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Citation: 2003TCC531
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Date: 20030731
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Docket: 2001-3832(IT)G
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BETWEEN:
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LENESTER SALES LTD.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent,
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AND BETWEEN:
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Docket: 2001-3852(IT)G
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SUSHI SALES LIMITED,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Bowman A.J.C.
[1] These appeals are from assessments
for the appellants' 1997 taxation years. They were heard
together on common evidence.
[2] Lenester Sales Ltd.
("Lenester") operated a Giant Tiger store in Pembroke,
Ontario, under a franchise and license from Giant Tiger Stores
Limited ("GTS") a Canadian corporation founded by
Gordon Reid with its head office in Ottawa. Lenester is now
wholly owned by Russell Bennett Kerr but in 1997, 501 of its
shares were owned by Mr. Kerr and 499 by GTS.
[3] Sushi Sales Limited
("Sushi") operated a Giant Tiger store in Campbellford,
Ontario. In 1984, 501 of the shares of Sushi were owned by
Mr. Havelock Bingley and 499 by GTS. In 1997, Mr.
Bingley's 501 shares were owned by 176485 Canada Limited, a
company whose shares were owned by Mr. Bingley and his wife
Mabel.
[4] The question in these appeals is
whether the appellants, who are both Canadian-controlled private
corporations ("CCPCs") are each entitled to the full
small business deduction under section 125 of the Income Tax
Act. In 1997, section 125 permitted a CCPC to deduct from the
tax otherwise payable by it 16 percent of the least of a
number of figures, one of which was its business limit for the
year. It is not suggested that Lenester or Sushi did not carry on
active businesses in Canada.
[5] Business limit is defined in
subsection 125(2) as $200,000 except where a corporation is
associated with another corporation, in which case it is nil
unless the associated corporation files an agreement allocating
the $200,000 among it and the other companies with which it is
associated or, failing such an agreement, the Minister of
National Revenue makes the allocation.
[6] In 1997, GTS had franchise
arrangements with between 80 to 90 corporations similar to those
it had with Lenester and Sushi. The Crown's position is that
Lenester and Sushi were each associated with GTS and therefore
with each other and indeed with the other 80 or 90 corporations
with which GTS had franchise arrangements. The reason for this is
that corporations associated with the same corporation are deemed
to be associated with each other.
[7] The basis for the contention that
GTS and the appellants are associated is that GTS "...
controlled directly or indirectly in any manner whatever
..." the appellants within the meaning of paragraph
256(1)(a) of the Income Tax Act.
[8] Subsection 256(5.1) reads:
For the purposes of this Act, where the expression
"controlled, directly or indirectly in any manner
whatever," is used, a corporation shall be considered to be
so controlled by another corporation, person or group of persons
(in this subsection referred to as the "controller") at
any time where, at that time, the controller has any direct or
indirect influence that, if exercised, would result in control in
fact of the corporation, except that, where the corporation and
the controller are dealing with each other at arm's length
and the influence is derived from a franchise, licence, lease,
distribution, supply or management agreement or other similar
agreement or arrangement, the main purpose of which is to govern
the relationship between the corporation and the controller
regarding the manner in which a business carried on by the
corporation is to be conducted, the corporation shall not be
considered to be controlled, directly or indirectly in any manner
whatever, by the controller by reason only of that agreement or
arrangement.
[9] The facts are not particularly in
dispute. GTS prior to, during and after the year in question
carried on the business of franchising the discount department
store business to independent operators who would operate the
stores.
[10] The arrangements were essentially as
follows: GTS would lease retail premises and then sublease them
to the franchisees, such as the appellants, or, if it owned the
store it would lease it to the franchisee.
[11] GTS would carefully select the people
who were to operate the franchises. For example, both Mr. Kerr
and Mr. Bingley had had many years of experience managing Woolco
or Woolworth department stores throughout Canada. There was a
period of training, which could run from six months to a couple
of years, in which they operated a store owned or leased by GTS.
Mr. Greg Farrell, the vice-president (finance) of GTS,
testified that there was a great deal more supervision and
control of the operation by GTS during the training period than
after the franchise took over.
[12] After the training period Mr. Kerr and
Mr. Bingley were offered a franchise to run the stores at
Pembroke or Campbellford, respectively. The pattern in this case
was, I understand, typical of that in the case of the other
franchisees. The arrangement entailed a number of aspects:
(a) the individual, such as Mr.
Kerr and Mr. Bingley, would acquire from GTS for a nominal
consideration 501 of the 1,000 shares of the existing operating
company (Lenester or Sushi). GTS retained 499 shares. A
shareholders' agreement was entered into between GTS, the
individual (referred to as the "executive" in the
Lenester agreement or the "manager" in the Sushi
agreement) and the company (Lenester or Sushi).
Mr. Arnell Goldberg, a solicitor also signed as escrow
agent.
[13] A few of the provisions of the
shareholders' agreement should be noted. The executive was to
be hired by the company as an employee and was to devote his full
time to his employment with the company. His remuneration was to
be determined from time to time by the board of directors.
[14] There were to be two directors, one a
nominee of GTS and one a nominee of the executive. The
shareholders agreed to vote their shares to effect this result.
There were to be no casting votes.
[15] There was a typical shotgun clause
permitting one shareholder to offer to sell his (or its) shares
to the other one who had to either accept or make the same offer
to sell to the other.
[16] In the Sushi agreement the shotgun
clause is slightly different, but its effect is the same.
Moreover, in the Sushi agreement it is provided that in the event
that there is a disagreement between the directors or the
shareholders relating to the conduct of the company either
shareholder can call a general meeting to pass a resolution
winding up the company.
(b) The second part of the arrangement
is the franchise whereby GTS grants a franchise to the franchisee
(Lenester or Sushi). Sections III and IV of the Lenester
franchise agreement read:
SECTION III - GRANT OF FRANCHISE
3.1 Subject to the terms
and conditions set forth in this Agreement, Franchisor hereby
grants to Franchisee, Franchisee hereby accepting, the right and
license to operate a Franchised Store, utilizing the System as
well as the Trade Marks, at the Premise, as well as the right to
indicate to the public that the business carried on thereat is
being operated as part of the System.
32. Franchisee
acknowledges and agrees that the right and license granted to it
herein are non-exclusive and are granted for use only at the
Franchised Store at the Premises, and such grant shall not in any
way hinder or prevent Franchisor from granting additional rights
and licenses as it, in its sole discretion may determine, to any
person, firm, partnership, corporation or other entity (including
Franchisor itself) for the use of the Trade Marks and/or the
System elsewhere than at the Premises.
3.3 Subject to the
provisions of paragraph 9.1.13 hereof, Franchisee shall not,
except with the prior written consent of Franchisor, use or
permit the use of any other trade mark, trade name or commercial
symbol in connection with the Franchised Store, nor use or permit
the use of the System or the Trade Marks, or any information
contained in the Manual, except in connection with the Franchised
Store.
SECTION IV - TERM AND RENEWAL
4.1 The term of this
Agreement, unless sooner terminated in accordance with the terms
and conditions hereof, shall be for a period of one (1) year
commencing on the date of execution hereof.
4.2 This Agreement shall
be renewed each year for a period of one (1) year unless either
party has delivered to the other three (3) months prior written
notice of its intention not to renew this Agreement.
The term of the Sushi franchise was 10 years, renewable for a
further 10 years.
[17] There is nothing unusual about the
franchise agreements. They certainly impose serious limitations
on the way this business is conducted. This, however, is typical
of all franchise agreements. One requirement in the Sushi
agreement is that the business be operated in accordance with an
operations manual. The manual was not put in evidence but I
understand it is lengthy and detailed.
(c) The third aspect of the
arrangement is the lease from GTS to the franchisee companies.
There is nothing unusual about the leases here.
(d) One final aspect upon which
counsel for the respondent placed some emphasis is the banking
and financial arrangements.
[18] Every day or bi-weekly the cash
receipts for the business would be deposited in Lenester or Sushi
bank accounts in Pembroke or Campbellford, as the case may be.
Once a week they would be transferred to the company's bank
account in the Canadian Imperial Bank of Commerce
("CIBC") in Ottawa. The amounts in all of the
franchisees' accounts at the CIBC in Ottawa are notionally
"pooled" along with the account of GTS and interest
paid on this amount. Where the particular franchisee's
account was in a deficit position it was charged interest.
[19] The purchasing function was also
performed by GTS. Inventory was either shipped from the GTS
warehouse or purchased from suppliers who billed and were paid by
GTS. GTS charged no mark-up on goods it supplied from its
warehouse or on goods shipped directly by the supplier to the
franchisee's store.
[20] The respondent contends that GTS
controlled the franchisees because of the wording in the first
half of subsection 256(5.1) and that the appellants are not saved
by the "franchise exception" in the second half of that
subsection.
[21] Counsel for the respondent accepts that
the franchise agreements are within the franchise exception but
contends that the shareholders' agreement and the financial
and banking arrangements do not fall under the wording of the
exception in subsection 256(5.1). The appellants contend that
they do not fall under the first part of subsection (5.1) and
that even if they did, they are within the exception in the
second part.
[22] Before dealing with subsection (5.1),
let us consider just what we have here. We have a successful
franchising operation run by GTS that enables small business
persons like Mr. Kerr and Mr. Bingley and their wives to engage
in business operations that they could never have engaged in by
themselves. By entering into such arrangement with GTS they
obtain numerous advantages:
(a) They are required to put up
only nominal capital;
(b) They have the advantage of
stepping into an existing and successful commercial retailing
operation;
(c) They can use well-known
trademarks;
(d) They have the economic benefits of
the purchasing, supply and distribution system of a large
organization; and
(e) They integrate with the
financial, banking and accounting system of a large organization
which handles their financial, banking and income tax affairs
competently and efficiently.
[23] They give up, of course, a measure of
independence but it is a part of a mutually advantageous business
relationship and it enables them to survive in competition with
huge organizations like Wal-Mart. The franchisor, GTS, requires
that the franchisee adhere to certain practices and procedures.
This is necessary to protect its goodwill, its trademarks and its
reputation. It is also necessary to protect the other franchisees
because if a customer has a bad experience with one franchised
outlet he or she may well regard all the other stores in the same
light.
[24] Nonetheless, it appears from the
evidence that the operators of the franchisees, such as Mr. Kerr
or Mr. Bingley enjoyed substantial autonomy in the way they ran
the business. This is hardly surprising, given the extensive
experience each of them had in merchandising before joining the
GTS organization.
[25] I would be remiss if I did not mention
the great contribution made by the wives of Mr. Kerr and Mr.
Bingley, Susan and Mabel. They worked with their husbands in the
stores and helped build them into successful operations.
[26] This strikes me as a perfectly ordinary
franchise operation, with the necessary and usual conditions and
restrictions imposed by the franchisor, but not inordinately
so.
[27] My conclusion is confirmed by the
evidence of John Sotos. Mr. Sotos is a lawyer with extensive
experience in franchising. He has published widely in the field.
He examined the GTS franchise operations and interviewed not only
the Kerrs and Bingleys but also the operators of several other
franchises as well as officers of GTS. I found Mr. Sotos an
impressive and knowledgeable expert witness and I have no
hesitation in accepting his report in its entirety. To illustrate
how typical the GTS arrangement is of franchising as it is done
in Canada, I am reproducing a portion of Mr. Sotos' report
that deals with such franchises:
Product franchising and business format franchising can each
be conducted by three different methods: unit franchising, area
development franchising and sub-franchising (often called
"master franchising"). The current Giant Tiger
franchise network is an example of unit franchising. In unit
franchising the franchisor licenses the franchisee to establish
and operate the franchise business at a single defined location
(or for a mobile franchise, along a defined route). The parties
enter into a "unit franchise agreement" and (usually)
one or more ancillary contracts (examples: sublease,
equipment/sign leases, supply agreement, security agreement,
owners' personal guarantees, directors'/officers'
confidentiality/non-compete agreements), all of which together
define the parties' obligations regarding the establishment
and operation of the franchisee's business.
There are many variations of unit franchising. One of these,
commonly called "joint venture franchising", involves
the franchisor taking an equity interest in its franchisee. A
corporation, limited partnership or other suitable investment
vehicle is created to hold the franchise and the franchisor then
grants unit franchise rights to the joint venture franchise
vehicle in the usual manner. The franchisor holds an equity
interest in the franchise vehicle. A separate shareholder,
partnership or other joint venture agreement is entered into to
define the parties' respective rights and obligations
regarding ownership and control of the joint venture franchisee.
The Lenester and Sushi franchises under review are typical
examples of joint venture unit franchises.
There are many reasons why a franchisor may want to use joint
venture unit franchising. For example, a franchisor may choose to
use the technique in order to assist undercapitalised individuals
(perhaps recently-graduated professionals such as pharmacists, or
perhaps managers of franchisor-owned outlets who have proven to
be exceptional retailers) to get into business for themselves,
since these individuals are either necessary as franchisees (the
regulated professionals) or highly desirable as franchisee (the
proven managers). Sometimes the joint venture franchisee will buy
out the franchisor's interest in the franchise business over
time from the franchisee's share of profits, but that is not
a necessary feature of a joint venture franchise.
[28] In his report Mr. Sotos described the
controls that the franchisor typically exercised over the
franchise. These controls are necessitated by both practical and
economic exigencies and by legal necessity. After discussing the
controls exercised in the GTS franchises he concluded as
follows:
4) The Giant
Tiger Franchise Operation
The 1995 Lenester Franchise Agreement and Sublease, and the
1982 Sushi Franchise Agreement and Sublease, contain most of the
controls discussed in the foregoing section of this report (those
relating to site selection and build-out are of course absent
since the franchise stores were already in existence when the
agreements were entered into). Those agreements do not contain
any controls that go beyond those I have listed. As well, it
appears from each of my franchisee interviews that GTS not only
does not impose controls outside those in its written contracts,
in practice it does not enforce all of the controls which are in
its written contracts. Each of the franchisee shareholders I
interviewed said that he, and not GTS, made all of the day-to-day
business decisions concerning his outlets. Therefore it is my
opinion that:
(a) the controls
imposed by GTS on Lenester and Sushi through the Franchise
Agreement and Sublease are typical of a business format unit
franchise;
(b) with a few
exceptions (discussed below), the Lenester and the Sushi
Franchise Agreements and Subleases are typical of the types of
franchise agreement and sublease customarily used by a franchisor
engaged in unit franchising; and
(c) again with the
same exceptions, the relationships and business arrangements
between GTS and the Appellants (as reflected in the Lenester and
Sushi Franchise Agreements, Subleases and Shareholders
Agreements, and in the information which I obtained during my
interviews with Messrs. Kerr, Havelock and the GTS managers), are
typical of those enjoyed by the parties to a joint venture unit
franchise.
As you requested, I will discuss those few aspects of the
Appellants' franchises that are somewhat out of the
ordinary.
[29] The aspects of the arrangements that he
considers somewhat out of the ordinary are:
(a) the unusual fairness to the
franchisee;
(b) the nominal initial franchise fee
paid to GTS; and
(c) the one-year initial term in the
Lenester agreement (albeit renewable).
His view was that these are not standard but they are not
unusual. I do not see in them a reason for dismissing the
appeals. For example, the low initial fee paid to GTS simply
reflects the corporate policy of GTS not to make money on the
initial fee, as some franchisors do, but on the service fees
payable during the carrying on of the operation. This has the
advantage of permitting people like Mr. Kerr and Mr. Bingley
without a large amount of capital to become franchisees in the
GTS organization without a large initial capital outlay.
[30] Do the controls exercised by GTS over
the operations of the franchisees amount to de facto
control as contemplated by subsection 256(5.1)? Certainly GTS did
not have de jure control since it did not have over 50
percent of the votes and could not elect the board of
directors.[1]
[31] I can see nothing in these
arrangements, including the documents and the shareholders'
agreements, the leases and the franchise agreements that could
result in control in fact of either Lenester or Sushi. The
banking, financial and accounting arrangements do not give
control to GTS. The classic statement on the meaning of de
facto control of a corporation is found in Silicon
Graphics Ltd. v. R.:[2]
66 The case law suggests
that in determining whether de facto control exists it is
necessary to examine external agreements (Duha Printers,
supra, at 825); shareholder resolutions (Caouette v.
Canada (Minister of National Revenue),[1996] T.C.J. No. 1568
(T.C.C.), para. 10); and whether any party can change the board
of directors or whether any shareholders' agreement gives any
party the ability to influence the composition of the board of
directors (International Mercantile Factors Ltd. v. R,
(1990), 90 D.T.C. 6390 (Fed T.D.) at 6399, aff'd (1994),
94 D.T.C. 6365 (F.C.A.); and Multiview Inc. v. R, 97
D.T.C. 1489 (T.C.C.) at 1492-93).
67 It is therefore my view
that in order for there to be a finding of de facto
control, a person or group of persons must have the clear right
and ability to effect a significant change in the board of
directors or the powers of the board of directors or to influence
in a very direct way the shareholders who would otherwise have
the ability to elect the board of directors.
[32] Applying that test obviously GTS had no
such right.
[33] Even applying the somewhat broader
interpretation suggested in some cases, such as
Société Fonçière
D'Investissement Inc. v. R.[3] and Transport M.L. Couture Inc. v.
R.,[4] it is clear that GTS had no direct or
indirect influence that would result in control in fact of
Lenester or Sushi.
[34] Even if I am wrong in this conclusion,
I think the GTS arrangement is precisely the sort of thing that
the franchise exception in the second part of subsection 256(5.1)
is aimed at. Parliament obviously recognized that franchisors
frequently exercise significant control over the way franchisees
run their operations. To refuse to apply the exception in this
case would be to write the exception substantially out of the
Act. Counsel argues that the banking and financing
arrangements as well as the shareholders' agreements are
outside of the exception. I do not accept this. The financial
arrangements are an essential part of the overall arrangements as
are the shareholders' agreements. They are all part of the
extremely broad range of contractual and financial arrangements
between franchisors and franchisees contemplated by subsection
256(5.1). Why the CCRA wishes to whittle away at this extremely
beneficial exception to the rule in subsection (5.1) for
franchise arrangements that form so important a part of the way
business is done in Canada and that enable small entrepreneurs to
compete with big and aggressive multinationals is, I must
confess, utterly beyond me. Their purpose is to govern the
relation between GTS and the franchisee as to the manner in which
the business is to be conducted.
[35] I am also of the view that the
franchisees and GTS were at arm's length. They had separate
interests and there was certainly no single or controlling mind.
Nor can it be said that they "acted in concert" in a
way that deprives the relationship of its arm's length
nature. To say that every time two independent business persons
in pursuit of their own business interests work together to
achieve a mutually beneficial commercial objective means that
they are "acting in concert" and are, therefore, not at
arm's length would mean that no business relationships would
ever be at arm's length.
[36] Counsel for the respondent pointed out
what might be an anomaly. He noted that if a franchisor
controlled a franchisee in such a way that the first part of
subsection 256 (5.1) applied it would follow that they would
necessarily not be at arm's length and therefore the
exception in the second part could never apply. He suggests that
therefore the phrase "dealing at arm's length" is
to be interpreted as implicitly being qualified by the word
"otherwise" if it is to make any sense. I tend to agree
with him but it is not necessary to reach a definitive conclusion
on that point in this case.
[37] The appeals are allowed with costs and
the assessments for the appellants' 1997 taxation years are
referred back to the Minister of National Revenue for
reconsideration and reassessment on the basis that neither
appellant was controlled by Giant Tiger Stores Limited, was not
associated with Giant Tiger Stores Limited or any other
corporation with which Giant Tiger Stores had a franchise
arrangement, and was therefore not required to allocate any
portion of their respective business limits to any other
corporation for the purpose of determining their small business
deduction under section 125 of the Income Tax Act.
Signed at Ottawa, Canada, this 31st day of July, 2003.
A.C.J.
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