Grand Toys Ltd. v. MNR, 90 DTC 1059, [1990] 1 CTC 2165 (TCC)

Lamarre Proulx, T.C.J.:—The appellant appeals reassessments of tax made pursuant to sections 215 and 227 of the Income Tax Act (the Act) involving non-resident tax.

The respondent has reassessed the appellant for its 1983 and 1984 taxation years on the grounds that in 1983 and 1984 the appellant paid to Panosh, a non-resident person, amounts totalling $269,221 and $366,262 respectively on account of or in satisfaction of, royalties or similar payments within the meaning of paragraph 212(1)(d) or on account of or in satisfaction of, payments for the use of or for the right to use in Canada the "names, characters, symbols, designs, likenesses and visual representations" [1] of certain dolls within the meaning of subparagraph 212(1)(d)(i) and failed to withhold and remit the amount of tax on behalf of the non-resident person as required by section 215 of the Act.

On December 15, 1983, the appellant, a corporation organized pursuant to the laws of Canada, [2] and Panosh, a joint venture organized pursuant to the laws of Hong Kong [3] executed an "Exclusive Distribution Agreement" (the Agreement) whereby the appellant was to have the exclusive right to distribute and sell throughout Canada 3V2"" articulated figurines, using the names, characters, symbols, etc. of Cabbage Patch Kids, The Little People From Babyland General and The Adoptables. I will reproduce what I consider the important parts of the Agreement:

WHEREAS, PANOSH and Distributor desire to enter into a relationship whereby Distributor will act as an exclusive distributor for PANOSH for the products specified in Schedule A hereto (the "Products") using the names, characters, symbols, designs, likenesses and visual representations (collectively, the "Names and Characters") specified in Schedule B hereto, upon the terms and conditions hereinafter set forth;

Now therefore . . .

1. Engagement of Distributor.

Subject to the terms and provisions hereof, PANOSH hereby grants to Distributor the exclusive and non-transferable right to distribute and sell the Products solely in the Territory described in Schedule C hereto (the "Territory") and Distributor hereby accepts such engagement.

3. Terms of Purchase and Sale of Products

3.1 Distributor shall place all of its orders with respect to the Products at the location designated in Schedule E hereto. Each such order shall be accompanied by an irrevocable letter of credit, payable on sight, in form and substance satisfactory to PANOSH. All orders shall be subject to acceptance or rejection by PANOSH; provided, however, that acceptance by PANOSH will not be unreasonably withheld. PANOSH shall promptly notify Distributor of any rejection of orders by written notice to Distributor.

3.3 PANOSH shall sell Products to Distributor in accordance with the price schedule set forth in Schedule F hereto. All prices are F.O.B. Hong Kong unless otherwise specified by PANOSH. All amounts payable pursuant to this Agreement shall be paid in United States dollars.

3.6 Distributor guarantees to PANOSH that the amount payable to PANOSH under this Agreement shall not be less than the Aggregate Buying Commission and Royalty Amount set forth in Schedule G hereto (such amount being hereinafter referred to as the “Guaranteed Minimum Purchases"). The Guaranteed Minimum Purchases shall be paid in the manner specified in said Schedule G. No costs incurred in the exploitation and sale of the Products by Distributor shall be deducted from the Guaranteed Minimum Purchases payable by Distributor hereunder.

Schedule F:

Price Schedule:

Per unit, the sum of

(i) the ex Hong Kong factory price, plus

(ii) 3% of such ex Hong Kong factory price (to cover office overhead), plus

(iii) a buying commission and royalty (the “Buying Commission and Royalty Amount") of U.S. $0.52.

Schedule G:

Guaranteed Minimum Purchases shall be a Buying Commission and Royalty Amount in the aggregate of U.S. $400,000 (the "Aggregate Buying Commission and Royalty Amount"), and shall be payable as follows:

(i) U.S. $250,000 shall be due on execution of this Agreement as a non- refundable credit against the Buying Commission and Royalty Amount payable per unit; and

(ii) U.S. $150,000, being the remainder of the Aggregate Buying Commission and Royalty Amount, shall be payable on or before 1/1/85.

It has to be noted that it is in relation to the purchase and sale of products that a price was quoted but not in relation to the granting of the distributorship.

The respondent considered that the Royalty Amount referred to in Schedule "F" of the Agreement was a payment within the meaning of paragraph 212(1)(d) or subparagraph 212(1 )(d)(i) of the Act. The Buying Commission was not separated in the first assessment. In the reassessment the Buying Commission was set at $0.07 U.S. per unit and excluded from the meaning of a payment contemplated by paragraph 212(1)(d). Nothing really was said about this distinction at the hearing.

The appellant submitted that the payments constitute part of the purchase price of goods acquired for resale by the appellant and therefore are not royalties within the common use of that term nor within any legal definition of that term and that, in any event, no matter whether the payments are characterized as part of the purchase price of the goods, the cost of the exclusive distribution rights, or a reimbursement to Panosh for some of its cost, they are clearly quite different from royalties, as they are not based on production from use of the property acquired.

I was first referred by counsel for the respondent to the case of M.N.R. v. Wain-Town Gas and Oil Co., [1952] 2 S.C.R. 377; [1952] C.T.C. 147; 52 D.T.C. 1138, a decision of the Supreme Court of Canada where Mr. Justice Kerwin said at page 151 (D.T.C. 1140):

It is settled by authority both here and in England that the appearance of the word "royalties" in the assignment does not necessarily dispose of the matter but, to quote Finlay J. in British Salmsom Aero Engines Ltd. v. Commissioners of Inland Revenue, (1937) 22 Tax Cases 29 at p. 35: —"the fact that people who, after all, know all about it, choose in their agreement to refer to these annual sums . . . as'royalties' is a matter not to be entirely neglected.”

In my view, this means that the use of the word "royalties" in an agreement between two parties is an element to be considered in the determination of whether a payment is a royalty or not but it does not mean that a payment that is described as a royalty is necessarily a royalty.

Counsel for the respondent referred me also to my own words in D & B Oilfield Contracting Ltd. v. M.N.R., [1989] 2 C.T.C. 2140; 89 D.T.C. 425, at

page 2145 (D.T.C. 429) where I said: "However, in view of the legal means chosen, I find that what has been sold is an interest in a partnership or a joint venture and shares of a company. The parties to the agreement could have chosen the route of purchasing or selling the assets directly, they did not." He argued that since the appellant had called the payments royalties it is bound by it and this means that it is the legal means chosen. I do not agree with this interpretation. What my words meant is that there may be various means to reach point B from point A and when that means is chosen, it cannot be said that it is the other means that had been chosen. I do not find that it relates to the name given to a contractual obligation.

As I have said already, to determine the nature of the obligations under an agreement, what an obligation is called may be of some assistance in interpreting the nature of the obligation but it does not mean that because someone has called an obligation something, that this resolves the nature of the obligation. The nature of a contractual obligation is determined by trying to ascertain from a careful review of the agreement, what was the intent of the parties, what was the nature of their undertakings or in other terms what is the agreement about.

Here are some excerpts from the testimony of Mr. Mars, the appellant's president, explaining the prepayment of $400,000 and how the $0.52 referred to in Schedule F of the agreement was arrived at:

Q. Mr. Mars, the problem that I have with your testimony, you indicate that it was a good price, "we felt that it was okay, it was good value” et cetera, but when a businessman comes to such a conclusion, it is because he has made some calculations. And the question I ask you is, what were those calculations?

A. Calculations as far as what is concerned?

Q. To establish the fifty-two cents ($0.52)?

A. The only way the fifty-two cents ($0.52) came about is that Mr. White, from Panosh, wanted two hundred and fifty thousand dollars ($250,000.00) in advance. I don't remember if he wanted more or less, we settled on two hundred and fifty ($250,000.00), this is what he wanted. If I don't give it to him, I lose the deal. I made a decision, is it "yes" or “no” to give it to him. As I explained, we said "yes" to the deal, we gave him a verbal commitment for approximately four hundred and eighty (480,000) or five hundred thousand (500,000) pieces and again the fifty-two cents ($0.52) was arrived by dividing the amount of pieces which was about four hundred and ninety thousand (490,000) or five hundred thousand (500,000) into the two hundred and fifty thousand dollars ($250,000.00), it came to fifty-two cents ($0.52). That's how we came to fifty-two cents ($0.52). It didn't come from the sky, it was division of amount of pieces into the two hundred and fifty thousand dollars ($250,000.00).

WITNESS: It was very simple, because that was the most simplest part of our agreement in the sense that we bought the goods, he asked for two hundred and fifty thousand dollars ($250,000.00), was clear cut. The amount of pieces that they said they could ship the first year totalled four hundred and eighty (480,000) or four hundred and ninety thousand (490,000) pieces. According to what they told us, we divided —it would have been easier to make it fifty cents ($0.50) a piece, an even number, but it came to fifty-two cents ($0.52) and that's how it fell. And it was very simple to divide the amount of pieces into the two hundred and fifty thousand ($250,000.00), it was clear cut. There was nothing to calculate, only dividing the amount of pieces by the two hundred and fifty thousand dollars ($250,000.00)

WITNESS: No, after we made the deal, we discussed it, it came to fifty-two cents ($0.52). I didn't discuss it myself, they said it comes to fifty-two cents ($0.52). That's the profit we want, fifty-two cents ($0.52), and I agreed to it. That two hundred and fifty thousand dollars ($250,000.00) was an advance against the quantity of pieces that we bought. And it just fell at fifty-two cents ($0.52), that's what they wanted. They wanted more but we negotiated down less.

Mr. White, who was at that time, Panosh's president also testified. Here are excerpts of his testimony:

A. At the time that I made the deal, I sold the rights to distribute the figures. And which was the issue of four hundred thousand dollars ($400,000.00), so that in a sense for the—I was guaranteed four hundred thousand dollars ($400,000.00) of profit for the rights to distribute those figures.

A. They had the right to purchase products from me and had the rights to distribute it. Whether they sold the product or they didn't sell the product or for how much they sold the product was an issue of no concern to me . . . My position in the product was such that my profits were generated irrespective of their sales, where in a royalty situation, royalties flow as a result of sales and these two (2) things are as much night and day as they could be.

My transaction was a concept related to business relationships and he and I made a deal that guaranteed us money in exchange for his right to sell product, whether he sold or he didn't.

he was going to distribute the product and we were going to get four hundred thousand dollars ($400,000.00). He was going to fifty-two cents ($0.52) plus three percent (3%) over the cost of the goods whatever they were . .. whether he sold them for a lot of money or a little bit of money was not my profit nor my loss . . .

It wasn't the purchase of goods, it was the right to purchase goods. When this contract was signed, they didn't buy one (1) piece of merchandise, what they bought was the rights subsequently to buy merchandise.

The “Buying Commission and Royalty Amount" is the profit of Panosh that was negotiated between Panosh and the appellant at the time of the purchase of the dolls. No one could explain why it was called a royalty. The agreement was prepared by an American lawyer of Panosh. For all witnesses, the president of Panosh, residing in New York, the operation manager of Panosh residing in Hong Kong and for the president of the appellant, this amount was the amount that Panosh wanted to receive over its actual cost. Panosh accepted the appellant as its distributor because the latter agreed to pay in advance a substantial amount.

Mr. Mars, president of the appellant, has been in the toy business for 29 years and has been the president of the appellant for 15 years. The appellant's business is importing and distributing toys throughout Canada. Mr. White, the chairman of Panosh, needed and wanted an advance of $250,000 U.S. In view of this, Mr. Mars decided: "I felt that it would be advantageous for Grand Toys, and we struck up a deal and we shook hands and we made a deal for $250,000 U.S. in advance against an order of approximately one half million pieces for the year 1984.”

Counsel for the respondent referred me to the case of Vauban Productions v. The Queen, [1975] C.T.C. 511; 75 D.T.C. 5371, where Mr. Justice Addy discusses the meaning of royalties, at page 513 (D.T.C. 5372): "The term royalties normally refers to a share in the profits or a share or percentage of a profit based on use or on the number of units, copies or articles sold, rented or used.” Counsel relies on the expression “a share in the profits". He says that contrary to what is expressed in the case of The Queen v. Saint John Shipbuilding and Dry Dock Co., [1980] C.T.C. 352; 80 D.T.C. 6272, at page 357 (D.T.C. 6276): "Here there was no limit as to time with respect to use or the right to use. Nor were the payments proportionate to or in any way related to use or extent of use or to revenues or profits therefrom or to a period of use." The respondent's basic contention is that the expression "in no way related to revenue or profit" is not a means of defence that the appellant can invoke in the present case. It is the respondent's contention that the payments in issue are clearly related to revenue or profit and therefore are royalties.

I cannot agree with this proposition. The profits referred to in the two cases cited are the payor's profits not the payee's profits. In the case at bar, the payments were the payee's profits and were in no way related to the appellant’s profits nor were they related to the appellant's gross sales of the units. Whether the appellant sold all the units or none of them, whether it made profits or not, did not influence the amount of money paid. There was no element of contingency in the payments in question and an element of contingency is the essence of a royalty payment.

I also have to determine whether the payments were for the use of or for the right to use in Canada any property, invention, trade name, patent, trade mark, design or model, plan, secret formula, process or other thing whatever. Nothing was manufactured by the appellant using the trade names. The property acquired was not used but sold. The Agreement stipulates that the appellant had no interest or property rights in the names, characters, trade mark and copyright. The appellant had however the right to advertise subject to the advertising material being approved by Panosh. No monetary value was put towards the right to advertise, most probably because that right being an intrinsic element of a distributorship right, it would be the distributorship right that would be paid for.

Were there any royalties paid for the exclusivity of the distributorship? The amounts of $250,000 and $150,000 that were paid in advance in accordance with Schedule "G" of the Agreement may appear to have been paid to obtain the exclusivity of distributorship, though the Agreement is not drafted in this manner. As I have mentioned previously, there is no price set for the value of this exclusivity. The prepayment is declared to be a credit against the cost of the products. However, even if it could be said that the payments were related to the distributorship, this would not make them royalties. Rather they would be capital payments. It is interesting to note here that the respondent, as the Minister responsible for the Customs Act, has determined that these amounts were part of the cost of goods upon entry into Canada.

Counsel for the respondent put forward that royalties may be part of a purchase price as it was determined in Wain-Town Gas and Oil Co., supra. However, in Wain-Town Gas and Oil Co., the royalty was contingent on the use of a franchise. Royalties were based on percentages of the actual gross sales of gas. In the case at bar, there is no contingency as to the amount of payments. The amount of the "Buying Commission and Royalty Amount" was predetermined and had been divided by the number of units purchased, to become the purchase price.

Counsel for the respondent says that lump sum payments have been accepted in Vauban Productions v. The Queen, supra, as being within the meaning of paragraph 212(1)(d). It is true but it was in a matter of rent or leasing of property. Counsel for the respondent referred me also to an English case of the High Court of Justice (King’s Bench Decision) Taylor (H.M. Inspector of Taxes) v. Dawson, [1938] 22 T.C. 189 (K.B.). It is a case where each year an amount was paid in advance, such advance payments to be treated as payments on account and in advance of the royalties. That case was decided on whether these payments were loans or not. The Court found that they were not in the nature of loans.

In my view, the payments in question were not in the nature of rents, royalties or similar payments or any payment for the use of any property. It was an unfortunate choice of words; the taxpayer never understood that these payments should be treated in the same manner as other payments that he makes for the use of trade marks. The words of Mr. Justice Heald of the Federal Court of Appeal in The Queen v. Farmparts Distributing Ltd., [1980] C.T.C. 205; 80 D.T.C. 6157, at page 212 (D.T.C. 6162) describe well the situation of the present case:

. . . it seems quite clear that these payments could not in any way be considered to be rentals, or royalties, or payments which are similar to rents or royalties. The payment made by the respondent was a lump sum payment, a "one-time" payment for the duration of the agreement renewable for a further 15 years by the respondent without payment of any additional fee; the payment was to be made irrespective of the extent of use by the respondent under the agreements and was unrelated to the profits made by the respondent as the result of any use. The payments made herein seem to be quite unrelated to rentals, royalties or similar payments.

The appeal is therefore allowed with costs and the matter is referred back to the respondent for reconsideration and reassessment.

Appeal allowed.