Andre Varga v. Minister of National Revenue, [1984] CTC 2295, 84 DTC 1278

Cardin, TCJ:—Andre Varga is appealing from an assessment of tax dated September 19, 1979. The issue is whether amounts of $37,715, $504,000 and $49,385 received by the appellant in 1972, 1973 and 1974 respectively were payments in consideration of commercially-transferable goodwill resulting from a transaction that took place in 1968 and are therefore a non-taxable capital receipt or whether the amounts were taxable income of the appellant pursuant to sections 3 and 5 and paragraphs 6(1 )(a) and 6(3)(e) of the Income Tax Act.

Although a great deal of evidence, both written and oral, were adduced at the hearing, much was undisputed. The principal point of contention is the nature of the payments received by the appellant in the years under review.

The appellant, a professional design engineer, was the sole owner of Varga Consulting Engineering Limited (Varga Engineering) whose business was mainly designing and developing special machinery and equipment used principally in the wire and steel rope industry.

In 1966 Varga Engineering and Hock Machine Manufacturing Company Limited (Hock Manufacturing), wholly owned by Mr Joseph Hock, a long time friend of the appellant, entered into a partnership agreement operating under the name of Central Engineering Co (Central).

Hock Manufacturing was essentially a machine shop engaged principally in the construction of machinery used in the wire cable industry. The partnership’s business was the designing and manufacturing of this specialized machinery.

It is my understanding there were very few, if any, companies in Canada engaged in the production of similar machinery. The demand for such machinery was greater than Central could supply. Although the partnership expanded very rapidly, the cost of producing the prototype of the required machinery was greater than its capital structure could afford. “Central” became known for the quality of its product and services. That Central was undercapitalized was also known by corporations interested in Central’s products such as Hugh Russel & Sons, Limited (Russel) and Industrial Wire & Cable Co.

Early in 1968, Mr Peter Foster, then Vice-President Corporate planning for Russel, approached Central through Mr Varga with a view to the possible purchase of Central.

The evidence of Mr Foster and Mr Varga established that several discussions were held in respect of a proposal and counter-proposal for the acquisition of Central by Russel. Correspondence corroborating the oral evidence was filed by the appellant as Exhibit A-l. The pertinent correspondence can be found at tabs 9 to 14 of Exhibit A-1. Reference will be made to some of these documents later.

On the basis of the above documents and the oral evidence given by both the appellant and Mr Foster, I can accept:

(1) that the partnership and Russel through their representatives, were transacting at arm’s length;

(2) Central was negotiating in order to get the best possible price for its business and Russel was trying to get the assets of Central at the lowest possible price.

Both the appellant and Mr Foster were not only good and credible witnesses, they were also very shrewd and experienced businessmen. Their testimony and the supporting documents establish that very hard negotiations had taken place between Russel’s and Central’s representatives.

Mr Foster had a thorough study made of Central’s earning potential (Tab 12, Exhibit A-l) as well as a comparison of three possible financial proposals for the acquisition of Central by Russel (Tab 13, Exhibit A-l). A proposal by Mr Foster signed by Mr Varga and Mr Hock set out the general principles on which the financial considerations and terms and conditions of sale and purchase were established (Tab 16, Exhibit A-l). On the basis of this proposal, the purchase and sale agreement was executed on April 25, 1968 (Tab 1, Exhibit A-1).

The memorandum of agreement signed April 25, 1968 provided that Hock Machine Manufacturing Limited and Varga Consulting Engineering Limited, were acquired by Russel as a going concern for an amount of $467,725.75, the effective date being March 1, 1968.

Purchase price was allocated as follows:

(set out in more details at pages 2 and 3, Tab 1 of Exhibit A-1).

However, the agreement stipulated that the consideration for goodwill shall be subject to adjustment, and the amount of goodwill was to be determined as set out in paragraph 7(d) of the agreement Tab 1, page 5. Exhibit A-1:

(d) as to the balance of the said purchase price 250,000 which the Vendors and Purchaser mutually agree shall be determined to be an amount equal to five times the average annual net after-tax profits (tax to be determined in accordance with the provisions of the Income Tax Act as presently enacted or as hereafter amended or supplemented, and being currently at the rate of 53.41%) attributable to the common shares of the subsidiary company of the Purchaser to which the benefit of this Agreement may be assigned as provided in paragraph 16 hereof (which subsidiary is hereinafter referred to as “Ceeco”) during the first five years subsequent to the effective date hereinafter referred to which, subject to the conditions of paragraph 8 hereof, shall be payable in five annual instalments .. . .

The fact that Messrs Hock and Varga entered into an employment contract with CEECO (a corporation wholly owned by Russel for the purpose of operating Central) is not disposed (paragraph 12, page 4, Tabs 2 and 3 of the employment contract Exhibit A-1). These contracts contained a non-competition clause applicable to both Hock and Varga.

In the sale agreement of April 25, 1968, by which Russel purchased the assets of Central, it is provided that the purchaser would be released of all further obligation toward the payment of the purchase price to Hock Machinery and Varga Engineering if Mr Hock and Mr Varga, of their own volition, ceased to be employed by CEECO during the first five years of its operations (paragraph 8, Tab 1, Exhibit A-1).

On August 15, 1969 Hock, who did not feel comfortable working for CEECO under a large corporation issuing orders and guidelines with respect to the operation of the machine shop, entered into an agreement with Russel, Varga and CEECO whereby Russel released Hock of the terms and conditions of paragraph 8 of this agreement of purchase and sale of April 25, 1968, with respect to his employment with CEECO.

Hock, of his volition, ceased to be employed by CEECO and by agreement, Hock’s right to receive proceeds of sale of goodwill, as set out in paragraph 7(a) of Exhibit A-l, were simply assigned by resolution to Andre Varga on August 15, 1969; Varga Engineering also assigned to Andre Varga personally its rights to receive proceeds of sale of goodwill. Andre Varga therefore had conferred on him all the rights to the proceeds of the sale of goodwill.

Pursuant to the purchase agreement of April 25, 1968, and the agreement of August 15, 1969, Andre Varga received from Russel the amounts of $37,715, $504,000 and $49,385 in 1972, 1973 and 1974 respectively. It is the nature of these payments to the appellant that is in issue.

It is the respondent’s contention that the amount of $250,000 as consideration of goodwill in the April 25, 1968 purchase agreement is a meaningless number because the amount can only be paid if the business generates sufficient profit to cover the payment of goodwill. He also pointed out that, according to employment contract (Tabs 2 and 3, Exhibit A-1), the goodwill payments by Russel would cease if either the appellant or Hock would voluntarily seek to terminate their employment within the first five years of operation of the newly formed company CEECO. From this, counsel concluded that the presence of both the appellant and Hock were essential for the successful operation of CEECO. The respondent overlooked however that several employees of Varga and Hock were also employed by CEECO. Mr Foster testified that either one of four persons, Varga, Hock, Russel and Horvath could be the key employees in CEECO, Tab 17, Exhibit A-l. Also included in the sale of assets transferred to CEECO were a very large number of finished and semi-finished products which Central had shipped or were in the process of shipping (Tab 18, Exhibit A-l).

A list of Central’s employees, their salaries and working hours were produced as Tabs 19, 20, 21 and 22 of Exhibit A-l. Most of the employees continued to work for CEECO after the purchase agreement had been executed. Photos of the type of specilized machinery already built or in the process of being built by Central are shown in Tab 23, Exhibit A-l. The evidence established that what was being transferred to CEECO was not personal goodwill of the appellant or of any other individual, it was the sale of tangible property and included not only the personnel and necessary machinery but was also transferring an ongoing business which had successfully manufactured and was still manufacturing specialized wire cable machinery.

As stated earlier, both the appellant and Hock were employees of CEECO after the sale and were to receive a remuneration of $18,000 a year plus an additional remuneration of $2,000 for each year in which the common shares of CEECO exceeded $4,000 (Tabs 2 and 3, Exhibit A-l). This, in my view, is totally independent of the undertaking by Russel to pay a stipulated amount (to be adjusted) as consideration for goodwill in the purchase of the assets of Central’s business (Tab 1, Exhibit A-l).

The evidence disclosed that the appellant’s remuneration for his services to CEECO increased over the years to some $50,000 a year.

These payments were clearly salary for services carried out by the appellant and were paid to him by his employer CEECO, on which the appellant paid income tax. Counsel for the respondent referred the Court to paragraph 6 of the notice of appeal where the appellant states:

. . . the Appellant received from Ceeco the full amount of the consideration paid by Ceeco to purchase the Goodwill.

The purport of this paragraph of the notice of appeal was clearly contradicted by the appellant and by Mr Foster who had no interest in the outcome of the appeal. Mr Foster, who represented Russel, stated clearly that the purchase price of Central’s business, including consideration for goodwill, was paid by Russel exclusively. It appears on the basis of paragraph 6 of the notice of appeal that counsel for the respondent assumed that by some non-arm’s length negotiation with Russel, CEECO assumed the obligation of paying the appellant the consideration for goodwill in the amount of some $600,000 as part of the purchase price. Counsel for the respondent however did not, in his cross-examination of the appellant and Mr Foster, seek in any way to point out the discrepancy be- twen paragraph 6 of the notice of appeal and the categorical statements made by Foster and Varga with respect to the source of the goodwill payment. No clarification of the point was sought by the respondent nor was there any evidence to contradict the sworn statements of two credible witnesses who were in the centre of negotiation of the April 25, 1968, purchase and sale agreement. In this context, Tab 15 of Exhibit A-l is a memo to the board of directors of Russel, dated March 18, 1968, including a proposal for the acquisition of Central by Russel (Tab 16, Exhibit A-1). Under the heading “The Deal’’ at page 3, paragraph 9, the proposal states:

This will be largely a contingency deal whereby the amount we pay for the company will depend on the profits earned by the company during the first five years of operation.

(1) Hugh Russel & Sons Limited will acquire all the assets and assume all the liabilities of the two partnership companies for $100,000 in cash and pass these assets to a new wholly owned subsidiary (Ceeco).

(3) Each year for 5 years when the net profit after tax attributable to the common shares held by HRS is determined a cash capital payment of 80% of this amount (20% holdback) will be made by Hugh Russel & Sons to the vendor companies, (italics mine)

This proposal dated prior to the sale agreement of April 25, 1968, discloses the intent of the parties and confirms the testimony made at the hearing by the appellant and Foster as to the nature of the payments made to the appellant in 1972, 1973 and 1974 as capital payments.

Counsel for the respondent was concerned with the wording of Mr Foster’s letter to the appellant, dated February 13, 1968. Counsel referred to paragraphs 1 and 2 of Tab 11, Exhibit A-1.

Mr A Varga,

President,

Central Engineering Co

48 Lepage Court

DOWNSVIEW, Ontario.

Dear Andre,

The major difficulty we both face in working out a purchase and sale of Central Engineering is that the earning power of the company cannot be known for sure. From your point of view, you wish to participate in the growing earnings of your company. From our point of view we wish to avoid giving guarantees in an uncertain situation.

Our first approach to solving this problem was a “contingency deal” which would have given you and your partner the full benefit of the growth of your company for the next five years, while minimizing the guarantees which we would have to undertake.

I presume counsel referred to these paragraphs to establish that Russel did not commit itself to any payment of goodwill in the consideration for the purchase of Central.

These paragraphs of Mr Foster’s letter to the appellant simply substantiate, in my opinion, the oral evidence given by Mr Foster and the appellant that, although they could not at that time determine the exact amount of payment of capital for goodwill, both the appellant as well as Mr Foster were optimistic with respect to the future earnings of CEECO. This is clearly stated in Mr Foster’s proposal to the Board of Directors of Russel with respect to the acquisition of full ownership of Central.

This optimism for the successful performance of the newly-found CEECO as a successor to Central was shared by Industrial Wire & Cable Co, as indicated in Mr Foster’s proposal to Russel (Tab 16, Exhibit A-1).

Counsel for the respondent appeared to say that both Russel and Industrial Wire & Cable Co did not have sufficient confidence in the future of CEECO, and were unwilling to risk a penny in the venture. That, as stated earlier, is not in accordance with the facts with respect to Russel and there is ample written evidence to rebut counsel’s conclusions on that point. With respect to Industrial Wire & Cable Co in recommending the purchase by Russel of Central it was not acting otherwise than in its own interests. As stated in Mr Foster’s proposal, Industrial Wire & Cable Co was not interested in becoming involved in the manufacture and sale of equipment, but it hoped that it might sell its own products in a close association with Central. Industrial Wire & Cable Co recognized the potential of Central but realized that Central needed financial backing to support its rapid growth. It therefore recommended that Russel should study the acquisition of Central (Tab 16, Exhibit A-1).

Counsel for the respondent objected to the inclusion in Exhibit A-l, a letter dated November 8, 1978, from Ian Campbell & Associates Limited (Tab 8, Exhibit A-1). Counsel’s first objection was that he had not been advised that the letter would be used as evidence. The letter was available in the Department of National Revenue in Toronto for some six years and its contents well known. I cannot see how its inclusion in Exhibit A-l, as part of the appellant’s case, can in any way be prejudicial for the respondent. Counsel also objected to Mr Campbell giving expert evidence in corroboration of the contents of his letter. The reasons given by the respondent was that the letter was argumentative; Mr Campbell was being very subjective; the letter was not a valuation report. Counsel concluded that a theoretical or abstract report was not needed and Mr Campbell was not qualified to give a legal opinion.

I agree with counsel that Mr Campbell was not to offer a legal opinion. However that was not what Mr Campbell was proposing to do nor is it what he in fact did. I allowed Mr Campbell to give expert evidence and I allowed filing his report (Tab 8, Exhibit A-1). Both counsel stated that they were unable to find a decision exactly on point. Perhaps one of the reasons was the manner in which the goodwill was to be paid. Counsel for the respondent seems to be arguing that because the amount of goodwill was not exactly determined at the time of the sale agreement and because it would not be paid if the appellant or Mr Hock voluntarily left the employ of CEECO, it was not goodwill.

The appellant clearly established in the earlier stages of negotations that an amount of goodwill was to be part of the purchase price. Even though the amount was not determined and even though its payment may have been conditional, the nature of the payment is not changed — it remains a capital payment and, in the present context, in the form of goodwill.

The amounts in issue are either for commercially transferable goodwill or they are not. The distinction between the two is in my opinion a matter of fact and not a matter of law. Mr Campbell, a business and security evaluator, in his report, Tab 8, Exhibit A-l, and in his testimony stated that the method used in adjusting the amount of the purchase price allocated to goodwill is a commercially accepted procedure and widely used in transactions where the purchaser and the vendor are not certain as to the prospective earnings of the business to be purchased. The vendor agrees to accept and the purchaser agrees to pay a greater or lesser amount than the amount of goodwill stipulated in the purchase price. This commercial procedure of “earnout” arrangement does not, as suggested by the respondent, destroy or alter the goodwill nature of the payments.

One of the legal aspects of the issue is whether the facts of this appeal can come under the provisions of paragraph 6(1 )(a) of [the] Income Tax Act, I am not certain that the respondent seriously attempted to apply paragraph 6(l)(a) of the Act. In any event, I am not persuaded that paragraph 6(l)(a) applies to the circumstances of this appeal.

With respect to the application of paragraph 6(3)(e) of the Act which reads in part as follows:

Sec 6(3)

(3) Payments by employer to employee. An amount received by one person from another

(e) in consideration or partial consideration for a covenant with reference to what the officer or employee is, or is not, to do before or after the termination of the employment.

There is no evidence that the appellant or Hock was ever an officer or employee of Russel. The conditional clause of the sale agreement was not a principal consideration of the contract. Indeed, Russel waived its rights with respect to Hock’s voluntary termination of his employment with CEECO. Russel also permitted the transfer to the appellant of Hock’s rights to the balance of the purchase price for CEECO and assigned these rights to the appellant personally.

The condition was operative only with respect to the voluntary termination of Hock or the appellant’s employment with CEECO. Dismissal by CEECO of the appellant or Hock from their employment, illness, death of either one or any other circumstances other than the voluntary termination of their employment with CEECO would not trigger the effect of the conditional clause and the rights of both the appellant and Hock to the balance of the purchase price would remain intact.

Although these considerations taken singly, may not be decisive, they do help to put the substance of the transaction into proper perspective. The preponderance of the evidence leaves no doubt in my mind that the consideration for the capital payment including goodwill was clearly for the assets of Central as a going concern. Paragraph 6(3)(e), of the Act is not applicable to the facts of this appeal.

The appeal is allowed and the matter referred back to the Minister for reconsideration and reassessment on the basis that amounts of $37,715, $504,000 and $49,385 received by the appellant in 1972, 1973 and 1974 respectively were in consideration for commercially transferable goodwill as part of the proceeds of disposition of a business in 1968 and as such are not taxable.

Appeal allowed.