R.L. Petersen v. Minister of National Revenue, [1988] 1 CTC 2071, 88 DTC 1040

Rip, T.C.J.: —In 1980, Mr. Reginald L. Petersen, the appellant, and a Mr. James A. Ross disposed of a day-care centre including land, building and equipment, to Andrej and Irena Vestenicky for an aggregate sale price of $157,500. The vendors and purchasers allocated the purchase price in the agreement of purchase and sale as follows:

Mr. Petersen filed his 1980 income tax return reporting his share of the proceeds of disposition allocated in the manner provided for in the agreement of purchase and sale.

The respondent, the Minister of National Revenue, did not consider reasonable the appellant's allocation of purchase price for the assets sold, and applying the provisions of section 68 of the Income Tax Act (“Act”), adjusted the allocation to what he considered reasonable. In reassessing the Minister assumed that at the time of disposition of the property in 1980, the land had a fair market value of $30,000, the building had a fair market value of $126,500 and the equipment had a fair market value of $1,000. On the basis of these values there resulted a recapture of capital cost allowance of $48,087 and a terminal loss on the sale of the equipment of $45. The recapture of capital cost allowance was calculated as follows:

The terminal loss resulting on the sale of the equipment was calculated as follows:

The building was a former church, acquired by the appellant and James Ross, each to as one-half undivided interest, in 1974 for $98,000, of which $22,469 was allocated as to the land, $75,531 to the building. The property (sometimes referred to as "subject property" or “church property") is located in Cambridge, Ontario. The original building was constructed in the early 1940's with a peaked roof; an addition was built sometime in the 1950’s.

The appellant and Mr. Ross purchased the property with a view to operating a children’s day-care centre on the site. In order to make the building acceptable for a child-care centre Mr. Petersen and Mr. Ross expended approximately $41,000 renovating the property. Renovations included the building of partitions and children’s washrooms and dropping the ceiling, thus making the building's use that of a child-care centre and reducing the flexibility of the building for other purposes.

At the same time as acquiring the church property Messrs. Petersen and Ross acquired another property across the lane from the church property. This property, with a house on it, had an area of 5,970 square feet. This property was acquired for rental purposes and in fact was rented. It was sold in 1982 for $25,000. The purchase price was allocated as to $5,220 to the land and $19,780 to the building.

Prior to acquiring the church property neither Mr. Petersen nor Mr. Ross had operated a child-care centre. Their previous experience had been in the operation of nursing homes. They hired a lady with child day-care experience to be the administrator of the centre. This lady took full responsibility for the day-to-day operations of the centre, including the hiring of employees and dealing with the families of the children who attended the centre. Messrs. Petersen and Ross would consult with her.

Mr. Petersen described the day-care centre as an "average-type day-care centre". He stated that he was familiar with the Day Nursery Act of Ontario, under which day-care centres operated, and had visited a few day-care centres prior to acquiring the property.

Mr. Petersen stated that the property was purchased to find a use for it and once this use was established, to sell the property. "From day one,” Mr. Petersen stated, "the business was for sale”.

The principal issue before me is whether or not the business of the daycare centre had a goodwill at the time of disposition, and if it did have a goodwill, whether $45,000 was a reasonable value of the goodwill.* [1] Mr. Petersen indicated that the day-care centre had a goodwill since what was being sold was an on-going business. Eighty children attended the centre at the time of sale and it was assumed these eighty children would continue to attend. In addition the centre had ten teachers on staff and was licensed by the Government of Ontario to operate the day-care centre. Mr. Petersen also indicated that the centre had a favourable relationship with the Region of Waterloo to care for the children; it also had contracts with various suppliers.

Messrs. Petersen and Ross commenced operating the day-care centre in parternship in 1975. In the first year of operation they incurred a loss in the amount of $40,557.04. The loss from operations in 1976 was $30,805; in 1977 the loss from operations was $18,865 and in 1978 the loss was $19,337. In the last year, 1979, the day-care centre was operated by Mr. Petersen and Mr. Ross, the loss from operations for ten months was $23,564. Gross revenue in each of the years was as follows:

The year-end of the partnership was November 30.

In 1979 the partnership carried on its business operations only until October 1, at which time it leased the premises to the purchasers pursuant to the agreement of purchase and sale. The agreement of purchase and sale provided that the vendors would lease the property to the purchasers for a period from October 1, 1979, or at such time as a licence to operate the daycare centre was issued; if such licence was to be issued earlier, the purchasers had the option "to take possession at such earlier date, to the closing date August 31st, 1980”. The purchasers took possession of the property on August 31, 1980.

The business had been carried on under the name Cambridge Children's Centre. In cross-examination counsel for the Minister produced to Mr. Petersen a letter addressed to him and Mr. Ross dated March 27, 1979, by the Ministry of Social Services, Waterloo Area Office. A consultant from the Waterloo Area Office of the Ministry had visited the Centre on March 22, and found it wanting in several respects; the consultant recommended the issue of a licence for only three months, during which time the consultant's recommendations could be implemented. The report of the visit indicated that the premises were dirty. The washrooms' walls, floors and fixtures were not clean and a strong smell of urine emanated throughout the washrooms and extended to the playrooms. The playrooms themselves had paint-splattered walls; the storage areas were cluttered and disorganized. The number of toys was limited and books and equipment were not attractively presented and were in poor condition. The playground's space did not seem adequate for the number of children attending the centre and lacked equipment. On June 23, 1979, the Ministry of Community and Social Services issued a renewal of licence to operate a day nursery to Messrs. Petersen and Ross, such licence to terminate on December 22, 1979.

In respect of the allocation of the purchase price Mr. Petersen testified that while the vendors and purchasers negotiated the purchase price he was not sure whether the allocation of the purchase price itself was subject to bargaining or negotiation. He stated that the "numbers were small and if the purchasers were not happy" he was sure he would have agreed to alter the allocation. He did not remember any "badgering" between the purchasers and himself, nor could he state whether the allocation was what he originally suggested.

Mr. Petersen stated that he could not recall whether he approached the purchasers to sell, or the purchasers approached him to purchase, the centre. He was aware that the purchasers owned and operated a day-care centre in Kitchener, not far from Cambridge.

Mr. S.R. Vaughan, a senior real estate appraiser with Revenue Canada, testified on behalf of the respondent. He is employed by the respondent in its Kitchener District Office. Mr. Vaughan has been a real estate appraiser since 1968, and since 1975 has been a member of the Appraisal Institute of Canada. He has been active in the Institute and has given courses on real estate appraisals in the Kitchener area. Counsel for the appellant consented to Mr. Vaughan being qualified as an expert witness.

Mr. Vaughan appraised the subject property to determine its market value and also to allocate the market value as to land and buildings as at October 1979, when the agreement of purchase and sale between the appellant and Mr. Ross, as vendors, and Mr. and Mrs. Vestenicky, as purchasers, was executed. Mr. Vaughan's appraisal of the subject property and allocation of the proceeds of disposition were used in making the assessment herein appealed from.

According to Mr. Vaughan's appraisal report the subject property is located in an older residential area of Cambridge. The homes in the area are mainly detached single-family residences, many of which were built prior to 1900. The property had a frontage on Brook Street of 110 feet and a depth of 120 feet on Cambridge Street for a total area of 13,200 square feet. The original church structure was framed with brick exterior, the addition was framed with concrete blocks on one side and brick on the front. In 1979 the City of Galt, now known as the City of Cambridge, designated the subject property as a general residential property by by-law no. 5319, passed on February 15, 1965. Because there were some questions as to whether this zoning specifically permitted a day-care centre a by-law 1901 was passed on May 19, 1981, specifically addressed to permit this type of property to be included in this zone.

Mr. Vaughan agreed the highest and best use of the property, that is, the use which was produced to the greatest benefit in either money or amenities over a given period, was as a day-care centre.

Before undertaking the valuation of this property Mr. Vaughan satisfied himself that the aggregate purchase price of $157,500 was market value. In satisfying himself that the purchase price was indeed market value he relied upon a sale in October 1979 of another church in Cambridge for $60,000. This property consisted of a 45-foot x 125-foot lot improved with a 3,400 square-foot church of brick, block and frame construction, originally built in 1924 and with an addition built in 1960. Mr. Vaughan considered this sale and costs of conversion of the subject property to a day-care centre in satisfying himself that the sale price for the subject property was representative of its market value for land, building and equipment.

Mr. Vaughan determined the value of the subject property and its component parts by applying the cost approach. In this approach, he explained, value is estimated by adding the market value of the land to the depreciated reproduction cost new of the improvements. He explained the value of the land itself is based on similar land sales on the market place and once determined, the land value is added to the reproduction cost new of the improvements as of the effective date less a loss from cost new due to the physical deterioration, functional or economic obsolescence. Mr. Vaughan was of the view that an income approach, whereby an income property is capitalized to determine value, was not pplicable to the subject property because it was not a rental property and too many assumptions, such as rent and capitalization rate, would have to be taken into account.

In determining the fair market value of the land Mr. Vaughan selected six comparable land sales in using the market data or comparison method of site valuation. The six sales ranged in time from August 1977 to March 1980. Mr. Vaughan was of the view that there did not appear to be any significant change in the market for the time interval involved and there were no resales in the area to support any adjustments.

The six lots varied in size from 4,356 square feet to 14,070 square feet. Three of the sales were properties in an older, more prestigious area of the city and were superior to the subject property. The values of these properties were $1.77 a square foot, $2.53 a square foot and $3.44 a square foot. These three properties and two other properties were “infilled lots”, that is, lots severed from larger parcels in the older areas of the City. The sixth property is located in a newer subdivision in Cambridge. The lots for the most part are irregular in shape and four of the six lots have an area substantially less than that of the subject property.

Mr. Vaughan determined that the value per square foot of the subject property was $2.30; the land would thus have a value of $30,000 in October 1979. Mr. Vaughan acknowledged that the property neighbouring that of the subject property which was owned by Mr. Petersen and Mr. Ross would have been a good property to compare for the purposes of valuing the subject property. He acknowledged that he did not use that property as a comparison. Upon being examined by counsel for the respondent he agreed that the sale of the neighbouring property took place in 1982, some three years after the sale of the subject property.

Mr. Vaughan then proceeded to estimate the value of the building on the property and in determining the reproduction cost new for the building he relied upon reproduction costs based on the Marshall Swift Reproduction Cost Manual. He determined that the reproduction cost new for the subject building was $447,694. In determining the reproduction cost new for the building he relied upon the original construction of the building as a church with a Sunday School. Normal physical depreciation was based on the agelife method and market analysis. He estimated functional obsolescence at 30 per cent based on cost new as built and cost new as utilized.

Mr. Vaughan explained the Marshall Swift valuation manual contains pictures of various buildings representing models. The reader chooses the picture of the building which best reflects the subject building and then refers to tables representing the building. Reproduction cost of the various buildings are set out in the manual; adjustments can be made for factors such as size. The costs of reproduction are for a new church, the original design and use of the building. Mr. Vaughan made adjustments for depreciation of the value of the building, functional obsolescence and material deterioration. After making such adjustments Mr. Vaughan calculated the value of the building to be $134,000, in the following manner:

Less: Depreciation

Functional Obsolescence	—
30% of $447,694		$143,308
Physical Deterioration	—
60% of ($447,694-$143,308) =		200,632	$343,940
Estimated Value			$133,754
Rounded to			$134,000
Summary
Cost approach to Value
Land		$ 30,000
Building		134,000
Total		$164,000

The 30 per cent adjustment for functional obsolescence is the difference between the reproduction of the building new as a church and reproduction of the building new as a church and the reproduction of the building new as a day-care centre the difference being a difference of 30 per cent. The cost of reproduction of the church was determined by Mr. Vaughan to be $480,000, in round figures, and the cost of reproduction of the day-care centre was calculated at $370,000, the difference of $110,000 is 30 per cent of $370,000. Hence Mr. Vaughan utilized 30 per cent as the depreciation for functional obsolescence of the church, as new.

Mr. Vaughan had replied to my question that the cost of reproduction of the building as a day-care centre new would be approximately $370,000, as opposed to $477,694 as a church and Sunday School. However, he said, an adjustment of 60 per cent would be necessary to reflect the physical deterioration of the building. This would yield a value of $150,000. There would be no adjustment for functional obsolescence. As a point of interest the cost of reproduction new of the building of $477,694 minus physical deterioration of the building as a day-care centre only would give a value to the building of $257,694. The $150,000 value attributed to the building new as a day-care centre, approximates the sale price of land, building and equipment.

Mr. Vaughan also considered sales of other churches at the time, including the church referred to earlier. He considered physical deterioration to vary between 50 per cent and 60 per cent and he selected a 60 per cent adjustment for the subject property to yield a value to the building in 1979 of 134,000.

Accordingly Mr. Vaughan allocated the purchase price of $157,500 as follows:

Mr. Vaughan's calculation of building value was not seriously challenged in cross-examination.

Thus in applying Mr. Vaughan's allocation of purchase price the Minister considered no amount of the purchase price was for goodwill.

Mr. Alan Jones, a certified general accountant and an officer of Revenue Canada since 1973 testified on behalf of the respondent. Mr. Jones has been a business valuator since 1981. He has taken business valuation courses at the University of Toronto and courses offered by the Canadian Association of Business Valuators. Counsel for the appellant agreed that Mr. Jones qualified to testify as an expert in valuing businesses.

Mr. Jones had been requested by his superiors to determine the fair market value as at October 1979 of the saleable goodwill attached to the Cambridge Children’s Centre.

In his valuation report Mr. Jones referred to the various dictionary legal and accounting definitions of goodwill. He concluded the legal and dictionary definitions stress customer relationships, the advantage of a good income and reputation. The accounting definition stresses earning power which can be transferred. For the purpose of his opinion he considered the term “goodwill to mean the amount represented by the difference between going concern value and the tangible asset backing”, that is, the difference between the value of the assets sold and the value of the business, including the assets, as a going concern.

Mr. Jones reviewed the financial statements of the partnership for the years 1975 to 1979 inclusive, the report of visits from the Ministry of Community and Social Services dated March 22, 1979, and follow-up letter from the Ministry dated March 27, 1979. He also interviewed Mr. Vestenicky, purchaser of the business, and reviewed the real estate appraisal of Mr. Vaughan.

In Mr. Jones' view the business of the Cambridge Children’s Centre had no saleable goodwill. The business had suffered losses in each year of operation and there was no change in the trend of the losses. There was no amount available to calculate goodwill based on earnings. The report of the visit to the centre by the Area Office of the Ministry of Community and Social Services indicated serious problems and a number of requirements, recommendations and suggestions had been made by the Ministry. In addition, the usual licence granted by the Ministry to a day nursery is for one year and only a three-month licence was being considered; however a six-month licence was eventually granted. Mr. Jones stated that in his interview with Mr. Vestenicky the latter stated that when he was approached by the owners of the Cambridge Children's Centre to purchase it, the Centre was in need of extensive repainting and decorating; he also informed Mr. Jones he was not concerned with the allocation of purchase price, only the total cost of the business.

Mr. Jones stressed that in all definitions of goodwill, goodwill is considered an intangible asset that has been created and is not an asset yet to be created. For accounting purposes, goodwill is based on earnings to permit capitalization; further, goodwill must be transferable to have value. Mr. Jones considered that in each year of operation the business carried on by Messrs. Petersen and Ross incurred losses and in each of the two years prior to the sale the losses were greater than in the previous year. The operation of the centre required much improvement and was operating under a shortterm licence. In his view the total selling price of the business was no greater than the value of the underlying assets.

Mr. Vestenicky, also testified on behalf of the respondent. He stated he could not recall whether he approached the vendor or the vendor approached him in respect of the purchase and sale of the Cambridge Children's Centre in 1979. He could not recall the details of goodwill. In any event he carried on business on the subject property under the name Pluto Day Care Centre, the name under which his other centres operated, as permitted by the Agreement of Purchase and Sale of the Centre. He stated that it was “easier to operate under our own name" than under another. He also revealed that once he acquired the property he painted and generally cleaned the premises. To date he only has one employee who was with the day-care centre when it was operated by the vendors.

However, Mr. Vestenicky acknowledged that even if an established daycare centre has a negative cash flow he would prefer to buy the established business rather than starting up anew; he stated there was some value in acquiring an established business, although he would not venture to even suggest a value.

Mr. Vestenicky also testified that a nursery licence issued by the Ministry of Social Affairs is not transferable; a potential purchaser must apply to the Ministry for a new licence.

Section 68 of the Act reads as follows:

68. Where an amount can reasonably be regarded as being in part the consideration for the disposition of any property of a taxpayer and as being in part consideration for something else, the part of the amount that can reasonably be regarded as being the consideration for such disposition shall be deemed to be proceeds of disposition of that property irrespective of the form or legal effect of the contract or agreement; and the person to whom the property was disposed of shall be deemed to have acquired the property at the same part of that amount.

The position of the appellant is that where there is an arm's length sale of property and in the agreement of sale the vendor and purchaser have allocated amounts to the various assets transferred, the Court should regard such allocation as being prima facie evidence of the values allocated. This is of course subject to a finding that the allocation is not a mere sham or subterfuge.

While case law does provide some support for the appellant's position, it does not necessarily support its application in the present circumstances.

In the case of The Queen v. Golden, [1986] 1 C.T.C. 274; 86 D.T.C. 6138, the Supreme Court of Canada considered the application of section 68. The majority of the Court held that the allocation established by the contract between the parties was reasonable for the reasons given by Mr. Justice Heald in the Federal Court of Appeal [1983] C.T.C. 112 (83 D.T.C. 5138) who stated at 116 (D.T.C. 5142):

It is my opinion that the correct approach to a section 68 determination would be, as suggested by the above authorities, to consider the matter from the viewpoint of both the vendor and the purchaser and to consider all of the relevant circumstances surrounding the transaction. Where, as in this case, as found by the trial judge, the transaction is at arm's length and is not a mere sham or subterfuge, the apportionment made by the parties in the applicable agreement is certainly an important circumstance and one which is entitled to considerable weight. Furthermore, in this case, the trial judge made a specific finding of fact (AB p. 159) that the figure of $5,100,000 which the parties apportioned to land in the agreement was not an unreasonable price for the purchaser to pay for the land alone in March, 1973. Accordingly, based on that specific finding and on the other circumstances appearing from the evidence and addressing the question from the point of view of both the appellant and its purchaser, I am of the opinion that the amount that can reasonably be regarded as having been paid and received for the land apart from the buildings, etc., was $5,100,000 and for the buildings, equipment, roads, sidewalk, etc., was $750,000. [Emphasis added.]

Notwithstanding that Mr. Justice Heald considered the finding by the trial judge that the agreement in the Golden case was not a sham or subterfuge his decision was based on the specific finding of fact that the amount apportioned by the parties was not an unreasonable amount. Where an agreement, although evidencing neither sham nor subterfuge, stipulates an amount which is clearly unreasonable in the circumstances, it is still very much open to the Court to conclude that section 68 should apply to reallocate the proceeds in a reasonable manner.

In the case at bar there is no evidence, nor did the respondent even suggest, the agreement in issue was a sham or subterfuge. However the appellant’s claim of $45,000 to goodwill is suspect. The business operated throughout its existence with losses and there was no indication of any change in the future. The evidence also indicated that problems existed with respect to the operation and licensing of the business.

The courts have held that evidence of negotiations leading to an apportionment of value to be an important factor in determining the weight to be given to the parties' allocation (see: The Queen v. Shok et al., [1975] C.T.C. 162; 75 D.T.C. 5108 (F.C.T.D.)). The evidence in the case at bar indicates no bargaining between the parties as to allocation of purchase price.

The lack of any foundation for a value to goodwill in the business sold, let alone a value of $45,000, coupled with the absence of bargaining between the purchaser and vendor in allocating the purchase price would ordinarily lead me to conclude the allocation, in which approximately 30 per cent of the purchase price is said to be for goodwill is not reasonable.

On the other hand, Mr. Vestenicky's testimony cannot be disregarded. He stated that he would be prepared to pay something in order to acquire an established business. He could not say what this amount would be. The question to determine is whether it is possible to determine what a reasonable businessman like Mr. Vestenicky would have been prepared to pay for the business.

In the case of Herb Payne Transport Limited v. M.N.R., [1963] C.T.C. 116; 63 D.T.C. 1075 (Exch. Ct.), Mr. Justice Noël outlined the factors to be considered in determining the value of goodwill (at page 123 (D.T.C. 1079)):

As stated by Lord MacNaughton in C.I.R. v. Muller Limited, [1901] A.C. 217, goodwill is a thing very easily described but very difficult to define. He however defined goodwill by embracing the elements which are the sources of goodwill.

His definition was:

Goodwill is the benefit and advantage of a good name, reputation and connection of a business. It is the attractive force which brings in customers. It is the one thing which distinguishes a well established business from a new business at its first start . . . Goodwill is composed of a variety of elements. It differs in its composition in different trades and on different bases in the same trade. One element may preponderate here and another there.

Other factors to be considered are good relations with employees, favourable commercial contracts, franchises, good financial relationships and finally good management.

All these advantages are interrelated and form a composite which will assist in estimating the value of goodwill in a business.

It is then necessary to examine a number of things such as the profits over a selected number of past years, placing a value on net tangible assets used in the business as a going concern, determining a normal rate of return which an investor in a business would receive on his capital, estimating the possible duration of the profits from the business.

It is only because of Mr. Vestenicky's evidence that he would prefer to purchase an on-going business rather than “starting from scratch" that I consider the possible existence of goodwill in the business carried on by Mr. Petersen and his partner.

The evidence, however, indicates that the business had suffered losses for years prior to the sale, renewal of the license was subject to numerous improvements being implemented by the appellant and, in any event, was not transferable to the purchaser, and other factors. Thus any goodwill would have a relatively small value and certainly not $45,000. There has been absolutely no evidence before me which would permit me to calculate the value of this goodwill. In this respect the appellant has failed to establish his case.

The Minister, on the other hand, submitted two reports in support of his allocation of proceeds of disposition and that there was no element of goodwill in the consideration paid for the business. The appraisal report of Mr. Vaughan, while slightly deficient in that it did not consider the property next to the day-care centre, does establish the approximate fair market value for the tangible assets to be slightly higher than the consideration received by the vendors. The valuation report prepared by Mr. Jones concludes that no saleable goodwill existed in connection with the business at the time of the sale. I find no serious error in Mr. Jones’ report. While it is clear from the case of Klondike Helicopters Ltd. v. M.N.R., [1965] C.T.C. 427; 65 D.T.C. 5253, that fair market value is not necessarily determinative of the proper or reasonable allocation of consideration as between various assets in a transfer of property, the appellant has failed to provide the Court with any evidence to support a finding that the assets were transferred at less than fair market value and has also failed to establish any error in Mr. Vaughan's appraisal which would affect the assessment.

The onus is on the appellant to prove the Minister's allocation under section 68 is unreasonable; it is incumbent on the appellant to provide the Court with evidence which not only supports a conclusion that the Minister's allocation is unreasonable, but also to provide evidence to establish, with some degree of certainty, the allocation which the appellant submits is correct.

While the evidence establishes that goodwill in the business did exist, it does not establish its value and in that respect it is not possible to conclude that the Minister’s allocation was unreasonable.

The appeal is dismissed.

Appeal dismissed.