Jack Linett- v. Minister of National Revenue, [1978] CTC 2478, [1978] DTC 1359

Delmer E Taylor:—This is an appeal against an income tax assessment in which the Minister of National Revenue increased the taxable income of the appellant by an amount of $284,939.78 for the year 1971. The appellant and the respondent relied, inter alia, upon sections 3 and 4 of the Income Tax Act, RSC 1952, c 148.

FACTS

On November 30, 1960, the appellant entered into an exclusive franchise agreement, (hereinafter referred to as ‘‘the agreement”), with a company incorporated in the State of Delaware, Home Reader Service Inc (hereinafter referred to as ‘‘HRS’’). He carried on, in the City of Montreal, Province of Quebec, an unincorporated business of magazine distribution known as Home Reader Service of Montreal (hereinafter referred to as “Linett” or “Dealer”), until the termination of the agreement in 1971.

CONTENTIONS

It was contended by the appellant that under the agreement:

—he would sell magazine subscriptions to the public and would bear all costs of his operations;

—he would be entitled to receive from HRS a certain amount calculated as a percentage of the value of orders sold;

—in and prior to 1971 HRS advanced capital to him by way of loan and he signed promissory notes under which he was obliged to repay the loans irrespective of whether he earned income from the sale of magazine subscriptions;

—on June 7, 1971, he signed an agreement with HRS, terminating the relationship. The termination agreement (hereinafter referred to as ‘the termination agreement”) provided, inter alia, that upon payment of an amount of $15,000 to HRS, he was to be released from any and all liabilities towards HRS, on account of loans or other monies advanced during the term of the agreement;

—upon termination of the agreement, the debt in the amount of $284,939.78 owing to HRS was forgiven at a time when the relationship between them was that of debtor and creditor.

The position of the respondent was that:

—the agreement provided a 20% advance on commissions, computed on the face value of contracts subject to verification, to be reimbursed by equal instalments at 20% of collections commencing two months after the date the loan is made to the appellant;

—during the years 1960 to 1971, under the above arrangement, the appellant was owing $316,000 to HRS;

—on June 7, 1971, HRS ceased to do business in Canada:

—the agreement provided that upon termination, HRS agreed to repurchase all outstanding subscriptions at a rate of 35%;

—the amount so payable to the appellant was to be credited against the moneys loaned by the company to him;

—on his 1971 balance sheet, the appellant indicated an amount owing of $284,939.78;

—on September 24, 1971, an agreement was signed between HRS and the appellant whereby the agreement dated November 30, 1960, was terminated;

—this agreement provided that upon payment of a sum of $15,000, the appellant would be released from any obligation binding the appellant and the company;

—the appellant reported his income for the period 1960 through 1971 on a cash basis;

—in declaring his 1971 taxable income the appellant failed to include the amount of $284,939.78;

—the amounts owing by the appellant to the company were moneys advanced to him against his future commissions;

—the termination agreement whereby the appellant was discharged of all liabilities including the amounts owing by him to the company (advances or loans) offset those liabilities against the moneys payable to him for the purchase by the company of all outstanding subscriptions as provided by the agreement of 1960, and reduced the amounts payable.

Evidence

Through the appellant, the agreement (Exhibit A-1) and the termination agreement (Exhibit A-2), were submitted to the Board. The appellant’s evidence in summary was that from 1960 on, he gradually built up to a total staff of about 40 people, mostly salesmen operating on a commission. While he had a good volume, the operation never seemed to be able to meet its expenses and loans were continually made to him for financing. These loans did not follow the scale for such loans prescribed in the agreement, but were made available whenever he needed money. While he did make some repayments, he always seemed to be going further^ behind in total. His own drawings were controlled by HRS, and, averaged about $250 to $375 per. week. He was never happy with the system prescribed under the agreement and would have preferred to return to the system under which he had operated for HRS before 1960. In 1971 he was told by his district supervisor, Mr N Kenny, at a meeting arranged in Lake George, New York, that the entire operation of HRS (some 500 dealers) in Canada and in the United States would be wound up shortly. At that time he was aware that he owed a bank loan, and had payrolls to meet, in addition to the obligation of some $300,000.00 to HRS. The total customer contracts outstanding at the date of the termination agreement amounted to about $700,000.00. He had been greatly relieved at the offer from HRS to cancel his outstanding Obligation, and even borrowed some of the $15,000 to make the necessary payment.

Mr I Silverman, chartered accountant, described his lengthy involvement with the business affairs of the appellant, and the reasons he did not believe the $700,000 “contracts receivable’’ should have been shown as an asset by the appellant in his financial statements. Basically these reasons were that the collection percentage was very low (he believed finally that only 40% or 50% of the $700,000 had been collected): there was continual dissatisfaction from customers who did not receive their magazines, or were unhappy with the ones they did receive and would not pay; and the cancellation of any customer contract rested solely with HRS, leaving little control in the hands of the appellant. He had advised the appellant to accept the termination agreement and pay the $15,000.00, believing that the balance should be treated as an uncollectable loan forgiveness.

Mr N Kenny, who had been the district supervisor for HRS, substantiated the general testimony of the appellant. In his view, HRS had continually pressured the appellant for more and more volume, for circulation purposes, and had been quite content to loan the necessary funds to Linett for his operation. It was also his view that not more than 40% or 50% of the $700,000 customer contracts outstanding would have been collected after the date of the termination agreement.

ARGUMENT

The basic position of counsel for the appellant was that there was nothing contingent about the liability and there can, therefore, be no basis for suggesting that the loans were “advances against commissions’’. Even if they were, this does not justify bringing $284,939.78 into Mr Linett’s income in 1971. The loans were at all times simply that: loans by a lender to a borrower. Accordingly, when the franchise was terminated in 1971 the forgiveness of those loans was on capital account. Clear authority for this proposition was to be found in the cases of Golden Horseshoe Turkey Farms v MNR, [1968] CTC 294; 68 DTC 5198; The British Mexican Petroleum Company Ltd v Jackson, 8 TC 571; G T Davie and Sons Ltd v MNR, [1954] CTC 124; 54 DTC 1045; and J D Stirling Ltd v MNR, [1969] CTC 418; 69 DTC 5259.

According to counsel the termination agreement itself provided for the release of all liabilities of Jack Linett upon the payment of $15,000. The payment of $15,000 is the consideration for that release and nothing else: obviously Mr Linett, in an insolvent state, was making a compromise of his debts by the payment of a lesser amount. Even this amount had to be paid off over a period of time and in fact he borrowed the last $5,000 to complete his obligation. The law is clear that a creditor may accept a lesser amount in satisfaction of the amount owing and this is precisely what HRS did. There is no basis for assuming or suggesting that the parties put a value upon the outstanding contracts that in any way approximately Mr Linett’s outstanding loans. To suggest that by compromising the debts owing to HRS by Mr Linett HRS was paying $284,000 for the assignment of contracts that may or may not have had any value and which had in any event already been assigned to HRS, was pure conjecture. Even the franchise agreement of 1960, does not say that a fixed sum would be paid for the contracts. It provides only that Mr Linett was to receive 40% of amounts actually collected. Mr Linett testified as to the extreme doubtfulness of collecting the amounts owing by Subscribers.

From the viewpoint of the respondent, there had been a borrowerlender relationship, but that had not been the only relationship. The amount in question, $284,939.78, must be regarded as flowing out of the obligations detailed in the agreement respecting termination, and can only be viewed as income to the appellant and advances made by HRS. It is compensation which flowed to the appellant for profits from the franchise agreement which would have come to him, in any event, under other circumstances. A substantial list of authorities were noted by counsel, for the Board’s attention, and among these were: Enjay Chemical Co Ltd v MNR. [1971] CTC 535; 71 DTC 5293; Import Motors Ltd v MNR, [1973] CTC 719: 73 DTC 5530; F A Stewart Jones v MNR, 34 Tax ABC 48: 63 DTC 964: Gerhard William Kennedy v MNR, 25 Tax ABC 348; 60 DTC 648; William H Morgan v MNR, 25 Tax ABC 385; 61 DTC 14; The Oban Distillery Co Ltd v The Commissioners of Inland Revenue, 18 TC 33; Seaboard Advertising Co Ltd v MNR, [1965] CTC 310; 65 DTC 5188.

FINDINGS

In brief, counsel for the appellant founded his case on the interpretation of Exhibit A-2, the termination agreement, under which, according to him, a clear debt had been written off by HRS. The proposition of counsel for the respondent rested almost exclusively on an interpretation of Exhibit A-1, the franchise agreement, and in particular upon paragraph 14(d) therein. For the record, all of Exhibit A-2 and paragraph 14(d) of Exhibit A-1 are reproduced:

TERMINATION AGREEMENT

TERMINATION AGREEMENT (hereinafter called “Agreement”) made at Des Moines, Iowa between HOME READER SERVICE, INC, a Delaware corporation with offices at 111 Tenth Street, Des Moines, Iowa (hereinafter called “HRS”) and Jack Linett d/b/a HOME READER SERVICE OF MONTREAL (hereinafter referred to as “LINETT”)

WITNESSETH:

WHEREAS, HRS and LINETT entered into a Franchise Agreement dated November 30, 1960, and said Franchise Agreement has been amended from time to time, and,

WHEREAS, the parties desire to terminate said Franchise Agreement and all amendments thereto (hereinafter collectively called “Franchise Agreement”), and

WHEREAS, LINETT and HRS each desire to waive the sixty (60) day notice requirement set forth in said Franchise Agreement,

NOW, THEREFORE, in consideration of the terms of this AGREEMENT, it is hereby agreed by and between the parties as follows:

1. The Franchise Agreement dated November 30, 1960 between HRS and LINETT is hereby terminated effective June 7, 1971.

2. LINETT hereby assigns, transfers and delivers to HRS, as of the termination date, all outstanding installment sales contracts sold by him under the Franchise Agreement together with all of his rights therein not previously assigned to HRS, and LINETT agrees to deliver to HRS on demand all copies of such contracts, orders, books of accounts and other records relating to the operation of his franchise under the Franchise Agreement. LINETT further agrees to observe and fully comply with all terms of the Franchise Agreement relating to the termination thereof and the post-termination period thereof except as otherwise specifically provided herein.

3. LINETT hereby acknowledges that he is indebted to HRS in the sum of $15,000.00 and further agrees that this indebtedness may be deducted by HRS, or BUDGET MARKETING SERVICE, INC on behalf of HRS, from any commission due to LINETT under any Collection Agreement between LINETT and BUDGET MARKETING SERVICE, !NC, (BMS), pursuant to which LINETT is or will be authorized to collect or make collections with respect to any of the following debits:

FRANCHISE	DEBIT NUMBERS
Home Reader Service of Montreal	#560A & #560J
Civic Reading Club of Montreal	#591 A, #591J & #594J
Civic Reading Club of London	#481A & #481J
Home Reader Service of Quebec	#615A
Mutual Readers League of Montreal	#214A
Civic Reading Club of London	#507B
Civic Reading Club of Montreal	#590C
Home Reader Service of Toronto	#660B

The deductions from the commission referred to above shall be in an amount equal to three percent (3%) of LINETT’S gross collections made on the above debits and may be deducted in any manner permitted by any Collection Agreements between LINETT and HRS or between LINETT and BMS, including, but not limited to, payment directly to HRS or to BMS on behalf of HRS out of any qualified bank account into which collections are deposited by LINETT. “Gross Collections” shall mean all sums collected by LINETT, including but not limited to payments on subscriber accounts, late charges, postage and taxes.

4. HRS agrees that at such time as the $15,000.00 referred to in Paragraph 3 hereof is fully paid to HRS, it will release LINETT from any and all liability to HRS due to or on account of loans or other monies advanced to LINETT during the term of said Franchise Agreement.

9. LINETT agrees to be responsible for any outstanding indebtedness due and owing by him to third parties, including any. taxes due and owing to federal, state and local governments, incurred during the period of the Franchise Agreement. LINETT further agrees to indemnify and hold forever harmless HRS against any and all claims, demands, actions, causes of action of liability of any nature whatsoever made, raised, or asserted by any third parties against HRS arising out of or in any way related to his operation under the Franchise Agreement during the time period beginning. November 30, 1960, and ending as of midnight on the date of this TERMINATION AGREEMENT.

6. By this TERMINATION AGREEMENT, LINETT hereby releases. HRS from any and all claims, demands, actions, causes of action or liability of any kind arising out of or under the aforesaid Franchise Agreement, as amended.

7. This TERMINATION AGREEMENT shall be binding upon the parties, their heirs, executors, administrators, successors and assigns.

EXHIBIT A-1

14. (d) In the event of the termination by HRS other than for cause or in the event of DEALER’S death, HRS agrees to purchase from DEALER, and DEALER agrees to sell and immediately transfer, assign and deliver to HRS, all outstanding installment subscription sales contracts, including all of DEALER’S rights therein, together with all copies of contracts, orders, books of account, and other records relating to the operation of the franchise, in effect on the date when the termination becomes effective. The price to be paid for such purchases of contracts shall be an amount equal to thirty-five per cent (35%) of the monies then outstanding and payable by the subscribers, under the terms of such contracts, to DEALER (less any cancellations) and in no event is HRS to pay more than thirty-five per cent (35%) of the total monies actually collected under said contracts from subscribers over the’ remaining life of the subscription contracts. The thirty-five per cent (35%) purchase price shall remain in effect for the three (3) full calendar years immediately following the date of the within agreement. Beginning with the fourth (4th) calendar year immediately following the date of the within agreement, the purchase price of thirty-five per cent (35%) shall be increased by one per cent (1%) for each calendar year this agreement is in effect thereafter during the next five (5) years; thus reaching a maximum purchase price of forty per cent (40%) at the end of the eighth (8th) full calendar year following the date hereof. From such purchase price, HRS shall deduct the total amount of loans theretofore made by HRS to DEALER to the extent that such loans have not been repaid by DEALER, together with any accrued and unpaid interest thereon, as well as any other monies at that time owed by DEALER to HRS. After repayment to HRS, out of the collections made on said contracts thus purchased, of all amounts outstanding under loans previously made by HRS to DEALER and of any other amounts then owed by DEALER to HRS as of the date of termination, the balance of the purchase price remaining due to DEALER under this paragraph 14. d shall be paid by HRS prorata in monthly installments out of, and at the time of, the collection, by HRS or its representatives or agents, of the monthly installment payments from subscribers due from time to time under the outstanding contracts thus purchased by HRS from DEALER. In the event of termination of the within agreement, the purchase,. sale and transfer of said installment subscription . contracts outstanding shall be automatically effected on the date of termination, and HRS and DEALER agree that this franchise agreement shall be the only instrument necessary to effectuate and consummate such purchase, sale and transfer of said contracts and accounts from DEALER to HRS on said date.

The position of counsel for the respondent was that the agreement had been terminated by HRS. With respect, I am unable to reach that conclusion, and, in my view, this puts into question the basis upon which the Minister’s assessment was made, at least to the degree it was represented by counsel’s argument. Whatever might have flowed from HRS exercising its own rights of termination under paragraph 14(d) or under any paragraph of the agreement, it cannot be asserted that the same results would follow from a separate termination agreement, providing for such termination on a mutually acceptable basis.

A cursory reading of the agreement might indicate that due to the process set out therein for repayment of the loans from HRS (20% of the. dealer’s percentage of customer contracts subsequently collected), these loans showed characteristics of advances on such commissions. However, I have been unable to find any reference in the agreement to “advance on commissions’’ as asserted by the respondent. Indeed I have not noted the word “advance”, and “commissions” is used only once, in an oblique way. There is conversely the frequent use of the word “loans”, for example, in paragraph 10 of the agreement:

10. HRS may make such loans to DEALER as, in the sole determination of HRS, are reasonably required by DEALER for the operation of his business . . .

It appears to me that the respondent’s assessment therefore would probably also founder on the fact that all the evidence points to an interpretation the amounts received by the appellant from HRS were considered loans by both parties and not, at any time advances, commissions or advances on commissions.

It was not alleged by the respondent that there was anything improper about the termination agreement, in that it had been designed to avoid taxation, and accordingly the Board should accept it for precisely what it purports to be. If there is any ground for confusion, it might be that the termination agreement in clause 3 indicates an indebtedness of $15,000, not a much greater amount, whereas clause 4 implies that an amount in excess of $15,000 did exist. It is in this clause for the first time the word “advance (d)” arises in the documentary evidence available, and the Board has no basis upon which to interpret this as “advances on commissions". This lack of clarity in the termination agreement regarding the loans in my opinion does not detract from its import, evidenced by testimony of the witnesses, that it represented a vehicle for the forgiveness of a capital debt. The amount of $284,939.78, at issue here, should not now be translated into the receipt of an income amount.

DECISION

The appeal is allowed and the matter referred back to the respondent for reassessment accordingly.

Appeal allowed.