Seto Holdings LTD v. Minister of National Revenue, [1974] CTC 2347, 75 DTC 1

Judge Flanigan (orally: March 19, 1974):—This is an appeal by Seto Holdings Ltd against a notice of reassessment of the Minister of National Revenue for the taxation years 1968 to 1971 inclusive.

The facts briefly are that prior to the incorporation of Seto Holdings Ltd there was a restaurant in the 5000 block of Macleod Trail known as Harry’s Café, which has been operated for some 15 or 20 years by a Chinese by the name of Harry Seto. He had built up a large clientèle of farmers and ranchers who stopped on their way to and from the City of Calgary along the Macleod Trail, which the evidence indicates is one of the main, if not the main, arteries to Southern Alberta from Calgary. The restaurant operated, as I have said, on the Macleod Trail. Opposite it, in close proximity, was another restaurant operated by the Seto family, by the name of “Palm Restaurant”, and another further along, which I will refer to as “Oriental”, in which the Setos had a two-fifths interest. Both the Palm Restaurant and the Oriental eventually were closed down, leaving a relative monopoly in this area to Harry’s Café.

The evidence of Mr Pringle, a chartered accountant in this city, and of his partner is that Mr Harry Seto had been active for many years in the operation of this restaurant and had built up this terrific following of farmers and ranchers. In or about the year 1965 his two sons, who subsequently incorporated the appellant company, took a more active interest in the business and appear to have concentrated their efforts mainly in Harry’s Café from that point onwards.

Harry Seto, senior, died in 1966, and on May 1, 1967 a company which has been incorporated, with the two sons as, I take it by inference, the sole beneficial shareholders, transferred the assets of the previous partnership or proprietorship to the company on the basis of an evaluation made by their auditors, which evaluation came to $164,514.90. After bringing the land values up from $600 to $29,400 and increasing the value of the building by $55,000, the total tangible assets then amounted to $110,000, leaving some $54,000-odd for goodwill, which was rounded off at a figure of $55,000. In the reassessment the Minister has disallowed or failed to accept this $55,000 for goodwill and has acknowledged a figure of only $15,000 for goodwill. The net result, of course, is that the moneys paid, at the 6% interest rate, to the Setos under the notes taken by them on the closing of the transaction are not deductible to their full extent if the Department is correct in using the figure of $15,000. Mr Vanderkooi, of the Department of National Revenue, produced his working papers, filed as Exhibit R-1, on the valuation prepared by him. These valuations, which are extensive and which he obviously spent considerable time in preparing, are based on revenues of the business up to and including the closing date of April 30, 1967. Notwithstanding the fact that from 1964 to 1967 the gross profits showed a continual rise from 39.8% to 52.6% in the four months of 1967, he did not give any effect to or take into consideration any projected values or probable earnings of this company. He came to Calgary early in 1971 and joined the business valuation section of the District Office of the Department of National Revenue, so he cannot give us any direct evidence as to his knowledge of the situation that existed here in 1967. He has followed acceptable practices in arriving at the figures that he has, but in doing so has used certain generalities which, in my view, do not make his findings as effective as evidence as those presented by Mr Pringle and his partner. I cite as a couple of examples the fact that he considered general averages, as produced in a pamphlet by Dun & Bradstreet as to percentage of return of earnings on the net tangible assets of a company in the restaurant business. He accepted the principle that restaurant businesses are high-risk businesses, and failed to apply any specifics to this particular case. He also rejected out of hand the question of considering a year or part of a year as any indication of what the future might hold for the earnings of an enterprise. He did raise one issue, which has given me some concern, and that is the fact that in the appellant’s valuation of the business only $14,400 was allotted to salaries for the two brothers who, as I will indicate later, were very active in the business, and I think, as a result of their efforts, turned the business into a very profitable operation, as hindsight would show by virtue of some of the exhibits filed. Unfortunately, though, he has not been able to assist me by any specific: knowledge or evidence as to what would be a fair and reasonable salary for these people to have earned at the particular time, although he did agree with me that $10,000 would be a fair and reasonable sum. In putting that question to him I arrived at the sum of $7,000 odd in salary, plus the interest they would receive on the notes held by them and payable by the company. Payments by the company, of course, would depend upon their work and their producing sufficient income to honour the obligation of the company.

I turn, then, to the evidence of Mr Pringle, who was a partner, I believe in 1967, of a chartered accountancy firm named Pringle and Erickson, and of Mr Madsen who was his partner and was charged with this account; the valuations were carried out by Mr Madsen but were checked by Mr Pringle as the senior partner. Mr Pringle has been in practice as a chartered accountant since 1959, and he states that his experience includes many valuations of small businesses, and quite a few in the restaurant field. He says that in his opinion, because of the fact that this restaurant was located in such a favourable position without any real competitors and had built up, through Harry Seto, such a permanent clientèle, he could not or would not consider it to be a business of as high a risk as might generally apply in the restaurant field. He said that view was even further strengthened by the fact that when the two sons, the principals in the appellant company, became active in the business, they applied modern-day principles of restaurant operations by introducing monthly interim cost sheets and portion control, by increasing the price of the menu items, and generally approaching the business in a more professional manner than did Harry Seto, the father, who, as Mr Pringle put it in rather a colloquial way, “flew by the seat of his pants”—and served large portions. The valuations that were arrived at by Mr Madsen and Mr Pringle took into consideration some of these factors, and I think it is generally accepted that the factors affecting the choice of a proper multiple earnings ratio are numerous. They depend on certain well- established principles, and these include, as I have said, whether or not the business is a high-risk business, what the interest rates might be at material times, what the future economic outlook is for the general area, the question of competition and the matter of repayment of the purchase price, all of which in this particular instance were matters that could be fairly well appraised, because the company was going to be continued by two brothers who were the sons of the founder. The evidence indicates, in support of this belief, that 10% was a proper multiple at which to capitalize and arrive at the value of this company. It was shown that the prime bank rate at the material time was 4%, that Canada Savings Bonds were paying 5 /z to 6%, that the bank rates in the years into which he projected the values or the incomes that might be expected from the business were well within the range of 7%%, which today, of course, makes it look quite reasonable. He says in his evidence that the general economic conditions of Calgary, in that particular area, were good, that the city was expanding in that direction and the future of the restaurant was bright, particularly — and I emphasize this because of the result that I eventually hope to come to — on account of the approach of the two brothers as compared to the approach of the father to the operation of the business. Mr Pringle says throughout that he has been modest or conservative in his approach to the valuation of this business. He says that it is a sound accounting principle and practice to look forward, because although one is concerned, of course, with what the business has done in the past, and the evidence is that it had done well enough to exist for some 15 to 20 years, the major concern of anyone expecting to purchase this business or operate it would be, what are the future possibilities of earnings of this company?

it is for this reason, and for the other reasons that I have mentioned as contained in Mr Pringle’s evidence and as supported by Mr Madsen, that I much prefer the projected forward revenue approach to that adopted by the Department. It is true that this approach is not without weaknesses, but I feel that, when one considers all the factors that Mr Pringle has outlined, this was a much more reliable basis upon which to value this business than the basis of going backwards rather than forwards. Hindsight is a great thing, as I have said, and Exhibit A-5 shows a continued increase in gross sales, but I do not base my decision, or any aspect of my decision in this case, on hindsight.

I accept the fact that a fair average as shown in Exhibit A-2 was $35,224.67. Where I arrive at my decision is when I deal with the salaries of these two brothers. There is no question whatsoever from the evidence of Mr Pringle — and I can draw inferences from that evidence — that the Seto brothers really made this business take off. One of them eventually became president, I believe, of the Alberta Restaurant Association. They continued to improve their managerial functions. I think, as Mr Pringle himself said, that he was indeed conservative throughout, and that he has been overly conservative in fixing the proprietors’ salaries at only $7,200 each. It is true that the Department has not brought forward any evidence of great weight to establish just what the correct salaries would have been and, as learned counsel for the appellant has said, the onus on him is only the onus found in civil cases of proving by a preponderance of evidence. He can then shift or turn the duty of explanation over to the respondent. I do not disagree with this statement, but I turn it back on him and say that all his figures that he wishes me to accept must be proved by a preponderance of evidence, and that he has not satisfied me, nor has his evidence as adduced through Mr Madsen and Mr Pringle, that $14,400 for the Setos’ salaries was a correct figure. I have tried, by considering the evidence that I have heard and the answers to the questions put to the various witnesses by myself, to arrive at some reasonable amount that might be attributable to salaries for the proprietors at the time of the incorporation as of May 1, 1967 and which would be fair to both parties. In doing so, I have come to a figure of $9,000 each, which, when rounded off with calculations. and allowances for the 21% rate of tax, has brought me to the conclusion — notwithstanding that my arithmetic may be slightly out in some portions — that a proper valuation of goodwill for this business should be rounded off at $26,000 rather than the $55,000 chosen in the first instance. By so arriving at that figure, I conclude that the appeal will be allowed in part and the assessment referred back to the Minister for him to set the value of the business, by my figures, at $136,033 by fixing the amount in respect of goodwill at $26,000.

Appeal allowed in part.