Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
5-903045
XXXXXXXXXX D.J. Powrie
(613) 957-2109
Attention: XXXXXXXXXX
May 3, 1993
Dear Sirs:
Re: Franchise Transactions Request for Technical Interpretation
We are writing in response to your letter, dated October 23, 1990, in which you requested our views on the tax consequences of a number of hypothetical situations described below. We apologize for our delay in responding.
Situation A
1. A Co. is a Canadian corporation which is a franchisor of retail outlets.
2. X Co., a Canadian taxpayer dealing at arm's length with A Co., holds a franchise granted by A Co. and operates the business contemplated by the franchise.
3. A Co. acquires all of the assets and business undertaking of X Co. Pursuant to an agreement between X Co. and A Co., and/or , pursuant to a valuation of the assets and business acquired, an amount (the "Allocated Amount") is allocated to the franchise which is reacquired by A Co.
4. A Co. has acquired the business and franchise of X Co. with the intention of reissuing the franchise to a new franchisee either immediately or as soon as practicable.
It is your opinion that although the re-acquired franchise in law is extinguished due to A Co. being both the franchisor and franchisee, the amount paid to acquire X Co.'s franchise is properly capitalized to inventory.
Situation B
Situation B is identical to Situation A except that A Co. has acquired X Co.'s business with the intention of retaining and operating the business for A's own account.
You wish to know whether the Allocated Amount i) is deductible by A Co., ii) represents the cost of a Class 14 asset of A Co. or iii) represents an eligible capital expenditure of A Co.
Our Comments The initial questions in both situations A and B are what the Allocated Amount is paid for, and whether such payment is on capital or income account.
The term "franchise" covers a broad range of commercial arrangements and a payment on termination of a franchise might be in respect of a broad range of things. It appears likely, however, that the Allocated Amount in Situations A and B would be in respect of the termination of the franchisor's obligations under the franchise agreement. In this case, the franchisor would not have acquired any property as a result of the payment (Mandrel Industries, Inc. v. MNR ( 65 DTC 5142)).
Whether a payment in respect of the termination of contractual obligations is an outlay on account of capital or a currently deductible expense is a determination that must be made based on all of the facts of a particular situation. The issue of deductibility of expenditures incurred by a taxpayer to cancel a distributorship or a franchise agreement has been considered by our courts in the following cases:
Mandrel Industries, Inc. v. MNR, ( 65 DTC 5142) Dymo of Canada Ltd. v. MNR, ( 73 DTC 5171) Bomag (Canada) Limited v. Her Majesty The Queen, ( 84 DTC 6363) Angostura International Limited v. The Queen, ( 85 DTC 5384) In each of the above cases the Court was able to make its determination only after examining the details of the agreements between the parties and all of the relevant facts. One fact which the Department would view as relevant is whether the business in question was operated by the acquiring franchisor (which would support a finding of capital account) or discontinued or remarketed (which would support a finding of income account).
If the expenditure is on income account and its deduction is not otherwise prohibited, it will be deductible in the year it is incurred. If the expenditure is on capital account it may be an "eligible capital expenditure". It will not be the cost of a class 14 asset if no property has been acquired.
Situation C
1. A Co. acquires all the issued and outstanding shares of Y Co., an operating company which holds a franchise originally granted by A Co. The franchise has a limited life and is treated as a Class 14 asset by Y Co. Y Co. has an undepreciated capital cost (UCC) balance in Class 14 in respect of the franchise.
2. Subsequent to the acquisition of Y Co., Y Co. is wound up into A Co. under the relevant corporate law and in circumstances such that the winding-up is subject to subsection 88(1) of the Income Tax Act (the "Act").
It is your view that A Co would be entitled to a terminal loss pursuant to subsection 20(16) (assuming that A Co. does not hold any other Class 14 property) of the balance previously in Class 14 of Y Co. "inherited" by A Co. pursuant to subsection 88(1) upon the winding-up of Y Co.
You also are of the opinion that the same results would occur if A Co. and Y Co. were to amalgamate in a manner such that section 87 of the Act applied.
Our Comments
In a winding-up of Y co into A co, A co does not acquire Y co's franchise (see discussion under situations A and B). Thus paragraphs 88(1)(a) and (c) do not apply to deem A co to have any cost in respect of the franchise nor Yco to have any proceeds. Y co has, nonetheless, disposed of the franchise and it appears that Y co would have a terminal loss.
Similarly, in an amalgamation, the amalgamated corporation would not acquire any property in respect of the franchise and would not be deemed to have any cost in respect of it. It appears the cost would simply disappear. This result appears to be inappropriate and unintended and the Department would closely examine any actual case to see if a more appropriate result could be reached.
Situation D
1. C owns franchise rights granted by A Co.
2. C wishes to dispose of the franchise and related business and for this purpose desires to incorporate Newco and transfer the franchise rights and related business to Newco, followed by a sale of the shares of Newco. (this will enable C to be eligible for the enhanced capital gains exemption on the sale of shares of a small business corporation.)
3. A Co., the franchisor, does not permit the transfer of franchise rights. A Co. does however permit franchise holders to negotiate the "sale" of their franchises to third parties. The third party typically pays the franchise holder to surrender his existing rights and A Co. issues a new franchise to the third party for no further consideration. In this manner, A Co. retains complete control of the process and is able to ensure the periodic updating of the terms of the franchises it grants.
4. In order to defer the gain on the "sale" of the franchise and incur a gain on the shares of Newco, C desires to file a joint election with Newco under subsection 85(1).
5. In order to accommodate the requirements of A Co. that the franchise not be transferred, C grants Newco an exclusive right or option to deal with C in connection with the negotiation of the surrender of C's rights and the acquisition of a new franchise from A Co. The consideration given by Newco for the right or option is shares of Newco. C and Newco propose to elect under subsection 85(1) an amount of $1 in connection with the grant of the option and the issue of shares. In the event that A Co. agrees to issue a new franchise to Newco, Newco will be entitled to cause C to surrender the existing franchise upon the payment of a sum of money (or the issue of a promissory note) for an amount less than the value of the franchise. The balance of the value will reside in the shares previously issued to C pursuant to the grant of the right or option. C then proposes to sell the shares of Newco to a third party for fair market value and will realize a gain on the sale.
It is your view that the option granted by C would be considered a capital property subject to subsection 49(1) of the Act and that it is property which is considered "eligible property" as defined by subsection 85(1.1) of the Act. It is also your opinion that paragraph 13(7)(e) would have no application and therefore the amount added by Newco to Class 14 in respect of the property would not be restricted.
Our Comments
Paragraph 5 of Situation D indicates that C grants Newco an exclusive right or option. We question whether the rights granted to Newco would in fact be an option (that is, a right, but not an obligation, to acquire a particular property for a specified price on or before a certain time or times) since it is not at all clear that Newco will have the right to acquire any property from C. Therefore, depending on the facts of the situation, subsection 49(1) of the Act may or may not apply. Also, depending on the facts, the rights granted may or may not be capital property. If they are, in fact, capital property, in our view they would also be "eligible property" within the meaning of subsection 85(1.1) of the Act by virtue of paragraph (a) thereof.
We cannot confirm your view that paragraph 13(7)(e) of the Act has no application in the situation described. It is our view that the words "directly or indirectly, in any manner whatever" used in the paragraph are broad enough to encompass the indirect transfer of depreciable property from C to A Co. to Newco even if the particular property is temporarily extinguished when held by A Co.
Other Issues
The Department may consider that paragraph 110.6(7)(b) of the Act is applicable if fair market value consideration is not received from Newco for the transfer of the option or exclusive right by C.
Also, unless one of the exceptions in paragraph 110.6(14)(f) of the Act is applicable, C would have to hold her shares in Newco for 24 months to meet the "holding period" test in the definition of "qualified small business corporation share" in subsection 110.6(1) of the Act.
Situation E
1. A Co is a franchisor and F is a franchisee holding an unlimited life franchise issued to it by A Co.
2. F wishes to transfer the franchise to a corporation, however, the franchise is, by its terms, not transferable. A Co., however, wishes to rid itself of the unlimited nature of F's franchise and convert the franchise to a limited life franchise in accordance with A Co's current corporate policy. Accordingly, A Co. agrees to issue a new limited life franchise to a newly incorporated company ("Newco") created by F, provided F surrenders the original franchise.
3. The franchise owned by F has a fair market value greater than its original cost to F. F has a balance of cumulative eligible capital in respect of the franchise and the business carried on by F.
You request our opinion on whether subsection 69(1) will apply in the above circumstances to deem F to have disposed of the franchise for fair market value. You also ask certain questions that relate to the nature of the property to Newco if an election is filed under subsection 85(1) of the Act in respect of the franchise. Our Comments
It is our view that subsection 69(1) of the Act would not apply in the circumstances described because F is not disposing of anything to a non- arm's-length person. However, in our view subsection 56(2) would likely apply to include the fair market value of the new limited life franchise issued to Newco in F's proceeds of disposition of the old franchise. It appears that the issue of the new franchise to Newco is a transfer of property to Newco made pursuant to F's direction.
Further, it is our opinion that an election under subsection 85(1) of the Act cannot be made by F and Newco with respect to the franchise because the franchise is not being disposed of to Newco. If the franchise is not transferable in law, it is our view that it cannot be the subject of an election under subsection 85(1) of the Act.
The foregoing expressions of opinion are given in accordance with the practice referred to in paragraph 21 of Information Circular 70-6R2 dated September 28, 1990 and are not binding on Revenue Canada, Taxation.
Yours truly,
for Director Reorganizations and Foreign Division Rulings Directorate Legislative and Intergovernmental Affairs Branch
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