Dixie Lee (Maritimes) LTD v. Minister of National Revenue, [1981] CTC 2840, 81 DTC 647

M J Bonner:—This is an appeal from an assessment of income tax for the appellant’s 1977 taxation year ending July 31, 1977. The appellant at all relevant times carried on the business of a franchisor of take-out chicken stores. In the course of that business it entered into franchise agreements with persons who proposed to operate individual stores. It charged fees to such operators as consideration for entering into the franchise agreements.

In its financial statements, the appellant did not take such fees into income when they were paid or became payable.Rather it prorated them on the basis of the unexpired term of each franchise. It took one-tenth of each fee into income during each year of the ten year agreements. The respondent on assessment added to declared income the sum of $92,795 as “franchise revenue previously deferred”. It was the appellant’s position that the Minister erred in denying it a reserve in the amount of $92,795 pursuant to subparagraphs 20(1)(m)(i), (ii) and (iii) of the Income Tax Act.

Under an agreement with Dixie Lee Company Limited the appellant held the sole right to use and exploit the Dixie Lee trademark in the Maritime provinces and in part of the province of Quebec.

Exhibit A-3 is a franchise agreement typical of those which generated the fees in issue. Paragraphs 1 and 2 of the agreement read:

(1) The Company hereby grants to the operator, in consideration of the payment set out in Schedule “A” hereof, for a period of ten (10) years or for as long as the operator shall fully and faithfully perform all of the covenants, terms and conditions herein contained by the operator to be performed, the exclusive right and license:

(a) To operate a food take-out store at a location identified in schedule “B” hereof;

(b) To use, in the conduct of the operator’s business hereunder, the Company’s distinctive labels, designs, cartons, containers, and any advertising matter pertaining to the business or the product used or sold therein and to display the name “Dixie Lee” upon the premises, equipment, stationery and advertising matter used in convention with the sale of products at the take-out store.

(c) To sell, use and distribute only such products as are designated by the Company;

(2) The Company agrees:

(a) To supply the operator with equipment and supplies as listed on Schedule “C”;

(b) To distribute in the franchised area 3000 take home menus and to place ads in the newspapers and or on the radio and or television in advance of opening day at the option of the Company;

(c) To give the operator first option renewal for a further ten (10) years contract, said option to terminate on date of termination of this contract, that is the 21st day of December A.D., 1985 and demand for renewal of the option is to be made in writing to the Company;

(d) To ship promptly flavour spices and all supplies by the best possible means having regards to existing market conditions and transportation conditions at the sole option of the Company;

(e) To make available to the Operator supervisory personnel, who shall assist and train the operator in the operation of the take-out store, and to help train the operator’s employees before the store is open, any assistance rendered after opening day will be at the operator’s expense at the company’s option.

Paragraph 3 of the agreement contains a series of covenants by the operator, the most relevant of which are:

(3) The Operator agrees:

(a) To prepare Dixie Lee products strictly according to the Company’s methods;

(b) To co-operate fully with the Company in order to maintain a high standard of quality products;

(c) To conduct business at one location only unless otherwise permitted in writing by the Company;

(d) To use only flavour spices as supplied by the Company;

(e) To use only packaging as supplied by the Company;

(f) That in the event that the store cease operating for a period of 90 days or more without the written consent of the Company, the operator’s rights under this agreement shall therefore be terminated;

(h) To pay 2% per month interest on all money due to the Company;

(i) The operator shall sell and use such products as are designated by the Company.

The appellant made three principal submissions:

(a) the franchise fee revenue was included in income by virtue of paragraph 12(1 )(a) and the appellant was therefore entitled to a reserve under paragraph 20(1 )(m);

(b) the franchise agreement placed it under an obligation to deliver goods and render services after the end of the year and, under the agreements, amounts for the use of chattels, namely the trademarks, were paid in advance;

(c) the $92,795 was a reasonable amount in respect of such obligations and in respect of the use by the franchisees of the trademarks.

The respondent submitted:

(a) the $92,795 was income under sections 3 and 9 of the Act. Paragraph 12(1 )(a) has no application;

(b) there is nothing in the obligations of the appellant under the franchise agreements entitling it to a reserve under paragraph 20(1 )(m) of the Act;

(c) the $92,795 figure is in any event unreasonable.

I should observe first that, for a number of years, the appellant was apparently in the habit of deferring franchise fees. The amount included in income was the aggregate of parts of numerous franchise fees. Only one or two of such fees were paid or had become payable during the 1977 taxation year. The rest had been paid or become payable during earlier years. It was not suggested that the inclusion was in part an amount that had been deducted in 1976 as a reserve authorized by the Income Tax Act, the amount of which reserve was required to be included in 1977 by a parallel provision requiring the inclusion. It was not contended that the inclusion in 1977 income of parts of fees deferred from earlier years was wrong because such fees were income for the earlier years and were not income for 1977.

Evidence was given by Raymond Gary Keeley, president of the appellant. He testified that following receipt of an inquiry by a prospective franchisee, preliminary discussions are held. When a decision to proceed is made, preopening assistance is given to the franchisee in many areas, including layout of the premises, construction matters, equipment requirements, financial management, operational planning and employee training. As suggested by the franchise agreement, the appellant attends to advertising and publicity necessary to the successful launching of the operator’s store. The appellant’s advisory personnel remain at the store for up to three weeks following the opening. They leave only when the operation is running smoothly. I gather that despite the franchise agreement the appellant does not charge the operator for such services as are rendered after opening day.

The franchise agreement does not contain much in the way of express terms imposing upon the appellant obligations to be performed following the opening of the franchisee’s store. Mr Keeley testified that during the running of the franchises the appellant assists the operators in several ways without charge. From time to time it makes arrangements which in effect amass the purchasing power of the franchisees enabling them to secure some necessities such as french fries and chickens at favourable prices. In such cases the appellant does not itself buy the supplies. It simply bears the expense of making the arrangements.

The appellant assists the franchisees in carrying on their advertising and promotional activities. It arranges for television commercials which are produced and broadcast at the expense of the franchisees. It buys promotional goods such as T-shirts and balloons which it resells to the franchisees at a mark-up of 10% over cost. It bought a parade float which franchisees may hire at relatively low cost.

From time to time the appellant offers financial advice to franchisees. In the words of Mr Keeley: “when we can pass on a tip we will”. The appellant extends credit to its operators from time to time and does not always insist upon the payment of interest on overdue accounts.

The appellant inspects the operations of franchisees. When this is done reports are prepared which suggest, and indeed sometimes direct, improvements to the franchisee’s operation. Failure to maintain standards acceptable to the appellant has resulted in the cancellation of franchises.

The appellant relies on the activities just described as circumstances which bring it within subparagraph 12(1 )(a)(i) and qualify it for a paragraph 20(1 )(m) reserve. It woduld characterize its unremunerative post-opening activities as involving either the provision of service or the supply of goods. Further it submits that the ten year period for which the right to use the Dixie Lee name and symbol is granted falls under subparagraph 20(1) (m)(iii).

Mr Keeley characterized the appellant’s business, accurately I think, as that of a distributor of rights and a supplier of goods. He testified that the appellant does not charge “royalties” by which I understood him to mean fees based on sales made by the franchisees. Instead it derives most of its revenues and profits from the sale to the franchisees of spices, packaging and cleaning supplies. As well it of course charges franchise fees of the sort in issue.

William Osmond, an accountant who acted for the appellant, gave evidence. He stated that he had concluded, from an accounting viewpoint, that deferral of the $$92,795 in revenue was proper because the appellant incurred costs throughout the ten year term of the agreements. He did not see the costs of earning the franchise fees as ending with the opening of the franchisee’s operation. He stated that there is little specific guidance for accountants who must deal with franchise revenues. However, he justified revenue deferral in part upon a ruling issued in May 1981 by the Financial Accounting Standards Board of the United States. That ruling required “. . . that franchise fee revenue from individual and area franchise sales be recognized only when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor”. The ruling requires that the portion of the initial franchise fee to be deferred be . . an amount sufficient to cover the estimated cost in excess of continuing franchise fees and provide a reasonable profit on the continuing services”.

Mr Osmond stated that the appellant “could never know with assurance what the costs of servicing the agreements would be”. When asked as to the reasonability of the $92,795 figure, he stated that he felt it was reasonable and he added that it relates to uncertainty as to the costs of earning the fees. He did not however explain what relationship exists. He indicated that the accounting treatment which he adopted was not an attempt at matching revenues and the costs of earning them because in the circumstances “you don’t know what the costs will be”.

Mr Osmond’s evidence is somewhat beside the point. This is not a case in which it was suggested that the appellant is entitled to defer the recognition of revenue, the accounting operation to which Mr Osmond’s evidence related. Rather the appellant’s position was, as previously noted, that it was entitled to set off against such revenue a paragraph 20(1 )(m) reserve. In any event I am not persuaded on the evidence that the appellant was, following the opening of the franchisee’s store, under any obligation to the franchisee to supply goods or perform services for which the franchise fee was consideration.

I do not accept the appellant’s submission that the onus was on the respondent to establish that the franchise fees were not amounts described in paragraph 12(1 )(a) of the Act. That submission was based on the appellant’s assertion that the respondent, on assessing, assumed that the disputed inclusion was an inclusion of amounts described in paragraph 12(1 )(a). The pleadings raised as an issue of fact the question whether such assumption was in fact made. The only evidence tendered in support of the contention that such assumption was made was a letter which Mr Keeley said he received from the assessor. That letter was written more than six months before the assessment was made. There was no evidence that the assessor did not change his mind between the time of writing of the letter and the time the assessment was made. Counsel for the appellant did not avail himself of the opportunity of calling the assessor to give evidence. The letter is not admissible as proof of the assertions that the amount included comprises a number of amounts described in paragraph 12(1 )(a), it does not follow that the assumption is correct. As indicated previously, one of the issues to be decided in this appeal is whether the fact alleged to have been assumed is correct. The evidence adduced leads me to conclude on the balance of probabilities that the franchise fees are not amounts described in that provision not only because a large part of the $92,795 was not received in the year but also because the franchise fees are not amounts described in subparagraph 12(1 )(a)(i).

As to services not rendered before the year-end, the appellant pointed to the advertising and promotional assistance, the bulk-buying arrangements made, the inspections of franchisee’s premises, and the financial assistance offered. The result of the advertising arranged by the appellant was, as admitted by Mr Keeley, increased sales by the franchisees. Those increased sales in turn resulted in increases in the profitable sale by the appellant to the franchisees of packaging materials, spices and cleaning supplies. Such advertising was also shown, together with economies resulting from the bulk-buying arrangements, the financial tips and the inspections of franchised operations, to improve the prosperity of the franchised businesses and thus to increase the prices which could be exacted by the appellant upon future sales of franchises. None of the activities in question form a part of the appellant’s express obligations under the franchise agreements. The existence of implied obligations is negatived by paragraph 3(v) of the agreements.

It is unrealistic to suggest that any part of the franchise fees were received “on account of such services”. I find that the cost of the activities relied upon by the appellant may more clearly be regarded as the cost of its current sales to franchisees and of its future sales of franchises than as the cost of fulfilling obligations arising from its past franchise sales.

The further contention that promotional goods bought by the appellant, then resold at a minimal mark-up and delivered to the franchisees are “goods not delivered before the end of the year” on account of which the franchise fees were paid is equally unrealistic. Nothing in the evidence suggests that any expectation that the appellant would engage in such activities led to the receipt of the franchise fees. Mr Osmond’s assumption that the cost of such activities is a cost of “servicing the (existing) agreements” is in my view unfounded tn fact.

For the foregoing reasons I am unable to find that any part of the $92,795 is an amount “.. . described in paragraph 12(1 )(a) . . .” of the Act. Thus the appellant has failed to show that it is entitled to a reserve under paragraph 20(1)(m) of the Act.

At the commencement of the hearing the respondent’s counsel consented to judgment in respect of the second issue. In accordance with that consent the appeal will be allowed and the assessment referred back to the respondent for reconsideration and reassessment on the basis that the building referred to in paragraph 26 of the notice of appeal is property described in Class 7 of Schedule B (II) to the Income Tax Regulations. In all other respects the appeal is dismissed.

Appeal allowed in part.