86103 Ontario Incorporated v. Minister of National Revenue, [1982] CTC 2614, 82 DTC 1652

The Chairman:—The appeal of 86103 Ontario Incorporated, is from an assessment with respect to the 1975 taxation year. In issue is the fair market value of the appellant’s land and building as at December 31, 1971.

Summary of Facts

Prior to its sale in 1975 the appellant was in the business of manufacturing cheese under the name of Baden Cheese Limited. Mr Raymond Gingerich, the appellant’s principal shareholder and general manager, testified that the main building of the plant was built around 1915 and was then owned by his father.

Additions to the appellant’s main building were constructed in two phases: the first took place in 1962 at a cost of $33,700 and the second in 1969 at a cost of $24,900. The building, designed for use as a cheese manufacturers, consisted of a relatively small office and retail store, a warehouse occupying one third of the floor area, the rest of the building being occu- pied by the cheese processing plant which consisted of a laboratory, curing facilities and a culture room. From 1970 to 1974 the appellant was engaged in the processing of limburger, brine cured brick, colby, skim and Cheddar cheese (Exhibit A-1).

In April 1975 the appellant sold the land and building to Mr Gregory F David for a price of $203,000. In the agreement of sale $30,000 was allocated to the value of the land and $173,000 to the value of the building (Schedule C — Exhibit A-2).

For purposes of computing his taxable capital gain, the appellant estimated the fair market value of land and building to be $170,000 as at December 31, 1971. In reassessing the appellant for the 1975 taxation year, the Minister of National Revenue however fixed the V-Day value of the appellant’s land and building at $113,000.

To determine the issue the Board must not only review the basis for the expert Opinion expressed in the appraisal report produced as Exhibit A-19 by Mr R M Robson of the Real Estate Appraisers and Consultants firm of Mashke, Robson Limited which supports the appellant’s evaluation, the basis for the expert opinion expressed by Mr A B Tonin, an appraiser in the Audit Division of Revenue Canada Taxation, in his appraisal report produced as Exhibit R-1, but the Board must also decide whether a special and distinct value attributable to the bacteria necessary in the processing of cheese — which according to the appellant is part of the physical structure of the cheese plant — can or should be added to the value of the bricks and mortar.

Mr R M Robson and Mr A B Tonin, who were both accepted as accredited appraisers, agreed that the highest and best use of the subject was its continuation as a cheese manufacturing plant. I propose to deal first with the V-Day value of what was referred to as the brick and mortar of the plant. Both appraisers, in their respective reports, relied almost exclusively on the cost approach to value.

Mr Robson included as an addition to his appraisal report (Exhibit A-19) the report of Mr East Ostvik, a contractor with 30 years of experience and owner of Norge Building Industries Ltd. In estimating the replacement cost of the Baden Cheese Limited plant, Mr Ostvik and Mr Robson measured the interior and exterior of the plant and made extensive notes of the interior finishes. A detailed description of the plant is set out in Mr Ostvik’s report. The replacement costs calculated as of August 1980 on the basis of estimates received from local subcontractors were then adjusted backward to reflect the cost as at December 31, 1971 by using the Canadata Southam Construction Cost Index (Exhibit A-15) and a V-Day replacement cost of $282,073 was arrived at by Mr Ostvik.

Mr Robson in his report states that the original building with its two subsequent additions, had been subjected to a high standard of maintenance and was in good condition at the end of 1971. The design and structure of the cheese plant were not functionally obsolescent in 1971 but were economically viable for the foreseeable future. Mr Robson, applying a depreciation factor of 50% to Mr Ostvik’s replacement cost, arrived at a fair market value of $145,500 for the subject property as at December 31, 1971.

Mr Tonin, the respondent’s appraiser, based his evaluation on the actual costs of the improvements made in 1962 and 1969 which he had obtained from Mr Ariss, the accountant of Baden Cheese Limited, whose books had been audited twice prior to 1971. Mr Gingerich did not dispute the cost figures nor did he question that the cost of the two additional buildings had been properly capitalized. The respondent’s appraiser used the Marshall Swift Manual to bring the estimated cost of the improvements forward to December 1971. However, the Marshall Swift Manual for March 1971 (Exhibit R-2) contained no costs figures for a cheese manufacturing plant and Mr Tonin used as his model the costs set out in the Marshall Swift Manual for creameries. The Manual at page 5, Section 17 classifies creameries in three categories: a good creamery where the 1971 cost is stated to be $19.01 per sq ft; an average creamery where cost is $13.76 per sq ft; and a low cost creamery at $9.12 per sq ft. Of the three, Mr Tonin chose as his model the low cost creamery and used the figure of $9.12 per sq ft as the basis for his calculations of the V-Day value of the subject which he estimated to be $113,000.

As often happens when the issue is the fair market value of a property as at December 31, 1971, the appraisal reports submitted by expert witnesses, though properly based on what are accepted evaluation methods, often contain weaknesses or errors in calculations, wrong premises, unsupported figures and at times, factual misinformation which affect the estimated V-Day value of property and render unreliable the value figures expressed by expert evaluators which normally should be helpful to the Board in determining the issue. Both appraisal reports in this appeal contain such weaknesses.

The appellant’s appraiser, Mr Robson, using the cost approach to the V- Day value of the land and building, relied exclusively on the replacement costs of the subject provided by Mr Ostvik, admittedly an experienced contractor. I accept that both Mr Robson and Mr Ostvik were meticulous and thorough in their inspection of the entire structure, the size of the plant, the plumbing, the materials used and the special sterilized finishes necessary in a cheese plant. However, Mr Ostvik’s evidence was that he had obtained his basic replacement cost figures in 1980 from various local subcontractors. No evidence was called to substantiate the suggested figures and cross- examination as to their accuracy was therefore not possible. I can understand the impracticability of having some 15 subcontractors appear as witnesses but surely some way could have been found to support the 1980 replacement costs figures used by Mr Ostvik on which Mr Robson based his V-Day value.

The accuracy of the Canadata Southam Construction Cost Index used by Mr Ostvik (Exhibit A-15) to carry the 1980 replacement costs of the subject back to December 1971 is also questionable, not so much because it is not generally known to or used by professional appraisers but because the figures stated therein, representing as they do averages of general construction costs on an annual basis, may not be sufficiently detailed and precise for purposes of arriving at a V-Day value of the subject. Probative weaknesses therefore exist in the appellant’s calculation of the V-Day value of $145,500 for the land and building.

Dealing now with the respondent’s appraisal, it is clear from Mr Tonin’s report and in cross-examination that his inspection of the plant was much less thorough than that of Mr Robson and several special costly features of the cheese plant, both outside and inside the structure, had not been taken into account in arriving at his V-Day value of the property.

True, the respondent’s appraiser used as the basis of his calculations the actual costs of constructing the two additions to the original building in 1962 and 1969, which Mr Gingerich accepted as being correct. The propriety of the use by Mr Tonin of the Marshall Swift Manual to adjust the replacement cost to December 1971 is of course not questioned. However, in the absence of replacement cost figures for a cheese manufacturer in the Marshall Swift Manual, a significant weakness of Mr Tonin’s appraisal is in not having given any valid reason for choosing from the Manual figures given for a low-cost creamery rather than those representing an average or a good creamery.

The respondent also failed to establish any relationship between replacement cost of a low cost creamery and those of a cheese plant. The basic figures used in establishing the respondent’s V-Day value of the land and building are therefore also questionable.

Considerable technical evidence was given by Dr Donald McLean Irvine, Professor of Food Services since 1955. Dr Irvine, who over the years had worked closely with cheese manufacturers in Ontario and Quebec, was accepted as an expert witness. His curriculum vitae was filed as Exhibit A-11.

According to Dr Irvine, the appellant’s cheese plant was functionally designed; it contained high quality plumbing and structural finishes required in processing cheese and indeed the appellant’s plant served as a model cheese processing plant for Dr Irvine’s annual tour of cheese plants organized for his students.

Summarizing Dr Irvine’s technical evidence, cheese is made and matured by a variety of bacteria developed in cultures which, when added to milk, change the milk sugar into lactic acid. These living organisms are essential in making the 18 existing distinct varieties of cheese.

All cheese is processed by means of bacteria. However, cheese such as limburger cheese and brine cured cheese, among the varieties of cheese manufactured by the appellant, require the presence of special bacteria referred to as “bacteria linens”. The presence and growth of bacteria linens in a cheese plant is maintained, among other things, by heat and humidity control and the bacteria must be well established in the plant to the point of attaching themselves to the walls, ceilings, floors and shelves of the processing area and being literally imbedded in the surfaces before limburger or brine cured cheese can be produced.

These bacteria linens, as well as other indigenous bacteria used in manufacturing other varieties of cheese, are extremely sensitive and can be destroyed by the infiltration of other bacteria into the culture of Curing areas with the result that either surface ripened cheese can no longer be manufactured or the quality and texture of the cheese becomes such that it is no longer edible. Sterilization or spraying the processing sections of the plant with chlorine or iodine solutions — as indeed was done at one point by the appellant — causes the destruction of the bacteria linens and indeed all bacteria and makes the processing of good quality limburger or brine cured brick cheese impossible. Indeed the appellant’s colby cheese, which as I understand it is not a surface ripened cheese, also became unsaleable and had to be thrown away as a result of the destruction of indigenous bacteria. In Dr Irvine’s opinion, after the washing down of a cheese plant, a period of three months is required to restore the conditions necessary for the presence and the growth of bacteria linens in quantities sufficient to process the special varieties of cheese. To do so however, the bacteria linens would have to be obtained from another manufacturer of limburger or brine cured cheese or other surfaced ripened cheese and reintroduced into the culture and processing rooms of the appellant’s plant.

In stating that bacteria had an economic value, Dr Irvine pointed out that commercial houses kept pure strains of various types of bacteria which are sold to manufacturers of various types of cheese. However, to Dr Irvine’s knowledge, bacteria linens cannot be purchased commercially but must be acquired by washing the bacteria linens off limburger or brine cured cheese in the process of being cured in another cheese plant and by re-establishing a new Culture of the bacteria in the appellant’s plant without any assurance that the new product would be identical or equal to the quality of the cheese Originally processed. Dr Irvine added that there were relatively few surface ripened cheese plants in Canada and the United States.

The importance of bacteria in the cheese processing plants and their high sensitivity to the presence of other micro organisms require special construction materials, particularly in the culture and curing rooms in order to create aseptic conditions and ensure the quality of the product. A high standard of maintenance is also required for health reasons and cheese plants, according to Dr Irvine, are subject to regular and frequent inspections by government officials.

In Dr Irvine’s opinion, the Baden Cheese Limited plant (the appellant) with which he was quite familiar, was functionally organized; the plumbing and interior finishes of processing areas made the plant adequately aseptic, its products were good and it was recognized as a good cheese plant.

The appellant also called as an expert witness Dr John R Finlay, PhD, whose qualifications are set out in his curriculum vitae filed as Exhibit A-13. In his report (Exhibit A-14) to which I will return later, Dr Finlay set out to determine the economic value of “bacteria linens” which are stated to be attached to and became part of the walls, ceilings and floors of the appellant’s cheese plant as at December 31, 1971.

It is Dr Finlay’s opinion that a purchaser would pay more to acquire a cheese plant with bacteria than he would pay to purchase or build a new plant or acquire one in which there existed no indigenous bacteria necessary for making cheese.This opinion was also reflected by Dr Irvine who stated that were he in the market to purchase a cheese plant, it is the kind and the quality of the cheese manufactured and therefore the indigenous bacteria required to produce the cheese which would be the determining factor in arriving at his decision.

In order to arrive at the economic value of bacteria in the subject cheese factory, Dr Finlay first proceeded to establish the capital value of the appellant’s business by considering its present value on the basis of expected future cash earnings. This he did by first assuming that the bacteria were present in the plant and then making comparable calculations on the basis that no bacteria existed in the plant. The difference between the expected earnings from the plant with bacteria present as opposed to earnings without the bacteria — when no earnings would be realized but losses incurred — provides, Dr Finlay suggests, an estimate of the economic value of bacteria in a cheese plant.

To arrive at his estimated capital value of the appellant in 1971, Dr Finlay utilized two formulas (one with and one without the presence of bacteria) which took into account the appellant’s 1971 after-tax profit of $25,639 plus depreciation of $11,810 for a total of $37,449; using a figure for total assets of $282,993, he arrived at a rate of return of 9.1%, the time projection used was 15 years. Dr Finlay concluded that the capital value of Baden Cheese Limited in 1971 with bacteria was $284,200.

By applying his second formula on the assumption that no bacteria existed in the plant and adjusting the capital value by deducting the loss of 1971 earnings and the fixed costs, he estimated the capital value of the enterprise without bacteria to be $284,200, $80,000 or $204,200. The value of the bacteria would then be $80,000.

Owing to the possible variations in the time required to cultivate bacteria in quantities sufficient to produce the required quality of cheese, Dr Finlay estimated a value of $40,000 for a cultivation period of 6 months; $60,000 for a cultivation period of 9 months and $80,000 for a cultivation period of 12 months.

In allocating the capital value of the enterprise to the land and building Dr Finlay, on the basis that the land and building were sold in 1975 for $203,000 out of a total purchase price of $280,000, established a ratio of .725. Applying this ratio to the capital value of the enterprise in 1971 ($284,200 — Exhibit A-14), the V-Day value of the land and building with bacteria would therefore be $206,000.

Although the value of the appellant’s business is not in issue, counsel for the respondent, in support of his V-Day value of the subject, also called evidence with respect to the overall worth of the appellant’s business to be referred to and used only as a test or guideline in determining whether extra value arising from other sources such as the existence of goodwill or indeed the presence of bacteria could reasonably be considered in establishing the V-Oay value of the building.

The respondent’s witness was Mr David Aldridge, a certified general accountant and supervisor of Business Equity Valuation with the Department of National Revenue. Mr Aldridge’s evidence was accepted as that of a qualified business evaluator. In his valuation report filed as Exhibit R-3, Mr Aldridge, on the basis of the appellant’s maintainable earnings and applying a Capitalization rate of 12.5%, arrived at a value for the business of $187,812. Mr Aldridge, using the V-Day value for land and building found by Mr Tonin to be $113,000, arrived at an adjusted asset value of $192,759.

Mr Aldridge estimated the fair market value of the company in 1971 to be between $185,000 to $200,000 and concluded that since the asset value of the appellant was approximately equal to its earning power, no intangible value could reasonably be added to the property on V-Day. According to Mr Aldridge, therefore, the existence of bacteria in the cheese plant had no economic value.

Mr Aldridge’s calculations were admitted by the respondent to be a very rough estimate of value. Indeed in calculating the appellant’s asset value, Mr. Aldridge used the figure of $113,000 as the V-Day value of land and building which, in my opinion, was not shown by Mr Tonin to have been an accurate V-Day value for the appellant’s land and building. On the basis of substantial evidence to the contrary, I find that Mr Aldridge’s figures do not justify his conclusion that bacteria in a cheese plant had no economic value.

Returning now to Dr Finlay’s report (Exhibit A-14) in which the V-Day value of the appellant’s business as a going concern is stated to be $284,200, while not disputing the formula used by Dr Finlay in arriving at his conclusion, it is the respondent’s contention that Dr Finlay’s value of the business as a going concern was too high because he did not include depreciation in his computation. The use by Dr Finlay of a 9.1% rate of return was also, according to the respondent, inappropriately low for a cheese manufacturer subject to more than usual risks.

Counsel for the respondent also pointed out that, in determining a value for the land and building based on the ratio of these assets to the total purchase price, Dr Finlay made a significant error by using $280,000 as the total purchase price of the enterprise when in fact the total purchase price, according to the agreement of purchase and sale (Exhibit A-2), adds up to over $439,000. The ratio of the value of the land and building to the total purchase price would not be .725, as suggested by Dr Finlay, but would be closer to .46. Applying the .46 ratio to the capital value of the enterprise of $284,200 in 1971, the land and the building (with bacteria) would then have a value of slightly over $130,000 as of December 31, 1971.

Reviewing the formal appraisal reports of Mr Robson and Mr Tonin and the report on the value of the appellant’s business as a going concern as well as that on the economic value of bacteria, I am somewhat astonished at the lack of accuracy or substantiation of one or more of the significant figures used in the reports. In rendering my decision, I cannot wholly accept any one of the opinions expressed by experts with respect to the fair market value of the appellant’s land and building on V-Day but must, in order to dispose of the appeal, fix an almost arbitrary figure which appears to me, in the circumstances, to be a reasonable V-Day value of the property. Because of the high content of intangibles, personal appreciation of facts and a variety of considered opinions that come into play in establishing V-Day values, I have often asked myself whether a more accurate and satisfactory determination of fair market value as at December 31, 1971 could not in most cases be arrived at by greater effort of the parties in reaching a reasonable compromise on their own.

In arriving at my decision, I have considered and accepted Dr Irvine’s evidence that a cheese plant such as the appellant’s is, for many reasons, different from other manufacturing plants and its value — which is more than bricks and mortar — rests in its inherent capacity to produce by means of its indigenous bacteria, special varieties of cheese. In my opinion, Mr Tonin’s V-Day value of the land and building is too low, not only because he did not take the value of bacteria into account, but also because he evaluated the plant as any other manufacturing plant and did not consider the existence in the plant of costly structures and finishes required to create aseptic conditions necessary in a cheese plant. In my opinion, a cheese plant differs significantly from a creamery. In the latter, the usual problem is to keep the bacteria from spoiling the milk; in the former, the bacteria is actually cultivated, preserved and controlled in order to make cheese. The description of the interior of a low-cost creamery found at page 5 of the Marshall Swift Manual (Exhibit R-2), used as a comparable model by Mr Tonin to establish the replacement cost of the appellant’s building, reads:

The evidence clearly established that the interior finishes, the plumbing and the electrical wiring of the appellant’s plant was far superior to the model chosen by Mr Tonin.

It is begging the question to suggest that the accuracy of Mr Tonin’s V- Day value of the land and building at $113,000 is somehow confirmed because his projected 1962 and 1969 actual cost figures approximate the 1971 replacement cost computed on the basis of the figures given in the Marshall Swift Manual for a low-cost creamery, when it appears clear to me that Mr Tonin’s choice of that model was inappropriate.

I also hesitate to use Mr Robson’s V-Day value of $145,500 for the bricks and mortar because of the lack of corroboration of some of the basic figures used by Mr Ostvik in arriving at his 1971 replacement cost of the subject.

I have, under the circumstances, therefore arbitrarily chosen $130,000 as being a reasonable V-Day value for the appellant’s land and building (bricks and mortar).

On the basis of Dr Irvine’s evidence, I am of the opinion that bacteria has an economic value, not only as a necessary ingredient in the manufacturing of cheese as was rightly suggested, but also as an additional tangible asset actually attached to, imbedded into and part of the surfaces of the building which, according to Dr. Irvine, is essential in manufacturing cheese and constitutes an important selling factor for a building whose highest and best use is its continuation as a cheese plant.

I have also accepted Dr. Irvine’s opinion that, once bacteria have been destroyed, a period of three months is required to re-’establish their constant presence, their growth and permanent adherence to walls, ceilings and floors of the processing areas of the plant in quantities sufficient to manufacture cheese. Applying Dr Finlay’s estimated economical value of bacteria on the basis of a three-month cultivation period, an economic value of $20,000 for the bacteria appears, in my opinion, to be reasonable.

My decision therefore will go allowing the appeal and referring the matter back to the Minister for reassessment on the basis that the value of the land and the value of the building, including bacteria, as of December 31, 1971 is $150,000.

Appeal allowed.