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Citation: 2005TCC776
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Date: 20051206
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Docket: 2001-2083(IT)G
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BETWEEN:
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EXCELL DUCT CLEANING INC.,
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Appellant,
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And
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
CampbellJ.
[1] The Appellant, a franchisor, advanced sums of money to another company, 991830 Ontario Inc., one of its franchisees, in the 1992, 1993, 1994 and 1995 taxation years. Due to operating difficulties and mounting losses, 991830 Ontario Inc. terminated its operations. For the 1995 taxation year, the Appellant claimed the following expenses in respect to those advances which were not repaid:
(a) $177,009.00 as a bad debt; and
(b) $28,003.00 as a related company expense.
The parties agreed that the amount of $28,003.00 was properly disallowed by the Minister of National Revenue (the "Minister") and that the only amount in dispute for the purposes of this appeal is $177,009.00.
[2] The Minister assessed the Appellant on the basis that these advances, totalling $177,009.00, were capital in nature and therefore not deductible as business expenses. The issue is whether the Appellant's expense of $177,009.00 is on account of capital or a current expenditure, and therefore whether the loans were made for the purpose of gaining or producing income from the Appellant's business so that they can be deducted pursuant to paragraph 18(1)(a) of the Income Tax Act (the "Act").
[3] In addition to the pleadings, the parties submitted an Agreed Statement of Facts, as follows:
General Description of the Appellant
The Appellant is the franchisor of a duct cleaning business in Canada. Part of its business includes enlarging its market by selling franchises to owner-operators. Part of that activity includes helping the franchisee to set up its business, providing technical advice and ensuring quality control. On occasions, the Appellant would help finance its franchisees for a time in order to alleviate start up costs and to attract/assist promising franchisees. The Appellant would assess on a case by case basis the merits of making such loans. Some of the loan bore some interest while some others did not. The total interest income generated makes a very small portion of the Appellant's revenue.
The Appellant holds franchises in 26 locations across Canada.
Both the owners of the Appellant, Mr. Gottfried and Mr. Guitard have an extensive background in operating as franchisers prior to creating the Appellant. Mr. Gottfried works mostly on the administrative side of directing the Appellant and Mr. Guitard does more operational work like training and technical support.
The Appellant's duties as franchisers under their licence with SEARS is to train, assist, vehicle preparation and procurement, hiring, system, contact with relevant people and equipment.
The business of the Appellant's franchisees is to clean air ducts under licence to use the SEARS' name. Their operation is seamless: their trucks bear the name SEARS and their employees use the SEARS uniform.
The profit sharing structure
The profit is shared as follows:
For every $1 spent by a Sears consumer of duct cleaning services, the Appellant receives 90 ¢ . Of that 90 ¢ , 80 ¢ goes to the franchisee.
Diagram:
Retail Customer pay $1 for service performed by 991830
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Appellant pays 80 ¢ to Franchisees
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991830 (franchisee)
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Franchisee#2
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Franchisee#3...
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991830
Sears demanded that the duct cleaning service be provided in the Toronto area. This endeavour involved a very large market and the services were to be performed in a highly developed area, which would require many adjustments to the way the Appellant normally did its business.
In order to help open up the Toronto franchise, Bill Gottfried and Wallace Guitard on behalf of the Appellant approached Mr. Mike Hand to attempt to make this work, so that he might eventually run the franchise. Mr. Hand had experience in a successful franchise established in Burlington. He sold his interest in that franchise in order to start 991830.
The shares of the 991830 were held equally by Bill Gottfried, Wallace Guitard and Mike Hand as to 33 common shares and as to 1 common share by the Appellant.
The holding of at least 1 share in the franchisee being a requirement of Sears, for each franchise operation. In the case of this Toronto franchise, Sears also approved that Wallace Guitard and Bill Gottfried hold shares in the franchisee. Mr. Hand would run that day to day operations of 991830 and the Appellant would provide financing. The financing provided by the Appellant was incremental over the period of operations of 991830 (cash was provided to purchase equipment and pay expenses as they came in). The detail of the loans made to the Appellant is attached hereto as Schedule "A".
As it turned out, there were numerous problems that soon became evident when they started operations. The problems were such that Mr. Guitard, who normally provided technical support services for all the franchises, ended up having to work considerable hours and spend more than half of his time at 991830.
Some of the major technical difficulties encountered included:
• Office problems
The office selected was not cost effective. It was located on the top floor of a Mall, which did not make sense when you work with trucks. To make things worse, the office did not offer a parking area for trucks and they ended up having to park across the street.
• Parking problems
The Appellant is very conscious of the quality of its services and requires the use of a very large truck. Many streets did not have a large parking area in front of the places for which cleaning services were requested. Even if they had parking on the street, it was hard to have a parking spot that was large enough and close enough. Besides, the trucks couldn't park at all in some areas (like alleyways).
• Multi floors units
Most of the places where the services were performed were multi floor buildings creating a number of technical problems for the equipment.
• Image problems
Due the fact that the Appellant was using Sears name on the truck and the outfit, 991830 could not be as cavalier as most competitors in that area were in backing up on the lawn or closing a street to circulation. If someone files a complaint with Sears it could have a detrimental impact on the whole of the Appellant's business, given its complete dependence on the Sears label.
Profits generated by 991830
As detailed above, the purpose for creating any franchise is to obtain the 10 ¢ on the dollar of income for the Appellant. The financing of it is also provided with the aim of generating that income. During the period that 991830 was operating, it generated sales of over two million dollars, which resulted in royalty income of $218,474.63 for the 1993, 1994 and 1995 fiscal years of the Appellant, which it duly reported as income for tax purposes. The details of the royalty income are attached hereto as Schedule "B".
991830 terminated its operations
In light of the many problems encountered and increasing losses, 991830 terminated its operations. The losses of the Appellant were $177,009 from the amounts advanced and never repaid. This loan is three times larger than the next outstanding loan to other franchisees.
The total amount claimed as a bad debt was $205,402 but the parties now agree that an amount of $28,033 was properly disallowed by the Minister of National Revenue and is not in dispute.
[4] The Appellant's position is that the Sears' request to open a franchise in the Toronto market was a requirement and that the Appellant had no choice but to comply in order to preserve its business relationship with Sears. The Respondent argued that the Agreed Statement of Facts used the word "demand" (Statement of Facts page 2), in referencing Sears' request to open a Toronto franchise, and not the word "required". To prove a request went beyond a demand into the realm of a requirement, the Appellant would need to call witnesses to support that position. However, the Respondent contended that this argument was irrelevant because it is not part of the agreed facts that this was the operating motive for making these loans. The Appellant also argued that funding was a necessary pattern to its business operations. Because of the size and competitive nature of the Toronto market, the Appellant advanced larger sums of money to 991830 Ontario Inc. than it did to any of its other franchisees. In addition, according to the Appellant, the participation, by the shareholders of the Appellant in this franchisee corporation, was not relevant because the primary intent of the Appellant was to generate royalty income as it was with its other franchisees. The Appellant also argued that the purpose of these loans was part of the nature of its business to generate income by bringing in new franchisees and providing funding to keep those franchisees viable. This was contrary to the Respondent's submissions that the purpose of the loans was to acquire new goodwill by increasing the number of its franchisees which created an asset of an enduring benefit and therefore of a capital nature. An increase in the number and size of franchisees meant growth for the Appellant's business which translated to something of an enduring nature to the Appellant. As a result there is a "stream of income" derived from each of the franchisees which increases and benefits the goodwill of the Appellant.
[5] Although the Notice of Appeal references the loans as an expense under paragraph 20(1)(p) of the Act, both parties agreed that this provision did not apply in the circumstances of this appeal.
Analysis:
[6] My determination in this case depends on whether I view the loans made by the Appellant as being for the purpose of acquiring an enduring benefit and increasing its goodwill or whether these loans were for the purpose of increasing its profitability and protecting the existing goodwill.
[7] In Easton et al. v. The Queen, 97 DTC 5464, the Federal Court of Appeal stated the general proposition that an advance made by a shareholder to or on behalf of a corporation will be treated as a loan for the purpose of providing working capital to the corporation. Any resulting loss would therefore be capital in nature as either the loan was given to generate a stream of income or to secure an enduring benefit. However the Court in Easton recognized certain exceptions to this general proposition. One of these exceptions exists where the loan was made in the ordinary course of the business. This exception has been recognized as extending to cases where the loan was made for income producing purposes as it related to the taxpayer's own business (The Queen v. Lavigueur, 73 DTC 5538 and Paco Corporation v. The Queen, 80 DTC 6328). Other examples of this exception are where the loan was made for the purpose of increasing the profitability of the taxpayer's own business (Williams Gold Refining Co. of Canada Limited v. The Queen, 2000 DTC 1829) and where the loan was made for the purpose of protecting the existing goodwill of the taxpayer's business (L. Berman & Co. Ltd. v. M.N.R., 61 DTC 1150).
[8] According to the Agreed Statement of Facts in this appeal, the Appellant's operation is subject to a licence with Sears and the duct cleaning business of each franchisee is under license to use the Sears' name. The trucks bear the Sears' name as do the employee uniforms. Sears "demanded" that the Appellant open a franchise in the Toronto market. The Respondent argued that the word "demand" used in the Agreed Statement of Facts did not mean that the Appellant was "required" to open in this market. However I think the Respondent is "splitting hairs" here. The terms "demand" and "requirement" as defined in the Oxford English Dictionary, 2nd. ed. provides the following:
"demand" - an act of demanding or asking by virtue of right or authority; an authoritative or peremptory request or claim; also transf., the substance or matter of the claim, that which is demanded.
"requirement" - the act of requiring; a requisition, request; the fact of being requisite; necessity; that which is called for or demanded; a condition which must be complied with. (emphasis added)
The term "demand" certainly incorporates the term "require" and I therefore reject the Respondent's argument.
[9] I think it is reasonable to deduct that, when Sears demanded the Appellant to open in the Toronto area, the Appellant felt it was essential to expand into this market to preserve its existing business relationship with Sears. After all, its business was wholly dependent on this relationship with Sears. Although the facts are silent on this point, it seems logical to deduct that it was one of the underlying motives for making these loans. The loans assisted with the success of the franchisee, which had a direct impact on the profitability of the Appellant but those same loans also ensured the continued existence of its business dealings with Sears. The loans were both commercially practical and prudent in these circumstances.
[10] The approach adopted in establishing a franchise operation in Toronto was a little different than in other areas in two respects: the size of the advances and the holding of shares by the Appellant's two shareholders in the franchisee company. There is no question here that the funds advanced were used solely in the franchisee's business. In some instances the Appellant will decide to financially assist its franchisees, so the advances to 991830 Ontario Inc. were within its ordinary business practices. The Appellant's loans to this franchisee were larger than those made to other franchisees. However facing a market the size of Toronto with all its complexities, compared to other markets, one would expect that the advances, which the Appellant made to 991830 Ontario Inc., to assist it to infiltrate the Toronto market, would have to be larger than in other areas where the Appellant had enlisted franchisees. In respect to the second differentiating factor, Sears actually required the Appellant itself to hold one share in each franchisee operation. In addition to the Appellant's one share in 991830 Ontario Inc., Sears approved the Appellant's two shareholders themselves holding two-thirds of the shares of the franchisee company. An independent third party, recruited by the Appellant, was the owner of a third of the shares and the day-to-day operator of 991830 Ontario Inc. There was no question that this arrangement was done in a commercially appropriate manner and that it had been sanctioned by Sears. The Appellant simply varied its usual approach in the Toronto market because it appeared to be the method that would be the most commercially viable. In addition, I agree with Appellant counsel's submissions that the Appellant's shareholders would receive little benefit in depleting the funds of the Appellant where they were 100% owners, by transferring amounts to the franchisee, where together these individuals owned only two-thirds of the interest.
[11] According to the Agreed Statement of Facts "...the purpose for creating any franchise is to obtain the 10 ¢ on the dollar of income for the Appellant" and the purpose of advancing funds to franchisees, including 991830 Ontario Inc., was "with the aim of generating that income" (Statement of Facts, page 3, last paragraph). Every time the Appellant added a new franchisee to its roster, it simultaneously increased its own profitability while also creating an asset of an enduring benefit, that is, the new franchise operation. At first glance, therefore, it would appear that these loans are likely to be capital in nature. However the critical distinguishing factor in this appeal is that the Appellant's business is franchising. Its business is to increase the number of its franchisees which create new franchises being assets of an enduring benefit. The advances, which the Appellant makes, were in the course of the Appellant's business operations to generate business income directly from its franchisees' operations. In this respect the case of Lavigueur is particularly helpful. In that case a landlord made loans to a tenant of commercial premises, as he was in the habit of doing with other tenants, to assist that tenant's business operations and ensure the continuity of a rent paying tenant. The Federal Court allowed the loans to the tenant as a deduction from income as expenses incurred to produce income. At page 5545 of that decision the Court stated:
The loans were apparently an integral part of the profit-making activities of the business, since from time to time, although not carrying on a money lending business as such, (the Appellants) did lend money to lessees to retain them as such with a view to keeping the premises rented and collecting as much rent from same as possible. (Change in italic mine.)
[12] Also in the case of Panda Realty Limited v. M.N.R., 86 DTC 1266, where a taxpayer guaranteed a tenant's loan to preserve the taxpayer's ongoing source of rental income, this Court held that the resulting loss was on account of income because the guarantee was vital to the taxpayer's business and provided to preserve an ongoing source of rental income.
[13] Because the Appellant's business is franchising, its goal is to gain royalty income through creation of new franchises. Loans to new franchisees were made in the ordinary course of its business activities but not to acquire new goodwill, as the Respondent submitted. Once the new franchise is created in an area, it is at that point in time that the Appellant has acquired any "new goodwill". I view the loans as a means of preservation of "existing goodwill". The Respondent's argument is that the increase in the number of franchises meant a growth in the Appellant's business by creation of a "stream of income" from each franchisee. According to the Respondent, every time the Appellant added a new franchisee, its goodwill was increased which created an asset of an enduring benefit. If I accept the Respondent's argument that a "stream of income" flowing to the Appellant from the franchisee is to be characterized as goodwill, then how can I possibly reconcile this proposition with the Agreed Statement of Facts which states that the "stream of income", per se, flowing to the Appellant, is royalty income. Specifically in the last paragraph, page 3, of the Agreed Statement of Facts, it states that:
...the purpose for creating any franchise is to obtain the 10 ¢ on the dollar of income for the Appellant. The financing of it is also provided with the aim of generating that income.
[14] The primary intent and focus of the Appellant is to generate royalty income. The Court in Morflot Freightliners Ltd. v. M.N.R., 89 DTC 5182 (F.C.T.D.) stated at page 5185:
It has frequently been said in cases of this nature that one must try to characterize a situation from a practical business point of view to determine the intent with which the money was provided.
[15] Growth in the Appellant's business is directly related to acquiring new franchisees. This growth occurred through expansion of its duct cleaning business into new markets by recruiting and selling franchises to new operators. Part of its business included helping new franchisees set up their business by providing training and ensuring quality control. On occasion the Appellant also helped finance a franchisee. This is the nature of its business and it is how its income is generated. The Appellant's intent in some instances was to assist a franchisee by advancing funds to ensure growth and continuity in the Appellant's own income. In this particular case, there was considerable royalty income generated by 991830 Ontario Inc. and paid to the Appellant before 991830 Ontario Inc. encountered financial problems. To attempt to characterize these loans as something akin to a permanent or enduring benefit is simply wrong.
[16] When I look at the substance and nature of the loan transactions in light of the Appellant's business of franchising, I conclude that the Appellant made the loans for the purpose of gaining or producing income from its business, despite the incidental shareholding in the franchisee by the Appellant's shareholders.
[17] The appeal is allowed, with costs, to permit the Appellant to deduct the amount of $177,009.00 as a general business expense.
Signed at Ottawa, Canada, this 6th day of December 2005.
Campbell J.
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