Les Immeubles Réal Verreault Ltée v. Minister of National Revenue, [1979] CTC 2583, 79 DTC 455

Guy Tremblay [TRANSLATION]:—This case was heard in Quebec City, Quebec on December 8, 1977.

1. Point at Issue

The issue is whether the appellant’s proceeds from the sale of two service stations to its lessee, Texaco, with an option to purchase, should be considered as capital gains or as business profits. These proceeds were $48,242 in 1971 and $34,030 in 1973.

2. Burden of Proof

The burden is on the appellant to show that the respondent’s assessments are incorrect. This burden of proof derives not from one particular section of the Income Tax Act, but from a number of judicial decisions, including the judgment delivered by the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. Facts

3.1 The appellant company was incorporated in 1968.

3.2 As appears from letters patent filed as Exhibit A-13, the company’s principal objectives were the following: to acquire by lease or purchase or otherwise and to own, manage, improve or contribute to the improvement of real estate of all types and to sell, mortgage or otherwise dispose of the same.

3.3 At the time of the incorporation, Mr Réal Verreault was the appellant’s principal shareholder.

3.4 In 1968, Mr Verreault had been in business for 13 years, that is, since 1955. He had purchased or been responsible for the construction of eight service stations, including the St-Félicien station (Lac St-Jean and the Chibougamau station. At the time of the incorporation, he had these stations transferred to the appellant (Exhibit A-11).

3.5 From 1968 to 1971, the appellant constructed or purchased four other service stations.

3.6 According to the testimony of Mr Réal Verreault and Mr Pierre Boivin, Personnel Manager of Texaco since 1965, all the service stations belonging to the appellant were leased to Texaco.

3.7 Texaco itself then re-leased the stations to the appellant or to another sub-lessee.

3.8 A considerable number of these service stations were financed by Texaco.

3.9 One of the essential conditions for obtaining the distribution of Texaco products or the company’s financing was to grant a purchase option on the service station to Texaco Canada Limited.

3.10 This purchase option clause, at a predetermined price (the evidence will show that discussion is possible on the price in the event that the option is exercised), is known as a right of first refusal clause.

In the event that the owner receives an offer to purchase from a third party, Texaco Canada limited has less than three months to purchase, as appears inter alia from the Texaco Canada Limited Petroleum Products Agreement (Exhibit A-3).

3.11 This purchase option clause is a condition sine qua non. According to Mr Boivin, this clause protects Texaco Canada Limited, which invests a great deal in loans, advertising and so forth in order to increase its business. Without this clause, a Texaco service station which is doing well and is then sold to a competitor causes a considerable loss of assets primarily because it is through these service stations that Texaco Canada Limited sells its products.

3.12 Mr Réal Verreault stated that he was aware of the purchase option clause at the time contracts were drawn up and signed and the eight service stations transferred to the appellant company. According to him, he would have preferred not to have this clause included but he did not have any choice. He further stated that the clause held no importance for him because when he constructed or purchased the stations, his aim was to exploit the profitability of the distribution service and not to resell the station itself. He was not an expert in real estate and he trusted Texaco. In addition, at the time the loan or lease contracts were drawn up and Signed, a price had to be set in the event of repurchase. This price was to be discussed and properly assessed in the event of sale. Mr Verreault stated that he never advertised nor offered to sell one of his service stations.

3.13 The repayments on a loan from Texaco Canada Limited were made in 120 instalments. The first 119 were made in 10 years and the 120th instalment was made during the 15th year.

3.14 In December 1969, Mr Réal Verreault incorporated the company Chauf- fex Inc which had the objectives, inter alia, of administration and distribution of petroleum products in conformity with the letters patent filed as Exhibit A-12. At a later date, Chauffex Inc purchased 100 per cent of the shares of Réal Verreault Limitée.

3.15 According to Mr Verreault, in 1956 he sold 600,000 gallons of petroleum products, and in 1974 the appellant sold 4,000,000 gallons. However, according to Exhibit A-16 (List of gallon sales from 1969 to 1974), the appellant sold 2,152,013 gallons in 1974. In 1969, it had sold 1,405,623 gallons.

3.16 In 1956, a “good” service station sold 100,000 gallons per year and 300,000 in 1976.

3.17 On November 27,1970 (Exhibit A-4), Texaco Canada Limited decided to exercise the purchase option on the Chibougamau service station for the sum of $65,000. The notarized contract was entered into on January 15, 1971 (Exhibit A-5).

3.18 The land had been purchased on October 5, 1955 (Exhibit A-1) and a mortgage deed for $17,000 (Exhibit A-2) signed on April 4, 1955 in favour of the McCoy Frontenac company (which became Texaco Canada Limited).

3.19 The predetermined price in the purchase option on the Chibougamau Station had been $40,000, but as the result of discussions relative to an increase in value Texaco Canada Limited agreed to pay $65,000.

3.20 The appellant had informed Texaco Canada Limited that it did not wish to renew the supply contract. In fact, Mr Réal Verreault, the manager and principal party concerned, wished greater freedom. Indeed, in 1975 Mr Verreault decided that he personally would no longer be a sub-lessee of Texaco Canada Limited. He worked from 90 to 95 hours per week and did not wish to continue doing so for the rest of his life. The Chibougamau station was far from the Lac St-Jean region where Mr Verreault’s residence and the other stations were located. More specifically, it was situated 146 miles (by gravel road) from St-Félicien. In addition, the appellant was interested in purchasing a Chain of parking lots. Finally, the Chibougamau service station in particular would have required from $25,000 to $30,000 in repairs. The appellant was not interested in re-investing in this station. According to Mr Verreault, after the purchase by Texaco Canada Limited this company spent $25,000 in repairs.

3.21 If Texaco Canada Limited had not purchased the Chibougamau station, Mr Verreault did not know what he would have done with the station. He had not considered this.

3.22 On January 31, 1973, pursuant to a letter from the appellant stating that it did not wish to renew the St-Félicien contract, Texaco Canada Limited (Exhibit A-9) decided to exercise the purchase option clause and purchase the station for $46,000.

3.23 The notarized contract relative to this sale of the St-Félicien station was entered into on April 10, 1973 (Exhibit A-10).

3.24 Mr Verreault did not personally attend to the St-Félicien station. His reason for selling it was that it was not very profitable. According to Mr Verreault, the interest from the sale price obtained brought in more than the net income of the station.

Some of the service stations were profitable (St-Prime, St-Bruno, Normandin), others less so (Hébertvi I le station). The Hébertvi I le station, which cost $30,000, was sold by the appellant for $15,000.

4. Act, Case Law and Comments

4.1 The sections concerned in the case at bar are sections 3 and 4 of the old Act and 3 and 9 of the new Act.

4.2 One of the factors that the Board does not hold against the appellant is the fact that one of the purposes contained in the letters patent was that it could purchase or resell real estate. It has already been pointed out many times the extent to which purposes contained in letters patent come from stereotyped forms, and that they do not easily serve as a basis for making the distinction between a capital gain and income. In the view of the Board, this purpose is as significant, and no more so, than the following purposes found in the appellant’s letters patent: performing industrial and technical services, purchasing and selling shares. The presumption that a company has a commercial function (MRT Investments Ltd v Her Majesty the Queen, [1976] CTC 294; 76 DTC 6158; and MNR v Muzly Lawee and Naima E Lawee, [1972] CTC 359; 72 DTC 6342,) is only juris tantum and not juris et de jure. In practice, according to the evidence, the company’s general activities did not show that it was involved in the sale of real estate. Furthermore, if it were not for the purchase option clause, the Board would have allowed the appeal immediately.

4.3 The point which claims the Board’s attention is the purchase option clause relating to the service stations, which Texaco Canada Limited was entitled to exercise. This clause was included in the lease and distribution contracts. According to the appellant, this clause is not significant. It cited the following precedents:

Ball Brothers Limited v MNR, [1975] CTC 2312; 75 DTC 236; [1976] CTC 793; 77 DTC 5004

Westcon Engineering and Contractors Ltd v MNR, [1977] CTC 2387; 77 DTC 284; [1977] CTC 567; 77 DTC 5398.

The respondent further regarded this purchase option clause as an absolute indication of the intent of the appellant company. He cited a judgment of the Supreme Court of Canada, MNR v Edgeley Farms Limited, [1969] CTC 313; 69 DTC 5228, and a judgment of the Federal Court of Canada, Her Majesty the Queen v Soalta Development Ltd, [1975] CTC 517; 75 DTC 5359.

4.4 Analysis of the Case Law

In Soalta Development Ltd, Cattanach, J, relying on a judgment rendered on Edgeley Farms Limited, stated:

For the purposes of the present appeal with respect to the sale of the 6th St Property I repeat for the purpose of emphasis Mr Justice Judson’s statement that “The option, in my opinion, is all important”. Obviously the option is an absolute indication of a willingness by the Hilson Company to sell however unwillingly that option may have been granted. Assuming that the land was purchased by Hilson prior to the beginning of the negotiations with Alberta Mack Truck, which is the assumption more favourable to the defendant, then Hilson had no specific plans for its use. The land was not dedicated at the time of acquisition to any particular use. It could become stock-in-trade or it could be used as the site for an incomeproducing building.

In Edgeley Farms Limited, the company had bought from two estates, in 1958, a plot of land of approximately 350 acres for $497,000. At the time of purchase, the company had no specific plans for the use of this farm. In 1960, after selling the livestock and machinery, it leased the farm in its entirety for 25 years at an annual rent of $52,800, with the right, inter alia, to purchase the property at any time before January 1, 1968 for $825,000, or even to purchase it in parcels of not less than 10 acres at $2,500 per acre, the rent being reduced by $150 for each acre sold. During the years mentioned below, the lessee exercised the following purchase options:

In addition, in 1963 and 1965, 2.1 acres and 2.3 acres were expropriated.

The Supreme Court of Canada held, at p 5229:

When the company gave this lease and option its earlier indecision was resolved. This is not the “bare land leasing proposal” referred to in the quoted reasons for judgment. The option, in my opinion, is all important. It was the method which the company adopted in putting through its real estate transactions. The property was in a rapidly developing area. The mortgage given back when the property was purchased provided for partial discharges on 5 acre lots. The option was granted within 17 months from the date of acquisition of the property and provided for the purchase of 10 acre parcels. The issue in this appeal is whether the company was selling its land in the course of the operation of a business for profit. It undoubtedly was and the gains in question are income.

In Her Majesty the Queen v Ball Brothers Limited, the appellant company had been engaged in the business of construction since 1930. It constructed large buildings such as churches, factories, schools and other types of commercial buildings. The buildings were constructed according to the specifications of customers but were often easily adaptable to other purposes. The company had never engaged in the business of buying or selling land or in constructing buildings for resale.

In 1967, 1968, 1969 and 1971, the appellant company constructed Adult Training Centres in five different cities in Ontario, including Guelph. It leased them to the educational authorities concerned with a purchase option clause. The construction contracts were obtained through tenders. The purchase option clause was required by the educational authorities.

Mahoney, J of the Federal Court of Canada, who rendered judgment in this matter, examined the incidence of the purchase option clause in great detail, especially in Edgeley Farms Limited and Soalta Development Ltd.

After citing the two texts mentioned above, Mahoney, J stated:

The succinct statement that “The option in my opinion is all important” ought not be taken out of context; it must be read with the following sentence:

It was the method which the company adopted in putting through its real estate transactions.

The totality of that method is outlined in the balance of Mr Justice Judson’s Statement.

In this case the fact that the defendant granted the option to Conestoga demands explanation. If unexplained, the property optioned would have to be held to be “stock in trade” rather than a capital asset held as an investment. The defendant’s witnesses were credible and their evidence convincing. The option here was not a method the defendant “adopted in putting through its real estate transactions”. It was, in the circumstances, a condition necessarily attached to an asset on its acquisition which, if met, would require that an asset be sold.

If it is the law that the attachment of an option, which may or may not be exercised, to an interest in land ipso facto regardless of surrounding circumstances, renders that interest stock in trade and not capital then surely redeemable or term securities, acquired in the market place at something less than their redemption price or face value, whose eventual mandatory disposition at a profit is virtually certain, rather than the possible to probable range, are even less susceptible of being vehicles for capital investment. Such a proposition would be startling.

The granting of an option is obviously prima facie evidence of a willingness, at the time it is granted, to sell the optioned asset at the stipulated price and on the prescribed terms. However, what is necessary to constitute a transaction to be an adventure in the nature of trade is not just a willingness to sell under certain circumstances, which may very well be imputed to the purchaser in any case. A willingness to sell is only an essential ingredient of what is necessary, namely: an intention to resell at a profit.

It is apparent from the portion of his judgment in the Soalta case dealing with the “Edmonton property”, at p 5365, that Mr Justice Cattanach was very much aware that the obvious conclusion to be drawn from the bare fact of the grant of an option is susceptible of considerable modification by evidence of the circumstances in which it was granted, although he did not find it necessary to say so in connection with the “6th St Calgary” transaction. Where the purchaser grants an option to resell property at a loss, it is by no means obvious that he contemplates its resale at a profit. On the contrary, the apparent result is that, for so long as the option is open to acceptance, he has foreclosed any opportunity to realize a profit on its disposition, with the distinct possibility that he may never have that opportunity.

Having regard to all of the circumstances, I am satisfied that the Defendant acquired the Guelph Centre as an investment, that the possibility of its resale at a profit was not an operating motivation for the acquisition, and the profit on its sale was a capital gain, not income. The action will be dismissed with costs.

4.5 Comments

The Board is largely of the view taken by Mahoney, J.

What this case has in common with Ball Brothers Limited is that Mr Real Verreault, and subsequently the appellant, did not have a choice of refusing the inclusion of the purchase option clause in the loan or supply contract. Furthermore, the purchase option did not necessarily give a guarantee of resale or of resale at a profit. The evidence showed that the appellant was prepared to resell the station at a loss (paragraph 3.24 of facts). In addition, the term of the purchase option in the above-cited case was ten years, whereas in the case at bar it is 15 years. The length of this period is in the appellant’s favour.

In this matter of the purchase clause however, as in many other tax matters, each case is sui generis. Often, a single factor can change the final outcome.

In the case at bar, is the fact that the purchase options were all given to the same company, namely Texaco, a factor of sufficient weight to warrant that all transactions resulting from the exercise of the purchase option by Texaco must result in a taxable profit, and not a capital gain? The Board does not believe so.

The supplementary factors peculiar to each transaction must be examined in order to arrive at a conclusion that the operation was commercial.

The sales of Chibougamau and St-Felicien both resulted from the exercise of a purchase option. The exercise of the purchase option in both cases was preceded, moreover, by the appellant’s notice to Texaco that it would no longer renew its contract with this company. Did this not oblige Texaco to make a decision on the exercise of the purchase option? It seems to the Board that if Texaco itself had decided to exercise the purchase option, the appellant would be in a better position to maintain the argument of capital gain.

Is the notice by the appellant, therefore, not an important factor which should be taken into account in deciding whether this is a case of capital gain or of commercial profit?

The Board believes so. However, there are circumstances which may justify the appellant’s decision to no longer do business with Texaco.

Do such circumstances exist in the case of the two service stations at issue?

In the case of Chibougamau, the Board feels that the facts described in paragraph 3.20 fully justify the appellant’s decision, made through Mr Verreault, to cancel the contract with Texaco.

According to the facts described in paragraph 3.24, the St-Félicien station was sold mainly because it was not operating at a profit. Is the fact that it was not operating at a profit a sufficient reason to cancel the contract with Texaco? The Board believes it is.

Finally, with regard to the Chibougamau station, does the fact that after discussion the appellant was able to increase the sale price to $65,000, from $40,000 as set in the original contract, have any influence on the case? The Board does not think so. Since Texaco had taken up the option, the appellant was obliged to sell. It did indeed have the right to use all admissible arguments in order to have the price raised. The appellant’s case is similar to that of the expropriated party. He cannot prevent the expropriation but can indeed use every legal means to obtain the highest indemnity possible.

The Board is of the opinion that the appellant discharged the burden of proof.

5. Conclusion

The appeal is allowed and the matter referred back to the respondent for reassessment in accordance with the above reasons for judgment.

Appeal allowed.