Tremblay T.C.J.:
1 This appeal was heard at Trois-Rivières, Quebec under the informal procedure on April 7, 1997.
1. Point at issue
2 According to the Notice of Appeal and the Reply to the Notice of Appeal the issue is the value of the goodwill transferred by the appellant when he incorporated his business under the name “Renseignement téléphonique Trois-Rivières Inc.” in February 1990. The problems of taxable advances, taxable capital gains, disallowed capital gains deductions and so on during the 1990, 1991 and 1992 taxation years all depend on the quantum of the goodwill allowed.
2. Burden of proof
3 2.01 The appellant has the burden of showing that the respondent's reassessments are ill-founded. This burden of proof results from various judicial decisions, including a judgment of the Supreme Court of Canada in Johnston v. Minister of National Revenue, [1948] S.C.R. 486, 3 DTC 1182,[1948] C.T.C. 195 (S.C.C.).
4 2.02 In the instant case the facts presumed by the respondent are set out in subparagraphs (a) to (j) of Paragraph 6 of the Reply to the Notice of Appeal. They read as follows:
[TRANSLATION]
6. In issuing the notices of reassessment of October 19, 1993 the Minister took into account among other things the following facts:(a) during the years on appeal, the appellant was the principal shareholder in Renseignement Téléphonique Trois-Rivières Inc. (“the company”); [admitted that he was the only shareholder]
(b) a review of the company's books disclosed among other things that the appellant transferred certain assets to the company at the time of the incorporation, February 1, 1990; [admitted]
(c) at the time of this rollover under s. 85 of the Income Tax Act (“the Act”), the appellant transferred goodwill, assigning it a value of $70,000; [admitted]
(d) the Minister asked the business equity valuation section of the Department to value the said goodwill at the time the assets were transferred, February 1, 1990; [not known]
(e) the Minister's valuation indicated that the market value of this goodwill on February 1, 1990 was nil; [denied]
(f) following discussions between the Department and the appellant's representatives, Robert Marcotte and Jude Leblanc, a settlement was reached in the amount of $15,000 as to the value of the goodwill, as indicated by the letter of acceptance signed by the said representatives on June 8, 1993; [denied]
(g) when the goodwill was transferred an “Owed to Shareholder” in the amount of $69,999 was entered in the company's books in addition to a share worth $1; [admitted]
(h) as the amount of the goodwill was reduced to $15,000 the “Owed to Shareholder” had to be adjusted accordingly; [admitted]
(i) as the shareholder had already cashed a large part of the $69,999 the result was that the amounts paid to the shareholder over $15,000 became advances to the shareholder under s. 15(2) of the Act in the amounts of $5,218 in 1990, $18,784 in 1991 and $9,752 in 1992; [admitted if goodwill is $15,000]
(j) the result was that the taxable capital gain in the amount of $52,500 and the capital gains deduction in the amount of $50,500 for the 1990 taxation year were revised in each case on the following basis:
| CAPITAL GAIN | |
| Revised proceeds of sale of goodwill | $15,000 |
| Less: adjusted cost base | 0 |
| Revised capital gain | 15,000 |
| Less: capital gain reported | 70,000 |
| Reduction of capital gain | $55,000 |
| 75% of that amount taxable | $41,250 |
| Amount reported | 52,500 |
| Revised taxable capital gain | $11,250 |
| DEDUCTION OF CAPITAL GAIN |
| Claimed on filing | $52,500 |
| Reduction in assessment of 17-07-91 | 2,000 |
| Revised amount | 50,500 |
| Reduction of deduction | 41,250 |
| Revised capital gain deduction | $ 9,250 |
| [admitted] | |
3. Facts in evidence
5 3.01 On October 31, 1987, pursuant to an agreement with Rentel Renseignements téléphoniques Inc. (“Rentel Inc.”), the appellant acquired the right to operate a telephone information service.
6 This service consisted of providing information on businesses, industries, factories and so on (telephone number, fax number, address, place where a service or product could be found and so on). The businesses were approached by Mr. Boucher, who explained the nature of the service to them. In short, the information provided was taken from the telephone directory's yellow pages (without the errors) to which was added the information given to Mr. Boucher by the customers.
7 According to the agreement, Mr. Boucher gave Rentel Inc. a list of his customers and requests for information by the public were routed directly to it. The Rentel Inc. operators gave out the information.
8 3.02 The franchisee (Mr. Boucher) had to pay the franchiser $10,000 every two years, and also among other things pay 7% of the gross proceeds of the sale of each contract, for any contract signed after December 1, 1988 (clause 4 of Exhibit A-1).
9 3.03 During 1987-1988 the appellant obtained 200 customers whom he charged $325. At the end of 1989 and in early 1990 he had 305 customers whom he charged $450. The witness stated that in his experience 95% of customers renewed their contracts from one year to the next.
10 3.04 During the two years of the contract a number of problems originating with the franchiser occurred: bad service by operators, the franchisee even had to advance money to the franchiser and so on.
11 3.05 In order to protect what was his the franchisee decided to create his own software, hiring three or four persons for two and a half months for this purpose.
12 On February 1, 1990, the appellant formed his own company, Renseignement téléphonique Trois-Rivières Inc., to which he transferred his business including goodwill of $70,000.
13 3.06 The calculation of this amount came essentially from half the income from the list of his 305 customers: 305 × $450 / 2 = $68,625, rounded off to $70,000.
14 3.07 The sales of contracts in the following years and profits broke down as follows:
| 1988 | 1989 | 1990 |
|---|
| Periods | 1/12/87 to 30/11/88 | 1/12/88 to 30/11/89 | 1/12/89 to 31/01/90 |
|---|
| Sales of contracts | $53,623 | $86,922 | $33,787 |
| Profit or loss |
| (operating) | ($1,375) | $7,942.32 | $18,965 |
| (capital) | ($3,000) | | |
| Net loss | ($4,375) | | |
15 3.08 As indicated in subparagraphs 6(e) and (f) of the Reply to the Notice of Appeal, the respondent first set the goodwill at nil, and after discussions between the respondent's appraiser (Réjean Asselin) and the appellant's representatives, Robert Marcotte and Jude Leblanc, an agrologist, a settlement was reached in the amount of $15,000.
16 3.09 As Exhibit A-3 shows, Jude Leblanc sent Diane Lambert, the respondent's employee, the following letter on June 8, 1993:
[TRANSLATION]SERVICES FISCAUX T.R. INC.
747 Laviolette, Trois-Rivières, G9A 1V7
Without Prejudice
Date: June 8, 1993
To: Diane Lambert
From: Denis Boucher
Dear Madam:
As you requested during our telephone conversation today, please find enclosed the balance at December 31, 1992 of the accounts “Owed to director” and “Withdrawals - Denis Boucher” of the company “RENSEIGNEMENT TÉLÉPHONIQUE (TROIS-RIVIÈRES) INC.”
As part of an overall settlement we hereby confirm our acceptance of the valuation of the commercial goodwill which was the subject of a tax rollover in 1990 at $15,000 instead of $70,000. We nevertheless consider that the actual value of the goodwill was $70,000, and possibly more.
We also understand that the taxable advances of $5,218.00 ($20,218 - $15,000) in 1990 and the advance of $18,784.00 will be taxed pursuant to s. 15(2) ITA, and that the capital gains deduction account will be altered by $41,250.00 ($52,500 - $11,250).
Trusting this is all to your satisfaction,Yours truly,
Jude LeBlanc, agr.
M. fisc. Adm. A.
17 3.10 Additionally, on December 20, 1994, Réjean Asselin sent Mr. Boucher, at his request, a copy of the internal report (Exhibit A-4) he had made following the settlement reached in 1993.
18 Paragraphs 7 and 8 read as follows:
[TRANSLATION]
7. Approach to Valuation:
Before determining the fair market value of the goodwill its existence and basis have to be established.
For goodwill to exist it must be associated with excess profits, be transferable and be durable or not likely to deteriorate in the medium term. For this, it must have been built up over the years.
The important point to note is the transferability of the goodwill.
In the case currently under review we are of the opinion that we cannot assign any amount for goodwill since the profits generated by the business were insufficient. Further, if goodwill exists it belongs to Denis Boucher personally, and so has no commercial value.
To do this, we contacted Denis Boucher in order to determine how his business operated. Mr. Boucher explained that he began the business himself in 1988, doing door-to-door work to obtain service contracts, and worked very hard to build it up.
There was no other salesman but him on the road at the time of the valuation and the business relationship was with Mr. Boucher personally.
We also reviewed certain texts and articles dealing with the point.
In addition, we consulted various precedents including that of Georges-Henri Couture (78 DTC 1511), in which the judge in that judgment referred to 16 other precedents.
We have considered the operating statements of the registered business and, allowing for a reasonable salary, no profit remains that could represent any kind of commercial goodwill.
8. Opinion:
After analysing this case as a whole and taking into account all the information and documents we had in our possession at the date of the valuation, we consider that the fair market value of the goodwill is nil as of February 1, 1990.
However, after a discussion with Robert Marcotte the Department agreed to a value of $15,000 for the goodwill for settlement purposes.
Accordingly, we take into account the fact that at the time of the transfer the business had about 300 names on its customer list. A possible purchaser might have been interested in taking over these customers.
In our opinion the $15,000 value is reasonable in this case as it is a business which has operated for only 18 months.
This settlement value corresponds to $50 a customer.
19 3.11 Following the appellant's appeal Réjean Asselin prepared a valuation report in March 1997, filed as Exhibit I-1.
20 According to Mr. Asselin, he contacted Mr. Boucher at the start of his investigation. The latter admitted that he found his valuation of $70,000 rather high. He also explained to Mr. Asselin that as a result of problems with the franchiser he paid a high cost to set up his own software and paid the franchiser $3,000 to be released from his contract. He calculated the start-up cost at $10,000. The appraiser maintained that though he went to the appellant's workshop in Trois-Rivières he did not think fit to stop to see two computers, which were required for the operators. It would not have helped his investigation.
21 3.12 In Part V of his report on the valuation of the shares Mr. Asselin, after describing the scope of his review, explained the valuation technique:
[TRANSLATION]
(B) Valuation technique:
Traditionally, a business is valued in two ways: one is based on the net asset value and the other on the value of profits (or cash flow) or a value based on profitability.
We also use the liquidation value when the business does not show sufficient profit potential, has suffered repeated losses in the recent past, is in a precarious financial position or cannot achieve a certain level of profitability without obtaining new capital.
In most cases, for an operating business the method based on profitability is the most appropriate as the value of a business depends primarily on its ability to produce income. This method is used more with businesses whose future profitability can be determined with relative accuracy and when such profitability, produced by tangible assets, is usually greater than a prudent investor would require if he was only buying the assets.
The value based on assets may also represent the basis of a company's value when, because of significant market influences or conditions prevailing in industry, future prospects are hard to quantify or are directly associated with certain identifiable assets.
This method is generally used for businesses for which, for various economic, sectorial or other reasons, it is hard to determine with some degree of accuracy the future profits that will be produced by tangible assets as used by the business.
In general it can be said that the total value of a business determined by this method corresponds to the value of tangible assets and that it is unusual for it to include large amounts for intangible assets.
Referring to the documentationon the valuation of intangibles, there are four rules that should be observed in relating value to an intangible asset, namely:1- an intangible asset must secure economic benefits of a durable and permanent nature for it to be assigned a value;
2- although the value of an intangible asset may be hard to determine exactly it must be associated with profits (excess profits) or anticipated cash flow that will be generated by this asset;
3- when an identifiable intangible asset has value that can be separately established the value must be added to the fair market value of the net tangible assets: this asset must thus be associated with the operations of the business;
4- goodwill is often the primary component in the intangible assets of a business but must be identifiable in order to be recognized by a possible purchaser and so have commercial value.
To do this an analysis of the business and its environment must be made to ensure that it exists and can be continued into the future.
After establishing its existence and basis we must quantify it and determine whether it is transferable and will give the business some permanency.
In the case under review we are of the opinion that the technique involving excess profits is the most appropriate.
In the event there are not sufficient profits to calculate any value for the goodwill, we must consider what an investor would pay for an intangible asset such as a customer list. To value this customer list, we must use three applicable valuation approaches used in assessing intangible assets, namely:(C) Valuation:
Profitability approach
Based on the income statements filed with the Department for the years ending November 30, 1988 and November 30, 1989, we can determine the profitability of the business. We do not take into account the income statement of January 31, 1990 as the profit generated is not representative since it was only for a two-month operating period.
We have estimated a salary of $30,000 for Mr. Boucher. This salary seems more than reasonable, since Mr. Boucher devoted many hours per week to his business both in recruiting new customers and renewing contracts - business card and presentation for yellow pages concept.
Using this valuation basis, there is no longer any profitability that could justify any value being assigned to this intangible asset.
Cost approach
On cost, the initial investment was only $3,000 plus two computers. We estimate the start-up costs at about $10,000.
Market approach
So far as we know there are no comparable assets that were traded on the market during our valuation period.
Part VI - Conclusion:
We must consider an approach in the context of a hypothetical market on the basis of a free market, in relation to a transaction between persons dealing at arm's length, in order to comply with the definition of “fair market value”.
Accordingly, after analysing this case as a whole and taking into account all the documents and information we have in our possession at the date of the valuation, we are of the opinion that the fair market value of this intangible asset transferred by Denis Boucher to Renseignement Téléphonique (Trois-Rivières) Inc. on February 1, 1990 was nil.
Although we are not really persuaded that an investor would pay anything for this intangible asset, the Department is prepared to accept the amount of $15,000 already agreed to by the parties for the purposes of settlement in this case.
22 3.13 At p. 33 of his report Mr. Asselin gave the figures for the valuation:
[TRANSLATION]
| Book value: |
| Owner's equity at January 31, 1990 | | 17,342 | |
| Profitability basis: |
| 31-01-90 | 31-11-89 | 30-11-88 |
| Pre-tax profit: | 18,965 | 7,942 | (4,375) |
| Deduct: |
| Reasonable salary | 30,000 | 30,000 | 30,000 |
| Revised pre-tax profit after salary | (11,035) | (22,058) | (34,375) |
Allowing for a reasonable salary, there is not sufficient profit to justify any goodwill.
23 3.14 The appellant did not file any valuation report prepared by an expert witness.
4. Analysis
24 4.01 Counsel for the appellant properly objected that in calculating the two-month period ending January 31, 1990 (3.13) Mr. Asselin deducted the salary for a complete year, $30,000.
25 In fact, the actual figures were the following:
| Income | | $33,787 |
| Commissions | $3,500 | |
| Salaries | $5,842 | |
| Other miscellaneous expenses | $5,480 | $14,822 |
| Net pre-tax profit | | $18,965 |
26 Accordingly, no other pre-tax profit can be deducted.
27 At the same time, the Court cannot share the view that income for two months can be extrapolated by multiplying by six to give the income for 12 months, which would be $202,722. The income came from contracts at $450 each. There were 305 of these. In the two months at issue (December 1989 and January 1990), income from 75 contracts was collected, that is, $33,787 / 450. That left 230 contracts to be collected (305 - 75) for the ten-month period, or the sum of $103,500.
28 Neither would it be realistic, in order to determine the expenses for the entire year, to multiply the expenses for two months ($14,822) by six, which would give $88,932.
29 However, if the salary of the president for two months, that is $5,000 ($30,000 / 12 × 2) is added to the expenses of $14,822, this would give $19,822. It would leave a net pre-tax profit of $13,965 ($33,787 - $19,822) for two months. Can this net pre-tax profit be extrapolated for 12 months at $83,790 ($13,965 × 6)? The Court strongly doubts it.
30 4.02 The appellant filed no report made up by an appraiser.
31 Nonetheless, his reasoning was as follows (3.06):
| 305 customers × $450, | that is $68,625 |
| 2 |
32 This figure was rounded off to $70,000.
33 A common method of determining the goodwill of a business is to consider the average profits over the last five years. In his calculation the appellant did not use profit but half the gross income for a year instead.
34 Additionally, the Court certainly considers that the 305 contracts are the basis for the business's regular income. This permanent source of income is due to the preliminary work done by the appellant in 1988 and 1989 with 305 businesses, merchants and so on, supported by quality software and qualified operators. This source might certainly be sufficiently interesting to attract a potential purchaser.
35 The appellant did undertake to pay $10,000 every two years to acquire the right to operate a telephone information service. Why would someone else not be interested in acquiring the shares of an incorporated and well-organized business with 300 customers for whom there was a contract renewal rate of 95% a year?
36 How much would such a person be prepared to pay for the goodwill?
37 The Court has no information for the years after 1990 on the number of customers, the price paid by each one and net profit, which might have provided valuable background information.
38 The goodwill must be determined in 1990. Profits in earlier periods are hard to determine if a salary of $30,000 is taken into account.
39 In fact, the foundation is there to indicate that potential goodwill exists. But how is it to be valued in 1990? No valuation expertise setting it at $70,000 was presented to the Court. 1990 is still too close to the establishment of the business.
40 The Court is bound by the evidence and considers that the agreement on the amount of $15,000 offered by the respondent is reasonable in the circumstances.
5. Conclusion
41 For the foregoing reasons, the appeal is dismissed.
Email this Content