination of
the Appellant, Transcript, January 30, 2012, Questions 239, 241, 244
and 253; franchise agreement (including promissory note), Exhibit A‑1.2.1,
Volume 1, page 24; agency and management agreement, Exhibit A‑1.2.2,
Volume 1, page 47; 2008 promissory note, Volume 1,
page 108).
(p)
As was the case with
the 2007 promissory note, the appellant understood, when he signed the 2008
promissory note, that he had to pay the amount due upon maturity. The appellant
adds that no one told him otherwise (Examination of the Appellant, Transcript,
January 31, 2012, Questions 422 and 423).
(q)
On December 31,
2009, he wrote PIN a cheque for $15,000 (Examination of the Appellant,
Transcript, January 30, 2012, Question 508; Examination of the
Appellant, Transcript, March 21, 2012, Question 27; cheque dated
December 31, 2009, Exhibit A‑2.3, Volume 1, page 58).
(r)
He attended the 2009
annual general meeting and the 2010 annual general meeting (Examination of the
Appellant, Transcript, January 30, 2012, Questions 338, 339, 343,
345, 388 and 389).
(s)
After the 2010 annual
general meeting, he became a member of the franchisees' committee so that he
could keep closer tabs on his investment:
[translation]
[423] Q. Why
did you submit your name for membership in this committee?
A.
Well, I wanted to keep tabs on my investment. For me, this was a lot of money,
and I wanted to know exactly where it was going.
(Examination of the Appellant, Transcript, January 30, 2012,
Question 423)
(t)
He also joined the
Association (Examination of the Appellant, Transcript, January 30, 2012,
Questions 440 and 441).
(u)
In 2010, he was
notified that a new Web portal had been set up, and he started visiting it once
or twice a month (Examination of the Appellant, Transcript, January 30,
2012, Questions 622 and 627).
(v)
On August 18,
2010, he agreed to the new 2010 franchise agreements by signing them
electronically through the intranet site (Examination of the Appellant,
Transcript, January 30, 2012, Question 485; "PIN Franchise
Agreement, 2010 Version" (Appellant's Undertakings, Appendix 28),
Exhibit A‑41, Volume 26, page 10278; Examination of the
Appellant, Transcript, March 21, 2012, Question 31).
(w)
He then noticed an
error in the territory assigned to him in the new contract (a territory in
Idaho had been given to him instead of his territory in New York), so he asked
Mr. Duhamel to correct it.
[translation]
[102] Q. Could
you explain to the Court why the list, the territory appearing on
page 10,302 mentions the state of Idaho and why the list on
page 10,660 (sic) talks about New York?
A. Yes.
When the franchisor, Mr. Bernier, redid the territories in 2010 in a way
that was, as I said, more scientific, with Deloitte, at that time, there were,
in his view, the territories all had the same weight. So, he made changes, and
some kept the same territories while others had their territories changed. He
also mentioned to everyone at the 2010 meeting that if anyone wanted a
different territory for whatever reason, all they had to do was send in the
information, and then he could do it because, as I was saying, it had been done
much more scientifically so that each of the territories had the same weight.
When I say weight, it's. . . we're still
talking about potential, and when I myself talked to Mr. Drouin, well, I must admit that I don't remember whether it was
Mr. Drouin who told, who told me that he had Idaho instead of New York or
whether I was the one who mentioned it. I'm a bit confused. It's
been. . . it was in 2010, and at that time, what was said
with. . . in the conversation I had with Mr. Drouin, in the end,
it was why he wasn't keeping the same territory he had in New York, and I
simply called the franchisor and asked if he could have his old territory back.
Even if it's the same weight, Idaho is worth the same as New York, but at that
time, the franchisor just gave the New York territory back.
[103] Q. But
did you. . . could you tell the Court whether
you have personal knowledge of these facts?
A. Absolutely,
I was the one. . . I was the one who brought them together and asked.
(Examination
of Mr. Duhamel, Transcript, February 7, 2012, Questions 102 and
103. See also the Examination of the Appellant, Transcript, January 30,
2012, Questions 495 to 504; Examination of Mr. Duhamel, Transcript,
February 7, 2012, Question 102; Examination of Mr. Duhamel,
Transcript, February 8, 2012, Question 398).
(x)
In 2010, he paid PIN
$3,500, an amount which took into account PIN's retroactive interest reduction
(Examination of the Appellant, Transcript, March 21, 2012, Questions 36
and 42 to 44; change to the agreement, Exhibit I‑43).
The appellant's original tax returns for
2007, 2008 and 2009 do not reflect the changes brought in by the 2008 franchise
agreement and the 2010 franchise agreement. For example, in the tax returns for
2008 and 2009, the appellant claimed $15,000 in interest charges even though
the 2008 contract and the 2010 contract did not allow such deductions. By the
time of trial, the appellant had still not amended his tax returns. The
appellant's explanations for this and as to what he understood to be his
financial obligations under the 2008 contract and the 2010 contract were
nebulous, to say the least, and contradictory at times. For example, the
appellant testified that the $3,500 payments in 2010 and 2011 were interest
payments (see Examination of the Appellant, Transcript, January 30, 2012,
from page 128, line 18, to page 129, line 2). This
statement is contradicted by Exhibit I‑29, which shows that the
$3,500 includes capital and interest.
(y)
Despite the disappointing
return on investment to date, he still believes in the future of his franchise
and its future commercial success (Examination of the Appellant, Transcript,
January 30, 2012, Questions 652 to 655).
(z)
He is not surprised
that his franchise has not made any sales yet, as his experience in the field
has made him well aware that marketing innovations take time:
[translation]
[376] Q. And
what are the consequences of the fact that this takes a lot of effort?
A. The
consequences are that to enter a market in these situations, given that it's a
company that you call. . . what you call a start-up, well, it takes
an enormous amount of effort, time and resources to successfully enter a new
market. You're talking, on average, you're talking between three and five years
before successfully entering a new market.
[377] Q. And
for the period until the entry is made, what impact does it have on the product's
sales?
A. In
general, there are very few sales until then. What you try to look for, it's
really major clients who are going to let us have letters of reference.
[378] Q. But
did this situation come as a surprise to you?
A. No,
it was a normal situation for the field.
[379] Q. Were
you familiar with this field?
A. I've
been working in information technology, software development, validation,
verification and project management for 20 years now.
(Examination
of the Appellant, Transcript, January 31, 2012, Questions 376 to
379.)
Similar fact evidence
A. Similar fact
witnesses
[107]
I note that, in its order
dated February 27, 2012, the Court rejected the appellant's objection and
authorized the respondent to adduce similar fact evidence. The Court heard the
testimony of five other taxpayers (the franchisee witnesses), called by the
respondent to testify on their acquisition of licences or franchises from
Prospector, namely:
(a)
Marc Ghanoum,
Nephrologist (Dr. Ghanoum);
(b)
Gino Villeneuve,
Optometrist (Dr. Villeneuve);
(c)
Christian Thibault,
Orthodontist and Dental Implant Specialist (Dr. Thibault);
(d)
Van-Khai Ngô, Dentist
(Dr. Ngô);
(e)
Dave Rioux, Dental
Specialist in Oral Surgery (Dr. Rioux).
[108]
The respondent also
subpoenaed two financial planners, Pascale Cauchi (Ms. Cauchi) and Charles
Godbout (Mr. Godbout), to testify on the activities promoting the licences
and franchises. Ms. Cauchi did not testify. With the authorization of the
Court, the parties agreed to simply file the transcript of the examination of Ms. Cauchi
by Gaétan Paul of the Autorité des marchés financiers rather than have her
testify before the Court (see Exhibit I‑47).
[109]
The respondent
subpoenaed these witnesses because she was satisfied that their evidence would
increase the likelihood that the agency agreements and the promissory notes
signed by the appellant were shams since, according to the respondent, the
franchisee witnesses had participated in identical transactions to those of the
appellant. In my opinion, a great deal of care and caution must be used when
examining this evidence, since all the franchisee witnesses became licensees or
franchisees before 2007. The testimony of Dr. Ghanoum reveals, for
example, that he acquired two licences in 2003, one licence in 2004, three
franchises in 2006 and two franchises in 2007. Dr. Rioux testified that he
acquired two licences in 2003, three franchises in 2006 and three franchises in
2007. Dr Ngô stated that he acquired one licence in 2003, one franchise in 2006
and three franchises in 2007. Dr. Villeneuve testified that he acquired one
franchise in 2005 and another in 2007. Lastly, Dr. Thibault testified that
he acquired one franchise in 2005, another in 2006, and two further franchises
in 2007. Another reason for exercising a great deal of caution when analyzing
this evidence is that the appellant did not have the same advisor as the
franchisee witnesses.
[110]
It would be unwise, in
my view, to conclude that the examinations of Ms. Cauchi and
Doctors Villeneuve, Thibault, Ngô and Rioux by the AMF support the
respondent's new position that the actual cost of the franchises, specifically
those acquired in 2007, was $45,000 (the new position). In fact, the CRA's
questions about the costs of the licences and the franchises did not
distinguish between the periods before and after 2007. The vagueness of the AMF's
questions could, in my opinion, only lead to answers from which it is difficult
to draw any conclusions whatsoever.
[111] The testimonies of the franchisee witnesses
reveal the following:
(i)
The franchisees did not
know the appellant and had not done business with Mr. Legault.
(ii)
They had heard about
Prospector from Ms. Cauchi whom they trusted and who is still their
financial advisor. They explained that Ms. Cauchi described Prospector to
them as an investment—which was structured to give tax benefits—in a computer
company marketing new, innovative software with long-term growth potential.
(iii)
They acquired their
franchise licences in order to earn an income.
(iv)
They employed an agent
to operate their franchises.
(v)
In 2007, they acquired
new franchises using full recourse promissory notes. Each of the franchisee
witnesses explained that he had understood that he had to pay the full balance
stated on the promissory note at maturity and that he could no longer simply reassign
the franchise.
(vi)
In 2008, they had
signed new agreements, which, among other things, increased the amount owing to
$230,000, in consideration for an extension of the term and a reduction in the interest
rate.
(vii)
They were not told that
they did not have to pay all of the amounts indicated on the promissory notes, be
that in 2007 or in 2008.
(viii)
Their debt was not
insignificant. However, each of them explained that they found that the risk
was offset by the tax benefits offered by the franchise and the royalties they
expected to make from the franchise. Their testimony also reveals that they had
high incomes and other safer investments.
(ix)
They themselves had used
Mail it Safe.
(x)
They had attended several
annual meetings (except for Dr. Ngô, who had attended only one because of
his many obligations).
(xi)
They had received
communications and letters regarding Prospector by e‑mail or mail and had
read them.
(xii)
They were also aware of
the partnerships that Network had entered into and the sales it had made.
(xiii)
Except for
Dr. Thibault, who went bankrupt, they continued to believe that Mail it
Safe and CashOnTime had real potential and to hope not only that these programs
would sell, but also that a major company would want to buy the technology and
the rights to market it.
(xiv)
With the exception of
their involvement in Prospector, the CRA had almost never challenged their
income tax returns.
[112]
I must also point out
that the testimonies of the franchisee witnesses regarding the following issues
were confusing and incomprehensible, to say the least:
(i)
the changes to their
franchises and licences prior to 2007 and the resulting financial obligations;
(ii)
the agreements signed
in 2008 and the resulting financial obligations;
(iii)
the retroactive agreement
of 2010 and the resulting financial obligations.
Very often, their testimonies contradicted
the agreements. In addition, the franchisee witnesses were not able to explain
why their income tax returns did not reflect their obligations under these agreements.
However, must one therefore conclude that the franchisee witnesses perjured
themselves when they testified that they had to pay in full the amounts
indicated on the 2007 and 2008 promissory notes at maturity? All that confusion
and vagueness in their testimonies and the contradictions between their
testimonies and the agreements and their income tax returns can all, in my
opinion, be explained by the following facts:
(i)
Many complex changes, negotiated
not by them but by Ms. Cauchi, were made to the franchisees' financial
obligations. The franchisee witnesses testified that they had not read the agreements
Ms. Cauchi had negotiated for them. Since they trusted Ms. Cauchi
blindly, they signed the agreements she presented them with after briefly
explaining to them the nature of the documents and the franchisees' rights and
obligations. It is my opinion that the respondent should have subpoenaed
Ms. Cauchi to testify. Her testimony would certainly have made it possible
to elucidate all of the inaccuracies and contradictions and thus to properly
assess the credibility of the franchisee witnesses.
(ii)
The structural changes
and conversions dated back several years.
(iii)
The witnesses never
examined their income tax returns, specifically the Statement of Business or Professional
Activities (T2125). The franchisee witnesses explained that, in any event, they
were not qualified to determine whether they were correct. They also explained
that the information in the Statement of Business or Professional Activities
had been sent directly by Ms. Cauchi to their accountants, who prepared
their income tax returns. Again, it would have been extremely interesting to hear
Ms. Cauchi and the accountants in question testify on this matter. Their
testimonies would certainly have made it possible to clarify the reason why the
Statements of Business or Professional Activities did not reflect the
franchisee witnesses' contractual obligations.
(iv)
They frequently failed
to understand the meaning of the questions they were asked, partly because they
confused the meaning of [translation]
"costs" and [translation] "disbursements".
[113]
For all of these
reasons, it is my view that this evidence does not increase the likelihood that
the agency agreements and the promissory notes signed by the appellant are
shams. The franchisee witnesses have satisfied me of what is important to know:
they undertook to pay at maturity the amounts indicated on the 2007 and 2008
promissory notes. This is especially true in Dr. Thibault's case. In fact,
it can hardly be said that Dr. Thibault's testimony is self-serving, since
Dr. Thibault has no interest in the current proceeding given his
bankruptcy.
[114]
The respondent
essentially submits that the testimony of Ms. Cauchi confirms her new
position (new in that the CRA's pleadings contain nothing in this respect) that
the appellant's first three payments (3 x $15,000) were not interest but the
actual, total price of the investment as agreed by the parties. The respondent
draws this conclusion from the testimony of Ms. Cauchi (Court Reporter's
Notes, November 28, 2008, Ms. Cauchi, from page 22,
line 20, to page 23, and page 28, lines 10 to 25), where
she states that the costs related to the acquisition of a franchise [translation] "amount to three (3) times fifteen thousand
dollars ($15,000)"; and also from the evidence purportedly showing that
none of the terms and conditions of the agreements or of the promissory notes
of 2004 to 2008 confirm the payments described by Ms. Cauchi.
[115]
The respondent erroneously
drew this conclusion from the testimony. First, the CRA erroneously alleged
that none of the agreements provided for a $15,000 reimbursement over three
years. In fact, these are the terms of the 2006 agreement; see the limited
recourse promissory note at Exhibit A‑27,
Volume 28, page 11077, (page 11121)). The excerpts from the testimony to which the
respondent refers to support her new position may relate to 2006. In my view,
it is extremely difficult to draw any conclusions from the testimony since the
AMF's questions did not distinguish between the period before and the period
after 2007. At pages 22 and 28 of her testimony, Ms. Cauchi is
probably referring to the pre-2007 agreements, while at page 40, she is
referring to a post-2007 franchise. In my opinion, the CRA cannot take
advantage of replies to vague questions that led to testimony that is confusing
to say the least. Only Ms. Cauchi's testimony would have helped elucidate
all of the ambiguities, if indeed there are any. Unfortunately, the respondent
did not subpoena Ms. Cauchi to testify.
[116]
Mr. Godbout is a
tax expert who has worked for Ms. Cauchi since 2006. In support of her new
position, the respondent entered into evidence during the cross-examination of
Mr. Godbout a letter he had sent to Chantale Laliberté of the Canadian
Imperial Bank of Commerce (Exhibit I-55), which concerned the 2007
franchises. In cross-examination, Mr. Godbout was referred to the following
excerpt from the letter: [translation]
"Investors will have to
disburse three times $15,000 over three years. After that, the matter is
settled." Mr. Godbout explained in cross-examination that he had
realized a few days before testifying that there was a mistake in this letter:
he had [translation] "mixed up" the conditions of the 2005 and
2006 franchise agreements with those of the 2007 agreement (Court Reporter's
Notes, March 15, 2012, Mr. Godbout, page 191, lines 18 to
22). Mr. Godbout explained that he believed that, under the 2005 and 2006 agreements,
it was enough to make three $15,000 payments for the franchises since the
promissory notes were limited recourse ones (Court Reporter's Notes, March 15,
2012, Mr. Godbout, page 197, lines 10 to 25). The respondent
submits that Mr. Godbout's explanations to justify his mistake (according
to which the letter to Ms. Laliberté set out the conditions of the 2005
and 2006 franchise agreements) are not credible since they contradict the terms
of these agreements. Indeed, the respondent submits that none of the 2005 and
2006 agreements provided for $15,000 reimbursements over three years, even
though these are the terms of the 2006 agreement, with a limited recourse
promissory note, as they appear in Exhibit A‑72,
Volume 28, page 11077 (page 11121). Even though the 2006 agreements provided for $15,000
reimbursements over three years with limited recourse promissory notes, when
cross-examined about the terms of the 2006 franchise agreement,
Mr. Godbout recognized that his explanation for the errors in his letter
to Ms. Laliberté was incorrect. This clearly shows that Mr. Godbout
confused the agreements of before and after 2006 while being cross-examined
(as, indeed, most of the franchisee witnesses did, and that he did so despite
being a tax expert) and that, consequently, it cannot be concluded from this
confusion that his explanations for his error in the letter to
Ms. Laliberté are not credible. Ultimately, it would be inappropriate, in
my opinion, to conclude that this testimony increases the likelihood that the
promissory notes and the agency agreements signed by the appellant were shams.
Mr. Beaulieu
[117]
From the testimony of
Michel Beaulieu (Mr. Beaulieu), a chartered accountant with no interest in
the present proceeding, I essentially gather that he did not want to convert
his 2005 franchise into a 2007 franchise because he did not want to sign a full
recourse promissory note. Mr. Beaulieu's explanations in this regard are
worth quoting:
[translation]
[394] Q. Explain
why to the Court.
R. The
2007 franchise was a franchise with a full recourse promissory note, so I
decided that I wasn't going to get involved. I have assets now; when one is
fifty (50) years old, one has assets, and one doesn't want to lose those
assets. So, I said to myself that a full recourse promissory note meant that
even if Prospector didn't work out, I would have owed some two hundred thousand
(250,000) dollars. That was one of the reasons, in fact, it's not, it was the
reason why I decided to get out.
Examination
of Mr. Beaulieu, Transcript, March 15, 2012, Question 414.
Testimony of Mr. Ouellet
Education and work experience
[118]
Mr. Ouellet, the
appellant's expert witness, holds a Master's degree in Business Administration
(MBA) with a specialization in international marketing from Laval University, a Ph.D. in Management Sciences (Marketing) from the Université
Pierre-Mendès-France in Grenoble, and a post-doctoral degree in Innovation
Management from the M.I.T. Center for Innovation in Product Development in Boston. He has been a lecturer in marketing at HEC Montréal since 2004 and an associate
professor since 2008. He has also collaborated in the international MBA and
Doctor of Business Administration programs of various European universities. His
research and teaching focuses on product and innovation management, brand
management, business-to-business marketing and direct and database marketing. He
is the co-author of a university textbook on marketing, and his research has
been widely published.
[119]
Since 2003, Mr. Ouellet
has been working as a marketing consultant for companies of various sizes, particularly
start-up companies. He is also the academic associate of a marketing research
firm. He has worked as a corporate speaker and trainer for various companies
and organizations, and currently hosts a business show. He has received many
prizes, grants and awards.
[120]
In the past, he has worked
as the assistant director of marketing and then director of a Quebec company.
For this company, he has developed a network of distributors and resellers in
several countries, in addition to forming and supervising a team of
representatives and marketing support personnel. He has also acted as the
national spokesperson of two well-known corporations (eBay Canada and Doritos).
[121]
The appellant asked
Mr. Ouellet to assess the commercial viability of a company in respect of
(a) the Solutions Prospector, Mail it Safe and CashOnTime products; (b) the
franchisee's marketing of these products as "Software as a Service" ("logiciel-service");
and (c) the franchisee's operating the franchise through an agent. Mr. Ouellet's
team, composed of himself and two researchers, reviewed the pleadings, the
documentary evidence of both parties and the transcripts of the examinations
for discovery of the appellant and the CRA auditor; it also met with members of
Prospector, the franchisee association and the law firm representing the
appellant. In the light of these documents and of management studies,
Mr. Ouellet concluded that a company belonging to a Prospector franchisee
is realistic and commercially viable.
Commercial viability of
Prospector products
[122]
First, it appears from
Mr. Ouellet's highly convincing, enlightening and credible testimony that
the three Prospector products are [translation]
"real, functional"
products the benefits of which meet actual needs in their target markets. According
to Mr. Ouellet, the benefits of Mail it Safe address data confidentiality
and protection issues, which, according to studies, are serious concerns,
particularly in the health sector. He also explained that CashOnTime, in
automating the debt collection procedure, is designed to resolve companies'
cash flow problems. He added that, in his opinion, Solutions Prospector met the
tracking challenges of a web-based marketing campaign, which continue to be a
major challenge for any direct marketing company on the Internet. He concluded
that the products were commercially viable in that they had market potential
and offered an attractive return on investment.
Commercial viability of
Software as a Service
[123]
Mr. Ouellet is of
the view that the manner in which Prospector products are being run, that is,
as Software as a Service, is also commercially viable and promising. However,
it makes the marketing of Prospector products more complex and their adoption
by potential clients slower.
[124]
According to
Mr. Ouellet, Software as a Service has significant benefits. Users do not
have to install the software on their own servers or computers, or to maintain
or operate it, meaning lower software acquisition and adoption costs, as well
as quicker implementation and greater flexibility. However, potential users of
Software as a Service are reluctant to use this technology mainly because of
risks related to data security, the integration of this way of operating with
other software programs used by the company, and costs, which may be higher, particularly
for larger companies. These concerns mean that it takes a considerably long
time for users to decide to use Software as a Service.
[125]
Furthermore, Mr. Ouellet
is of the view that, in sectors such as debt management, client relations
management and e-mail monitoring, current standards and practices are not
entirely compatible with the use of Software as a Service. Software as a
Service is therefore a radical innovation in these particular sectors. In
contrast to ongoing innovations, radical innovations create their own product
category by meeting latent needs in an unexpected or novel manner. Even though
this type of innovation generally translates into a distinct, long-term competitive
advantage and a substantial return on investment, its marketing presents
difficulties. Indeed, considerable time (between 6 and 10 years, or even as
much as 12) is required for users to adopt such a product for the long term. In
addition, the ability and know-how to market such products are key factors, but
few companies and professionals are specialized in this type of marketing. The
risk linked to introducing a radical innovation on the market is also higher.
Decades can go by before a highly innovative company makes any sales.
[126]
Mr. Ouellet also
explained that the process for marketing an innovation entails several stages,
which any normal company has to go through and on which it has to spend time.
Depending on the context, a company may have to undertake certain strategic
steps. It may, for example, have to build a business storefront before even
launching its sales and marketing activities. In the case of a strategic repositioning,
the logical step for a business could be to go as far as suspending its sales
activities to concentrate on market segmentation and positioning.
[127]
According to Mr. Ouellet,
Software as a Service is starting to become a trend. The Software as a Service
market is growing in the United States, Asia and Europe. Major companies are
turning to this way of operating. Studies see the move towards [translation] "cloud"
computing, which Software as a Service is a part of, as [translation] "the biggest change
organizations have had to adapt to since computers entered the workplace 20
years ago". Running Software as a Service is therefore viable and
promising, but, since it is a radical innovation, the marketing of this technology
is complex and slow.
Responsibility of operating
the franchise
[128]
Lastly, Mr. Ouellet
finds that the appellant made the right business decision in tasking a
specialized agent with operating his franchise, given his limited resources.
Giving similar mandates to the same agent also contributed to achieving maximum
economic benefits.
[129]
According to Mr. Ouellet,
franchising is a [translation] "relatively
popular" business approach that is becoming increasingly important and
that offers significant organizational benefits, in particular for companies targeting new [translation] "niches" or
wishing to grow. It is a structure that is often used in the technology sector.
[130]
According to Mr. Ouellet,
franchisors have obligations towards franchisees. They have to carry out
communications and marketing activities and provide franchisees with the
necessary sales material, which should include virtual storefronts in the case
of software. Indeed, in the field of software marketing, developing
storefronts, that is, authority sites to show other clients the benefits of the
products being marketed, is highly recommended.
[131]
Mr. Ouellet also
explained that even though the classic franchising model involved
entrepreneur-franchisees operating their franchises themselves, franchisors are
more flexible towards franchisees wishing to be involved only part-time. Different
forms of allocating work are used nowadays. Franchisees can use a third party
or companies or professionals that have a relationship with the franchisors.
[132]
To sum up, Mr. Ouellet has
satisfied me of the following:
(a)
The software in
question are real, functional products that meet real needs in the target
markets and that have market potential and offer an attractive return on
investment.
(b)
The operating mode,
built on the Software as a Service model, is a radical, avant-garde innovation
that has gained in popularity.
(c)
The operating mode,
built on the Software as a Service model, offers a greater potential return
even if its novelty initially caused significant marketing difficulties that
contributed to delaying its launch.
Analysis and conclusion
Preliminary objection – the
reassessment is invalid and does not impose a burden on the appellant
[133]
I will now deal with
the appellant's preliminary objection according to which the reassessment is
invalid and does not impose a burden on him.
[134]
On August 27, 2009,
the CRA made a reassessment whereby it disallowed the $85,873.33 in deductions claimed
by the appellant in respect of capital cost allowance, eligible capital
property and interest with regard to the purchase of a franchise authorizing
him to market the software.
[135]
The appellant objected
to the reassessment on October 28, 2009, and filed an appeal before this
Court on December 21, 2010, before the Minister of National Revenue (the
Minister) confirmed the reassessment. The appellant submits that, on this date,
the CRA had not informed him of the assumptions of fact and law on which it
relied to make the reassessment.
[136]
The respondent filed
the Reply to the Notice of Appeal on March 14, 2011. At paragraph 25 of
the Reply, the Respondent sets out the facts it assumed to determine the tax
payable; paragraph 26 contains other facts relevant to the appeal.
[137]
The appellant submits
that the failure to disclose the assumptions should render the reassessment
invalid. In the alternative, he submits that the burden to prove the undisclosed
assumptions is on the respondent.
[138]
The appellant bases his
submissions on Johnston v. M.N.R., [1948] S.C.R 486, and on the
basic rules of fairness, which, in his opinion, oblige the CRA to disclose the assumptions
of fact and law on which it relies before or at the time of making an
assessment. In his opinion, that is what emerges from the following excerpt
from Johnston:
Notwithstanding
that it is spoken of in section 63(2) as an action ready for trial or hearing,
the proceeding is an appeal from the taxation; and since the taxation is on the
basis of certain facts and certain provisions of law either those facts or the
application of the law is challenged. Every such fact found or assumed by the assessor
or the Minister must then be accepted as it was dealt with by these persons
unless questioned by the appellant.
. . .
The allegations necessary to the appeal depend upon the construction of the
statute and its application to the facts and the pleadings are to facilitate
the determination of the issues. It must, of course, be assumed that the Crown,
as is its duty, has fully disclosed to the taxpayer the precise findings of
fact and rulings of law which have given rise to the controversy.
[139]
The appellant submits
that, at the very least, if the CRA fails to disclose certain assumptions that
it then reveals in its pleadings, the burden of proof is on the CRA. That
principle was confirmed in Hsu v. The Queen, 2001 FCA 240, which
the appellant cites in the following excerpt:
. . .
the Minister is obliged to disclose the precise basis
upon which it has been formulated (Johnston v. M.N.R. (1948), 3 D.T.C. 1182 at 1183 (S.C.C.)).
Otherwise, the taxpayer would be unable to discharge his or her initial onus of
demolishing the "exact assumptions made by the Minister but no more"
(Hickman Motors Ltd. v. The Queen (1997),
97 D.T.C. 5363 at 5376 (S.C.C.)).
[140]
In the case at bar, the
appellant submits that the assumptions were not disclosed: neither the
reassessment nor the letter dated July 6, 2009, accompanying the draft
assessment contained any explanations that revealed any assumption whatsoever.
[141]
The appellant alleges
that the reassessment therefore has no basis. He submits that since the CRA
must disclose all the assumptions of fact and law on which it relies before
making a reassessment, if the CRA had established any assumptions, it would
have disclosed them.
[142]
The appellant submits
moreover that there is an overlap between the facts the Minister [translation] "assumed" (paragraph 25 of the Reply) at the
time of the reassessment and the [translation]
"other relevant facts" (paragraph 26
of the Reply), for which the onus rests on the CRA. According to the appellant,
that overlap makes it impossible to distinguish the facts that the CRA intends
to prove from those the CRA allegedly assumed when making the reassessment. He
submits that the overlap merely confirms his position that the CRA did not make
any assumptions in support of the reassessment and that the reassessment
therefore has no basis. In addition, and in the alternative, the appellant
submits that overlapping assumptions in the Reply are facts for which the
burden of proof is on the CRA.
[143]
Lastly, the appellant
submits that the absence of assumptions is aggravated by the admissions of Carole
Bartolini, the team leader tasked with supervising the two CRA auditors who
audited the appellant's company. Ms. Bartolini testified that she had been
obliged to follow the instructions from management with regard to [translation] "Project Prospector", in which the appellant
was involved. According to the appellant, these instructions rendered the [translation] "audit" illusory
and meaningless: the CRA gave
the impression of wanting to have a real dialogue with the appellant, even
though it was actually following the steps imposed by management without
questioning their relevance. The CRA therefore failed to respect its duty to
verify the facts and to apply the applicable legislation before making an
assessment. According to the appellant, this merely supports his position that
the CRA did not make any assumptions of fact or of law in support of the
reassessment and that the reassessment should therefore be invalid.
Respondent's position (see
Transcript, May 9, 2012, at pages 360 and following)
[144]
Relying on the Federal
Court of Appeal's decision in Orly Automobiles Inc. v. Canada,
2005 FCA 425, the respondent submits that the CRA does not have to
disclose the basis for a reassessment at a particular point in time.
[145]
The respondent adds
that the facts on which the CRA relied to make the reassessment can be found in
the audit report (Exhibit I‑60) (the Report). The respondent also
submits that the Notice of Appeal reveals that the appellant was aware of the
issue, namely, whether the appellant had carried on a business, and that he can
therefore not pretend to have been taken by surprise.
[146]
Furthermore, relying on
the Federal Court of Appeal's decision in Main Rehabilitation Co. v. Canada,
2004 FCA 403, the respondent argues that the CRA's actions and conduct during
an audit should not be taken into consideration on appeal.
[147]
I note that the
respondent did not make any statements regarding the burden of proof, counsel
for the respondent simply stating at the hearing that, in any case, he had
established the facts underlying his arguments.
[148]
Since the respondent
submitted, among other things, that the basis for the assessment is in the Report
and the appellant objected to the Report being entered into evidence, I will
first look at the merit of this objection.
[149]
In his written
submissions, the appellant argues that he was not provided with the Report at
the time of the reassessment and that it was also not part of the documents
disclosed by the CRA in its list of documents under section 81 of the Tax
Court of Canada Rules (General Procedure) (the Rules) on June 6, 2011. The
Report was not disclosed to the appellant until September 15, 2011, at his
request. The appellant states that he obtained the redacted Report on
February 21, 2011, in response to an access to information request.
[150]
The appellant further
submits that Normand Desjardins (a CRA representative) expressly stated in the
examination for discovery that the assumptions on which the reassessment was
based were listed in the Reply. According to the appellant, this statement is a
judicial admission binding the CRA, as acknowledged by the Court in
paragraph 12 of Drouin c. La Reine, 2011 CCI 519 [not
translated]. In the appellant's
view, therefore, if the Report reiterates the facts and the analyses appearing
in the Reply, it is superfluous and of no relevance to the Court.
[151]
The appellant further
submits that since the facts and the analyses appearing in the Report are not
referred to in the pleadings, it would be perverse for the CRA to attempt to prove
them. In his opinion, over a third of the Report concerns the issue whether the
appellant's franchise was a [translation]
"tax shelter". Yet in Drouin c. La Reine,
2011 CCI 519 (specifically paragraphs 29 and 30), the Court rejected the
CRA's attempt to amend the Reply in order to include arguments regarding the
tax shelter, ruling that this would be an abuse of process. The appellant adds
that if is was abusive on the part of the CRA to add [translation] "tax shelter"
allegations to its Reply the day before the hearing, a fortiori, it is absolutely intolerable that the CRA is seeking
to introduce into evidence what is essentially an argument on the same subject at
the close of the evidence.
[152]
The appellant adds
that, on six occasions, the Report refers to the conclusions of a valuation of
a franchise allegedly performed by the CRA's valuations section. Yet this valuation
does not appear in the CRA's list of documents on which it relied. Moreover,
when, during Ms. Bartolini's testimony, the CRA sought to adduce the valuation,
the appellant objected on the ground that it was expert testimony. During the
examination for discovery, the CRA allegedly admitted that the decision not to
adduce this valuation as expert testimony was intentional and strategic. The
appellant adds that the respondent cannot now seek to adduce the Report, which
reiterates the conclusions of the valuation on six occasions and thus prove
indirectly what it could not do and waived to do directly. In that regard, I
note that when the appellant objected to the filing of this valuation at the
hearing, the respondent withdrew its request.
[153]
Moreover, according to
the appellant, the respondent is seeking to file a valuation through Ms. Bartolini
rather than its author, a procedure the Court held unacceptable in Drouin c.
La Reine, 2012 CCI 94 [not translated], when it rejected Denys Goulet's expert testimony.
[154]
Lastly, the appellant
submits that the CRA cannot file into evidence for historical purposes the
auditor's Report given that he himself filed the two Wise, Blackman reports, on
the following grounds: (a) in contrast to the Report, the two reports he
filed appear in the appellant's list of documents; (b) contrary to the
respondent, the appellant had given the notices required under section 145
of the Rules in a timely manner; (c) contrary to the respondent, the appellant
had not made any judicial admissions rendering these reports superfluous; and
(d) the two reports were of real historical interest, contrary to the respondent's
Report.
[155]
In sum, according to
the appellant, by seeking to adduce the Report, the CRA is attempting to do
indirectly what the Court expressly prohibited the respondent to do directly,
in addition to attempting to encumber the record with clearly irrelevant
allegations without reasonable notice to the appellant.
[156]
The respondent's
position is that it is entitled to adduce this document into evidence under
section 89 of the Rules. It submits that it is section 89 rather than
section 81 that governs the admissibility of documents. The respondent
argues that a document "produced by one of the parties, or some person
being examined on behalf of one of the parties, at the examination for
discovery" (paragraph 89(1)(b)) can be filed in the same way
as a document referred to in a party's list of documents (paragraph 89(1)(a)).
[157]
Moreover, the
respondent submits that the principle underlying sections 81 and 89 of the
Rules is the parties' disclosing the documents they wish to file. The Report
was disclosed to the appellant on two occasions, first, on February 21,
2011, in a redacted version, in reply to a request for access to information,
and again, on September 15, 2011, in reply to the respondent's
undertakings. The principle of pre-trial disclosure has therefore been
respected.
[158]
In reply to the
appellant's arguments, the respondent adds that the purpose of filing the
Report is to rebut the appellant's allegations that the CRA did not make any
assumptions of fact and law in support of the reassessment. The Report is
therefore entirely relevant and admissible evidence, and there are no grounds
for excluding it.
[159]
I disagree with the
majority of the appellant's arguments. The fact that during the examination for
discovery, Mr. Desjardins recognized that the basis for the reassessment
could be found in the Reply does not change the fact that the issue here is
whether the Crown relied on the facts at paragraph 25 of the Reply to make
the assessment. The auditor's draft is therefore relevant. It is also true that
most of the Report deals with tax shelters, an argument that was not raised in
the pleadings and that the respondent unsuccessfully attempted to add to the
Reply. Since the respondent is not seeking to prove the tax shelter argument
and the Report is relevant for determining whether the facts in the Reply are
the true basis for the reassessment, the Report should be admissible. There is
no question here of adducing an evaluation indirectly.
[160]
In my opinion, the only
issue here is whether the failure to include the document in the list of
documents is fatal to the respondent. In other words, does section 89 of
the Rules allow one party to file a document that one of its witnesses filed in
reply to the undertakings taken during the examination for discovery?
[161]
It is useful here to
reproduce section 89:
89.
(1) Unless the Court otherwise directs, except with the consent in writing of
the other party or where discovery of documents has been waived by the other
party, no document shall be used in evidence by a party unless
(a)
reference to it appears in the pleadings, or in a list or an affidavit filed
and served by a party to the proceeding,
(b) it has been produced by one of the parties, or some
person being examined on behalf of one of the parties, at the examination for
discovery, or
(c)
it has been produced by a witness who is not, in the opinion of the Court,
under the control of the party.
(2)
Unless the Court otherwise directs, subsection (1) does not apply to a document
that is used solely as a foundation for or as part of a question in
cross-examination or re-examination.
[162]
The respondent did not
provide any case in support of its arguments. I did not find any case that
specifically discussed the application of paragraph 89(1)(b) of the
Rules. The case law most often deals with subsection 89(2) of the Rules,
which concerns cross-examinations: Morency v. Canada, [1998] 2
C.T.C. 2024, Scavuzzo v. The Queen, 2004 TCC 806, Large v. The Queen,
2006 TCC 509. However, in these three cases, the judges had reservations about
the exception to the principle of pre-trial disclosure. In Sydney Mines
Fireman's Club, 2011 TCC 403, Justice Campbell exercised her discretion
under subsections 98(1) and 89(1) of the Rules to allow the filing of
documents that were found and disclosed to the opposing party a few days before
the hearing.
[163]
In other cases, judges
have preferred not to allow the filing of documents that did not appear on the
list of documents: Walsh v. The Queen, 2009 TCC 557, and Savoy v. The
Queen, 2011 TCC 35. In both of these cases, however, pre-trial disclosure
of documents had not been at issue, and it therefore seems that the filing was
entirely subject to the judge's discretion, within the meaning of
subsection 89(1) of the Rules.
[164]
In Savoy, supra,
Justice Hershfield wrote the following in a footnote (No. 6):
. . .
Nothing in section 89 of the Tax Court of Canada Rules (General Procedure)
dealing with the admission of documents is permissive of an undisclosed
document being allowed short of a direction of the Court to allow it.
. . .
[165]
I doubt that this
comment applies in situations such as this one, covered by paragraphs (a),
(b) and (c). The wording of the provision is clear, and the
filing of the Report should therefore be allowed, since it is a document that
was subject to an undertaking and should therefore be considered as having been
filed in cross-examination.
[166]
I also share the
respondent's opinion that the Report is relevant for determining the basis for
the reassessment. Moreover, the appellant had been aware of the Report for
several months and therefore did not suffer any prejudice, since the Court will
not consider the conclusions based on the evaluation and the other grounds
raised. The goal is truth-seeking. Form should not be elevated over substance,
and it is in the interest of justice that the Court review a document that is
fundamental to the appeal and draw the relevant conclusions from this document.
[167]
To return to the
appellant's objection that the reassessment is invalid and does not impose a
burden on him because the draft assessment dated July 6, 2007 (Exhibit I‑59),
and the reassessment did not reveal any assumptions of fact and law, no legal
rule allows me to conclude that the reassessment has no basis because the
assumptions of fact and law were disclosed late. The only issue is whether
because of the delay, the burden of proof is shifted.
[168]
In Drouin c. La Reine,
2011 CCI 519, Justice Lamarre, dealing with a motion to amend the Reply,
drew the following conclusions regarding the draft assessment and the new
assessment:
[translation]
7 In her submissions, the respondent argues
that the amendments being sought are made for the purpose of adding legal
arguments pertaining to the issue of the tax shelter and that no new facts are
added. The respondent submits that in the tax audit of the appellant for the
2008 taxation year, the auditor considered the tax shelter argument in order to
refuse the deductions claimed by the appellant for that year. The tax shelter
therefore provided a basis for the initial assessment. The initial
assessment, dated August 27, 2009, filed in the appellant's Reply record
under Tab C, does not provide any explanation for the basis of the assessment
that amended the appellant's net income. Moreover, a letter had been sent to the
appellant previously, on July 6, 2009, whereby the Canada Revenue Agency (CRA)
explained to the appellant that the audit had only looked at [translation] "the capital cost
allowance claimed for Class 12, the deduction of eligible capital property and
interest charges" and told him that it would make the appropriate
adjustments to his tax return (Exhibit E of the appellant's Reply record).
The CRA did not mention whether it had looked at the tax shelter issue to make
the assessment.
[169]
I agree with these conclusions.
Having examined each of the two documents, I conclude that they are terse, to
say the least, and in fact do not contain an explanation of the basis for the
reassessment.
[170]
However, the present
state of the law does not allow me to reach the same conclusion as the
appellant regarding when the Minister is obliged to disclose the assumptions on
which he relies.
[171]
In Orly Automobiles
Inc. v. Canada, supra, to which the respondent referred, the Federal
Court of Appeal found that Johnston, supra, does not propound a
time limit. It simply sets out the Crown's duty of disclosure:
[13] Counsel for the appellant conceded, when answering a
question from the panel, that the case of Johnston, supra, does not
expressly state that disclosure must be made prior to or at the time of
reassessment. As a matter of fact, the case merely stands for the proposition
that the Crown must fully disclose to the taxpayer the precise findings of fact
and rulings of law which underline the reassessment. It does not establish the
specific time-limit advanced by the appellant for doing so.
[172]
In Orly Automobiles
Inc. v. Canada, supra, the respondent had made a reassessment on
April 27, 1998, and had disclosed the assumptions supporting this
assessment about a month later. The appellant, citing Johnston, supra,
had argued before the Federal Court of Appeal that the trial judge had erred in
imposing on the taxpayer the burden of disproving the assumptions of facts and
law upon which the respondent had relied, since these assumptions had been
communicated to the appellant after the assessment was made.
[173]
Among other things, the
Federal Court of Appeal recalled the purpose of the requirement of disclosure
and the appropriate remedy when disclosure was delayed:
[15] Counsel for the appellant recognizes that there are
no cases supporting the position advocated by the author. Indeed, the purpose
of the requirement of disclosure is to ensure that the taxpayer can properly
and effectively exercise his right to object to the notice of reassessment
within the ninety-day period allocated by the Act. It seems to us that, in the
vast majority of cases, the appropriate remedy is the seeking and compelling of
disclosure. We cannot imagine the taxpayer being refused an extension of the
time, as the case may be, to amend a pending appeal or to file an appeal or a
notice of objection when disclosure of the assumptions of facts and law has
been delayed and, as a result, compliance with the ninety-day time limit is
made difficult, if not impossible.
[174]
The Federal Court of
Appeal also noted that, in any event, the appellant had suffered no prejudice
from the fact that the assumptions were communicated to him a month after the
notice of reassessment: the appellant had filed an Amended Notice of Appeal
and, at the end of the hearing, the appellant's counsel stated that he had
filed evidence rebutting prima facie the Minister's assumptions.
[175]
In the case at bar,
about 21 months elapsed before the time the Minister made the reassessment
(August 27, 2009) and the time he allegedly, according to the appellant, first
disclosed his assumptions (Reply to the Notice of Appeal filed on
March 14, 2011). This delay is certainly deplorable, but not to the point
of resulting in the nullity of the reassessment or of reversing the burden of
proof.
[176]
In the case at bar, the
appellant does not seem to have suffered any prejudice. The appellant filed an
appeal before the Court even before the Minister confirmed the reassessment.
After the Reply was filed, the appellant did not file an Amended Notice of
Appeal, and, to my knowledge, there was no question of him doing so. On the
contrary, it was the respondent who sought to amend her Reply, which, again,
indicates that no prejudice was caused. Moreover, as the respondent argued, the
appellant correctly stated the issue in his Notice of Appeal.
[177]
In the light of my
previous conclusions regarding the overlap between paragraphs 25(p), (q) and
(s) and paragraphs 26(m), (p), (q) and (cc) of the Reply, it is hard for
me to find that the delayed disclosure caused prejudice. Indeed, a review of
the facts alleged in the other subparagraphs of paragraph 25 of the Reply
(which are not at issue and with which, in any event, the appellant is
familiar) leads me to conclude that the issue whether the burden of proof is
reversed as a result of the delayed disclosure is rather academic.
[178]
In his reply to the
respondent's pleadings dated May 10, 2012, the appellant submitted that Orly
Automobiles, supra, did not hold that the respondent may disclose
assumptions to the taxpayer in the pleadings. In his view, that case must be interpreted
in the light of R. v. Anchor Pointe Energy Ltd., 2003 FCA 294,
and R. v. Anchor Pointe Energy Ltd., 2007 FCA 188, in which
the Federal Court of Appeal ruled that the Minister could, at the confirmation
stage, make new assumptions that the taxpayer has the burden of refuting. He
adds that the law is clear: if the assumptions are not disclosed at the time of
the assessment or the confirmation, the burden shifts (see Transcript, May 10,
2012, pages 534 to 536).
[179]
I cannot arrive at this
conclusion based on my reading of the case law submitted to me. In my view, Orly
Automobiles, supra, holds that not disclosing the basis at the
actual time of the reassessment will not necessarily have an impact on the
burden of proof, especially when the taxpayer has not suffered
any prejudice. In both Anchor Pointe Energy Ltd. cases, supra, the
Federal Court of Appeal decided that the word "assessment" refers to
a process that stretches from the making of the assessment to the confirmation
of the reassessment and that the Crown benefits from a presumption with regard
to the assumptions made at any time during this process.
[180]
Indeed, at
paragraph 22 of Hsu, supra, which the appellant referred to
in his written submissions, the Federal Court of Appeal simply noted the
Minister's duty to disclose the precise basis upon which an assessment has been
formulated. It said nothing, however, about when the Minister is required to
make such a disclosure.
[181]
Consequently, even
though it would seem to be fair for the taxpayer to be aware of the assumptions
underlying his or her assessment before challenging that assessment, nothing in
the current state of the law allows me to conclude that the CRA has a duty in
that regard. I can therefore not infer that the assessment has no basis merely
because the Minister did not disclose his assumptions prior to, or at the time
of, making the reassessment.
[182]
The applicant, among
other things, submitted that the reassessment had no basis because the CRA had
failed in its duty to verify the facts and to apply the applicable legislation
before making the assessment.
[183]
In my opinion, the comments
of the Federal Court of Appeal in Main Rehabilitation Co., supra,
suffice to reject the appellant's argument. My jurisdiction does not allow me
to rule on the CRA's manner of proceeding, but is limited to determining
whether the amounts could be validly established under the Income Tax Act.
[184]
Lastly, I note that the
appellant drew the Court's attention to the overlaps between certain facts
enumerated at paragraph 25 of the Reply and other facts enumerated at paragraph 26
of the Reply. It is useful to reproduce these paragraphs here:
[translation]
25.
. . .
(p)
The franchise and the rights related thereto were not acquired for the purpose
of earning or generating an income, but rather to obtain a tax benefit.
(q)
The appellant acquired the franchise and the rights related therefore solely in
order to benefit from tax deductions.
. . .
(s)
The fair market value of the franchise and the rights related thereto was nil.
26.
. . .
(m)
The applicant did not intend to realize a profit from his franchise; his
intention was rather to obtain tax benefits.
. . .
(p)
The appellant's goal was to obtain tax refunds and not to carry on a business.
(q)
The activities pertaining to the Prospector International franchise were not
business activities and did not offer an opportunity for realizing a profit
other than by saving taxes.
. . .
(cc)
The fair market value of a Prospector International Networks Inc. franchise was
very low if not nil.
[185]
It is my opinion that
there is an overlap between paragraphs 25(p), (q) and (s) and
paragraphs 26(m), (p), (q) and (cc), as they set out the same facts,
albeit with a different wording.
[186]
The Report, which I
have decided to admit into evidence, is of no help in distinguishing the
assumptions from the relevant facts since the respondent stated at the hearing
that both the assumptions it relied on and the other relevant facts were in the
Report. I therefore accept the appellant's arguments that the respondent bears
the entire burden with regard to paragraphs 25(p), (q) and (s).
[187]
In my view, moreover,
by applying such a practice in drafting its pleadings, the respondent breaches
the requirements of fairness, as described in Anchor Pointe Energy (2007),
supra:
29 Fairness requires that the facts pleaded as assumptions be complete,
precise, accurate and honestly and truthfully stated so that the taxpayer knows
exactly the case and the burden that he or she has to meet: Canada v. Anchor
Pointe Energy Ltd., supra, at paragraph 23, Holm et al. v. The Queen,
supra, Canada v. Lowen [2004] 4 F.C.R. 3, at paragraph 9.
(F.C.A), Grant v. The Queen et al. 2003 DTC 5160, at page 5163, First
Fund Genesis Corporation v. Her Majesty the Queen 90 DTC 6337, at page
6340, Shaughnessy v. Her Majesty the Queen 2002 DTC 1272, at paragraph
13, Stephen v. Canada [2001] T.C.J. No. 250, at paragraph 6.
[188]
These facts are not
precise and accurate, and the taxpayer cannot clearly know whether or not the
burden of proof falls upon him or her. Such a practice on the part of the Crown
is deplorable. Indeed, in Holm v. The Queen, 2002 CanLII 47030,
Associate Chief Justice Bowman, as he then was, made the following comments:
[19]
. . . If the court sees many
more instances of pleading incomplete, inaccurate or misleading assumptions we
may have to reconsider the whole matter of pleading assumptions and the reverse
onus and require the Crown at least to prove that the assumptions were made. I
know of no rule in any court that permits the mere pleading of a fact, without
evidence, to have the fact taken as true. It is an advantage that the Crown has
that it will lose if it abuses it.
[189]
In addition, the facts
alleged in paragraphs 25(o) and (r) of the Reply can also be found in the
Report (respectively at subparagraph 2(a)(ii), at page 6, and section 2.4,
at page 11 (which, however, concern the years 2004 to 2006)):
[translation]
25.
. . .
(o)
The appellant's only interest in this franchise was to obtain substantial tax
benefits, principally to claim the capital cost allowance, which was much
higher than the amount paid by the appellant, and to make the following tax
savings, without earning any income: . . .
. . .
(r)
The appellant did not disburse the sum of $15,000 upon the signature of the franchise
agreement in order to earn or generate an income.
[190]
To sum up, aside from
the overlapping facts in paragraphs 25(p), (q) and (s), the appellant has
not satisfied me that the CRA did not actually make the assumptions of
paragraph 25 to make the reassessment. It must, therefore, be presumed
that these statements are a complete and honest communication of the facts on
which the Minister relied to make the reassessment. The initial onus of
demolishing these assumptions is on the taxpayer.
The law
[191]
In my opinion, the
evidence produced must be analyzed in the light of the following principles:
A. Nature of the company
[192]
The applicable test for
determining whether a taxpayers' activities are a source of either business or
property income for the purposes of section 9 of the Act is set out in Stewart
v. Canada, [2002] 2 S.C.R. 645 (Stewart), at paragraph 50,
and in Walls v. Canada, [2002] 2 S.C.R. 684 (Walls), at
paragraph 20, which read as follows:
[50]
It is clear that in order to apply s. 9, the taxpayer must first determine
whether he or she has a source of either business or property income. As has
been pointed out, a commercial activity which falls short of being a business,
may nevertheless be a source of property income. As well, it is clear that
some taxpayer endeavours are neither businesses, nor sources of property
income, but are mere personal activities. As such, the following two-stage
approach with respect to the source question can be employed:
(i)
Is the activity of the taxpayer undertaken in
pursuit of profit, or is it a personal endeavour?
(ii)
If it is not a personal endeavour, is the source
of the income a business or property?
The first stage of
the test assesses the general question of whether or not a source of income
exists; the second stage categorizes the source as either business or property.
[20]
Applying these principles to this case, we find that it
is clear that the storage park operation constituted a source of income for the
purposes of s. 9 of the Act. It is self-evident that such an activity is
commercial in nature, and there was no evidence of any element of personal use
or benefit in the operation. Although we state in Stewart, supra,
at para. 55, that reasonable expectation of profit may be used as one factor in
making the overall determination as to whether or not the taxpayer's activities
are personal or commercial, where, as here, the activities have no personal
aspect, reasonable expectation of profit does not arise for consideration.
[193]
In essence, these two cases
hold that the tests of reasonable expectation of profit and the taxpayer's
compliance with "objective standards of businesslike behaviour" are
only relevant when it comes to distinguishing a business from a hobby. Where the
commercial-like activity in question is and cannot be viewed as a personal
pursuit, these tests are not relevant (Stewart, para. 47, reiterated
in Water's Edge Village Estates (Phase II) Ltd. v. Canada, [2003]
2 F.C. 25, para. 24).
[194]
According to Stewart,
therefore, the objective factors listed in Moldowan v. The Queen, [1978]
1 S.C.R. 480, apply only "where the nature of a taxpayer's venture
contains elements which suggest that it could be considered a hobby or other
personal pursuit". In that regard, paragraphs 52 and 55 of Stewart
read as follows:
[52]
The purpose of this first stage of the test is simply to distinguish between
commercial and personal activities, and, as discussed above, it has been pointed
out that this may well have been the original intention of Dickson J.'s
reference to "reasonable expectation of profit" in Moldowan.
Viewed in this light, the criteria listed by Dickson J. are an attempt to
provide an objective list of factors for determining whether the activity in
question is of a commercial or personal nature. These factors are what Bowman
J.T.C.C. has referred to as "indicia of commerciality" or "badges
of trade": Nichol, supra, at p. 1218. Thus, where the
nature of a taxpayer's venture contains elements which suggest that it could be
considered a hobby or other personal pursuit, but the venture is undertaken in
a sufficiently commercial manner, the venture will be considered a source of
income for the purposes of the Act
. . .
[55]
The objective factors listed by Dickson J. in Moldowan,
at p. 486, were: (1) the profit and loss experience in past years; (2)
the taxpayer's training; (3) the taxpayer's intended course of action; and (4)
the capability of the venture to show a profit. As we conclude below, it
is not necessary for the purposes of this appeal to expand on this list of
factors. As such, we decline to do so; however, we would reiterate
Dickson J.'s caution that this list is not intended to be exhaustive, and that
the factors will differ with the nature and extent of the undertaking. We
would also emphasize that although the reasonable expectation of profit is a
factor to be considered at this stage, it is not the only factor, nor is it
conclusive. The overall assessment to be made is whether or not the
taxpayer is carrying on the activity in a commercial manner. However,
this assessment should not be used to second-guess the business judgment of the
taxpayer. It is the commercial nature of the taxpayer's activity which
must be evaluated, not his or her business acumen.
[195]
Furthermore, Walls
holds that an operation that is designed simply to obtain a tax refund is not a
business, in the absence of any other commercial activity. In that regard,
paragraph 21 of that case reads as follows:
. . .
With respect, the case at bar is distinguishable from Moloney.
There, the taxpayer was not engaged in a commercial activity, but instead was
involved in a sham set up to appear as though it was commercial in nature where
in fact the only activity actually engaged in was that of obtaining tax
refunds. Here, in contrast, the Partnership purchased and maintained an
ongoing commercial operation.
B. Duke of Westminster
principle
[196]
When a taxpayer
assesses a business or investment opportunity, the tax treatment is an
important factor that a taxpayer has every right to consider. Furthermore, it
has long been recognized that, as a result of the Duke of Westminster
principle, taxpayers are entitled to arrange their affairs so as to attract the
least amount of tax (see Canada Trustco Mortgage Co. v. Canada,
2005 SCC 54, [2005] 2 S.C.R. 601, paragraph 31).
[197]
An important corollary
arises from this principle, namely that the fact that taxpayers structure their
business and amend their agreements to take account of existing and new tax
provisions is irrelevant when it comes to qualifying their business.
[198]
As the Supreme Court of
Canada explained at paragraph 22 of Walls:
Although
the respondents in this case were clearly motivated by tax considerations when
they purchased their interests in the Partnership, this does not detract from
the commercial nature of the storage park operation or its characterization as
a source of income for the purposes of s. 9 of the Act. It is a
well-established proposition that a tax motivation does not affect the validity
of transactions for tax purposes: . . .
C. Business operated by an
agent
[199]
It is trite law that a
taxpayer carries on a business even if the taxpayer entrusts an agent to manage
the business. The leading case in this regard remains E.S.G. Holdings Ltd. v.
The Queen, 76 DTC 6158, of the Federal Court of Appeal, where the
judge wrote as follows:
With
respect, I do not agree that there is any material difference in principle, in
so far as the carrying on of an active business by a corporation is concerned,
between carrying it on through the agency of officers or servants of the
corporation and carrying it on through the agency of an independent contractor.
The question is whether the taxpayer's income is 'from an active business' and,
in my view, the answer must be the same in both cases.
[200]
It follows that a
taxpayer's personal involvement in a business is a red herring and does not
affect the fact that the taxpayer has to be carrying on a "business".
D. Financing of the business
[201]
The relevant principle
is set out in paragraph 46 of Stewart and reads as follows:
In
addition, the way in which a particular venture is capitalized may have
significant effects on its profitability. The extent of capitalization,
rates of interest, and level at which a venture is capitalized (for example
partner financing versus partnership financing, or corporate financing versus
shareholder financing) may have significant effects on the bottom line, and it
is difficult to see why the characterization of a commercial venture as a
source should depend on the extent or method of financing: . . .
E. Sham
[202]
In Canada v. Nunn,
2006 FCA 403, the Federal Court of Appeal summarized the concept of a sham in
the following terms:
[19]
However, in my analysis, the Judge erred in grounding her ultimate decision on
the doctrine of sham. The Supreme Court of Canada in Stubart Investments
Ltd. v. The Queen [1984] 1 S.C.R. 536 adopted Lord Diplock's statement in Snook
v. London & West Riding Investments Ltd., [1967] All E.R. 518 (C.A.) as
to what constitutes sham:
... it means acts done or documents executed by
the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating
between the parties legal rights and obligations different from the actual
legal rights and obligations (if any) which the parties intend to create
[Emphasis added].
[203]
In other words, the
elements of a sham require that the parties to an operation deliberately intended
to mislead third parties about the actual situation.
F. Section 67
[204]
In Williams,
2009 TCC 93, the appellant operated a business of providing day care
services at her home. This Court examined the substantial body of case law
regarding section 67 of the Income Tax Act. Quoting from Ankrah v.
The Queen, 2003 TCC 413, at paragraph 14, the Court wrote as
follows:
[14]
Justice Woods in Ankrah v. The Queen [2003] 4 C.T.C. 2851 stated as
follows:
[32]
The Crown submits that it was unreasonable for Mr. Ankrah to incur large
expenditures after the business had incurred losses for several years. It was
suggested that instead of spending large sums of money on recruits, the same
result could have been achieved by personal training.
[33]
The difficulty with the Crown's position is that supplants the business
judgment of the taxpayer. Mr. Justice Rothstein commented on this in another
Amway case, Keeping v. R., [2001] 3 C.T.C. 120 (F.C.A.), at paragraph 5:
With
respect, I am of the opinion that the analysis conducted by the Tax Court
Judge, [1999] T.C.J. No. 277, amounted to second-guessing the business acumen
of the appellant which is not the place of the Courts. As stated in Mastri
v. R. (1997), [1998] 1 F.C. 66 (Fed. C.A.), at paragraph 12:
In
summary, the decision of this Court in Tonn does not purport to alter
the law as stated in Moldowan. Tonn simply affirms the
common-sense understanding that it is not the place of the courts to
second-guess the business acumen of a taxpayer whose commercial venture turns
out to be less profitable than anticipated.
In
basing his decision on profit margins, potential market opportunities and
costs, as well as the appellant's approach to operating his distributorship,
the Tax Court Judge was second-guessing the business acumen of the appellant.
In doing so, the Tax Court Judge erred in law.
This
comment was made in the context of the REOP doctrine but I see no reason why it
should not also apply in the context of section 67.
[34]
The phrase in section 67 "reasonable in the circumstances" is broad
but I do not believe that it should apply to reduce expenses based on poor
business judgment. Section 67 is commonly applied to reduce the quantum of
expenses in cases where the taxpayer is motivated partly by something other than
business reasons, such as a payment of salaries to family members. This was
described by Mr. Justice Cattanach in the case of Gabco Limited v. M.N.R.,
68 D.T.C. 5210 (Ex. Ct.) at page 5216 as follows
It
is not a question of the Minister or this Court substituting its judgment for
what is a reasonable amount to pay, but rather a case of the Minister or the
Court coming to the conclusion that no reasonable business man would have
contracted to pay such an amount having only the business consideration of the
appellant in mind.
In Williams, the Court added:
[15]
As noted by Justice Cattanach in Gabco Limited, if the court reaches a "conclusion
that no reasonable business man would have contracted to pay such an amount
having only the business consideration of the appellant in mind" then the
provisions of section 67 of the Act would apply. It seems to me that this is
consistent with the statement of the Supreme Court of Canada in Stewart
that section 67 will apply "if, in the circumstances, the expense is unreasonable
in relation to the source of income". If an expense is unreasonable in
relation to the source of income then "no reasonable business man would
have contracted to pay such an amount having only the business consideration of
the appellant in mind".
[16]
It is also important to note that the determination of whether the amount would
have been paid by a reasonable business person should also be made as of the
time the expenditure was made and not with the benefit of hindsight. When
expenditures are being incurred by a business person, that person does not know
what the future will hold. Expenses should not be denied simply because a
person, with the benefit of hindsight, made a poor business decision. As stated
by Justice Rothstein (as he then was) in Keeping v. R., supra, in
quoting from the decision of that Court in Tonn, "it is not the
place of the courts to second-guess the business acumen of a taxpayer whose
commercial venture turns out to be less profitable than anticipated".
[17]
It is also not appropriate in my opinion to simply deny expenses on the basis
that they exceed revenue. This could lead to a conclusion that a person could
never incur a loss for tax purposes. Simply the fact that the expenditures
exceed revenue is not, in and of itself, sufficient to deny a deduction for
such expenditures.
[18]
In this particular case, the expenditures that were claimed were for
subcontractors, advertising, professional fees, motor vehicle expenses, and
telephone.
G. Parties' intention
[205]
In Riopel c. Agence
du revenu du Canada, 2011 QCCA 954, the Quebec Court of Appeal held that [translation] "the parties' intention take precedence over the
letter of their contract", writing as follows:
[translation]
[15]
Sobeys recognized that the parties' intention take precedence over the
letter of their contract and that, when it is possible to establish this
intention, the contract must be read in a manner consistent with it.
[16]
Moreover, Services environnementaux AES inc. recognized that:
[translation]
[11]
The appeal raises the issue of whether the Superior Court may allow a
contractual document to be corrected if there is a conflict between the parties'
common intention and the intention stated in the document.
[12]
The Court concludes that it may do so when, as in this case, the application is
legitimate and necessary and the sought correction in no way affects the rights
of third parties.
[13]
The appellant's argument concerning the importation into civil law of the
common law doctrine of "equitable rectification" does not stand. Quebec
civil law already has all the tools required to, under certain conditions, give
effect to a contract in accordance with the parties' actual common intention
when the wording does not reflect this intention. It is not necessary to resort
to a doctrine from another legal system in order to reach this result.
[14]
There are two ways of analyzing the inaccuracy of the stated adjusted cost base
of the shares in the documents recording the transaction of December 15, 1998,
between AES and Centre technologique: (1) an error that vitiates consent or (2)
conflict between the parties' common intention and the intention stated in the
contract.
[15]
If an error relating to the nature of the contract, the object of the
prestation or anything that was essential in determining consent is not
inexcusable, the error vitiates consent (art. 1400 C.C.Q.).
[16]
The error may be common but, even if it is common, it can only result in the
nullity of the contract and not its correction.
[17]
Furthermore, a judge who notes not an error but a discrepancy between the
parties' common intention (the negotium) and the intention they stated
in the contract (the instrumentum) may take this discrepancy into
account by giving effect to the contract (article 1425 C.C.Q.), on condition
that, obviously, the application is legitimate and the proposed correction in
no way affects the rights of third parties.
[18]
Indeed, the rule set out at article 1425 C.C.Q. concerning the interpretation
of contracts gives the parties' true intention precedence over the intention
stated in the contract.
[19]
The judge's power to make the instrumentum consistent with the negotium
is the implicit consequence of this rule, since it makes it possible to
match the text of the contract with the parties' true intention; however, once
again, the rights of third parties must not be affected (here an analogy is
possible with the rules of simulation, at articles 1451 and 1452 C.C.Q.). A
recent, unanimous judgment of the Court recognized this explicitly and, if one
wishes to base the trial judgment on a firm principle, this is the principle on
which it relies.
Preliminary remarks
[206] It is my opinion that the evidence very
clearly established the following:
(a)
The software had been
designed and developed. Not only did the software exist, it also worked the way
it had been designed and developed to do.
(b)
The software met actual
market needs. In this regard, the Court heard the convincing expert testimony
of Mr. Ouellet and the testimonies of experienced entrepreneurs such as Mr. Jones
and Mr. Vincent, who believed in the software's potential and who devoted
years of their lives to marketing the software in the hope of creating the next
Google. Are the conclusion of contracts with paying clients (including the
Agence du revenu du Québec) for each of the programs as well as the contracts
with and expressions of interest from the Barreau du Québec and its New York
counterpart, to say nothing of major partners such as IBM and Cablevision, not
irrefutable evidence that the software met real market needs? The fact that the
sales were not as successful as hoped is, in my view, not conclusive, as we
shall see later on.
(c)
Herculean efforts were
expended to market the software programs in Canada, the United States and
elsewhere.
(d)
Developing and
marketing the software programs had required significant funding.
(e)
The necessary funds
were lent first by licensees and then (from 2005 onwards) by the franchisees
who acquired licences or franchises.
[207]
I note that, essentially,
the Minister is not challenging these conclusions of fact. In other words, the
Minister now admits that PIN and its affiliate companies were carrying on a
business. In fact, the Minister's position is rather that all of the software
development and marketing efforts were solely invested to benefit PIN and its
affiliate companies. From this argument flows the Minister's position that the
appellant did not intend to carry on a business and was not carrying on a
business, any more than Network and its affiliate companies were carrying on a
business on behalf of the appellant, and that the promissory notes and the agency
agreements were shams.
[208]
Prima facie, the Minister's position that all of the marketing
and development efforts were expended solely to benefit PIN and its affiliate
companies seems implausible and illogical, to say the least, given that the
Minister has not alleged that the licences and the franchises are shams.
[209]
To illustrate the implausibility
and absurdity of this position, if suffices to imagine the following situation,
a situation that is far from being fanciful since the evidence very clearly
established that the strategy of PIN and its affiliate companies since 2002 was
to attract its first (paying or [translation]
"strategic") clients
and credible partners in order to prove the commercial viability of the
software, then to enter into agreements with value-added resellers in order to
achieve maximum market penetration in the United States and elsewhere, and ultimately
to incite a giant such as Google or Microsoft to buy everything or to prepare
an initial public offering. The disappointing results of this strategy do not,
however, change the nature of the business of PIN and its affiliate companies
or mean that PIN and its affiliate companies stopped hoping to make a profit. Let's
suppose that, thanks to the marketing efforts of Network and/or its affiliate
companies (which, according to the Minister's position, were expended solely to
benefit Network and its affiliate companies), Network had succeeded in signing
a value-added reseller agreement with a major U.S. player that resulted in high
sales in the United States, and let's suppose that, shortly afterwards,
Microsoft had offered to buy the entire technology for one billion dollars, an
offer that was announced with great fanfare in the press as being a major coup
for a young Quebec company. What would have happened? First, the franchisees
would have, under their licences and franchises (the existence of which the
Minister is not disputing), collectively claimed (and rightly so, in my
opinion, as we shall see later) a significant share of the gross sales achieved
in the United States. Using the same example, the billion dollars would
necessarily have served to buy out the franchisees, purchase the software
licence fees and the rights to market the software held by the franchisees
under their licences and franchise agreements, even if these agreements
contained ambiguities, misconceptions and even mistakes. Indeed, a buyer such
as Google or Microsoft would not have invested one billion dollars without
ensuring that it owned all the rights to market the software in the United States. If PIN and its affiliate companies are as deceitful and crafty as the
Minister suggests, they would necessarily have ensured that the licences and
franchises were also shams. Indeed, why would PIN and its affiliate companies
have taken the chance of sharing the fruits of their marketing efforts (which,
according to the Minister, they expended solely to their benefit) with
franchisees whose only reason for acquiring a licence or a franchise, according
to the Minister, was to obtain tax deductions? It seems inconceivable that PIN
and its affiliate companies could have explained their refusal of the
franchisees' collective claim for their fair share of the U.S. sales by telling them, "You're not entitled to a thing since you only paid to get
tax deductions and never intended to be part of this company." Such a
scenario reveals the absurdity of the Minister's position.
[210]
In the light of the
Minister's admission that the franchises and licences were real, the example shows,
in my opinion, that, prima facie, it is more likely than not that the
franchisees acquired their licences and franchises with the purpose of operating
them and of obtaining tax deductions, and that the promissory notes and the
management agreements are not shams. In other words, the CRA has never alleged
that the appellant's franchise was a sham. It is almost untenable to argue that
the operation of this franchise can be anything other than a commercial
activity.
[211]
For further
illustration, I note that if, in our example, the agency and management agreements
had been shams (as the Minister alleges), the franchisees would collectively have
received a higher share of the gross sales achieved in the United States thanks
to the efforts of the U.S. value-added reseller than if the agency and
management agreements were not shams. Indeed, the 2007 franchise agreement does
not provide for any royalties to PIN or its affiliate companies, while the 2007
agency and management agreement entitles the agent to fees equivalent to 94% of
the gross income generated through the distribution of the software or, in the
event that the franchisee participates in the marketing of the software, to 14%
of the net income (Exhibit A‑1.1.3,
Clause 3.1). The 2008 franchise
agreement provides for royalties amounting to 20% of the gross income for
Prospector (Exhibit A‑1.2.1, Clause 12.2 and Appendix A). Assuming that the 2008 agency and
management agreement was valid (I will address the question of its validity
later on), Prospector and its agent would have been entitled to a total of 88%
of the gross income since the agency and management agreement provides for a royalty
of 68% of the gross income for the agent (Exhibit A‑1.2.2, Clause 3.1). If,
on the contrary, the 2008 agency and management agreement was not valid and the
2007 agency and management agreement was the agreement in effect, PIN and Network
would have been entitled to 114% of the gross income, through the combined
effect of the 2008 franchise agreement and the 2007 agency and management
agreement.
[212]
Lastly, I note that
another piece of evidence illustrates the obvious absurdity and implausibility
of the Minister's position that the franchisees did not acquire the rights to
market the software in order to exercise these rights. The evidence very
clearly reveals that many of the franchisees (including the appellant) attended
several meetings organized by Network and its affiliate companies and read the
many messages and information letters sent to them by Network and its affiliate
companies keeping them informed about the development and marketing of the
software in the United States and elsewhere. The evidence even revealed that
the appellant attended the annual meeting in April 2009, which was held
before his tax record was audited. The annual meeting included a report on the
marketing efforts for Mail it Safe and the announcement of the new CashOnTime
software. What interest could he and the other franchisees have had in
attending a debriefing on the marketing efforts for Mail it Safe and an
announcement of the new CashOnTime software? To ask the question is to answer
it. Prima facie, it is therefore more likely than not that the appellant
and the franchisees participated in a commercial activity, contributed to this
activity financially and were interested in it like any other businessperson. If
the appellant's and the other franchisees' sole interest in acquiring a franchise
was to obtain tax deductions, they would not, in my opinion, have been interested
in keeping abreast of the work to market and develop the software. Assuming
that the appellant had other intentions makes no sense, especially if one
considers that his tax record was not even being audited when he attended the
annual meeting.
[213]
It seems obvious to me
that all the CRA's arguments, whether they were raised explicitly or not, are
based on the assumption that there was an elaborate scheme in place that was
carried out from 2002 until today. In other words, even though the scheme
theory was not referred to explicitly, it is apparent from the allegations made
in the Reply and the pleadings. In order to be plausible, however, such a
theory would require that, since 2003, thousands of taxpayers (most of whom are
doctors and dentists), together with the franchisor and its affiliate
companies, have been complicit in an elaborate deception, if not to say a vast
criminal conspiracy, to avoid paying taxes. In other words, in asking me to
dismiss the appeal, the Minister is indirectly asking me to confirm that all of
the promissory notes and all of the agency and management agreements entered
into between thousands of franchisees and the franchisor since 2002 are shams
and that therefore all of these individuals are essentially fraudsters, despite
the fact that at the end of an extensive search and seizure of the main
stakeholders, the Minister failed to find any counter letters or material
evidence suggesting that the promissory notes and management agreements were
shams. The respondent's theory, if it is established, necessarily means that
the appellant and the franchisee witnesses who testified (including Christian
Thibault, who, as a result of his bankruptcy, has no interest in the matter and
whose testimony is therefore not self-interested) perjured themselves. The
Minister's thinly veiled accusations are very serious. For this reason, and
because of the apparent implausibility and absurdity of the Minister's position,
I examined the evidence and the Minister's arguments with a great deal of
circumspection, reflection and care.
Respondent's position
[214]
The respondent bases
its analysis on Stewart v. Canada, supra. She submits that in
order to determine whether there is a source of income and, hence, a business,
one must ask whether the activity of the taxpayer is undertaken in pursuit of
profit, or whether it is a personal endeavour. According to the respondent,
this depends not only on the taxpayer's subjective intention to profit, but
also on a variety of objective factors that establish that the taxpayer carried
out a commercial activity in accordance with objective standards of
businesslike behaviour. In the respondent's opinion, that is the import of
paragraphs 53 and 54 of Stewart and in Symes v. Canada,
[1993] 4 S.C.R. 695. These standards or objective factors, which were listed by
Justice Dickson in Moldowan, supra, make it possible to make
an "overall assessment . . . whether or not
the taxpayer is carrying on the activity in a commercial manner"
(paragraph 55 of Stewart).
The respondent cites, inter alia, Madell v. The Queen, 2008 TCC
264, affirmed by 2009 FCA 193, where which Justice Little adopted this
approach.
[215]
The respondent adds
that tax considerations are not incompatible with the commercial nature of an
investment, as the Supreme Court of Canada determined in Walls v. Canada,
supra. However, for there to be a source of income, there must be
business considerations, otherwise the activity cannot be [translation] "clearly commercial in nature". Consequently,
an activity that is undertaken to give the impression that it is commercial in
nature, even though in fact the only activity actually engaged in is that of
obtaining tax refunds, is not, according to the respondent, a source of income.
The respondent also cites Moloney v. Canada, [1992] F.C.J. No. 905 (QL),
Bendall v. Canada, [1995] T.C.J. No. 1 (QL) (T.C.C.), and St-Laurent
v. The Queen, 2007 TCC 540.
Appellant's intention
[216]
The respondent submits
that, in the case at bar, the appellant acquired the franchise for the sole
purpose of reaping tax benefits.
[217]
Citing Walls, supra,
the respondent argues that for there to be a source of income, there must be
commercial motivations; otherwise the activity cannot be of a commercial nature.
In the case at bar, the respondent alleges that the appellant acquired the
franchise with the sole purpose of enjoying tax benefits, since he showed [translation] "a complete lack of interest in anything
regarding the marketability of his first business and did nothing to ensure
that the franchise would provide him with any kind of income". More
specifically, the respondent submits that the inquiries made by the appellant
before purchasing his franchise and his conduct after acquiring it merely
confirm the respondent's position that the appellant's sole purpose when
acquiring the franchise was to reap tax benefits.
[218]
In that regard, the
respondent has compiled a long list of items the appellant did not verify when
he acquired the franchise, such as the price of the software, competing
products, the history of the other franchises, the total number of other
franchises, the break-even point, potential clients, PIN's and Network's senior
managers and employees, the incorporation of PIN and Network, the agent who
managed the franchise for the appellant and the agent's ability to generate
sales.
[219]
Contrary to the
respondent, I do not believe that the absence of extensive inquiries is
indicative of the appellant's intention. Moreover, requiring that the appellant
had thoroughly looked into all aspects of the Prospector company is not in line
with the principles laid down in Stewart. In my opinion, taxpayers may
invest in a company on the advice of their broker or another advisor whom they
trust, without inquiring into the price of the company's products, the company's
competitors, the sales and profit history, the company's senior managers,
potential clients and the company's incorporation. Again, an absense of inquiries
does not prove that a taxpaying investor was not in pursuit of profit. If they
were no longer able to rely on their long-standing advisors, few Canadian
taxpayers could claim tax deductions in respect of their investment in a
company.
[220]
The evidence rather
shows that the appellant's motivations were both tax-related and commercial. Indeed,
the appellant's steps when he acquired the franchise clearly establish that he
had commercial motivations. Mr. Legault, the financial advisor he had been
dealing with since the mid-1990s, suggested that he purchase the franchise in
2005 and 2006 (Transcript, January 30, 2012, Questions 37, 43, 57 and
65). Mr. Legault told him that he himself had invested in the company (Transcript,
January 30, 2012, Questions 78 and 79). The appellant explained that he
had decided not to buy the franchise in 2005 and 2006 because he lacked the
necessary funds (Transcript, January 30, 2012, Questions 61, 62 and
64). He decided to only buy RRSPs, as he had done in previous years (Transcript,
January 30, 2012, Questions 63 and 64). In 2007, Mr. Legault
suggested a third time that the appellant purchase a franchise. He explained to
the appellant that the Mail it Safe software had attracted major clients such
as Revenu Québec, the Barreau du Québec and the Barreau's New York counterpart
(Transcript, January 30, 2012, Question 67). Mr. Legault also
told him that 2007 would probably be the last year in which such franchises
would be offered (Transcript, January 30, 2012, Questions 801 to
804). Before signing the agreements, the appellant reviewed two brochures (Transcript,
January 30, 2012, Questions 100 and 329 to 333). One of the brochures
(A‑3.1, Volume 1, page 59) described the history of PIN and Network;
the partnership with IBM; the software being marketed (Solutions Prospector and
Mail it Safe); the nature of the franchise; the marketing strategy; the valuation
of Wise, Blackman; and the tax implications. The second brochure (A‑3.2,
Volume 1, page 101) dealt with adapting Mail it Safe to various
platforms; Network's participation in trade fairs targeting the legal market;
partnerships with, among other organizations, the CsBQ, the CIGM, IBM and the
New York County Lawyers' Association (NYCLA); Wise, Blackman's valuation; the
company's vision for 2007, research and development activities and the franchisee
recommendation program. The brochure did not mention the tax consequences of
the franchises. After the 2007 annual meeting, the appellant thought about the
suggestion and contacted Mr. Legault one or two days later to ask him to
send him the paperwork, including the franchise agreement, the agency agreement
and the promissory note, and to mark with sticky notes where he had to sign (Transcript,
January 30, 2012, Questions 86 and 87). The appellant did not deem it
necessary to make additional inquiries because he trusted his long-standing
financial advisor, who himself had invested in the franchises (Transcript,
January 30, 2012, Questions 98 and 100).
[221]
The respondent submits
that the appellant's conduct after he purchased the franchise also shows that
he had solely acquired it to obtain tax benefits.
[222]
In her written
submissions, at paragraph 59 of her analysis, [translation] "Drouin's motivations for acquiring a franchise",
the respondent makes the following statement:
[translation]
[59] Another indication of Drouin's complete lack
of interest in his franchise is the fact that, during 2007, Drouin would have
had every interest in operating the franchise himself. In fact, the 2007 franchise
agreement (A‑1.1.1) does not provide for any royalties should Drouin have
done so without going through the agent!
In other words, to show that he intended to make a
profit, the appellant, according to the respondent, should have essentially
left his employment and gone door to door to sell software in the territory
assigned to him in the United States.
[223]
The respondent's
position that the appellant had to personally participate in operating his
franchise to show that not only he but also his so-called commercial activities
were serious is simply unfounded in law. As stated by Chief Justice Jackett in ESG
Holdings Ltd., supra, "the question as to how active the
proprietor was in the business activities would not seem to be relevant. To me,
this would seem self-evident and its statement does not constitute the
enunciation of any general principle". The appellant always intended to
operate the business through his agent, as was done by the taxpayers in Stewart
and Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536.
[224]
The respondent also
submits that the appellant showed an absence of interest in his franchise
(after he purchased it) by not having any contact with Network representatives
before the April 30, 2009, meeting.
[225]
In my opinion, the
evidence rather shows that the appellant's behaviour after his purchase was
consistent with his opinion that Network was in the process of marketing Mail
it Safe and its derivative products for his benefit. The evidence shows that in
2008, Mr. Legault informed the appellant that everything was going well. Mr.
Legault had him sign new agreements and told him that the term of the
promissory note had been extended to 10 years in order to better reflect
the product lifetime, in return for an increase of the balance owing to
$230,000. Mr. Legault informed him that this was a [translation] "normal operation" and that the agreements
were updated regularly to respect new standards and new legislation (Transcript,
January 30, 2012, Questions 237 to 241). The appellant received the
February 16, 2009, invitation to the April 30, 2009, general meeting
(Exhibit A‑40). I note that nowhere in this document is there any mention
of tax consequences. The appellant attended the meeting (Transcript,
January 30, 2012, Question 338) when he did not yet know that his
file was being audited (according to the testimony of Ms. Bartolini of the
CRA, the file was assigned to auditor Nathalie Belzile in mid-May 2009,
and the first form was sent to the appellant on June 1, 2009) (Transcript,
March 19, 2012, Questions 16 and 20). What interest could the appellant
have had in attending the April 30, 2009, meeting (which included an
update on Mail it Safe marketing efforts and the launch of the new product
CashOnTime) if his sole goal in acquiring the franchise was to obtain tax benefits?
To state the question is to answer it. The appellant also testified that he
read all the information sent to him by Network. Again, why would the appellant
have read these releases before the annual meeting if his sole purpose in
acquiring the franchise was to obtain tax benefits?
[226]
Moreover, the
respondent criticizes the appellant for not having a [translation] "plan" for [translation] "rectifying the situation". In my opinion,
this criticism is unreasonable, given the history of his participation in the
business. I note that the appellant became a franchisee in December 2007. He
was not expecting any returns in the short term because of the nature of the
products. In 2008, Mr. Legault assured him that everything was going well.
In 2009, he attended his first meeting, where Mr. Vincent and Mr. Yacoub
announced that the company had been sold and that new software had been
developed. A few months later, he learned that his company was being audited. The
question is how the appellant could have known in summer 2009 that he would
have to prepare a [translation]
"recovery plan" for
his franchise.
[227]
The appellant provided
an honest testimony according to which he was motivated by two considerations
when he acquired the franchise in 2007: first, taking advantage of tax benefits
and, second, making a profit from this long-term investment. Since he was
familiar with the computer industry, he saw great sales potential in Mail it
Safe (Transcript, January 30, 2012, Question 112). The testimony of
the five franchisees is similar. All seemed to be credible, honest witnesses
(including Dr. Thibault, whose bankruptcy ended the dispute with the CRA
and who, consequently, no longer has an interest in the proceeding at bar). They
submitted that they acquired their franchises because they saw it as a good
investment that would also allow them to reduce their tax burden.
Commercial nature of the franchise
[228]
The respondent's
arguments regarding the commercial nature of the appellant's franchise are
found at paragraphs 556 to 560 of the respondent's written submissions, as
reproduced below:
[translation]
556. As in Madell, Moloney and Bendall, the
evidence shows that, during the year at issue and at any other relevant point
in time, Drouin did not carry out any activities to market his franchise, any
more than his agent Network did (section 2.3 of the Facts).
557. The Drouin franchise "is nothing more than a pale
imitation of a business" (see Bendall, above at note 16,
paragraph 13) and the structure that was set up serves merely to make it
look commercial. Even though Network or even MIS could have carried out
activities to their own benefit, at no point was it intended for the marketing
activities to benefit Drouin or the other franchisees.
558. With regard to the marketing efforts, the evidence shows
that none of the marketing activities was carried out for Drouin's franchise,
be it by Drouin himself or through his agent (sections 2.3.2 and 2.3.3 of
the Facts).
559. We have thus seen that, on December 27, 2007, when
Drouin signed the franchise agreement and the 2007 agency and management
agreement, Network already no longer had any employees assigned to developing
and marketing the software. Network also no longer had an office or employees
in the U.S. territory, that is, the territory allegedly assigned to franchisees
such as Drouin. Lastly, no marketing efforts were made based on the specific
list of Drouin or any of the other franchisees. It was impossible to undertake
marketing efforts on any of the franchisees' territories (sections 2.3.2.
and 2.3.4 of the Facts).
560. During the year at issue and at any other point in time,
there were no marketing activities for the Drouin franchise. Before Drouin even
signed the 2007 agency and management agreement, Network could not have intended
to act as agent to do the marketing on behalf of Drouin since, in any case, it
did not have the resources to do so.
[229] In short, the respondent essentially admits
the following:
(i)
The software existed:
(ii)
Herculean efforts had
been expended to market the software in Canada, the United States and
elsewhere;
(iii)
Developing and
marketing the software had required significant funding;
(iv)
The necessary funds had
been lent by licensees and franchisees.
[230]
I repeat that the
respondent's position is that all of the development and marketing efforts were
undertaken solely to benefit PIN and its affiliate companies. In other words,
the respondent submits that the commercial activities of Network and MIS were
never carried out on behalf of the franchisees.
[231]
As I explained earlier
(see paragraphs 208 to 211), the respondent's position seems implausible
and illogical, since the respondent does not challenge the existence of the
appellant's franchise. I could have understood the respondent's position if the
respondent had alleged that the franchise (like the promissory note and the agency
agreement) was a sham. Indeed, if it had been intended that the marketing efforts
solely benefited PIN and its affiliate companies (as the respondent submits),
it seems clear that the parties would have entered into a (oral or written)
agreement to ensure that PIN and its affiliate companies did not have to share
the fruits of their marketing efforts (efforts that are not being disputed by
the respondent). I repeat, if PIN and its affiliate companies were as deceitful
and crafty as the respondent suggests, they would have necessarily arranged (by
concluding an agreement with the franchisees) for the franchises to be shams in
order to ensure that the franchisees did not benefit from their marketing
efforts.
[232]
Regarding Network's
lack of activity as of 2007, the evidence has revealed the following:
(i)
In 2007, after three
years of costly efforts, Network realized that its strategy for taking the
United States by storm was not working and that it needed a new business plan
for marketing its two computer programs in the franchises' territory. Network
therefore decided to spend its efforts on making Mail it Safe successful in
Quebec, which was not part of the territories assigned to the franchises, and to
then use Quebec as a storefront that would benefit all franchisees (Examination
of Mr. Duhamel, Transcript, February 8, 2012, Question 913; Transcript,
February 28, 2012, Questions 33 and 36; and Examination of
Mr. Vincent, Transcript, January 25, 2012, Questions 656 to
658).
(ii)
To implement the
strategy, Network hired Mr. Yacoub. Mr. Yacoub's efforts bore fruit,
and on July 9, 2007, an agreement was concluded between Network and the
Ordre des conseillers en ressources humaines et en relations industrielles
agrées du Québec. Network was successful in making several sales in Quebec in
2007. Moreover, in the second half of 2007, Network and the Montreal office of
IBM were conducting intense negotiations.
(iii)
Mr. Yacoub hired
other executives in 2007, including Mr. Vincent and Mr. Lamontagne.
(iv)
In December 2007,
it was decided to create MIS to provide a structure for Mr. Yacoub's work.
The creation of MIS had two objectives. First, Mr. Yacoub and
Mr. Lamontagne did not want to have to deal with the dispute with the tax
authorities. Second, the creation of a new company made it easier to issue
shares as an incentive for senior managers. The Network employees who worked on
developing the two software programs were transferred to MIS.
(v)
Even though MIS was
successful in selling Mail it Safe to credible clients in 2007 and 2008, the
results were disappointing. As a result, in 2008, for the third time in six
years, it was decided to develop a new commercial computer program based on the
tracking technology previously developed by Network. In August 2009, work to
develop the commercial program CashOnTime therefore began.
[233]
Indeed, the respondent
submits, when the appellant signed the agreements on December 28, 2007, Network
no longer had any employees assigned to developing and marketing the two
programs, nor did it have offices and employees in the United States. The question now is the following: does the lack of marketing activities on
the part of Network as of 2007 therefore mean that the franchise was not of a
commercial nature?
[234]
The fact that Network
chose to cease operations while waiting for MIS to create a storefront in
Quebec before resuming its efforts in the United States in order to find value-added
resellers and to attract a giant does not, in my opinion, detract from the
franchise's commercial nature. Malo v. The Queen, 2012 TCC 75, is
instructive in this regard. Moreover, if I rely on what expert Mr. Ouellet
said, namely that, when it comes to radical innovations, and specifically in
the field of software, it is important to build storefronts and to perform case
studies to reassure the rest of the market (Transcript, March 13, 2012, page 87,
lines 17 to 25), the strategy Network adopted seems logical and appropriate
in the circumstances.
[235]
It was clear for
Mr. Vincent that, even though there was no legal relationship between the
franchisees and MIS, that MIS's activities had two major impacts on the
franchises:
(a)
the creation of a storefront
in Quebec would facilitate future efforts in the United States, especially with
regard to finding value-added resellers in order to attract a giant;
(b)
the technological
improvements to Mail it Safe and the development of derivative products would
immediately be added to the franchises under the franchise agreements (Examination
of Mr. Vincent, Transcript, January 25, 2012, Questions 659 to
663).
[236]
It is also true that
the agreements entered into with Prospector could have been interpreted as MIS
being a competitor of the franchisees. Yet, as one can see from the testimony
of Mr. Klein (Transcript, April 3, 2012) and Exhibits A‑136
and A‑138, MIS's and PIN's respective roles were clarified so as to respect
the parties' initial intention: MIS's role was to develop the software and to
market it only in Canada, and PIN was to market the software abroad, through
its network of franchises. Contractual errors are run-of-the-mill in business,
and they do not automatically destroy the legal relationships between parties. In
such cases, one must consider the parties' intention. In the matter at bar, the
parties' initial intention regarding MIS's role was clear.
Factors and objective elements
[237]
The respondent correctly
submitted that an activity that is undertaken to give the impression that it is
commercial in nature where in fact the only activity actually engaged in is
that of obtaining tax refunds is not a source of income. The respondent submits
that in the case at bar, the evidence clearly shows that PIN and its affiliate
companies had set up a structure and undertaken activities to give the
impression that the franchisees' business was commercial, although in fact the
only activity engaged in was that of obtaining tax refunds. In other words, the
evidence clearly shows, according to the respondent, that there was elaborate
deception to conceal the franchisees' true intention in acquiring franchises,
which was to obtain tax benefits.
[238]
In that respect, the
respondent argues that Network did not carry out any marketing activities on
behalf of the appellant's franchise in a specific marketing territory, meaning
that it was impossible to reap a profit from the sale of the software. It is my
opinion that the fact that the marketing activities were not carried out in the
appellant's specific territory does not mean, however, that it was impossible for
the appellant (and the franchisees) to realize a profit from his franchise. In
support of this opinion, let's return to the example where Microsoft offered one
billion dollars to buy the technology and the rights to market the software. It
is undeniable that Microsoft would not have invested such an amount without
ensuring that it owned all the rights to market the software in the United
States. It is therefore more likely that in such a situation, a substantial
share of the billion dollars would have been used to buy out the franchisees collectively
and to purchase their rights to market the software in the United States even
if each franchise's territory was vague. Indeed, it is more than likely that,
after its initial verification, Microsoft would have required PIN to obtain
from all the franchisees a waiver of their rights to market in the United States. PIN would have had no choice but to pay the franchisees a substantial share
of the one billion dollars, probably shared equally. Given the agreements, the
news releases PIN sent to the franchisees and the promises made to the
franchises, PIN could not have told the franchisees, "You're not entitled
to any of the one billion dollars because your territories are unclear". In
such a situation, the search for a logical interpretation that is consistent
with the parties' intention would probably have resulted in the amount
allocated by Microsoft to the rights to market the software in the United
States being equally distributed between the franchisees. I also note that the
2007 and 2008 franchise agreements include a shotgun clause, under which
franchisees must agree to an important change if 75% of the franchisees
convened for that purpose are in favour of the change, on the condition that,
if the change is a sale, the sale is realized under the same conditions for all
franchisees (Exhibit A‑1.1.1, Clause 2.2 and Exhibit A‑1.2.1,
Clause 3). Furthermore, the fact that the franchisees do not know what their
territories are and that the territories were not assigned without delay does
not affect the legal relationship created between the parties or the
description of their commercial activities. The apparent vagueness surrounding
the territories assigned to each of the franchisees does not cause the
franchise agreements to become null and void, but simply requires searching for
a logical interpretation that is consistent with the parties' intention. In my
opinion, the confusion about the territories is largely attributable to two
simple facts:
(a)
First, the description
of the territory evolved significantly over the years, in conjunction with
access to a databank.
(b)
Second, the evidence
has established that, since the birth of PIN, the guiding principle was to
attract the first clients and credible partners, then enter into an agreement
with important value-added resellers in order to achieve maximum market
penetration in the United States, and ultimately, to attract a giant such as
Google or Microsoft to buy everything, producing a profit for all of the
franchisees. Given this guiding principle and the fact that the implemented
strategy had not yet borne fruit, the specific territory of the franchisees was
of little importance to the franchisees and therefore not of particular
interest to the franchisees or PIN and its affiliate companies.
In Malo, supra, each investor owned "a
certain number of designated trees" (paragraph 2(d)), and the trees
were designated only after the contract was concluded. Some trees may even have
been planted after the contracts were signed. The lack of precision about the
nature of the property purchased did not prevent the Court from finding that
the appellant was carrying on a business.
[239]
To illustrate that the
whole thing was a deception, the respondent also submits that when the
appellant bought the franchise in 2007, Solutions Prospector was no longer
being marketed, and Mail It Safe did not allow the company to be profitable. The
respondent adds that the 2008 franchise agreement did not include CashOnTime
and that this program was only actually marketed after the period at issue. In
other words, the respondent submits that these elements show once again that
the appellant's business could not be profitable and that the motivation that
pushed the appellant to buy the franchise could only have been tax-related.
[240]
The fact that
Mr. Mathieu's use of Mail it Safe inspired the creation of CashOnTime, and
MIS's and PIN's promises to the franchises, lead me to believe that CashOnTime
was a derivative program that the appellant and the franchisees could market
under the 2008 franchise agreement. Indeed, in an update dated December 10,
2008, MIS informed the franchisees of the creation of CashOnTime and of the
marketing of this software (Exhibit A‑109, page 11509). On
February 16, 2009, MIS announced to the franchisees that CashOnTime had
been [translation] "officially launched" and invited them to a
meeting on April 30, 2009, the goal of which was [translation] "to share [with them] MIS International's
business plan". In the minutes of this meeting, sent to the franchisees in
July 2009, PIN reiterated the objectives and described the steps under way
and the CashOnTime market studies being performed (Exhibit A‑22.1.36,
Volume 17, page 7419). The evidence further reveals that the efforts to
market CashOnTime were initiated in 2008, while the program was still at the [translation] "vapourware" stage, that is, it wasn't
completely ready. This is what appears from a presentation to MIS's management
on August 28, 2008 (Exhibit A‑22.1.29, Volume 17, page 7314), and
an update sent to the franchisees (Exhibit A‑109, page 11509). I
note, moreover, that the efforts to market Mail it Safe continued in 2008
(Exhibit A‑109, page 11509) and that there were sales during that
year (Exhibit A‑31, pages 10028, 10055, 10078 and 10114).
[241]
The respondent
concludes from the fact that, in the case at bar, only the Mail it Safe software
was being or could be marketed (Solutions Prospector no longer being marketed)
when the appellant purchased his franchise in 2007 that the business was no
longer viable and that the appellant was therefore not carrying out a
commercial activity but was rather participating in a sham set up to appear as
though it was commercial in nature where in fact the only activity actually
engaged in was that of obtaining tax refunds. In other words, the respondent
indirectly alleges that the fair market value ("FMV") of the
franchise at the time of its acquisition in 2007 was nil, since, in fact, the
franchise entitled the appellant to market a single product (in the matter at
bar, Mail it Safe) and that the appellant's motivations when buying the
franchise could therefore not have been commercial. First, I note that the
Minister (who had the burden of proof) did not establish that the FMV of the
appellant's franchise in 2007 was nil. Moreover, it is my opinion that the
appellant's motivations when he acquired the franchise in 2007 were commercial,
the evidence revealing that what the appellant was told before he acquired the
franchise in 2007 had satisfied him that his investment would be profitable in
the long term. The evidence also revealed that PIN and its affiliate companies
were convinced in 2007 that Mail it Safe would be a success. In 2007, after
some costly efforts, Network realized that its strategy for taking the United
States by storm was not working and that it required another business plan for
marketing the software in the franchisees' territory. Network therefore decided
to temporarily suspend marketing the software in the United States. The
strategy was for MIS to first develop a storefront in Quebec, which would then
serve as a springboard for marketing the software in the United States. It is
therefore difficult for me to conclude from this evidence regarding the parties'
conduct that they participated in a sham set up to appear as though it was
commercial in nature.
MarketX
[242]
Since MarketX had not
been incorporated when the appellant signed the agency agreement in 2008, the
respondent submits that [translation]
"during the period at
issue", only Network existed and could have acted as agent for Drouin".
However, the respondent submits [translation]
"that Network never acted
as agent for Drouin during the year at issue". The respondent adds that [translation] "if, however, Network had
acted as agent for Drouin in 2008
(in replacement of MarketX, which never saw the day), it would have been
subject to the only agreement in effect, namely, the agreement to which it was
a party, the 2007 agency agreement". Consequently, according to the
respondent, [translation] "during the years at
issue, the 2008 version of the
franchise agreement combined with the only agency agreement in effect, that of
2007". According to the respondent, this combination [translation] "resulted in Drouin being obliged not only
to pay his franchisor 20% of his gross income (Exhibit A‑1.2.1, Clause 12.2,
page 38) but also to pay his agent 94% of his gross income (Exhibit A‑1.1.3,
clause 3.1, page 18)". Lastly, the respondent adds that [translation] "the result of both agreements
in effect being applied was absurd, since it meant Drouin having to pay 114% of
his gross income in royalties and commissions to his supposed partners".
[243]
The respondent submits
that the fact that MarketX did not exist when the 2008 agency agreement was
signed is another clue that the appellant had participated in a sham set up to
appear as though it was commercial in nature where in fact the only activity
actually engaged in was that of obtaining tax refunds.
[244]
The evidence has
revealed that the appellant signed an agency agreement with Network in 2007 in
order for Network to market his franchise (Exhibit A‑1.1.3). On
December 19, 2008, the appellant signed a new franchise agreement and an agency
agreement with MarketX (Exhibit A‑1.2.1), a company that was to be
created in order to put [translation]
"some distance between the international franchisor and the agent"
(Testimony of Mr. Teasdale,
Transcript, January 26, 2012, Question 420). According to the
testimony of Mr. Duhamel, PIN had to give MarketX the mandate to market the
franchises, and, in turn, MarketX had to give this mandate to Network (Transcript,
February 6, 2012, Question 385). MarketX was never incorporated, and
it wasn't until March 2009, during the sale to Mr. Bernier, that
Mr. Duhamel became aware of this (Transcript, February 6, 2012, Question 433;
and Transcript, March 21, 2012, Questions 82 to 84). The appellant
testified that he learnt that his agent didn't exist at the April 30,
2009, annual meeting. The appellant therefore took for granted that Network
remained his agent, since MarketX had been supposed to replace Network (Transcript,
January 30, 2012, Questions 459, 460, 464 to 474, 724 and 758 to 761;
and Transcript, March 21, 2012, Questions 23 and 24). According to a
resolution on March 25, 2009, entitled "Resolution of Board of
Directors of Prospector International Network Inc." (Exhibit A‑80),
PIN would take over all of MarketX's rights and obligations. In short, the
appellant was without an agent for barely three months.
[245]
First, the respondent's
allegation that [translation]
"Network never acted as an
agent for Drouin during the year at issue" seems unfounded. Indeed,
according to the 2007 agency agreement, Network was the appellant's agent until
December 18, 2008, the date on which the appellant signed the 2008 agency
agreement. At most, therefore, the appellant was without an agent for 11 days during
the period at issue in 2008. In any event, as of 2007, no marketing activities
were carried out in the franchisees' territory, given MIS's strategy of first
developing a storefront in Quebec, which would then serve as a springboard for
marketing the software in the United States.
[246]
In my opinion, the
issue here is not whether the 2008 agency and management agreement is null and
void and whether, as a result, the 2007 agency agreement remained in effect,
but rather whether the fact that the anticipated restructuring did not happen
as planned is a clue that the parties participated in a sham again set up to
appear as though it was commercial in nature where in fact the only activity
actually engaged in was that of obtaining tax refunds.
[247]
In the light of the
evidence, it seems clear to me that the fact that the restructuring did not
happen as planned does not show that the parties participated in a sham. When
PIN and the appellant realized that MarketX did not exist (a few months after
the signing of the 2008 agency and management agreement), they did not even
bother rectifying the situation in writing because, in their minds and in actual
fact, Network had not ceased being the appellant's agent. We must not forget that,
at the end of the day, a contract is made through an exchange of consent
between parties. The fact that Network temporarily suspended its marketing
activities in the territory of the franchisees (for the reasons explained above)
does not mean, however, that Network stopped being an agent.
[248]
Indeed, the combined
effect of the 2008 franchise agreement and the 2007 agency agreement created an
[translation] "absurd situation"
since, according to percentages
determined in these agreements, the proportion of the gross income earned by
the appellant would be negative. When faced with an [translation] "absurdity", the
obvious solution is to seek a logical interpretation that is consistent with the
parties' intention. It seems clear from the evidence that, in the minds of the
parties and in actual fact, Network
never ceased being the real agent and the conditions governing its mandate were
those set out in the 2008 agency and management agreement.
Are the 2007 and 2008 agency agreements shams?
[249]
The lack of marketing
efforts on behalf of the franchisees leads the respondent to challenge the very
existence of the 2007 and 2008 agency agreements. Under the heading [translation] "Other relevant facts",
the Minister alleges at
paragraph 26 of the Reply to the Notice of Appeal that the agency agreements were shams. The fact
that the burden of proving the sham allegations rests on the respondent is not
being disputed. But the respondent has failed to satisfy this burden.
[250]
For there to be a sham,
the parties must enter into an agreement to deliberately deceive the tax
authorities about the rights and obligations created by the agreement (see Stubart
and Nunn, supra). In the case at bar, as in Stubart, the agreement
recorded in the documents accurately reflects the reality in my opinion, and it
is impossible for me to conclude that the appellant signed an agency agreement with
the deliberate intention of misleading the CRA. Indeed, Network no longer having
any employees for it to be able to market the software on behalf of the
franchisees is not enough, in my view, to allow me to conclude that it never intended
to market the software. Indeed, Mr. Duhamel provided a logical, detailed
explanation for the fact that there was almost no activity on the part of
Network as of 2007 (see paragraph 52). Moreover, as I noted in my preliminary
remarks, the respondent's admission as to the reality of the franchise makes
the fact that the mandate existed more likely (see paragraphs 208 to 211).
Is the promissory note a sham?
[251]
The respondent submits
that the purpose of the $3,500 payment made in 2010 and the $3,500 payment made
in 2011 by the appellant (and the other franchisees) under an agreement entered
into between the appellant (and the other franchisees) and Prospector that
amended the 2008 promissory notes (see Exhibits I‑29 and I‑43)
was to conceal the actual agreement between the parties, which was that the
parties had agreed to the price of $45,000 for a franchise. The promissory
notes are therefore shams, for the following reasons:
(i)
The terms of the
agreement under Exhibit I‑43 were not consistent with the appellant's
explanations of the $3,500 payments made in 2010 and 2011. Indeed, the
appellant explained that, according to the information he received from his
financial advisor, Mr. Legault, he was to pay a total amount of interest
of $52,000 (3 x $15,000 + 2 x $3,500 = $52,000) for his
franchise (Court Reporter's Notes, January 30, 2012, Mr. Drouin, at page 128,
line 18; at page 129, line 2) following the agreement reached
between the parties to amend the terms of the 2008 promissory note. According
to this agreement, the interest rate was decreased to 1.75%, effective
retroactively to 2007, and the annual payments were $3,500, effective
retroactively to 2007. The agreement also stipulated that any sum paid by the
franchisee over the course of a given year (a period of 12 consecutive months
starting from the signature of the promissory note) that exceeded the interest
payable and the principal amount to be reimbursed each year ($1,500 in the case
at bar) was interest and principal paid in advance, [translation] "which the Franchisor
could apply to the interest and the principal owed by the Franchisee for a
subsequent year". The
final result of these amendments, according to Mr. Duhamel, was that the
franchisees had to pay $3,500 in 2010 and in 2011, $1,500 of which was a
capital payment, and that after 2011, the franchisees would not have to pay
anything before the maturity date, when a lump-sum and final payment became due.
(ii)
The agreement does not
make it possible to determine when it came into effect. It provides that the
agreement comes into effect on the date of signature of the promissory note,
without specifying whether the promissory note in question is the 2007 or the
2008 promissory note. The respondent notes that Mr. Duhamel's and the
appellant's explanations in this regard were confusing.
(iii)
The tax treatment of
the interest paid by the appellant is not consistent with the promissory notes
or the 2010 retroactive agreement.
[252]
The onus was on the
respondent to show that the promissory note was a sham. The CRA, after an
extensive search and seizure of the main stakeholders, was forced to recognize
that there were no counter-letters or other documents showing that the
obligation to pay on the maturity date was a sham (see the examination for
discovery of Normand Desjardins, June 23, 2011, pages 46 and 47). If
there was such an elaborate deception, would it not have left traces that the
CRA's searches would have discovered? As I mentioned in my preliminary
comments, concluding that the promissory note is a sham, to some extent, means
indirectly concluding that over a thousand franchisees (most of whom doctors
and dentists) concluded an agreement with Prospector or Network to knowingly
make a false declaration in order to mislead the tax authorities about their
obligation to pay on the maturity date. A sham requires prior planning and the
commission of acts or the creation of documents that give third parties a false
impression of the actual transaction. This false impression must be deliberate.
Among other things, I heard the testimony of the appellant and the five other
franchisees chosen by CRA on the nature of the contractual commitments to pay
their debt at maturity. In the light of these testimonies, I simply cannot
conclude that all these witnesses perjured themselves, as suggested by the
respondent, in order to deceive first the CRA and now the Court. Each witness
testified honestly that he had bought a franchise to reap tax benefits and to
be part of an attractive high-tech company. Each witness testified that he had promised
to pay the debt at maturity according to the terms of the promissory note. The
respondent's argument that the testimony of these witnesses is suspicious
because of their personal interest, therefore making it not credible, is
unfounded in my opinion. In any event, this argument can hardly be applied to
Dr. Thibault, whose bankruptcy put an end to the dispute with the tax
authorities.
[253]
Indeed, the
contradictions between the agreement and the appellant's testimony, the
ambiguities in the agreement, the inaccuracies in the testimony of Mr. Duhamel
in that regard, and the appellant's tax treatment of his interest payments,
which is not consistent with the terms of the promissory note or the 2010
retroactive agreement, are troubling and may suggest that the promissory note
was a sham. In my opinion, these factors are troubling, but not to the point of
satisfying me that the promissory note was a sham.
[254]
First, the
contradictions between the testimony of the appellant and the 2010 retroactive
agreement can be explained as follows in my opinion: the agreement is very hard
to understand. It was negotiated by the appellant's financial advisor. The
events date back a number of years, and the appellant's financial obligations towards
PIN and its affiliate companies were the subject of many complex changes. What
other explanation is there for the contradiction between the appellant's
testimony that the $3,500 payment in 2010 represented interest and his 2010
income tax return indicating that he was claiming interest charges in
accordance with the 2010 retroactive agreement (see Exhibit I‑27, Tab 154,
Statement of Business or Professional Activities T2125, page 2, line 8710)?
The appellant's failure to understand or to remember how his financial
obligations toward PIN evolved does not, in my view, affect the validity of his
legal relationship with PIN. Indeed, the agreement contains ambiguities. Such
ambiguities are run-of-the-mill in business and create a great deal of work for
lawyers and judges. They do not, however, remove the franchisees' obligation to
pay at maturity. I also find that the fact that Mr. Duhamel's testimony is
inaccurate in this respect can also be explained by the complexity and the
number of the changes to the franchisees' financial obligations and by their
dating back several years.
[255]
The many changes to the
franchisees' financial obligations can, in my opinion, be explained as follows:
every time the maturity date of the promissory notes approached, PIN was faced
with the dissatisfaction of the franchisees and, particularly, pressure from
the franchisees' financial advisors, first, because of the unsuccessful marketing
of the software and, second, because of the increasingly acrimonious dispute
with the CRA and Revenu Québec. Under such pressures, PIN had to resign itself
to reducing the franchisees' financial obligations by extending the maturity
date of the promissory notes and by lowering the interest rate without decreasing
the cost of the franchise. That at least is my interpretation of
Mr. Duhamel's testimony in this regard (Examination of Claude Duhamel, Transcript,
February 7, 2012, Questions 12 and 29 to 33). In short, the parties
found a way of postponing the maturity date of the promissory notes without
increasing the financial burden on the franchises and without reducing the
obligation to pay the $230,000 cost of the franchise. The fact that the parties
postponed the maturity date of the promissory notes several times does not
mean, however, that these promissory notes are shams. Lastly, I would add that
section 80 of the Act provides a comprehensive scheme for cases where
franchisees do not reimburse the amounts they owe and for which they claimed
deductions. In other words, the franchisees would not be able to avoid paying indefinitely
by postponing the maturity dates of the promissory notes.
Reasonableness of the claimed expense
[256]
Lastly, the respondent
submits that the capital cost allowance of $70,387 claimed by the appellant is
not deductible under section 67 of the Act since it is unreasonable in the
circumstances. The respondent submits that, under section 67 of the Act, excessive
or unwarranted expenses may be reduced (Stewart, supra, at
paragraph 57) and that this provision can be used to deny the deduction of
the whole expense, if it is shown to be unreasonable (Hammil v. Canada,
2005 FCA 252).
[257]
The respondent also
refers to the following excerpt from Gabco Limited v. M.N.R., [1968] 2
Ex.C.R. 511, in which Justice Cattanach set out the following test for the
application of section 67:
It
is not a question of the Minister or this Court substituting its judgment for
what is a reasonable amount to pay, but rather a case of the Minister or the
Court coming to the conclusion that no reasonable business man would have
contracted to pay such an amount having only the business consideration of the
appellant in mind.
[258]
The respondent submits
that the following factors clearly show that the expense claimed by the
appellant was unreasonable in the circumstances:
(i)
The appellant did not make
any inquiries prior to acquiring the franchise in 2007;
(ii)
The agent did not make
any marketing efforts for the benefit of the appellant, making it impossible to
generate sales;
(iii)
Given the cost
indicated in the franchise agreement, it was impossible for the appellant to
profit from his investment. The respondent essentially submits (see pages 32
to 36 of the respondent's submissions) that Network would have had to have
achieved annual sales of $582 million over 10 years for the appellant
to recover the actual cost of his 2007 investment in the franchise, which, I
repeat, was $200,000. Yet, according to the respondent, when the appellant
signed his agreement in 2007, a single product (Mail it Safe) was being
marketed, and the sales, which, moreover, were not generated to benefit the
franchisees, had reached a total of $43,894 (see Exhibit A‑81). The
respondent adds that Network had to achieve annual sales of $275,000,000 or $459,750,000
(depending on the actual number of franchises) in order for all of the
franchisees to recover the $15,000 in interest each of them had agreed to pay
in 2007. To some extent, the Minister is submitting that the FMV of the
appellant's franchise and the related rights is nil and that therefore the
expense claimed by the appellant for the 2008 taxation year is not deductible
under section 67 of the Act. I note that the Minister alleged at paragraph 25(s)
of the Reply to the Notice of Appeal that the [translation]
"fair market value of the franchise and the related rights was nil".
The Minister also alleged the following at paragraphs 26(cc), (dd) and (ee)
of the Reply:
[TRANSLATION]
Reasonableness
of the capital cost allowance expense
(cc)
The fair market value of a Prospector
International Networks Inc. franchise being low if not nil;
(dd)
The price paid by the appellant for the Prospector
International Networks Inc. franchise was much higher than the fair market
value of this franchise and is not reasonable in the circumstances;
(ee)
Consequently, the $70,387 claimed by the
appellant as a capital cost allowance for the cost of the rights related to the
acquisition of the franchise is not deductible since the argument is not
reasonable in the circumstances.
(iv)
Together, the 2008
franchise agreement and the 2007 agency agreement made it mathematically
impossible for the appellant to make a profit, since the total royalties and
commissions exceeded 100%.
[259]
Since I have already
analyzed the factors described in paragraphs (i), (ii) and (iv), above, I
will now turn to the question of the FMV of the appellant's franchise and the
related rights, since it is the basis of the Minister's assertion that the expense
of $70,387 is not deductible under section 67 of the Act.
[260]
The phrase "reasonable
in the circumstances" used in section 67 of the Act is certainly broad.
However, it is my view that it should not be applied to reduce expenses because
of the appellant's alleged poor business sense. It is my opinion that the
Minister's role and that of the Court is not to "to second-guess the
business acumen of a taxpayer whose commercial venture turns out to be less
profitable than anticipated" (Mastri v. Canada (Attorney General) (C.A.),
[1998] 1 F.C. 66, para. 12). I would add that Williams v. The
Queen, 2009 TCC 93, also referred to by the respondent, is of little
assistance in the case at bar since it deals with expenses related to the
appellant's home, while the present appeal concerns the cost of property.
[261]
Regarding the FMV of an
item of property, according to the Federal Court of Appeal as per Attorney
General of Canada v. Nash, 2005 FCA 386, that the assessment of the
appraisal was unnecessary and that the amounts paid by the taxpayers dealing
with each other at arm's length was the FMV of the works of art. In the case at
bar, the evidence reveals that the parties were dealing with each other at arm's
length and were acting freely and in their own interest. Moreover, the Minister
(who had the burden of proof) did not establish (with the help of an expert
witness for example) that the FMV of the franchises did not reflect the cost of
the franchises, and an additional appraisal was therefore not warranted. Even
if one assumes that the issue of the FMV is an assumption on the basis of which
the reassessment was made, it is my view that the evidence of the sale price of
the franchises between the parties dealing with each other at arm's length is prima
facie evidence that is sufficient for the appellant to discharge his
burden. Consequently, the expense claimed by the appellant seems reasonable in
the circumstances.
[262]
I would add that, even
though a cold, retrospective analysis to determine the FMV of a company may be
scientifically defensible, it does not reflect the actual situation of the
market at the time when the investment was made. As stated by Chief
Justice Bowman in McCoy v. The Queen, 2003 TCC 332:
[56]
. . . The business landscape is strewn with the cadavers of megadeals
that have gone catastrophically sour. I need not mention them by name. They are
legion and will be familiar to anyone who reads the business section of the
newspapers. Yet when the deals were consummated they were hailed euphorically
and the corporate movers and shakers who pulled off these spectacular mergers
and acquisitions, sometimes with less analysis than went into the launching of
MarketVision, were acclaimed as financial geniuses. When a year or so later the
structure falls to the ground the Monday morning quarterbacks shake their heads
and ask "How could they have been so stupid? Surely, it must have been
obvious that the deal had the seeds of disaster in it from the outset."
[57]
My common sense tells me that where a group of businessmen and professionals
with sufficiently high incomes that they find tax shelters attractive are
prepared to invest substantial amounts of cash for property that they
reasonably expect will yield income (including amounts sufficient to pay the
principal and interest on their promissory notes) and will produce a tax
advantage that the promoters, armed with a favourable opinion from a major law
firm, say will result, it is as unreasonable to say that the property was worth
nothing or virtually nothing as it is to say that it was worth $55,000,000.
Fair market value is in some measure a function of perception at the time
whether we are talking about real estate in boom times in the late 1980s,
stocks in 1929 before the crash or exotic tulips during the period of
tulipmania in 17th century Holland. In that perception irrational or overly
optimistic expectations may play a part. A cold blooded analysis five years
after the event, and after the rosy predictions have proved to be wrong, may be
scientifically defensible but it may not reflect the true state of the market
at the time. . . .
[263]
In conclusion, the
evidence shows the following:
(i)
The appellant acquired
his franchise in order to earn a business income. It is clear that the
appellant did not purchase the franchise as a hobby or other personal pursuit.
Even if tax considerations were a prime motivation for his acquiring the
franchise, they do not result in the appellant's business venture not existing.
(ii)
The intention of the
appellant's agent was to market the software on behalf of the appellant (and
the other franchisees). The information given to the franchisees in updates and
at franchisee meetings reveal that marketing efforts were made on their behalf.
(iii)
The appellant (and the
other franchisee witnesses) were under the obligation to pay the promissory
note on the maturity date.
In my opinion, the Minister erred in concluding that,
because of the commercial failure of PIN (and its affiliate companies) and of
the franchises; and the testimonies of the appellant, Mr. Duhamel and the
franchisee witnesses, which were ambiguous, confusing, incorrect and
incomprehensible at times and, on occasion, even contradictory; the parties had
devised an elaborate stratagem (to be implemented over several years) to give
the impression that they were operating a business when the only activity they actually
engaged in (still according to the Minister) was that of obtaining tax refunds.
[264]
Lastly, the case at bar
must be distinguished from Moloney, Bendall, Madell and St‑Laurent,
supra.
[265]
In Walls, the
Supreme Court found Moloney to be distinguishable, as follows:
21 The trial judge referred to the storage park operation as a "tax
shelter" and concluded that the reduction of tax was the sole motivation
for its existence, citing Moloney v. The Queen, 92 D.T.C. 6570
(F.C.A.). However, in that case, a circular scheme was set up for the
sole purpose of obtaining tax refunds with no intention on the part of the
taxpayer to carry on the business of marketing a speed reading course which was
the ostensible purpose of the transactions. It was in this context that
Hugessen J.A. stated, at p. 6570:
While
it is trite law that a taxpayer may so arrange his business as to attract the
least possible tax, it is equally clear in our view that the reduction of
his own tax cannot by itself be a taxpayer's business for the purpose of the Income
Tax Act. [Emphasis added.]
With
respect, the case at bar is distinguishable from Moloney. There, the
taxpayer was not engaged in a commercial activity, but instead was involved in
a sham set up to appear as though it was commercial in nature where in fact the
only activity actually engaged in was that of obtaining tax refunds.
Here, in contrast, the Partnership purchased and maintained an ongoing commercial
operation.
[266]
The present case is
distinguishable from Moloney in that the evidence has shown that, over
the years, a subsidiary of PIN had marketed the software to prestigious,
well-known Canadian clients in order to create a storefront, a strategy that
was described as being common and key by expert Mr. Ouellet and which
would have made it possible to do business with value-added resellers in the
United States, in accordance with the company's initial strategy. A great deal
of money was invested in the development and marketing of the software, whereas
in Moloney, the transactions between the related companies were circular
and simultaneous, meaning that no capital or credit was engaged by anyone in
the so-called business.
[267]
I also note that in Moloney,
Canadian sales were not considered, since the licensee's territory was in the
United States. In the case at bar, it has been shown that the Canadian sales
were of particular interest to the franchisees.
[268]
Moreover, contrary to Moloney,
the evidence in the case at bar showed the appellant's intention to market,
with the help of an agent, the software and to generate a profit from the
software. As the evidence has shown, the appellant had two goals, one, to take
advantage of tax deductions and to profit from the sale of software or the
potential acquisition of the company.
[269]
In Moloney, the
taxpayer also did not have to spend any of his own money and did not take a
financial risk. In the case at bar, the appellant had already spent $52,000 of
his own money, a sum that was not refundable under any condition, and agreed
unconditionally to pay his full recourse promissory note on the maturity date.
[270]
The present case can
also be distinguished from Bendall. In Bendall, the taxpayer had
participated in a similar operation as that in Moloney, with the
exception that the related companies did not engage in circular and
simultaneous transactions. Justice Bonner came to the conclusion that the
appellant's agent was not carrying on a business, while, in the case at bar, a
PIN subsidiary was working on building a storefront. Justice Bonner further
stated in his judgment that it was impossible to conclude that the taxpayers
seriously expected the agent to market the speed reading courses. In the case
at bar, not only were market and sales efforts undertaken, but also Network
told the franchisees that it had done a great deal to market the software. In
addition, the decision of the taxpayer in Bendall to make a new
investment two years later, even though he had not achieved any sales, does not
apply to the appellant who bought only one franchise.
[271]
The appellant's
situation is also distinguishable from the situation in Madell. In Madell,
the judge reached the conclusion that the taxpayer could not realize a profit
from his investment because he was required to return the entire revenues the
sales generated. In the case at bar, the agreements provided the appellant with
royalties.
[272]
Lastly, in St-Laurent,
the Court noted that if the facts had been different—if, for example, the
appellant had attended meetings, consulted the business plan and examined the
objectives—the outcome could have been different. Nothing in the evidence,
apart from the taxpayer's vague and unsubstantiated allegations, showed that
the taxpayer was pursuing profit.
[273]
For all of these
reasons, the appeal is allowed, with costs.
Signed at Ottawa,
Canada, this 3rd day of May 2013.
"Paul Bédard"
Translation certified true
on this 9th day of October 2013.
François Brunet, Revisor
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