Red Barn System (Canada) Limited v. Minister of National Revenue, [1973] CTC 2290, 74 DTC 1021

The Chairman (orally: September 18, 1973):—This is an appeal by Red Barn System (Canada) Limited against a reassessment of the Minister of National Revenue for the taxation year 1969.

The point at issue is whether certain sums of money received by the appellant from Red Barns in Western Canada, or “Western” as I will refer to them, and Red Barns in Australia are capital sums as alleged by the appellant and therefore not to be brought into its income in the year in question, or whether they are income, as alleged by the Minister, being moneys received in the normal course of its business operations.

The case has taken considerably more time to hear than at first appeared likely, and I am indebted to counsel for both parties for the care with which they have prepared their cases and to the extent to which they have endeavoured to assist, and have in fact assisted, me in reaching my conclusion in this matter.

The facts are really not in dispute. In or about the year 1963 a man by the name of Shneer entered into an agreement with Red Barn (US) to construct, on a franchise basis, a certain number of outlets in Ontario and Quebec. By 1967 twelve had been constructed, one being inoperative and in Calgary, the others, I take it, having been mainly in Ontario. In 1967 Mr Donald Swift and his associates entered the picture and were requested, or were approached, to take over this agreement of Shneer’s. Donald Swift was the only person to give evidence for the appellant, and I found him to be a credible witness. He indicated that under no circumstances would he have had anything to do with the operation if it was to proceed on the basis of the 1963 agreement which had been entered into between Red Barn (US) and Harold Shneer on April 2, 1963.

He therefore negotiated a new arrangement with Red Barn (US) which gave him the exclusive right to handle the franchise in all of Canada. He was to construct some 60 restaurants, I believe, within a period of so many years ending somewhere about 1972, but it is not really relevant in the matter. He did proceed to execute the agreement with the Red Barn (US) System and constructed some 40-odd restaurants by 1969. These restaurants were let on the normal franchise basis to individuals who would pay a sum of money for the right to the knowhow and the equipment. Exhibit A-4 is said to be a typical arrangement with an individual operator and the sum payable in that instance was $25,000.

It is also in evidence, I think, that the company itself (Red Barn System (Canada) Limited) was able to, and perhaps did in fact, operate some of these restaurants. It is also in evidence, and I have accepted the fact, that it involved a capital outlay of about $250,000 to put one of these restaurants in operation. Some of them were built by Red Barn (Canada). Others were built and taken on a lease-back arrangement. However, by 1969 the tight money situation had made it apparent to Mr Swift and his associates that he would not be able to meet his obligations under the agreement dated September 26, 1967 with respect to the number of restaurants to be built. He had tried normal or conventional financing arrangements and had received cooperation from the banks, but it was necessary to float a public issue of debentures totalling $5,000,000, which paid off the indebtedness of the appellant to its various creditors, including the bank, but it is obvious that this liability did not make its position any more attractive to conventional lenders for future developments.

I refer to Donald Swift synonymously with the appellant company because he really, as president of Capital Diversified Industries Limited, the owner of the appellant company, was the guiding light and the key man in all the operations, so far as the evidence indicates. He therefore entered into two agreements, one with Red Barn Western and one with Red Barn Australia, whereby he would, or rather the appellant company would, transfer to Western and to Australia the same rights that the appellant company had with the Red Barn System Inc in the United States. In order to do this, he had to renegotiate the agreement of September 26, 1967 ((appellant’s Exhibit A-3), and there are attached to the said exhibit three individual riders that show the negotiations that took place in order that the original agreement could be changed, lessening the burden on the appellant company and giving it the right to issue what have been called “area agreements”. What in fact happened was that, in Western Canada, Mr Swift, through his companies, was obliged to buy or to take a minimum equity of 10% in the operating company — and in fact took considerably more through his own company and through his brother. In turn, the parent Red Barn (US) reduced the obligations of the appellant company to it. The appellant company received from Western a sum of money for the use of the franchise in Western Canada.

The Australian situation was slightly different in that the rules in Australia, or the practice of the Australian Government, was to require a minimum of 50% or 51% of the holdings to be in the hands of Australian nationals before institutional lenders could grant loans. This resulted in further negotiations with the Red Barn System of the United States. Although there was not at the outset a written agreement giving exclusive jurisdiction to the appellant company in Australia, this was clearly understood by Mr Swift, and I accept his evidence on this point, as it is borne out by the fact that the US company did grant its permission by the addition of another renegotiation and rider to the Original contract, and allowed the Australian agreement to be entered into. Again, the appellant company, through Mr Swift, was obliged to invest in the Australian company and acquired a considerable proportion, or at least a considerable number, of its shares. In fact, in both instances, that is, in the case of both Western and Australia, the amount of money put up for the equity shares almost equalled the price paid to the appellant for the area agreements. Again Red Barn System (US) reduced the obligation of the appellant company under its original agreement with respect to the percentage of the gross that it would be required to pay.

All these were matters of serious and substantial negotiations, according to the evidence of Mr Swift, and I have no reason to disbelieve him. So we have the situation in Ontario and Quebec, but primarily in Ontario, of the appellant company issuing franchises of the type evidenced by Exhibit A-4 and carrying on business by dealing in these individual franchises. What it did in Western Canada and Australia was place Red Barn (Western) and Red Barn (Australia) in the exact same position that the appellant was in in Ontario. The appellant received a set amount for each new restaurant that was opened and received a percentage of the gross. I think the evidence is—but whether it was put in in the form of an exhibit or not, I am not sure—that in four years the Australian operation grossed some $90,000 to the appellant company, of which some $23,000-odd was sent off to the United States parent company under the original agreement (A-3), leaving some $60,000 of that gross for the appellant. This was not gross revenue, but not net revenue either, in the accounting sense, because it had to be taken into income in the hands of the Canadian company and treated along with its income from Canadian sources. There is no evidence that ! can recall of exact figures of payments by Western to the appellant company, which was its parent company, but I think it is a reasonable inference, considering the fact that restaurants were built, that the appellant company did receive money from Western.

Many cases have been cited to me and, as I have often said, and as I have been able to demonstrate from some of the cases cited to me today, each case depends upon its own material facts.

The appellant has cited the case of The Dixie Lee Co Ltd v MNR, [1971] Tax ABC 592; 71 DTC 406, which was a decision of the last Chairman of the Tax Appeal Board, as support for its contention that what it had done was dispose of a portion of its capital assets. That case I find quite easy to distinguish, because in that instance it was a complete sell-out of the Maritimes section of the franchise for a fixed sum of money, which was unquestionably a capital return.

The respondent, of course, relies to some extent on the case of Smitty’s Pancake Houses Ltd v MNR, 39 Tax ABC 297; 65 DTC 667. This was a decision of my colleague Roland St-Onge, QC (then a member of the Tax Appeal Board), who was dealing with a case which was really much more on all fours with the Ontario operation of this appellant than with its dealings with the Western or Australian groups, and there is no doubt whatsoever that the income received from the “franchisees”, if there is such a word, of Smitty’s Pancake Houses Ltd was income in the hands of the appellant in that case and that the amount laid out to obtain the original franchise for the whole of Canada was not a deductible expense because it was held, and I think rightly so, that it was a capital outlay.

The thrust of the respondent’s argument in the case before me is based to some extent on the case of Commissioners of Inland Revenue v Rolls-Royce, Ltd, 40 TC 490, a decision of the British House of Lords, and, although I can find support for many of the respondent’s arguments in that case, I can also find support for the appellant’s position.

The appellant has filed a copy of another British decision, Murray v Imperial Chemical Industries, Ltd (1967), 44 TC 175, and has relied to some extent on that case. Again, although some passages taken out of context in the case are helpful, there are others which are harmful. So, much as I would like to fall back on a reported decision and take the burden off myself, I think my responsibility is to determine the issue on the facts before me.

The thrust of the respondent’s argument in this case, as I understand it, is that the appellant acquired exclusive rights for Canada by area agreement Exhibit A-3; that through that agreement it expected to generate business income; and that it did so, at the outset, by the construction of a considerable number of restaurants in Ontario until it was unable financially, from a capital position, to continue to do so across the country. There is evidence that there were abortive attempts to sell the area agreement system or idea to Quebec and also to the Maritimes but, in the end result, only two area agreements, namely, Western Canada and Australia, were consummated.

It seems to me, and I find it as a fact, that the appellant has not disposed of any of its capital assets in an outright disposition. It has licensed “Western” and “Australia”, subject to the same terms and conditions as were imposed upon the appellant itself by the original agreement (A-3), with the appropriate changes in wording. In my view, all that it is doing is generating income in a different manner than it had intended when it entered into the agreement with the US company. In each instance there is a so-called “come-back” clause if things do not go according to the terms of the contract. In my view, it is no more than a licence for “Western” and “Australia” to do business, and any sums recovered under those agreements must be income to the appellant in this case.

I have therefore reached the conclusion that the company has not, by any stretch of the imagination, disposed of any of its franchise rights, and therefore has been correctly assessed by the Minister of National Revenue and the appeal must fail.

Appeal dismissed.