Charles R. Bell Ltd. v. The Queen, 90 DTC 6516, [1990] 2 CTC 333 (FCTD), aff'd 92 DTC 6472 (FCA)

Martin, J.:—At issue in this matter is whether $300,000 paid by Outboard Marine Corporation of Canada Ltd. (“OMC”) upon the termination of its distributorship agreements with the plaintiff should be characterized as an income payment, as the defendant claims, or as a capital payment, as urged by the plaintiff.

The plaintiff is the operator of a large well-known diversified business in the Province of Newfoundland. Originally based in St. John's it subsequently established significantly sized branch outlets in Grand Falls and Corner Brook. Although it has some retail operations the majority of its business is of the wholesale variety.

The plaintiff operates its business through divisions. The only division which appears to be clearly definable in its own right however is the food division which could be unquestionably separated from the others. Reference was made to a marine division which the plaintiff itself referred to as the "Motors and Engines" division on one of its exhibits. It was not clear to me just where some of the products in which the plaintiff deals fit into any particular division. For example the plaintiff also dealt in chain saws, household appliances and snowmobiles which one would not find in the food division and would not expect to find in a marine division.

The plaintiff's witnesses were at some pains to point to factors which would establish a marine division consisting almost exclusively of OMC products, Johnson and Evinrude outboard motors, and Lawn-Boy mowers and parts for them. However the same division sold Volvo Penta diesel marine engines, boating supplies and accessories which were not supplied by OMC. Furthermore, in 1982, the plaintiff acquired a skidoo distributorship which it appears to have combined with the operation of its marine division.

In carrying out the operations of its business the plaintiff did not have separate sets of accounts for each division but it could, with apparent ease, break out separately its sales of any given product as well as the expenses associated with the sale of that product.

Until 1984, when the plaintiff's distributorship agreements with OMC were terminated abruptly by OMC, the plaintiff had been the exclusive distributor of OMC products and parts for them in the Province of Newfoundland. There were some minor exceptions to this exclusivity and there may have been some OMC products for which the plaintiff was not the distributor but these are of no importance to the matter at hand. As well, for periods during the time the plaintiff was OMC's distributor, it also handled lawn mowers and snowmobiles manufactured by OMC but by far the distributorship concerned itself primarily with outboard motors. Henceforth, for the sake of convenience, I will, somewhat inaccurately, refer to the distributorship as if it had been exclusively for OMC outboard motors.

The plaintiff first became the exclusive distributor for OMC outboard motors in 1933. The idea of using an outboard motor was a new concept for Newfoundland fishermen but it became a popular one. Over the years the plaintiff's sales of OMC products and parts grew to be a significant part of its business, ranging anywhere from about 20 per cent to 60 per cent of its gross sales, reaching its peak in the 19705. Mr. Charles Randolph Bell, the son of the founder of the plaintiff company and its current president, said that for the three decades beginning with the 1950s the OMC distributorship was the main focus of the company's growth.

As already indicated the outboard motor became very popular with the Newfoundland fishermen, one could almost say it was indispensable. According to OMC the plaintiff's penetration of the outboard motor market in Newfoundland in 1982 was 74.6 per cent. OMC also indicated that the percentages fell in 1983 to 56.6 per cent and to 44.5 per cent in 1984. Bell disputes these figures, indicating they are too low, but it gives one a sense of the magnitude of the business. In dollars, taking 1983 as an example when sales of OMC products accounted for 20 per cent of the plaintiff's gross profits and about 25 per cent of the plaintiff's net profits, the sales of OMC products totalled about three million dollars.

The plaintiff's success in carrying out its distribution of OMC products was not accidental. Realizing that the majority of its sales would be to fishermen it began to establish a dealer network throughout the province. Being in the wholesale food business it had contacts with the local merchants in the fishing communities and it was these merchants who became the plaintiff's first dealers. At first they simply sold the outboard motors and when something went wrong with the motor it had to be returned to St. John's for servicing. Later, however, the dealers became more proficient and offered not only sales but parts and servicing as well.

As the business grew the plaintiff established two distribution centres of its own, one in Corner Brook and one in Grand Falls. These distribution and service centres did not relate exclusively to OMC products or even the marine division but were centres for the sale and distribution of the full line of products handled by the plaintiff. Presumably the plaintiff found it more convenient and better business practice to service its central Newfoundland dealers from Grand Falls and its western Newfoundland dealers from Corner Brook. At the time CMC decided to terminate the distributorship agreements the plaintiff had a total of 56 dealers of which 30 also provided some sort of service.

The plaintiff placed much emphasis on the value of its dealer network and how, as a part of the termination of its distributorship agreements with OMC, the latter acquired the benefit of that network which in itself was asserted to be a valuable asset. As I understand the evidence the dealer network was not transferred to OMC. The only change, vis-a-vis the dealers, was that instead of receiving OMC products from the plaintiff they would henceforth receive them from OMC directly. The dealers however remained dealers of the plaintiff for any other lines or products listed in their respective dealership agreements with the plaintiff. I also understand that the dealers were not exclusively dealers in products for which the plaintiff represented the manufacturers but that those products only represented a portion of the merchandise which the dealers stocked and sold. Accordingly, when OMC supplied the dealers with its product rather than the plaintiff, the plaintiff did not lose its dealer network but it simply stopped supplying its dealer network with one of the several lines of products in respect of which it represented the manufacturer.

In June of 1984 OMC informed the plaintiff that it would not be renewing its distributorship agreements in October of 1984 when they came up for renewal. The reason given was that prices had to be reduced to such an extent to meet the competition that it was no longer feasible to have a distributor.

Bell says, and I accept the fact, that this proposed cancellation came as a complete surprise and shock to him. He realized that OMC sales were down but, attributing it to the general economy and the special difficulties in the fishery, he thought the company could ride out the temporary setbacks and recover after the fishery had completed its restructuring and the economy improved. As well OMC had recently indicated that its relationship with the plaintiff would continue indefinitely because, according to Bell, OMC personnel had told him that the plaintiff company was doing the job in Newfoundland better than the management at OMC considered it could do it.

The June 13, 1984 written notice of termination directed the plaintiff to immediately institute price reductions on its inventory of parts and motors, provided for the repurchase of OMC products in the plaintiff's inventory at October 1, 1984, and agreed to pay the plaintiff $100,000 in consideration for the plaintiff releasing OMC from any claims.

Bell replied to OMC expressing his concern about the impact upon the plaintiff of the cancellation of the distributorship agreements. He pointed out that long time employees who worked exclusively on OMC product sales and services would have to be laid off. He anticipated that the reduction in sales for the Corner Brook and Grand Falls outlets would affect them to such an extent that they might have to be closed. He also expressed his concern with respect to some $700,000 in accounts receivable from the plaintiff's dealers who might not have the same incentive to pay these accounts after they began to deal solely with OMC. Bell suggested that the existing arrangement continue for a period of three years so that the plaintiff could arrange for a substitute product line which would enable it to adjust for the impact of losing the OMC distributorship.

Bell also wrote: "The most significant impact on this company is of course our loss of revenue that will result,. . .”.

Bell put this revenue in the form of annual gross profits of $650,000 for the previous three years and rejected the $100,000 offer as being only a token offer to compensate the plaintiff for the losses that would arise from the cancellation of the distributorship agreements. Bell’s reply made it clear that he was looking for compensation for the loss in profits which he anticipated would be sustained by the plaintiff as a result of OMC refusing to renew the agreements.

After some correspondence back and forth and a meeting on August 27, 1984 the parties agreed on a payment of $300,000. Bell had suggested that the proper compensation should be the equivalent of three years' net income resulting from the operation of the OMC distributorship which he calculated to be $450,000. To that he added $50,000 for what he said would be direct costs of the cancellation for a total of $500,000. The parties finally agreed on a figure of $300,000 to be paid over a three-year period.

The actual settlement agreement was not signed until October 23, 1984 but it appears that agreement had been reached shortly before because, on October 22,1984 at the annual meeting of the plaintiff's dealers held in Gander, Bell addressed them and endorsed the new arrangement with OMC. Even before the meeting Bell had written each dealer explaining that commencing November 30, 1984 OMC and not the plaintiff would be servicing them with OMC products and advised them the change was in the best interests of the dealers and that the dealers would benefit in the long term.

Although Bell had been concerned about the impact of the loss of the OMC distributorship on the overall business of the company, in fact the impact transpired not to have been all that serious. If memory serves me correctly not only were profits not reduced in the two years immediately following the cancellation of the OMC distributorship but they actually increased.

Earlier Bell had expressed his concern to OMC that the loss of the distributorship would result in the plaintiff having to terminate the employment of some 21 employees. Of the 21 employees who he thought might be affected, four employees in Grand Falls left their employment with the plaintiff to become employees of OMC which also rented from the plaintiff some 8,000 square feet of the plaintiff's premises in Grand Falls. In St. John's, four employees had their employment terminated and two retired. None of the plaintiff's employees in Corner Brook were affected by the loss of the distributorship. The remaining 11, of the original 21 employees, remained with the plaintiff unaffected by the loss of the distributorship. There was some suggestion that some of them may have lost their jobs when the plaintiff terminated its OMC dealership in 1985 and 1986 but the evidence was not very clear in this respect. It was not disputed however that during the two-year period immediately following the termination of the OMC distributorship the plaintiff's overall employees rose from 68 to 75.

As I see the evidence the loss of the OMC distributorship was prevented from having the disastrous effect which it might have had on the plaintiff's operations largely because of two acquisitions made by the plaintiff in 1982. During that year the plaintiff acquired the Bombardier distributorship for snowmobiles and the wholesale business of Steer's Ltd. which included the distributorships for Whirlpool appliances and Volvo Penta marine diesel engines. In 1985 and 1986 the products represented by the 1982 acquisitions accounted for more than 50 per cent of the plaintiff's annual sales.

The legal principles applicable to cases of this sort are, in my view, well set out by Strayer, J. in C.N.R. v. The Queen, [1988] 2 C.T.C. 111; 88 D.T.C. 6340 at 114-15 (D.T.C. 6342), in the following passage from his decision:

There is much jurisprudence on the question of whether compensation paid on the occasion of the termination of some business arrangement is capital or income. To a large extent each case turns on its own facts. It appears to me that there are two aspects which a court must consider in examining such a situation retrospectively: was the purpose of the payment to replace capital or income; and, whether or not the purpose can be reliably determined, was the effect of the payment to replace capital or income? It appears to me to be a dual test because the purpose may not be discernible, or it may not be reliably discernible in the sense that parties to settlements should not, by misstating the real purpose, determine the tax consequences of the receipt of such compensation. It is therefore necessary to look at both purpose and effect.

With respect to purpose, the essential question is to determine what the compensation—whether paid pursuant to a contract, a court award of damages, or otherwise—is intended to replace. [1] In some cases the contract providing for compensation may be clear. [2] The measure employed for calculating compensation is not always determinative: potential lost income may be taken into account in calculating a capital sum to be paid. [3] Nor on the other hand does the fact that an amount is paid as damages for breach of a contract necessarily make it a capital sum and not income. [4] On the contrary it appears to me that whatever the source of the legal right to the compensation, be it the contract or the law of damages, the substantive issue is: what is this amount intended to replace? [5]

With respect to the effect of the termination of the business arrangement and the role of compensation in respect thereto, I believe the two possibilities are well expressed in the judgment of Lord Russell in the Fleming case. [6]

. . .When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient's profitmaking apparatus, involving the serious dislocation of the normal commercial organisation and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilisation of a capital asset and is therefore a capital and not a revenue receipt. . . .On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned—where for example the structure of the recipient's business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than asurrogatum for the future profits surrendered—the compensation received is in use to be treated as a revenue receipt and not a capital receipt.

It will be noted that to apply such criteria it is necessary to make value judgments as to the severity of the impact on the taxpayer of the termination of certain business activities in respect of which compensation has been paid.

In the present case the purpose of the $300,000 payment was clearly expressed by both the plaintiff's and OMC's representatives to be compensation for loss of income. The president of the plaintiff asked for compensation for three years' loss of net income which he estimated would be $150,000 per year and settled for two years' net income at $300,000. This payment was described by the OMC president and general manager in his letter of September 4, 1984 in the following terms:

In our meeting we discussed your estimated annual net profit from the distribution operations you performed for our products, the termination costs you have estimated with respect to employees you will be terminating, etc. and your calculation of your proposed termination settlement.

The last proposal put forward by you was a settlement based on
1. The profit which you claim would otherwise have been earned	$300,000
with two years' notice at $150,000 per year
2. The estimated employee severance cost	50,000
	$350,000
Net proposed settlement	$350,000

I am reinforced in my view that the payment was intended to replace income and not capital when I consider Lord Russell's test in the Fleming case, supra. In this respect I cannot find that the termination of the OMC distributorship can be said to have materially crippled or destroyed the whole structure of the plaintiff's profit-making apparatus or that it had the effect of sterilizing a capital asset. In this matter there were some adverse effects following the termination of the distributorship such as the loss of a sizeable portion of the company's revenue, the loss of several employees, and the reduction of some space requirements. On the other hand overall sales increased, the plaintiff's dealership network remained in place for the distribution of the several other products for which the plaintiff had distributorships or agencies and the number of the plaintiff's employees actually increased from 68 to 75 within a period of two years following the termination.

The plaintiff's operations appear to fit precisely into Lord Russell’s description of the company the operations of which are fashioned in such a way so as to be able to absorb the shock of a termination of one of the several parts of its business as one of the normal incidents to be anticipated. In this case the 1982 acquisitions are a tribute to the business acumen of the plaintiff's directors. Those acquisitions enabled the company to absorb, with only marginal adverse effects, the shock of the loss of the OMC distributorship.

The assets associated with that distributorship were not lost or destroyed: the inventory was purchased by OMC, there is no evidence that the accounts receivable were uncollectible and the dealer network remained intact. What was lost or surrendered were the profits that the distributorship would have generated. Bell thought the plaintiff should have been paid on the basis of three years' loss of profits but by mutual agreement with OMC settled on two years.

As well there is some doubt that the marine division as such ceased to exist. The company continued to handle the Volvo Penta marine engines. There is no evidence they ceased to handle marine and boating supplies and accessories not manufactured by OMC and there is some suggestion that the Bombardier snowmobile distributorship was in fact attended to by the personnel of the marine division.

It follows from what I have said that the plaintiff's appeal will be dismissed with costs.

Appeal dismissed.