John Donaldson, Ronald Tobin v. Minister of National Revenue, [1983] CTC 2046, 83 DTC 51

John B Goetz:—This is an appeal by the appellant John Donaldson with respect to his 1974, 1975, 1976 and 1978 taxation years. It was agreed between the parties that the appeal of Ronald Tobin (81-895), the appellant’s partner, would be heard on common evidence and that Tobin’s appeal would abide by the results of the Donaldson appeal. The respondent, by subsequent reassessments in April 1981, pleaded in his reply to notice of appeal as follows:

2. With respect to the 1974, 1975 and 1976 taxation years:

(a) The Minister of National Revenue reassessed the Appellant with regard to the three years and added to his income certain amounts in each year which were funds appropriated to the Appellant by a corporation of which he was a shareholder.

(b) By subsequent reassessments made in April of 1981, the Minister of National Revenue deleted the said funds from the Appellant’s income in each of the three years.

(c) As a result of the April 1981 reassessment, the Minister of National Revenue assessed the Appellant in each of the three years on the basis of the Appellant’s income being the same as shown in the Appellant’s T-1 personal income tax returns for each of the three years (except with respect to the Appellant’s 1976 taxation year where the Minister made one small change which corrected an addition error on the Appellant’s return).

3. The Minister of National Revenue reassessed the Appellant’s 1978 taxation year by a Notice of Reassessment whose date of mailing was 6 April 1981 wherein he added to the Appellant’s income an amount of $321.18.

4. In reassessing the Appellant’s 1978 taxation year, the Minister of National Revenue made, among others, the following assumptions of fact:

(a) The Appellant and Ronald Tobin (hereinafter referred to as “his partner”) operated, a business partnership prior to 31 March 1971 under the name A & B Office Equipment (hereinafter referred to as “the partnership”).

(b) The Appellant and his partner formed a company named A & B Office Equipment & Leasing Company Limited (hereinafter referred to as “the com- pany”). The Appellant and his partner were the only shareholders of the company. The Appellant and his partner each had an equal number of shares of the company.

(c) On 31 March 1971, the company acquired the assets and assumed the liabilities of the partnership.

(d) The Appellant and his partner were not dealing with the company at arm’s length in the transaction transferring the assets and liabilities of the partnership to the company.

(e) The company acquired the assets and assumed the liabilities of the partnership for a consideration of $77,532.

(f) In the transaction, the company and the partnership assigned a value of $65,000 to the goodwill of the partnership.

(g) In fact, the fair market value of the goodwill of the partnership on 31 March 1971 was $27,000.

(h) This resulted in the value assigned to the goodwill being $38,000 above its fair market value with the result that the company was purchasing $38,000 of non-existent goodwill.

(i) The net fair market value of the assets and liabilities of the partnership was $38,000 less than the amount paid by the company with the result that the company purchased $38,000 of non-existent assets.

(j) In payment for the assets and liabilities of the partnership, the company agreed to pay the Appellant and his partner the consideration shown in Note 1 to the opening balance sheet of the company, a copy of which is attached hereto as Annex “A”.

(k) The company showed its assets and liabilities on its opening balance sheet to be those shown on Annex “A” hereto.

(l) $38,000 of the consideration shown in Note 1 to Annex “A” represented consideration for the non-existing assets purchased by the company and was subsequently converted in the company’s books to a shareholder loan from the Appellant to the company — half of which, $19,000, was the portion of the Appellant.

(m) During the Appellant’s 1978 taxation year, the company paid to the Appellant $1,321.19 of the $19,000 shareholder loan referred to in subparagraph (1) above. The company had already paid the Appellant all of his share of the $77,532 consideration for the partnership’s assets and liabilities apart from the $19,000 corresponding to his share of the consideration paid for non-existent assets.

(n) This $1,321.19 constituted an appropriation of funds of the company to the Appellant.

(o) These funds were received by the Appellant in his capacity as a shareholder.

9. He submits that the Appellant’s 1978 taxation year was properly assessed in accordance with section 152(4) of the Act.

10. He submits that the Minister of National Revenue properly reassessed the Appellant’s 1978 taxation year in accordance with section 15(1) of the Act by including in the Appellant’s income an amount of $1,321.19 which constituted funds of the company appropriated to the Appellant who was a shareholder of the corporation.

The appellant operated with Tobin as a full partnership in an office equipment and stationery business for several years as “A & B Office Equipment”. On March 31, 1971, they incorporated a business known as “A & B Office Equipment and Leasing Company Limited” hereinafter referred to as the “Corporation”. The Corporation acquired the assets of A & B Office Equipment for $77,532 and assumed the liabilities of the partnership. The business carried on in the same form as before, each partner owning 50% of the shares.

The appellant stated that the business started expanding very rapidly in the early 1970s and that their duplicating business “skyrocketed”. They had a five-year exclusive franchise with Apeco of Canada Ltd, a duplicating process which gave keen competition to Zerox, which firm was having patent problems at the time. At the time of the sale they had extant 65 duplicating contracts, with five or six new sales monthly. The sale of duplicating paper supplies is where they made their main profit. They also had service contracts on other office equipment. Between 1973 and 1976 they became the top Apeco dealers in Canada. They were aggressive and imaginative, and optimistic of a substantial increase in overall sales and business. Their staff increased in 1970-1971 from 5 to 25.

Tobin gave evidence, stating that he and the appellant took over an existing business. The “Profit and Loss Statement” as of May 31, 1970 of A & B Office Equipment showed a total sales of $70,545.37; as of March 31, 1971 their total sales were $134,594. This was a virtual doubling of sales in one year.

Maurice Portelance, a chartered accountant since 1969, had acted for the business for some time and when the appellant and Tobin sold the partnership to the Corporation, he was consulted as to the setting up of the books and for assistance in the establishment of a reasonable and acceptable figure for “goodwill”, which of course is an intangible asset. From the books and records of the business and in consultation with the appellant and Tobin, Mr Portelance reached a goodwill figure of $65,000 (see Exhibit A-1). He then set up an opening balance sheet as of March 31, 1971 as follows (Exhibit A-2):

A & B OFFICE EQUIPMENT & LEASING COMPANY LIMITED

NOTES TO THE OPENING BALANCE SHEET

MARCH 31, 1971

Note 1:

On March 31,1971 the company acquired the assets and assumed the liabilities pertaining to A & B Office Equipment for a net consideration of $77,532. The payment of this purchase price was as follows:

All of the Corporation’s records, excepting Exhibit A-3 which was composed of ledger sheets for 1971, were destroyed by fire in 1974. These remaining records showed paper supply sales increasing at the rate of $500 per month. Mr Portelance said: “If this was annualized it would have locked in revenue from such sales of $6,000 per annum”. He also said he took a conservative approach and, indeed, this is the common practice of chartered accountants under the circumstances. The preference shares were redeemed on De- cember 29, 1971 and a shareholder’s loan was recorded to show the transaction. Promissory notes were drawn for the balance payable on a monthly basis.

Mr Donaldson advised the Board that in 1972 S & L Diversified of Montreal offered them $500,000 for the business, payable by issue to the appellant and Tobin in S & L shares with a guaranteed profit of 20% a year for three years. The offer was apparently declined. This offer was not questioned in cross-examination. The Corporation had signed purchase contracts for stationery sales that would be capable of producing $1,000,000 in sales.

Portelance felt, from his dealings with the appellant, that Donaldson and Tobin had a unique approach and great scope for expansion.

The respondent’s position was set out in Exhibit R-3, the appraisal report of Gilbert J Murray. Mr Murray obtained his “Business Administration” degree in 1974. He was a Member of the American Institute of Chartered Financial Analysts, and had been employed in the public sector by banks and security investment houses. He was not recognized as a member of The Canadian Association of Business Evaluators. He is now an employee of the Department of National Revenue. He assumed that there would be no new contracts and gave no regard to subsequent growth “because it was a market easy to get into, with a low capital outlay”. He also assumed that the appellant had a small share of the market, which was incorrect. Mr Murray described goodwill as follows:

Its value accrues to the owner(s) of the business when the likelihood is such that such business will earn, in the future, profits in excess of those required to provide an economic rate of remuneration on the capital and labour employed therein.

In reaching his evaluation, Mr Murray relied upon the following:

(a) The financial statements of A & B Office Equipment on file with the Department of National Revenue-Taxation for the periods ending May 31, 1970 (9 months) and March 31, 1971 (10 months), as reported on by Desmarais, Arsenault & Cie/Co, Chartered Accountants.

(b) The opening balance sheet of A & B Office Equipment & Leasing Company Limited as at March 31, 1971.

(c) Notes to the opening balance sheet of A & B Equipment & Leasing Company Limited as at March 31, 1971.

(d) A & B Office Equipment’s calculation of the fair market value of its goodwill as at March 31, 1971.

In arriving at my opinion of value I considered the valuation approaches most commonly used and accepted in the market place applicable to a notional sale. The capitalized maintainable earnings approach, the adjusted asset approach and the orderly liquidation approach.

In using the capitalized “Super Profits” value, Mr Murray reached the following conclusion:

The indicated maintainable earnings was increased by $6,697 to reflect the increases in maintainable earnings that would come into effect within the next year as the result of signed sales and service contracts (Refer to Schedule III and appendices D and E). I then reduced maintainable earnings by $24,000 to reflect reasonable management compensation for the partners, commensurate with their duties and responsibilities . . . The “Super Profits” $4,615 was then capitalized at 15 and 20 percent, indicating a range of value from $23,075 to $30,767 for the goodwill of A & B Office Equipment as at March 31, 1971 (The basis for the capitalization rate used — Refer to Schedule VII).

The degree of risk involved:

(a) The absence of a history of demonstrated earnings, suggests that a higher level of risk should be considered.

(b) While the trend of growth in the industry is favourable it must be recognized that A & B Office Equipment has a small share of the market.

(c) The industry is classed as having easy entry requiring a low capital outlay.

The liquidity of the investment:

(a) The liquidity of the investment is judged to be low, due to the easy entry competition factor and no organized market for its assets.

Schedule VII referred to above reads as follows:

Schedule VII

The Basis for the Capitalization Rates Used

In arriving at the capitalization rates used I considered the following:

1. The rate of return on alternative investments.

(a) The chartered banks’ prime lending rate	6.50%
(b) Bond Yields
(i) Province of Ontario	8.60%
(ii) Municipality of Toronto	7.80%
(iii) Corporation of Domtar	8.35%
(a) Trust Co, GIC interest rate	7.50%
(d) Conventional Mortgage rate	9.25%
Sources — Bank of Canada Review, March 27, 1971

Mr Murray never met with the appellant or Tobin to discuss their method of establishing goodwill.

Counsel for the respondent referred the Board to the following cases:

The Queen v Frank Leslie, [1975] CTC 155; 75 DTC 5086;

Conn Stafford Smythe, Conn Smythe and Clarence H Day v MNR, [1967] CTC 498; 67 DTC 5334;

Herbert Wallace Losey v MNR, [1957] CTC 146; 57 DTC 1098;

Ernest A Hachey, Russel G Northrup v MNR, [1978] CTC 3117; 78 DTC 1794;

Georges-Henri Couture v MNR, [1978] CTC 2687; 78 DTC 1511;

Lucien R LeDaire v MNR, [1977] CTC 2539; 77 DTC 391;

William H Crandall v MNR, [1974] CTC 2289; 74 DTC 1204;

Louis Polsky v MNR, [1972] CTC 2219; 72 DTC 1185;

Nelson T Adair v MNR, 29 Tax ABC 324; 62 DTC 356;

Seto Holdings Ltd v MNR, [1974] CTC 2347; 75 DTC 1;

MNR v James N Sissons, [1969] CTC 184; 69 DTC 5152;

James A Milne v MNR, [1980] CTC 2769; 80 DTC 1668.

Three of the above-mentioned cases were decided in favour of the taxpayers, namely: Crandall (supra), Polsky (supra) and Seto Holdings (supra). I commend counsel for this fair approach.

In the case of The Queen v Frank Leslie (supra), the appellant admitted there was no “goodwill’, so it does not apply.

In the case of Herbert Wallace Losey v MNR (supra), the goodwill of the proprietorship was based on physical assets and an assumed capacity of the business to produce profit in excess of the capital represented by what the physical assets could be expected to produce. The appeal was dismissed on the basis that the sale of the goodwill of a business does not carry with it a right to the personal services or the business ability of the former proprietor of the business. In the case at bar, the appellant and Tobin intended to carry on the business as before, and did so.

Goodwill means: the intangible value of a business; and projected earning power.

I consider Mr Murray’s appraisal to have been prepared with due care and consideration. He said subsequent profit margins were much smaller than had been anticipated when the figure for “goodwill” was established on March 31, 1971, but he gave the appellants the benefit of their assumptions. Through various approaches he calculated the value of goodwill at between $27,000 and $30,000, and concluded with a final figure of $27,000.

The ability of the appellant’s chartered accountant, Mr Portelance, was not challenged. The final balance sheet as of March 31, 1971 was reached in the usual way as between client, lawyer and accountant.

The appellant relied heavily on the case of The Queen v Wolfgang Schubert, [1980] CTC 497; 80 DTC 6366, a decision of the Federal Court, Trial Division. At 499 and 6367 respectively, it is stated:

The owner of a business has more knowledge as to the value of the goodwill associated with it than a stranger who attempts to calculate it by the relation of the number of employees, profits in a particular year and the extent of the equipment used.

In the Topical Law Reports, Canadian Tax Reporter, Volume 1, (CCH Canadian Limited) under tab “Business and Investment Income” at 4258, the value of goodwill is discussed with reference to the above-mentioned cases:

. . . a taxpayer’s valuation of the goodwill of his proprietorship was accepted where it was reasonable and based on figures determined by two well-qualified accountants. Polsky v MNR (supra). See also Seto Holdings Ltd v MNR (supra) where, in the valuation of the goodwill of a restaurant business transferred to a company, the project revenue approach was held to be preferable to the Minister’s valuation which only took into account the revenues of the business up to the date of incorporation of the company. It was found to be a sound accounting principle and practice to look forward and to take also into account the fact that the restaurant was located in a favourable position without any real competitors and had built up a permanent clientele.

Similarly, it was held that the circumstances in one case formed an exception to the general rule that personal goodwill can neither be valued or transferred. The evidence in this case showed that goodwill was transferred from a highly professional engineer with excellent business contacts to a limited company bearing almost the same name so that the change in legal entity was hardly noticed by clients. Crandall v MNR (supra).

The projected and actual profits were optimistic and considering the evidence of the respondent’s appraiser who I feel, was too conservative and mechanical in his approach to the valuation, I therefore find the value of the goodwill as determined by the chartered accountant, Mr Portelance, to be realistic. The offer of $500,000 for the business in 1972 seems to reflect most accurately the perceived market value of the goodwill and value of the business by a company in the same business.

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

Appeals allowed.