Yesac Creative Foods Inc. v. MNR, 91 DTC 413, [1991] 2 CTC 2622 (TCC)

Bonner, T.CJ:— This is an appeal from an assessment of income tax for the appellant’s 1983 taxation year. During that year, the appellant entered into leases of premises in Ottawa and in Oshawa and received from the landlord payments described as "fixturing allowances”. The respondent included those payments in the computation of the appellant's income for the year on the basis that they were received in the ordinary course of the operation of its business. The appellant took the position that the amounts in question did not constitute business income but rather were non-taxable capital receipts received in connection with the expansion of the capital structure of its business.

In 1980, the appellant opened its first restaurant. The operation was very successful. Three months after the opening a decision was made to open a second restaurant, it too was successful. Soon, the appellant operated five restaurants. The rapid expansion required a great deal of capital. By 1982 the appellant found that it was both difficult and expensive to borrow money. The management of the appellant therefore considered expansion by franchising. A firm of franchising consultants was retained. There followed a period during which new restaurants were opened under franchise arrangements. As well, existing restaurants which had been directly operated by the appellant were converted to franchise operations. The conversion must have been very rapid. The appellant did not directly operate any restaurants during the 1983 fiscal period. The payments now in issue were made to the appellant by the landlord of the first two restaurants which from the beginning were franchise operations.

At the hearing of the appeal, evidence was given by Cazmer Wisniewski who is secretary-treasurer of the appellant and one of the principals of the company. In his evidence, he outlined the history of the company as briefly summarized above. He explained that under the franchise arrangements the role of the appellant was to provide support and expertise to the franchisee with respect to the location, marketing and operation of restaurants. Central buying services, accounting services, supervision of operations, control of labour and food costs ana staff training were provided to franchisees. He stated as well that the appellant's objective was not the sale of franchises in order to earn a “fast dollar”, but rather the earning over a long period of time of royalties calculated at four and one half to five per cent of the franchisees' gross sales.

In the two cases now in question the space for the proposed restaurants was leased from the Campeau Corporation ("Campeau"). The space was located in shopping malls owned by Campeau. Initially the space to be leased was nothing more than an empty shell. Thus, the appellant was faced with greater fitting-out costs than would have been involved had it taken over premises formerly used as a restaurant. In such cases plumbing, mechanical and electrical systems were normally in place already. Each of the leases from Campeau contained the following clause:

19.08 (3) Fixturing Allowance

The Landlord shall give to the Tenant a fixturing allowance of ONE HUNDRED, FIFTEEN THOUSAND DOLLARS ($115,000) [$50,000 in the case of the Oshawa lease] which shall be paid to the Tenant once the following conditions have been met:

(a) the Landlord has received and approved the Tenant's architectural, structural, mechanical and electrical plans and specifications;

(b) the Tenant’s work has been completed to the satisfaction of the Landlord in

accordance with the plans and specifications approved by the Landlord;

(c) the Tenant has produced evidence satisfactory to the Landlord that all accounts relating to the Tenant's work have been paid and that no lien has or may be claimed with respect thereto;

(d) the Landlord has received complete "AS BUILT” drawings certified by the Tenant's architect with respect to all work done by the Tenant in the Leased Premises;

(e) the Lease has been executed by the Tenant and delivered to the Landlord;

and

(f) the Tenant has taken occupancy of the Leased Premises and has opened the Leased Premises for business fully fixtured, stocked and staffed on the Commencement Date.

Each of the leases also provided:

The Tenant further agrees that all Leasehold Improvements made at any time prior to or after the Commencement Date, whether by the Tenant or the Landlord, shall immediately upon affixation or installation become the property of the Landlord and shall remain upon the Leased Premises . . .

The fixturing allowances were paid by Campeau on behalf of the appellant to contractors, suppliers and others engaged in fitting out the leased premises for use as restaurants. It should be noted that no significance was attached to the fact that payment was made by Campeau to such persons and not to the appellant directly.

It was the appellant's intention from the outset that the Ottawa and Oshawa restaurants would be operated by franchisees. The franchise agreements were substantially similar. Both called for payment to the appellant of an initial franchise fee and for a royalty computed as a percentage of gross sales. The Ottawa agreement provided:

8. INITIAL FRANCHISE FEE

The Franchisee shall pay to the Franchisor a non-recurring and non-refundable (except on the conditions, and to the extent, stated in paragraph 14B) Initial Franchise Fee for the Franchise in the amount of Twenty Five Thousand Dollars ($25,000), payable upon the execution of this Agreement. The Initial Franchise Fee shall be deemed to have been fully earned by the Franchisor when paid.

9. ADDITIONAL FEES

9A. ROYALTY AND SERVICE FEE

The Franchisee shall pay to the Franchisor by the seventh (7th) day of each month throughout the Term a monthly Royalty and Service Fee of four and one half percent (41/2%) of his Gross Revenue for the preceding month.

The agreement with the Oshawa franchisee is not materially different.

The appellant sublet the premises to the franchisees. The subleases each provided in part:

NOW, THEREFORE, in consideration of these premises and the mutual covenants herein set forth, it is hereby agreed by and between the parties hereto that:

1. GRANT OF SUBLEASE

The Franchisor's Affiliate hereby subleases to the Franchisee the Leased Premises for and during a term commencing on the date that the Franchisor provides the Franchisee with vacant possession of the Leased Premises and ending on the termination date of the Master Lease, less one day, in accordance with and subject to the terms, covenants and conditions contained in this Sublease and to the observance and performance by the Franchisee of all the terms, covenants and conditions contained in the Master Lease to be observed and performed by the Franchisor's Affiliate with respect to the Leased Premises. Breach of such terms, covenants and conditions by the Franchisee shall be deemed a breach hereof. The Franchisor's Affiliate covenants with the Franchisee for quiet enjoyment. If at the end of the term of this Sublease the Franchisee, with the consent of the Franchisor, continues to occupy the Leased Premises, then the Franchisee shall be deemed to be a monthly sub tenant and shall remain therein subject to the terms of this Sublease.

In the five years following the year under appeal 22 new restaurants were opened. Mr. Wisniewski stated that in about 30 per cent of those cases inducement payments were received from landlords. By the end of the 1986 fiscal period the appellant had received six of them totalling $1.3 million. Mr. Wisniewski also stated that in 90 per cent of the cases in which such payments were received the premises leased were empty shells.

In the appellants financial statements for the 1983 fiscal period it

(a) included the initial franchise fees in computing income;

(b) deducted as a current expense, the fitting-out costs including the amounts which had been paid by Campeau on its behalf;

(c) entered the inducement payments on the balance sheet under the heading "shareholders" equity.

A note to the financial statements explained:

During the year the company has received payments from lessors to induce them to lease premises in the lessors' buildings. These payments have been reflected on the balance sheet as an increase in shareholders equity.

Evidence was given by James Corless, a chartered accountant and partner in the accounting firm which prepared the appellant's financial statements. He was the partner who supervised the preparation of the financial statements for the year under appeal. He stated that he decided to account for the inducement payment in this manner after reviewing statements in accounting text books dealing with similar situations. One such statement read:

Sometimes a corporation will receive a gift or a donation of an asset or assets. For example, as an inducement to locate a plant in a particular city, a corporation may receive a plant site as a gift. Such a donation increases both assets and stockholders' equity by the fair value of the contributed asset. The increase in stockholders' equity is contributed capital, capital contributed by others than the stockholders.

He referred as well to a definition of “contributed surplus" which included capital donations from sources other than shareholders. This evidence is not helpful. The accounting treatment adopted in relation to the shareholders' equity entry can be correct only if the inducement payments were received on capital account. That, of course, is the central point in dispute.

Counsel for the appellant argued that the taxpayer is not trading in franchises which are sold and then cease to be of importance to it. He pointed out that the location of individual restaurant premises is absolutely critical to the success of the business of the franchisees and, by reason of the ongoing stream of royalty revenue, critical to the appellant as well. He emphasized that the appellant remains liable to the landlord on the lease notwithstanding the subletting to the franchisee. He submitted that the leases are part of the appellant's permanent capital structure and that the payments in issue relate only to the leases. Revenue from franchise sales was not, he said, a profit centre to the appellant, the appellant's profit was, he said, generated by the royalty stream and not by activities involved in launching a franchise. He relied, inter alia, on the decision in Consumers' Gas Company Ltd. v. The Queen, [1982] C.T.C. 339; 82 D.T.C. 6300 (F.C.T.D.); [1984] C.T.C. 83; 84 D.T.C. 6058 (F.C.A.); [1986] 1 C.T.C. 380; 86 D.T.C. 6132 (F.C.T.D.); [1987] 1 C.T.C. 79; 87 D.T.C. 5008 (F.C.A.).

The issue in Consumers' Gas was quite different. Those cases dealt with reimbursements in respect of the cost of relocating capital assets. Here the issue is whether the leasehold inducement payments were received as a result of a transaction or operation which is an integral part of the current profitmaking activities of the appellant's business. A payment as a result of such a transaction must be included in the income from the business (M.N.R. v. Independence Founders Ltd., [1953] C.T.C. 310; 53 D.T.C. 1177). In considering such a question it is important to remember that:

In deciding upon the meaning of income, the courts are faced with practical considerations which do not concern the pure theorist seeking to arrive at some definition of that term, and where it has to be ascertained for taxation purposes, whether a gain is to be classified as an income gain or a capital gain, the determination of that question must depend in large measure upon the particular facts of the particular case.

Per Abbot, J. in Oxford Motors Ltd. v. M.N.R., [1959] C.T.C. 195; 59 D.T.C. 1119 at 202 (D.T.C. 1122). ;

It is also of importance to remember what a business is:

Ordinarily, a business is a scheme involving a series of transactions of one or more modes of dealings, more or less repetitive, for making a profit from the total activities.

Per Rand, J. in Gairdner Securities Ltd. v. M.N.R., [1954] C.T.C. 24; 54 D.T.C. 1015 at 27 (D.T.C. 1016).

I am of the view that the inducement payments formed part of the income from the appellant's business. That business consisted of the creation of prepackaged restaurants with a view to selling them to franchisees. It was the franchisees who were intended to operate the restaurants although with the ongoing supervision and guidance of the appellant. In consideration the appellant was to receive both initial franchise fees and a stream of royalties based on the gross sales of the franchisees. It was in the course of acquiring and preparing the restaurant premises which were intended to form part of the package to be sold that the inducement payments were received. [1] The royalties were not the only revenues generated by the ordinary operations of the appellant’s business. The franchise fees and inducement payments were also a product of such operations. It matters not that such payments were insignificant in the overall scheme of the business.

The suggestion that the inducement payments were incidental to the creation of a capital structure intended to generate a stream of royalty payments over a long period of time is at odds with the facts. The payments were made to induce the appellant to enter into leases which it intended to turn over to franchisees for use by them as restaurants. It is of no practical significance that the mechanism chosen to put the franchisees in possession of their restaurants was a sublease and not an assignment of the lease with the consequence that the appellant as sublessor retained a one day reversion. No capital structure which included the leases was either created for the benefit of the appellant or retained by it.

Counsel for the appellant argued in the alternative that the inducement payments, if income, should be amortized or brought into income over the term of the lease in respect of which they were paid. He relied on Tower Investment Inc. v. M.N.R., [1972] C.T.C. 182; 72 D.T.C. 6161 as authority for the proposition that revenue and expenses should be matched. It is sufficient to note that if the inducements received are to be matched with any expense incurred the relevant expense must be the fitting-out costs. Those costs were deducted by the appellant on a current basis. There is no basis for deferring recognition of the revenues.

For the foregoing reasons the appeal will be dismissed.

Appeal dismissed.