Services Farmico Inc v. Minister of National Revenue, [1979] CTC 3012, 79 DTC 208

The Chairman [TRANSLATION]:—This is an appeal by Services Farmico Inc against an income tax assessment dated May 5, 1976 for the taxation year 1974.

Summary of the Notice of Appeal and Appellant’s Pleadings

1. Messrs Jean Coutu and Louis Michaud, two pharmacists, each of whom owned two pharmacies, operated their respective pharmacies under the names of ‘‘Pharmacie Jean Coutu Enrg”, “Pharmacie Escompte Jean Coutu Enrg’’ and “Pharmescompte”.

2. Messrs Jean Coutu and Louis Michaud had developed a method of organization and marketing of pharmaceutical products at a discount, including prescriptions.

3. The commercial success resulting from operation of their respective pharmacies, known as “Pharmacie Jean Coutu Enrg”, and so on, encouraged them to offer their entrepreneurial skills, methods, reputation, purchasing power and trade name to other pharmacists wishing to be identified with the Pharmacies Jean Coutu group.

4. Messrs Michaud and Coutu held desirable leases in Montreal for the operation of pharmacies.

5. On June 26, 1973, Messrs Michaud and Coutu sold certain rights which they owned and used in the operation of their pharmacies to the appellant, Services Farmico Inc, for the sum of $700,000 payable in 7 annual instalments beginning on June 1, 1974, In particular, this sale included:

(1) intangible property such as leases;

(2) good will;

(3) exclusive rights to operate the pharmacies;

(4) all trademarks;

(5) franchises;

(6) the right to grant franchises and offer intangible property with the exception of the pharmacies at that time operated by Messrs Michaud and Coutu, including inventories, and movable and other property located in the said pharmacies.

The Appellant’s Claim

The appellant, Services Farmico Inc, maintained that the said amount of $700,000 constituted a capital expense within the meaning of section 14, and in accordance with paragraph 20(1)(b) of the Income Tax Act, SC 1970-71-72, c 63, as amended, and that 10% of half of $700,000, namely $35,000, is deductible from the appellant’s income for tax purposes for the taxation year 1974. Alternatively, the appellant maintained that the sum of $700,000 is entirely deductible as current operating expenses. The ap- pellant concluded that the respondent had erred in fact and in law by not allowing him to deduct the amount claimed from his income for 1974.

Position of the Respondent

The respondent, on the other hand, maintained that the payment by the appellant of $700,000 cannot be a basis for any deduction, and that in any case the amount of the expense claimed is exaggerated. In his reply to the notice of appeal, the respondent submitted:

12. the assets acquired by the respondent for a consideration of $700,000 are such that by their very nature they could not be the basis for a capital expenditure within the meaning of section 14 of the Income Tax Act;

13. the respondent submits that the obligation to pay and actual payment of a part of the sum of $700,000 was not intended as an eligible capital expenditure, and could not be regarded as such, for that obligation and payment were for the purpose of paying, in whole or in part, any debt existing between the appellant and Messrs Michaud and Coutu; or

14. the appellant, a corporation, undertook to pay and allegedly paid part or the whole of the amount of $700,000 to Messrs Michaud and Coutu, in their capacities as shareholders of the appellant;

15. the obligation to pay and any partial payment of the sum of $700,000 does not constitute expenditure or an expense incurred for the purpose of earning income from the appellant’s property or business;

16. the obligation to pay and the partial payment of any sum of $700,000 constitutes a capital outlay within the meaning of paragraph 18(1)(b) of the Income Tax Act, but the said assets so acquired do not in any way fall within the classes of assets provided for the purposes of a capital cost allowance in Regulations 110 and 1100 of Schedule B of the Income Tax Act;

17. this obligation to pay the sum of $700,000, or any partial payment thereof, cannot therefore be a basis for any deduction as a current expense, as an eligible capital expense, or as a Capital outlay for which a certain percentage of capital cost allowance is possible as a deduction; it is accordingly impossible to allow a deduction pursuant to the provisions of paragraphs 18(1)(a), 18(1)(b) and 20(1)(b) of the Income Tax Act;

18. alternatively, the amount of the expenditure of $700,000, and hence a proportionate deduction, is clearly exaggerated having regard to all the facts, and has proven not to be based on the market value of the said property and/or debts for which the appellant wishes to compensate and/or reimburse its two shareholders, Messrs Michaud and Coutu;

From the evidence which was presented in the case at bar, I do not see how, as the appellant suggested in its alternative submission, this sum of $700,000 paid by Services Farmico Inc could represent current operating expenses. The facts also do not support the respondent’s allegations that the payment of $700,000 by Services Farmico Inc to Messrs Michaud and Coutu was a repayment of a debt or a payment in their capacities as shareholders of the appellant.

I am satisfied that this was in fact a sale of intangible assets from Messrs Michaud and Coutu to Services Farmico Inc, as appears in the contract dated June 16, 1973 (effective June 1, 1973—Exhibit A-1).

The assets which Messrs Michaud and Coutu transferred to Services Farmico Inc, according to the contract, are as follows:

1. The sellers hereby sell, assign and transfer to the buyer, here present and accepting, their business now operated under the trade names “Pharmacies Jean Coutu Enrg” or “Pharmacies Escompte Jean Coutu Enrg”, including all tangible and intangible assets of the sellers relating to this business, and in particular, but without limiting the generality of the foregoing, the following assets:

(i) all rights of the sellers under leases not in effect for the premises occupied by the pharmacies at present operated by the sellers, or by one of them, under the trade names “Pharmacies Jean Coutu Enrg” or “Pharmacies Escompte Jean Coutu Enrg”;

(ii) the good will of the sellers;

(iii) the exclusive right of the buyer to continue the sellers’ operations under the said trade names, with the exception of operation as such of the sellers’ pharmacies, which will continue to be their exclusive property;

(iv) all business and trade names used by the sellers, whether registered or not, including “Pharmescompte”, to be registerd in the 10 largest judicial districts in the province of Quebec;

(v) all franchises, licenses, rights and privileges relating to “Pharmacies Jean Coutu Enrg”, “Pharmacies Escompte Jean Coutu Enrg”, or “Pharmescompte”;

(vi) all rights and interests of the sellers in any contracts relating to the business of the sellers which is the subject of this agreement, except those relating to the operation as such of the sellers’ pharmacies;

(vii) the right to grant franchises to operate pharmacies under the trade names “Pharmacies Jean Coutu”, “Pharmacies Escompte Jean Coutu”, or “Pharmescompte”, and the right to use these names; and

(viii) all other intangible assets relating to the business or to the assets which are the subject of this agreement;

excepting, however, the pharmacies now operated by the sellers, inventories, furnishings and all other assets contained in these pharmacies or used for their own purposes, including, but without limitation, the cash balance, accounts receivable and improvements to the property.

It is clear that Messrs Michaud and Coutu did not by this agreement sell their pharmacies or their business, and accordingly, did not sell the goodwill which accompanied the operation of their respective businesses, and which cannot be sold independently of the business.

In Adamson’s volume titled Valuation of Company Shares and Businesses, 4th ed, at pp 40 and 41, it states:

The particular feature of goodwill is that although it can be sold or transferred, this must be on the basis of the business as a whole. Other assets, however, may be sold separately, even if only at their break-up value. If on a rare occasion goodwill were sold separately it could only be on the assumption that the purchaser would himself provide the other assets necessary to continue the business.

The evidence established that Services Farmico Inc, the appellant, did not own or operate a pharmacy and was not incorporated for this purpose. What Messrs Coutu and Michaud sold the appellant was “something” other than the goodwill which was still part of the operation of their own pharmacies. I think a distinction must be made between the goodwill still enjoyed by Messrs Michaud and Coutu in the operation of their pharmacies and what they in fact and in law sold to the appellant. It is the nature of these “things” which Messrs Coutu and Michaud transferred to Services Farmico Inc which is at the root of this case.

It seems clear the success which Messrs Michaud and Coutu had in operating their four pharmacies under the trade name “Pharmacie Escompte Jean Coutu Enrg” gave rise to the possibility of joining other pharmacies to the “Pharmacie Escompte Jean Coutu Enrg” group.

One of the first pharmacists to become interested in Messrs Coutu and Michaud’s project, through Services Farmico Inc, was Mr Jean-Paul Duquet, the owner of ‘‘Pharmacie Montréal”, which had existed for some time and was well known to Montrealers.

On July 20, 1973, Mr Jean-Paul Duquet concluded an agreement with Services Farmico Inc which states in part, in Exhibit A-4:

WHEREAS Farmico holds all the rights of Messrs Jean Coutu and Louis Michaud, both pharmacists doing business under the trade names of “Pharmacies Jean Coutu Enrg” and/or “Pharmacies Escompte Jean Coutu Enrg”, to grant the rights relating to use of the said trade names: and

WHEREAS J P Duquet operates a pharmacy located at 916 St Catherine Street East, Montreal (the “Pharmacy”), and wishes to obtain the right to operate the Pharmacy under the trade name “Pharmacie Jean Coutu” and/or “Pharmacie Escompte Jean Coutu”;

THE FOLLOWING IS ACCORDINGLY MUTUALLY AGREED BETWEEN THE PARTIES HERETO, TO WIT:

1. Farmico hereby grants J P Duquet, here present and accepting, the right and privilege to operate the Pharmacy as a Jean Coutu pharmacy, on the terms and subject to the conditions provided therein;

2. the Pharmacy will be known and operated under the trade name “PHARMACIE JEAN COUTU (J P DUQUET) ENRG”, so long as this agreement shall remain in effect; J P Duquet shall also be entitled to use the phrase “Pharmacie Escompte Jean Coutu” in its trade name, but he may only register any trade name containing the phrases “Pharmacie Jean Coutu” or “Pharmacie Escompte Jean Coutu” with the express consent of Farmico or of Messrs Coutu and Michaud; the right conferred by this paragraph to do business under these trade names shall also include that of using them for any advertising or promotion and for purposes of the general operation of the Pharmacy by J P Duquet;

3. in addition to the aforementioned right to use the trade name, this agreement shall also confer the following privileges and benefits on J P Duquet:

(a) advice and counsel by Farmico regarding the organization and planning of the Pharmacy and its operation during the course of this agreement;

(b) the option to buy certain products of Farmico, Pharmacies Jean Coutu Enrg or any other firm or business belonging to this group, as the case may be, at the election and in the discretion of J P Duquet;

(c) participation in the advertising done by “Pharmacies Escompte Jean Coutu Enrg”; and

(d) the services of a Farmico representative, in particular Mr Louis Michaud, for a period of three (3) months following the commencement of this agreement, to oversee the operations of the Pharmacy and make the necessary recommendations; however, only Mr Michaud shall decide how much time shall be spent on these purposes;

5. Farmico expressly undertakes not to open, operate or grant any rights for the operation of pharmacies in the territory bounded by Bleury, Rachel and Delorimier Streets, and on the south, by the St-Lawrence River, so long as this agreement shall remain in effect;

6. in considertation hereof, J P Duquet agrees to pay Farmico a fee equal to five per cent (5%) of all his gross sales after October 1,1973, with the sole exception of tobacco and Loto-Québec tickets, but including gross sales made by the Centre Orthopédique, made on the premises occupied by the Pharmacy or from those premises, or by the staff of J P Duquet attached to those premises, whether for cash, credit or any other consideration, including all deposits not returned to customers, orders taken on the premises or from the premises, whether filled on the premises or elsewhere, sales of any sub-tenant, concessionnaire or other authorized person on the premises occupied by J P Duquet, all rights and commissions collected by the pharmacist for sales on these premises, without deducting for accounts not collected or unrecoverable, but after deducting for repayments In good faith to customers and for sales taxes and duties collected for any taxing authority.

From this contract and the testimony of Mr Michaud it appears that Services Farmico Inc, the appellant, was concerned only with granting franchises to use the trade names of Pharmacies Jean Coutu, the group advertising of the Pharmacies Jean Coutu group, the right to buy certain phar- maceutical products from Services Farmico Inc, and the administrative advice and promotion of Mr Michaud. For these services, Mr Duquet was to pay a charge of 5% of all sales from October 1, 1973 onwards (except for sales of tobacco or of lottery tickets). The right to use the trade name “Pharmacie Escompte Jean Coutu Enrg” and the servies offered by Services Farmico Inc to Mr Duquet had already been acquired from Messrs Michaud and Coutu.

Although the transaction in which Messrs Michaud and Coutu transferred these assets to Services Farmico Inc was not at arm’s length, and although it did not involve a sale of their business or goodwill, it should not be concluded that nothing was sold to Services Farmico Inc or that the intangible assets (“other nothings”) acquired by Services Farmico Inc could not be eligible capital property.

It is reasonable to conclude that Mr Duquet would not have undertaken by contract to pay such large amounts if he had received nothing in return. What Mr Duquet received, and what other pharmacists would have obtained from Services Farmico Inc, had a real commercial value for them.

I am satisfied that Services Farmico Inc acquired intangible assets, which it was planning to grant in the form of a franchise as a means of earning income, and that these assets were acquired in order to obtain assets with long-lasting benefits. In my opinion, the intangible assets acquired by Services Farmico Inc meet the definition of eligible capital property in paragraph 54(d) of the Income Tax Act, SC 1970-71-72, c 63, as amended. It only remains to determine the value of this eligible capital property.

The financial impact of the acquistion of the intangible assets by Services Farmico Inc may be clearly seen by comparing the opening balance sheet of Services Farmico Inc and that existing one year after the transaction.

The opening balance sheet of Services Farmico Inc, dated June 26,1973, reads:

Assets

Cash	$2,000
Share Capital Authorized
50,000 no par value shares
Issued and Fully Paid
200 shares	$2,000

A year later, on May 31, 1974, the balance sheet of Services Farmico Inc read as follows:

For the purposes of this appeal and in order to arrive at a fair valuation of the assets in question, it should be noted that the principal source of the income of Services Farmico Inc consisted of royalties paid by pharmacies which, through a franchise, obtained the right to use the trade name “Pharmacies Jean Coutu Enrg” or “Pharmacies Escompte Jean Coutu”. However, these figures do not necessarily represent the market value of the intangible assets acquired by Services Farmico Inc on the date of their acquisition, namely June 26, 1973.

In support of their respective positions, the parties to the case at bar summoned certain expert witnesses on valuation, each of whom gave his opinion on the market value of the intangible assets on the date they were acquired.

After examining the valuation report of each of the expert witnesses, I accepted the report of Mr R M Wise, an appraiser for Touche Ross and Co, chartered accountants, whose valuation appeared to me to be the most objective, and best suited to the facts as I interpret them.

In order to arrive at a fair determinatin of the value of the assets acquired by Services Farmico Inc on June 26, 1973, it is worth including here certain passages from the Wise report, which I found of particular interest:

Exhibit 1-10—pp 4 and 5:

In our review and examination of the business operated by the vendors’ four pharmacies, we are of the opinion that two types of goodwill existed:

(i) goodwill of location and (ii) commercial goodwill. These are difficult to separate in the circumstances. It is very likely that the locations of the four pharmacies would have enabled profits to be obtained in excess of a normal commercial return even if the name “Jean Coutu” had not been used and the particular marketing policies of the vendors had not been in existence. Goodwill of location will, of course, remain with the pharmacies. Some commercial goodwill could be transferred with the trade name. However, we can only apply a value to the commercial goodwill to the extent that it is a saleable item. The best judgment of this Saleability is the willingness and ability of outsiders to use the trade name and pay for such privileges. We have assumed that, since personal goodwill cannot be transferred, the only assets transferred to Farmico were trade name (which could give rise to “super profits”), licences and leases—the last two of which we attach no particular significance.

(Page 7):

In the case of Farmico, the contracts entered into between the company and the vendors, qua pharmacists operating retail drug stores, could be characterized as franchise agreements, particularly when they contain terms and conditions that are usually found in such agreements. These would include, inter alia:

—Use of trade name;

—counsel, advice and assistance relating to the organization of, and planning for, the pharmacies;

— possibility of purchasing from franchisor;

— publicity, advertising and promotion;

— initial assistance and guidance during start-up period.

(Page 8):

The usual basis of valuation where revenues are being considered is either to consider normalized maintainable revenue as being an average or weighted average based on past experience or, in the case of a significantly rising trend, to consider only the latest figures available prior to the valuation date. (The stock market reacts to a great extent on one year’s or the latest period’s results). In our calculations, we have considered only the performance of the year ended May 31, 1973 for our assessment in view of the trend over the past years; we consider any more historical performance to be inappropriate in these circumstances for the assessment of maintainable revenues.

It should be noted that we have applied the rate of 4% to all revenues (excluding tobacco and loto tickets) although it is likely that at least one of the four pharmacies had sales of over $2 million, thus attracting a 3% rate on the excess over this figure.

(Page 9):

According to the agreements between Farmico and the vendors, advertising of the name Pharmacie Jean Coutu and the products sold by the pharmacies were to be the responsibility of Farmico. We have assumed that the advertising expenditures in the future would be slightly in excess of those incurred by the four operating pharmacies in that year, namely $107,000, and accordingly, we have assumed that such expenditures could reasonably be projected at approximately $125,000, having regard to the increases over the past few years.

(Pages 11 and 12):

Risk

On or about June 26, 1973, the yield on virtually risk-free, gilt-edge investments such as Federal Government long term bonds was 7.7%. According to the Montreal Stock Exchange indices at May 31, 1973, the rate of return on quoted industrials was 6% and on quoted securities in the trade and finance section was 8%. To enable a realistic comparison to be made with risk-free or minor risk investments, we considered risks applicable to the income under review.

In June 1973 the Quebec Law of Pharmacies was awaiting assent, which was granted on July 6, 1973. Under this legislation, restrictions were placed upon pharmacists operating under professional names other than their own. In addition, the College of Pharmacists had decreed that it was illegal for a pharmacist to “share” his income from the operation of his profession, ie, the sale of drugs and phar- maceuticals. The full impact of these measures could not have been judged at the valuation date; however, a prudent purchaser would consider the possibility, first that franchises under the name ‘‘Jean Coutu” would not be legal, as the pharmacy would be operated by a person other than Mr Jean Coutu and, secondly, in all likelihood only non-pharmaceutical and non-drug sales (other than tobacco and loto tickets) could be subject to a franchise fee.

Furthermore, at the valuation date, the only contracts in force were with the four pharmacies controlled by the vendors. There were no provisions in any of the contracts relating to non-competition by Messrs Michaud or Coutu nor any guaranteeing their personal services to the pharmacies. Futhermore, there was the normal business risk of others imitating this type of operation with the possible consequence that future franchises would be limited.

It is normal valuation practice to consider, in addition to the maintainable earnings, the tangible asset backing of the enterprise in assessing risk. A company with tangible assets of close to the capitalized value of the earnings generally presents the investor with a lower risk than when the net assets are substantially less. In this case, the tangible assets, per se, are non-existent and a potential purchaser would have regard to this in his assessment of the value of the potential future income stream.

However, to counter these major risk factors, there are certain positive elements in assessing the risk. First, an increasing trend had been shown in the revenues of the four pharmacies over the last few years which could indicate a future increase in revenue to Farmico. Secondly, we understand that other pharmacists had expressed interest in operating under the “Jean Coutu” name and indeed negotiations were taking place with Mr Duquet.

In summary, therefore, there was a potential for obtaining income from the intangibles although the amount and duration of such income was uncertain. It is our opinion that the high risks involved would lead a prudent investor to pay for the trade name(s) between 3.5 and 4.5 times the after-tax maintainable earnings, taking into account the arm’s length negotiations in progress with Mr Duquet.

While the success enjoyed by Messrs Michaud and Coutu in the operation of their pharmacies under the trade name “Pharmacie Escompte Jean Coutu Enrg”, and the turnover which they realized before their transaction with Services Farmico Inc, might indicate a commercial potential at the date of the transaction, namely June 26, 1973, there were facts and circumstances at the time of the transaction which could have unfavourably affected, if not completely destroyed, the financial expectations based on creation of a larger chain of “Pharmacies Jean Coutu Enrg”. This inevitably affected the market value attributable to the assets on the date they were acquired.

The facts existing on June 26, 1973 which, in my opinion, seriously affected the market value of the assets acquired, concerned especially the legality of pharmacists operating their pharmacies under the name “Pharmacie Escompte Jean Coutu Enrg” after obtaining a franchise. In his testimony the appellant admitted, and it is in evidence, that there was some concern regarding the provisions of the Quebec Pharmacy Act in this regard. Although Mr Michaud was fairly certain that the problem would finally be settled, as a prudent buyer Services Farmico Inc should, in determining a price for the assets to be purchased, have taken into account the legal uncertainty which at the time of the purchase surrounded the franchises which were in fact the principal basis for the success of “Pharmacie Jean Coutu Enrg”. This was all the more true as Services Farmico Inc acquired no tangible assets, and the price paid by the appellant was only for a different and better concept of operating pharmacies, the most important right in which (that of the franchise) was vitiated by legal uncertainty. There appears also to have been uncertainity as to the legality of subjecting the sale or purely pharmaceutical products and prescriptions to a franchise fee. The idea of a chain of discount pharmacies did not originate in Montreal. Mr Michaud recognized the existence of such pharmacy chains, which were their competitiors, and which might have limited the number of pharmacies belonging to the “Pharmacies Escompte Jean Coutu Enrg” group.

Although Services Farmico Inc had some income-earning potential, the amount and duration of the projected income from these intangible assets was unknown and unforeseeable at that time, since it was accompanied by a significant element of risk and speculation.

In his report Mr Wise concluded, and I quote:

CONCLUSION

In conclusion, it is our opinion that the fair market value on or about June 26, 1973, of the assets transferred—to the extent this was legally permissible—was in the range of $119,600 and $153,800, and attached to the right to receive income pursuant to the above-mentioned contracts.

The financial statement prepared by Mr Wise reads as follows:

SCHEDULE II

SERVICES FARMICO INC

VALUATION OF INTANGIBLE ASSET

(RIGHT TO RECEIVE INCOME UNDER CONTRACTS)

Results of 4 operating pharmacies

Franchisable

Pharmacies Total sales Franchisable Net Net

31/5/70	1	$1,302,519	$ 241,065	$1,061,454
31/5/71	1 Yr /smos	2,748,846	357,027	2,391,819
31/5/72	3	5,053,179	1,013,493	3,039,686
31/5/73	3 Yrs 1/9 mos	8,524,211	1,710,345	6,813,866
Sales for 4 pharmacies on 1973 basis			each	$1,817,031
@ 4% (4 pharmacies)					290,725
Advertising (See page 9)			$125,000
Other expenses (See page 10)			100,000
					225,000
Pre tax income					65,725
Tax 48%					31,548
After tax income				$	34,177
Multiple			3%		4 /2
Range (rounded)			$119,600	$ 153,800

Having already concluded that the intangible assets acquired by Services Farmico Inc on June 26, 1973 constituted eligible capital property, I accept Mr Wise’s valuation, and I find that the market value of these assets on the date of their acquisition was $150,000; this also fixes the amount of the eligible capital expense which the appellant incurred to acquire these assets at this moment.

the appeal is accordingly allowed in part and the matter referred back to the respondent for re-assessment, taking into consideration that the amount of the eligible capital expense is $150,000, and that paragraphs 14(5)(b) and 20(1 )(b) of the Income Tax Act, SC 1970-71-72, c 63, as amended, must be applied.

Appeal allowed in part.