Les Placements A & N Robitaille Inc. v. MNR, 96 DTC 1062, [1996] 1 CTC 2141 (TCC)

Archambault J.T.C.C.:— In April 1977 a scandal erupted in the newspapers of Québec. The Royal Canadian Mounted Police (“RCMP”) had uncovered a major fraud committed by one of the city’s well-known businessmen. André Robitaille had allegedly defrauded the Government of Canada of about $425,000 by declaring the value for duty of goods imported by his company, Robitaille Marine Inc. (“Marine”) [1] at a price lower than their real cost. Marine manufactured, sold and repaired boats. Criminal charges were laid in December 1977. The bad publicity surrounding those proceedings caused a serious financial crisis for Marine. To solve that problem, Marine transferred its business to a new company, Marine Robitaille (1978) Inc. (“Marina-Québec”), [2] on March 1, 1978. Among the assets transferred was its goodwill, to which Marine did not assign any value. On the other hand, the Minister of National Revenue (the “Minister”) assigned it a value of at least $820,000, and by reassessment dated October 31, 1984 increased Marine’s income by $287,000? [3] The only issue before this Court relates to the existence of that goodwill and, if applicable, its fair market value.

Facts

The business

The evidence established that Mr. Robitaille has been building boats since his teenage years. At the age of 12, he built his first canoe. At 17, he built a sailboat that he sold to purchase tools. At 24, this hobby became a business which he operated in a shop located behind his parents’ home. Three years later, in 1965, he left the family premises and set up shop at the junction of the Beauport and St. Lawrence Rivers. In 1970 he transferred his business to Marine, a newly incorporated company in which he held almost all the shares. Marine’s balance sheet showed goodwill of $10,000. In 1978, Mr. Robitaille personally owned three buildings in Beauport. The smallest he used as a family home. Several feet from that building stood the two other buildings, which Marine occupied. In the first there was a showroom and the manufacturing and repair shop. To the rear was the second building, a huge warehouse in which Marine stored its inventory of boat motors. However, the land on which these buildings were constructed belonged to the National Harbours Board to which Marine paid annual rent. On March 25, 1975, the National Harbours Board sent a notice of résiliation of the lease. It denied that it was acting for public interest reasons; however, it had been public knowledge since 1974 that the Government of Quebec wanted to build a highway that would ultimately bring, in 1982, the business to relocate.

From 1976 to 1978, Marine’s presence was tolerated on the site as it continued to pay its annual rent to the National Harbours Board. Its primary activity consisted in importing defective boats from a Texas company, Glastron Boat Company (“Glastron”). For several years, Marine held a Glastron franchise which allowed it to acquire these boats, which it reconditioned and resold in eastern Canada. This was essentially an oral agreement, since the written agreement sent to Marine every year was not. signed, and even though that document specified a non-exclusive franchise, Glastron did not sell its products to Marine’s competitors. At the very beginning, Marine purchased new products in good condition. However, Marine did not have sufficient financial resources to maintain a large inventory of these products, and given Mr. Robitaille’s expertise, Marine considered it more advantageous to purchase defective boats, repair them and resell them at a profit. Mr. Robitaille himself travelled to Texas to inspect Glastron’s boats. He alone had the experience and knowledge to determine the nature and extent of the repairs that had to be made and assess the profitability of the process. He was very familiar with the resale market because he was the one who looked after that. Since he was right there in Texas he was better able to negotiate the purchase price. Mr. Robitaille transported these boats himself in a tractor-trailer he used for travelling. They were generally acquired without motors; he was thereby able to eliminate some customs duties.

Marine made the necessary corrections in its Beauport shop so that it could offer its customers a boat in good condition, and installed the motor to provide the best possible performance. Mr. Robitaille was very proud of the work he did. He often showed his customers the defective boat before doing the repairs. He believed that his boats were often better than the original. These boats had a useful life ranging from 25 to 30 years. His customers liked his work and Marine was known by word of mouth. This was essentially a small-scale business manufacturing boats and selling nautical products. In 1978, the reconditioning activity represented 65 per cent of his total sales volume. Marine’s other activities were divided among sales of small canoes and trailers (8 per cent), storage and the repair service (15 per cent) and sales of nautical accessories (12 per cent). Marine had no exclusive franchise for supplying the motors used for its boats. These reconditioned boats were sold either directly to consumers (65 per cent) or to retailers (45 per cent). The retailers were located primarily in the Drummondville, Chicoutimi, Rivière-du-loup and Québec region.

Competition was very strong. Marine had several competitors in Québec. There are numerous boat manufacturers in Canada, particularly in Quebec and Ontario. Glastron boats account for about 6 per cent only of the market in Quebec, but 60 per cent of the market within a 100-mile radius of Québec.

During the summer, Marine employed about a dozen people. It employed Nicole Robitaille, Mr. Robitaille’s wife, who looked after the administration. Other employees looked after the storage, cleaning and launching of boats belonging to customers of the business. In his shop, Mr. Robitaille was surrounded by three or four technicians who helped him year-round in his reconditioning activities. Mr. Robitaille trained them himself since there was no boat-building school. These technicians often had a background that had little or no connection to their work. One was a barber, another a restaurant cook and the third was a construction worker. The work they performed did not require great expertise. Mr. Robitaille did the more difficult jobs, such as repairing the fiberglass. He even designed and produced some of the parts that were required for the reconditioning. He supervised the work done by his technicians. When he was away getting boats in Texas, they worked on things that required little supervision. There was some turnover in the business’s staff, and this meant that Mr. Robitaille had to train new employees.

The transfer of the business

On April 5, 1977, the RCMP seized all Marine’s inventory stock and demanded payment of $425,000 assessed by Revenue Canada-Customs and Excise. Every sale by Marine had to be authorized, which slowed operations down. Marine therefore negotiated an agreement with the tax authorities and in the summer of 1977 made a payment of $100,000. On December 14, 1977, criminal charges were laid against Mr. and Mrs. Robitaille. They were accused of defrauding the Government of Canada of about $425,000 by declaring the value for duty of goods at a price lower than their real cost. In addition, they were accused of uttering forged documents and falsifying invoices. In early 1978, the amount of duties, penalties and interest owing by Marine amounted to more than $582,000. This tax debt jeopardized its financial situation. The bank refused to continue to finance its operations. The bad publicity generated by these proceedings in the newspapers alerted suppliers, who altered their business relationship with Marine. Specifically, starting on December 19, 1977, Outboard Marine Corporation of Canada Ltd., a supplier of outboard motors, demanded payment on delivery of its products. On January 20, 1978, in order to establish a line of credit, it demanded an audited balance sheet and also personal guarantees. Mr. Robitaille became discouraged.

A solution to these financial problems had to be found. Marine disposed of all its assets to a new company, Marina-Québec, which was incorporated on February 9, 1978. A contract signed before a notary on June 26, 1978 confirmed that on March 1, 1978 the “business of the distribution, sale, repair, service and manufacture of boats, parts and accessories” had been transferred for total consideration of $695,011. This sale “includes, among other things, and without restricting the foregoing, the following goods” [translation]:

Furnishings: $1,838

Equipment: $1,840

Sign: $7,045

Rolling stock: $9,288

Inventory: $675,000

Intangible [4]

Total: $695,011

This agreement stipulated that Marina-Québec assumed no responsibility for the potential liability of about $500,000 claimed by the tax authorities. On the other hand, the purchaser undertook to pay any income tax or sales tax that might become payable as a result of the sale. The Bank of Montreal agreed to grant a $350,000 line of credit to Marina-Québec. Mr. and Mrs. Robitaille had to give the bank personal guarantees.

In September 1980, Mr. and Mrs. Robitaille were acquitted of the counts of fraud and falsification of invoices, but pleaded guilty to the charge of uttering forged documents. They were each sentenced to pay a fine of $5,000. It should be noted that although Mr. and Mrs. Robitaille uttered forged documents, their intention was not to defraud the government of $425,000. The customs duties that Marine should have paid would apparently have been refundable to it afterward. The forged documents were used to skip this temporary disbursement.

Paul Vézina confirmed to Mr. Robitaille that Marine had no legal recourse for contesting the résiliation of the lease by the National Harbours Board. In the early 1980s, when the Government of Quebec was prepared to build a highway along the shores of the St. Lawrence River in Beauport, Marine contested this plan, which affected a navigable waterway under federal jurisdiction; it demanded that the federal government hold a public consultation. In order to avoid delay, it would appear that the Government of Quebec agreed to acquire the business operated by Marina-Québec. For the purpose of that sale, Mr. Robitaille first transferred ownership of the buildings to Marina-Québec and then, on December 23, 1981, Marina- Québec signed a contract for the sale of its business before a notary. The assets included the buildings, the business operation, the rights in the National Harbours Board lease, the business name, the clientele and the goodwill, but not the accounts receivable, the inventory and the furnishings. The Government of Quebec paid $2,391,178 for these assets. [5] The government was to take possession on April 30, 1982.

Valuation reports

Marine and the Minister called their expert witnesses, who entered their valuation reports in evidence. Richard Wise of Richard Wise et Assoc. defended the valuation prepared on behalf of Marine. Mr. Wise has an impressive track record. He has specialized in business and securities valuation for over 18 years, and has participated in the valuation of shares and interests in more than 1,500 companies operating in various sectors of activity, including a competitor of Marine. In his opinion, based on the information and documents he examined and the explanations he obtained, the fair market value of Marine’s goodwill on March 1, 1978 lay in the zero to $88,000 bracket.

To arrive at this value, he first valued the entity as a whole. Once he had determined this value, he then deducted the value of the tangible assets and the after-tax value of the excess assets. To value the entire entity, Mr. Wise chose the earnings-based valuation method, which he described as follows (at page 14 of his valuation report):

In order to determine the value of the business based on earnings, the book earnings, normally for the last three to five fiscal years (which normally are to be used as a guide in order to determine future trends) are adjusted, if necessary, to take into account the following factors:

extraordinary non-recurring factors which would, otherwise, skew the estimate of future earnings

non-arm’s length expenses that are not economic

accounting with operating conditions that should prevail

increases or reductions in the capital invested.

When the adjusted operating results and sales show a definite trend, the standardized earnings the business will be in a position to maintain) are generally weighted (so as to give greater weight to the most recent years) in order to determine a probable trend in the future annual earnings/cash flow that the business will be able to maintain. When there is an obvious upward trend or circumstances have recently changed, it might be appropriate to consider only the figures most recently completed before the valuation date. These adjusted results are then multiplied by a specific factor (price/earnings ratio), which is the opposite of the rate of return required by the purchaser on its investment in the business) to get a value based on the capitalized earnings, or operating value.2

The (realizable) fair market value of all the assets belonging to the business, but which are not used in its day to day operations, that is, excess or “useless” assets, less tax, is then added to this value. It is assumed that a wise vendor would remove these excess assets from the business before the sale or would require compensation from the purchaser for the fair market value of the net excess assets.

The amount thus obtained represents the value of the entity taken as a whole, that is, the “value of the business”.

2 In other words, the anticipated earnings or cash flow is converted into a capital amount at the beginning of the period in which the earnings or cash flow is realized, based on the rate of return that the hypothetical purchaser expects.

[Translation.]

Rock Martel, a business valuator employed by the Minister since 1964, defended the valuation report he prepared for his employer. His activities have been limited to valuation since 1966. While Mr. Martel adopted the valuation method followed by Mr. Wise, he concluded that the fair market value of the goodwill was $820,000. It is therefore necessary to analyze their reports in order to understand how the two experts came to have such divergent opinions.

Using the earnings-based valuation method, it is first necessary to determine the indicated earnings of the company. Like Mr. Martel, Mr. Wise used the earnings for the 1976 and 1977 fiscal years. The indicated earnings used by both experts were essentially calculated in the same way, except for the adjustments made to the shareholders’ salaries and for financial expenses relating to payment of the duties. Mr. Wise did not adjust for the financial expenses [6] because they were in dispute at the date of the valuation. For the salaries, he assigned an economic salary of $120,000 while Mr. Martel recognized a salary of about $70,000. Mr. Wise determined indicated earnings to be $218,018 for 1976 and $70,520 for 1977. Mr. Martel arrived at $254,420 for 1976 and $111,022 for 1977.

The second stage in this valuation method consists in standardizing the indicated earnings: a weighted average of pre-tax earnings is determined. Mr. Wise assigned a weighting factor of 2 for the 1977 results and 1 for the 1976 results. He explained this weighting factor by taking into account various external factors relating to the RCMP investigation that had affected the business’s operations since April 1977. The following table shows the calculations done by Mr. Wise in determining indicated after-tax earnings of $99,000:

Indicated after-tax

[Translation.]

Mr. Martel did not do any weighting of the net earnings, in order to give equal weight to 1976 and 1977. His calculation of the indicated aftertax net earnings is as follows:

Average adjusted pre-tax net earnings:

1976 * 254,420.00

1977 111,022.00

Total $365,442.00

divided by 2

Indicated pre-tax earnings * 182,721.00

Less:

Income tax:

Indicated earnings		* 182,721.00
Less:	3% allowance for
	inventory 0000,000)	( 19,500.00)
		* 163,221.00
Less: income tax of 21% on $163,221		* (34,277.00)
Indicated after-tax net earnings,		* 148,444.00
	rounded off	* 146,400.00

[Translation.]

The following tables describe the last step taken by Mr. Wise and Mr. Martel in determining the fair market value of the goodwill:

FAIR MARKET VALUE OF THE GOODWILL

Bracket

	High	Low
Indicated earnings	* 99,000	* 99,000
LESS: Discount for key man
25%	( 24,750 )
35%	-	( 34,650 )
Adjusted indicated earnings	74,250	63,350

Capitalized using ratios of:

4.0 times (25%) 297,000 _°

3.0 times (33%) 193,050

Value of the company as going concern 297,000 193,000

LESS: 10% non-liquidity discount ( 29,700 ) ( 19,300 )

267,300 173,700

PLUS: Excess assets of $43,000

(met of income t.: of 15%) 36,550 36,500

Fair market value of the shares

of the company, rounded off 304,000 210,000

LESS: Pair market value of the

net tangible assets ( 179,000 ) ( 179,000 )

Excess assets ( 34,550 ) ( 36,550 )

Fair market value of the oodwill,

rounded off $ 88,000 $ Mil

FAIR MARKET VALUE OF THE GOODWILL

(according to Mr. Martel)

Minimum Inxilmn

Net indicated

after-tax earnings $148,400 $148,400

Ratios (rate of

capitalization)		6 (x)	7.5(a)
Fair market value
of the operations		890,400	1,113,000
Add
---
Superfluous assets	$ 43,000
Income tax - 15%	( 6,450 )	36,550	36,550
Fair market value
of the business		926,950	1,149,550
Less:
Fair market value of
the net tangible assets		( 221,900 )	( 221,900 )
Fair market value of the goodwill
om March 1, 1978		$705,050	$927,650
Rounded off average		$ 820,000

[Translation.]

It will be noted that Mr. Wise adjusted his indicated earnings again. The key man discount recognizes that Mr. Robitaille’s contribution was so important that there would definitely be a negative effect on the current earnings level if Marine were to lose his services. Mr. Martel did not apply this discount.

The ratios used to capitalize future earnings take into account the rates of return prevailing at the date of the valuation having regard to several available investments, in particular 9.58 per cent on long-term bonds and the risk level that a purchaser would have to consider in acquiring the business. There were internal factors concerning Marine, in particular the fact that the business was well established and profitable at the date of the valuation. Mr. Robitaille had a good reputation among his customers. His relations with his suppliers and his employees were good. However, the company was vulnerable and small, and depended heavily on the services of Mr. Robitaille. In addition, the capitalized assets belonged to Mr. Robitaille personally, but were constructed on rented land belonging to the National Harbours Board for which there no longer was a lease. One of the external factors to be noted were generally good economic conditions, a stable political and social climate and a very competitive pleasure craft industry. Among the uncontrollable factors we note the danger of forced relocation because of the construction of the highway and the impact of the proceedings initiated by the RCMP. The ratios used by Mr. Wise are three and four.

In his assessment of the factors influencing the choice of ratios, Mr. Martel considered that the position occupied by Marine in the operation of its business was a virtual monopoly. He placed much more weight on the Glastron franchise. Marine had a team of four or five well-trained full-time employees working for it. Although he did not consult any market study, Mr. Martel believed that there would be strong demand for this type of product in the future. Among the negative factors, Mr. Martel recognized the fact that Marine was operating its business in rented premises that were going to be expropriated and that the seizure by the RCMP had had harmful effects on the business. In addition, in selecting his ratios, he took into account transactions by companies operating a business similar in size to Marine. However, because of his duty of confidentiality, Mr. Martel could not disclose the specific cases on which he relied.

Mr. Wise believed it necessary to deduct a discount for lack of liquidity, defined as the inability to convert an asset into cash within a short period of time. Since the shares of Marine were shares in a private company, they did not have the same liquidity as shares listed on the stock exchange. The discount rate he used was 10 per cent. Mr. Martel did not apply any discount for non-liquidity.

Both experts used the same adjustment for excess assets.

Parties’ arguments

Counsel for Marine argued that Marine had no transferable goodwill on March 1, 1978. The goodwill was essentially personal, attributable to Mr. Robitaille’s knowledge and reputation. Given the important role played by Mr. Robitaille in operating this business, no purchaser would be prepared to pay anything for this goodwill.

In the alternative, if the Court were to conclude that there was transferable goodwill on March 1, 1978, the value of that goodwill could not exceed $88,000.

Counsel for the Minister contended that Marine had goodwill in 1977 since in 1981, when Marina-Québec disposed of its business to the Government of Quebec, the contract provided for consideration of nearly $2,400,000 for the buildings used by the business, the business name and the goodwill. In addition, when Marine acquired the business from Mr. Robitaille in 1970, it showed goodwill of $10,000 on its balance sheet. The report prepared by Mr. Martel confirms that this goodwill had a fair market value of at least $820,000 on March 1, 1978. Marine is deemed under section 69 of the Act to have received proceeds of disposition equal to that fair market value.

Analysis

Existence of the goodwill

Did Marine have an intangible asset, that is, the goodwill, on March 1, 1978? Determining whether goodwill exists is a major challenge, since it is an intangible asset; it cannot be seen or touched. In addition, it is not an asset that is distinct from the other assets of a business. Professor Durnford described this difficulty very well: [7]

Each asset of a business generally has an independent existence of its own. While it is true that a particular asset may have considerably less value when considered apart from the group of assets of a going concern, this does not take away from the fact that each can exist independently and can be sold separately as a consequence. The same cannot be said of a goodwill. Because it is inseparable from the business to which it belongs and is the factor that gives the business its excess value, it cannot normally be sold apart from the sale of the business itself as a going concern, or at least a portion of that business, though it may sometimes be possible to sell it along with a particular product.

[Emphasis added.]

The Act does not define this expression. In Losey v. Minister of National Revenue (1957), 57 D.T.C. 1098 at 1101, one of the important decisions on this issue, we find this definition of goodwill which was adopted by the House of Lords:

And in C.I.R. v. Muller & Co.’s Margarine Ltd., [1901] A.C. 217, another House of Lords decision, Lord Macnaghten said at page 223:

What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of a business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old established business from a new business at its first start.

In Ian R. Campbell’s Canada Valuation Service we find the following accounting definition of goodwill (at pages 6-12):

Goodwill has been subject to much misuse and misunderstanding as it applies to valuations. In a study published by the Canadian Institute of Chartered Accountants, “Terminology for Accountants”, goodwill is defined (at page 46) as:

An intangible asset of a business when the business has value in excess of the sum of its net identifiable assets. Goodwill has had a. variety of definitions, some relating to the nature of the asset, others to its value. As to its nature, it has been said to fall into the three classes of commercial, industrial and financial goodwill, which are the consequences of favourable attitudes on the part of customers, employees and creditors, respectively. As to its value, the common explanations emphasize the present value of expected future earnings in excess of the return required to induce investment.

[Emphasis added. ]

It is clearly recognized in the case law that the Act covers only transferable goodwill, which we might call commercial goodwill. Personal goodwill has no commercial value and is not a transferable good. Professor Durnford defines personal goodwill, contrasting it with commercial goodwill, as follows (supra, at page 775):

Just what is personal goodwill? As is often the case, an extreme example will give a clear idea. Take a well-known and currently successful author or painter. He will possess goodwill of a substantial value, but only he can realize on the monetary advantages that go with such goodwill. He cannot sell it to another because it is inseparably attached to his person and has no sale value whatever.

The foregoing situation is contrasted with that of a commercial business such as a store, especially a large one, which will continue to attract its old customers regardless of a change of ownership. This is despite the fact that goodwill is a fragile thing and the acquirer of the business may in time lose it. [8] The relevant point is that if the goodwill in such a case is lost by the new owner, the loss occurs subsequently to the transfer and for different reasons (for example, boorish behaviour toward customers).

Thus personal goodwill is so intimately identified with a particular person that once he withdraws from the business, none of the value will remain. [9]

[Emphasis added.]

The evidence established that Mr. Robitaille played a key role in Marine’s business. The reconditioning of defective boats imported from the U.S. comprised Marine’s chief activity. It was a small-scale operation. Mr. Robitaille went to Texas to select the boats that he would recondition, negotiated the purchase price and transported them to Canada and, with his team of technicians, made the necessary corrections. The most delicate operations were performed by Mr. Robitaille. He personally made the corrections to the fiberglass and designed the parts to replace defective parts. The technicians did more routine jobs requiring less expertise. Mr. Robitaille also looked after selling Marine’s products. There is no doubt that Mr. Robitaille was a key man in the operation of Marine’s business. Mr. Robitaille therefore had substantial personal goodwill.

However, the personal goodwill Mr. Robitaille had did not mean that no commercial goodwill could coexist in Marine. In order to be able to conclude that the only goodwill that existed was Mr. Robitaille’s, I would have to conclude that someone who purchased Marine’s business would have paid nothing above the value of the tangible assets. I do not believe that Marine would have agreed to sell its business to a stranger for an amount made up only of the value of its inventory, its equipment, its furnishings and its rolling stock. This was a business with sales exceeding $2,400,000 in 1976 and $1,815,000 in 1977. During the summer, the business had a dozen employees working for it. Marine had been operating its business since 1970. Mr. Robitaille had operated the business for eight years before transferring it to Marine. This business had therefore existed for about 16 years when it was transferred to Marina-Québec. Marine had an excellent reputation. Marine’s activities were not limited to reconditioning defective boats. That activity accounted for about 65 per cent of its sales during the years preceding the transfer. I am satisfied that a third party purchaser would have paid a bonus to acquire Marine’s business name and clientele. Of course, in view of the notice of résiliation of the lease by the National Harbours Board, the site on which Marine operated its business could be of only uncertain value. A third party purchaser would certainly have weighed the risk of potentially having to relocate the business and of the unpredictable rights to compensation for expropriation.

In my opinion, Marine’s business resembled the store described by Professor Durnford and Marine had commercial goodwill at the time of the transfer to Marina-Québec on March 1, 1978. Moreover, in the contract of sale of June 26, 1978, care was taken to specify that the list of goods transferred was not exhaustive. Although that contract did not refer to it, this asset was part of the business transferred to Marina-Québec. Moreover, it had been shown on Marine’s balance sheet since 1970, when Marine acquired the business from Mr. Robitaille.

Fair market value of the goodwill

Having determined that the goodwill did exist, we still have the more difficult task of determining its fair market value. While the two valuators retained by the parties essentially used the same method of valuation, they suggest quite disparate values. When confronted with a similar difference in values in Losey (supra, at page 1101), Thorson J. wondered whether the valuators had valued the same business: “It is obvious from this sharp divergency of opinion that the witnesses could not have been thinking of the same thing”’.

I have no reason to doubt the professionalism of the two experts who testified in this case. However, I must observe that the valuation of a business involves a strong dose of subjective judgment in applying the earnings-based valuation method. It is not surprising that in Neuls v. Minister of National Revenue, [1975] C.T.C. 2215, 75 D.T.C. 170 at page 2216 (D.T.C. 172), Mr. Flanigan of the Board described valuation as an “imprecise science almost verging on guesswork”. Mr. Justice Gibson made similar comments in Butler v. Minister of National Revenue™ [10]

Since the valuation experts cannot agree as to the market value of the goodwill, it falls to the Court to resolve this issue. The earnings-based valuation method used by the two experts appears to me to be entirely adequate for establishing this value. We shall therefore go back over the various steps taken by them. The amount that the Court will use for indicated pre-tax earnings is the amount calculated by Mr. Wise. However, I believe that the salary adjustment he made is too high: he took into account an “economic” salary of $120,000. In reaching this figure, he considered that four employees would be needed to replace Mr. Robitaille. I share his opinion that the remuneration paid to Mr. Robitaille was insufficient. However, even though Mr. Robitaille did the jobs of manager, technician, salesperson and purchaser, Mr. Robitaille could only work ten or 12 hours a day for six days, which amounts to a maximum of 72 hours per week. Even if these four employees replacing Mr. Robitaille had each worked only 40 hours per week, the business would have had their services for 160 hours. This reasoning therefore appears to be erroneous. In my opinion, a salary of $90,000 appears to me to be very adequate in the circumstances. The indicated earnings for 1977 would therefore be $100,520 and for 1976, $248,018.

With respect to standardization of the indicated earnings, I prefer the method used by Mr. Martel who did not do any weighting, so as to place equal weight on 1976 and 1977. This approach appears to me to be more reasonable in the circumstances. By applying a weighting factor of 2 to the indicated earnings for 1977, Mr. Wise amplified the consequences that the seizure by the RCMP had on Marine’s earnings. Marine did indeed suffer from the bad publicity surrounding the proceedings initiated by the tax authorities against Mr. Robitaille. In addition, the seizure of Marine’s inventories slowed down the operation of its business. These factors certainly contributed to the substantial drop of $600,000 in Marine’s annual sales. However, the bad publicity suffered by Marine did not relate to the poor quality of its products or services. The problem related to a dispute with the Minister concerning payment of duties. It is not reasonable to believe in 1978 that the consequences of the seizure on Marine’s 1977 earnings might be permanent. The evidence did not establish that Marine had lost part of its clientele because of these events. By taking a simple average of the indicated earnings for 1976 and 1977, without weighting, we take reasonable account of the risk of long-term harmful effects. Applying a weighting factor of 2 to 1976 would, in my opinion, have underestimated this risk. I therefore arrive at indicated earnings of $174,269, from which we must deduct 3 per cent for the inventory allowance. After deducting income tax, the rounded off indicated after-tax earnings amount to $142,000.

For the following reasons, I conclude that the fair market value of Marine’s goodwill on March 31, 1978 was $190,200. This value may be justified as follows:

FAIR MARKET VALUE OF THE GOODWILL

ON MARCH 1, 1978

		1*77	1976
Adjusted pre-tax earnings			$100,520	$248,018
Average indicated pre-tax
earnings				174,269
Income tax:
Indicated earnings		$174,269
LESS: 3% allowance for
$673,751 inventory		( 20,213)
	$154,056
LESS: income tax at the rate of
21% om $154,056			(32,352)
After-tax indicated earnings, rounded off			142,000
LESS: 35% discount for key man			(49,700)
Adjusted indicated earnings			92,300
Capitalized using	ratio of 4 times (25%)		369,200
Value of company as a going concern			369,200
PLUS:
Recess assets of $43,000
(net of 15% income tax)			36,550
Fair market value of the shares of the company,
rounded off			405,750
LESS:
tu.:- market value of the net tangible assets			(179,000)
excess assets			(36,550)
Fair market value of the goodwill, rounded off			$190,200

[Translation.]

In order to take account of Mr. Robitaille’s personal goodwill, I believe that it is essential to recognize a key man discount, as Mr. Wise did in his report. The evidence clearly established that Mr. Robitaille plays a preponderant role in the operation of this business. I am satisfied that if Mr. Robitaille were to leave the business, Marina-Québec would suffer a substantial reduction in its earnings. In the circumstances, I believe that it is reasonable to use a discount rate of 35 per cent.

The capitalization rate or the choice of a ratio seems to me to be more difficult to resolve. The amount used has a significant impact on the determination of the fair market value. We need only try out various scenarios on an electronic calculator to see this. For example, if we applied a ratio of 6.75 to the adjusted indicated earnings, the fair market value of the goodwill would rise from $190,200 to $444,025. In the circumstances of this case, the ratio 4 used by Mr. Wise appears to me to be the most reasonable.

The ratios of 6 and 7.5 used by Mr. Martel give a rate of return varying between 13 1/3 and 16 2/3 per cent. These rates appear low to me, taking into account the interest rates of 10.25 per cent on ordinary mortgage loans and interest rates of 9.58 per cent on 1977 long-term Canada Savings Bonds. In addition, certain external and internal factors which Mr. Martel took into account appear to me to be unjustified.

He believed that the position occupied by Marine in operating its business was a virtual monopoly because of the franchise it held. First, this was an oral franchise renewable yearly. Even if Marine had had an exclusive franchise from Glastron, Marine was faced with ferocious competition from other distributors of nautical products in the Québec region. There was also a large number of boat manufacturers in Quebec and Ontario. In my opinion, Mr. Martel underestimated the impact of that competition. Mr. Martel believed that Marine had a captive core clientele. The evidence established that the boats had a useful life of 25 to 30 years and that new customers came in by word of mouth.

Mr. Martel placed considerable weight on the quality of Marine’s staff. He seems to me not to have fully understood that Mr. Robitaille alone had the knowledge and experience to do the most delicate repair jobs. Marine’s technicians had diverse professional backgrounds, such as barber, cook and construction worker. Mr. Martel also assumed growing popularity of pleasure crafts among consumers. However, he had no market study to back up what he said.

Mr. Wise did a better valuation of the external and internal factors affecting the business in selecting his ratio. Among other things, he considered the competitive market for Marine’s products, the risk of expropriation of the premises occupied by Marine and the impact of the seizure on the operations of the business to be negative factors.

If Mr. Martel had been able to demonstrate, with supporting examples, that the ratios used in the acquisition of businesses involving the distribution and sale of nautical products varied between 6 and 7.5, this might have influenced my choice. However, he was unable to corroborate his claims. He merely asserted that ratios of 10 were used for small and medium-sized businesses. I find this assertion surprising, since a ratio of 10 represents a rate of return of 10 per cent. Since an investor can get a return of 9.58 per cent with no risk on long-term government bonds, I find it hard to believe that a purchaser would risk $820,000 for the goodwill of a small or medium-sized business subject to the risks described above.

Mr. Wise has not persuaded me that the discount for non-liquidity is reasonable. I could recognize the merit of such an adjustment if the issue were the valuation of minority shares in a private company. However, what we have to value here is the goodwill of a business that has been transferred as a whole to another entity. Mr. Wise emphasized that a purchaser of a business would want to take into account the possibility of reselling the business and that the non-liquidity factor could play a role in such a resale. As Mr. Wise himself said, at page 14 of his valuation report:

In the earnings-based valuation method, it is therefore assumed that the business will continue to be operated and that the purchaser wishes to acquire the business’s earning capacity or to obtain a share of it.

[Emphasis added; translation.]

Unless someone purchasing such a business is a speculator, he or she will make the purchase as a long-term investment. I do not believe that it is reasonable to deduct such a discount. The ratio of four, which assumes repayment of the cost of acquisition spread over four or five years, takes adequate account of this factor.

For these reasons, the appeal is allowed and the reassessment for the 1978 taxation year is referred back to the Minister on the basis that the fair market value of Marine’s goodwill on March 1, 1978 was $190,200. The whole without costs.

Appeal allowed.