Guy Tremblay [TRANSLATION]:—This case was heard in Montreal, Quebec on June 9, 1977. Following the submission of written pleadings, it was taken under advisement on December 13, 1977.
1. Point at Issue
The Board must decide whether the architectural partnership of Roux, Morin and Langlois, which included the appellant, possessed goodwill at December 31, 1972 and, if so, how much.
In order to determine the amount deductible against his share of the accounts receivable existing in the partnership at December 31, 1971, we must know the adjusted cost base of his interest in the partnership at December 31, 1972.
In order to establish this adjusted cost base, we need to know the tax equity of which goodwill is one part. The appellant argued that the existing goodwill amounted to $155,000. The respondent, however, contended that it was nil, which would result in the addition of $21,763.94 to the appellant’s income for 1972.
2. Burden of Proof
The burden of proof is on the appellant to show that the respondent’s assessment is incorrect. This burden of proof derives not from one particular section of the Income Tax Act, but from a number of judicial decisions, including the judgment delivered by the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.
3. Facts.
3.1 The main facts that resulted in the issuing of the assessment are as follows:
(1) In calculating his income for 1972, the appellant had included the sum of $50,302.02, that is, his share of the accounts receivable at December 31, 1971, in the architectural partnership of Roux, Morin and Langlois. The appellant’s interest in the partnership was 40%, Mr Roux’s 50% and Mr Langlois’ 10%.
(2) The appellant had also claimed as a deduction a reserve for accounts receivable of $50,302.02. According to him, this sum was the lesser of the following two amounts: the above-mentioned $50,302.02 in accounts receivable, and $65,070.44, which he said was the adjusted cost base of his interest in the partnership.
(3) According to the respondent, however, the adjusted cost base of the appellant’s interest in the partnership was $28,538.08, which left $21,763.94 in the income for 1972, that is, $50,302.02 less $28,538.08.
(4) The difference in the appellant’s and the respondent’s data is explained by the fact that the respondent considered the goodwill to be nil; goodwill is a factor that must be taken into consideration when calculating tax equity pursuant to subsection 26(9) of the Income Tax Application Rules, 1971. The appellant, on the other hand, placed the value of the goodwill at $155,000.
(5) The other figures that must be taken into account in calculating the adjusted cost base and the tax equity are not challenged. Goodwill remains the only point in dispute.
3.2 The main facts entered as evidence before the Board regarding the matter of goodwill are well summarized in the appellant’s written submission, as reported below in paragraphs 1 to 27.
1. Mr Maurice Roux has been a practising architect since 1952.
2. Mr Jean Morin joined with Mr Roux in 1956 to form the architectural partnership of Roux and Morin.
3. In 1972, the partnership was known as Roux, Morin, Langlois et Associés when it acquired the services of Mr. Charles Langlois, an architect, as a partner.
4. Messrs Roux and Morin also acquired the services of another architect, Mr Lagace, in the Sept-Iles region, and operated under the name of Roux, Morin and Lagace; this partnership was separate from the one in Montreal.
5. The partnership of Roux, Morin and Langlois in addition had four full- time employees at December 31, 1972:
— Mrs Yolande Capobianco, a secretary with the firm since 1964;
— Mr Jean Daigneault, an architectural draftsman with the firm since 1962;
— Mr Joseph Fiore, an architectural draftsman with the firm since 1957;
— Mr Serge Perras, an architectural draftsman with the firm since 1964;
6. Architectural draftsmen were in great demand at December 31, 1972, and had been for a number of years because of work resulting from the Staging of the Olympic Games in Montreal.
7. The partnership of Roux, Morin and Langlois did not specialize, and did all kinds of construction work.
8. It was established that architectural work was closely connected with that of engineers who construct buildings. Whereas the engineer was in charge of carpentry, electricity and plumbing, the architect was in charge of the remainder and his chief concern was the esthetic aspect of the building.
9. It was established that draftsmen frequently moved back and forth between architects’ and engineers’ firms, with both professional firms preparing plans and supervising the work.
10. The Montreal partnership had a diverse clientele, primarily composed of:
— school boards,
— cities and towns,
— religious orders,
— private and public corporations,
— individuals and
— promoters.
11. The partnership’s clientele chiefly resided in Ville LaSalle, Lachine, Ville St-Pierre, St-Laurent and Dorval.
12. Messrs Roux and Morin reside in Lachine.
13. Some of the partnership’s clientele are repeat customers who either award new contracts because they were satisfied with previous contracts, or who want additions or alterations made to a construction that the partnership had designed. Below are four examples cited by Mr Jean Morin:
(a) a school board gave four different contracts to the partnership: these were for the construction of a “polivalente” school, a student resi- dence, schools and the repair of the said schools:
(b) the City of Lachine gave the partnership a contract for the construction of an arena, a fire hall, a community centre and a civic centre;
(c) Spinelli’s Garage, which is owned by two brothers, gave the partnership four contracts for enlarging the garage and others for constructing a showroom and building each of the brothers a home;
(d) the partnership was given a contract to convert a school it had constructed in 1969 into a “polivalente” school.
14. The general breakdown of the fees charged by an architectural firm is as follows:
(a) 15% of the gross fees for the sketch (preliminary plans);
(b) 55% for the complete plans and specifications;
(c) 30% for supervision.
15. It was established that all an architect had to prepare was the sketch. The complete plans and specifications are generally done by draftsmen,
and supervision of the work might just as easily be entrusted to a senior architect, junior architect or a senior draftsman.
16. Transferring the projects of Messsr Roux and Morin to prospective buyers could be accomplished fairly easily, by introducing the buying architects to their clients, and by urging that the technical team that was on hand remain. One example cited was the case of Mr Lagacé, to whom Messrs Roux and Morin had transferred their contracts in Sept-Iles, and who in the second year of operation, namely 1973, reported a $60,000 profit.
17. Contracts are obtained primarily by the senior partners. The junior partners and even the draftsmen nevertheless thought so highly of the firm that they were always promoting it and, in a number of cases, attracted clients.
18. Both the junior architects and the draftsmen came into contact with the clients, especially when supervising work.
19. One way to make contact with prospective clients is to mail out a prospectus containing a description of the organization, the work performed, and so on.
20. To Mr Morin’s knowledge, no client of the partnership has had another
architectural firm enlarge or alter one of its constructions.
21. The client must approve the transfer of architects working on a project.
22. There is a mandatory fee if another architect uses the partnership’s plans to renovate a building or other construction which the partnership originally designed.
23. Very rarely did the partnership give subcontracts to other architectural firms, although it did obtain them from time to time.
24. An architect may receive from 33 /3 to 50% of the fees on work given to another architectural firm.
25. Mr Morin would not have obtained as many contracts as he did if he could not point to the quality of the organization behind him.
26. A firm’s past achievements are just as important as contact with the client for obtaining contracts.
2/. The partnership had $388,000 on its order books at December 31, 1972
(these were contracts that had been signed but not begun or not completed).
3.3 The facts relating to the issuing of the notice of assessment and the objection and appeal proceedings are as follows:
(1) a notice of reassessment was issued on April 14, 1975;
(2) a notice of objection was filed on May 26, 1975;
(3) on March 12, 1976, the Minister made known his reply, upholding the assessment issued on April 14, 1975;
(4) on June 9, 1976, the appellant appealed to the Tax Review Board.
4. Act, Case Law and Comments
4.1 The Board does not feel it is necessary to cite at length the sections of the Act and Regulations relied on by the parties, since these are not being challenged and are not involved in the dispute, which is solely concerned with goodwill. We need only mention the main sections here: section 23, subsection 26(9) and paragraph 26(12)(g) of the Income Tax Application Rules, 1971, and subsections 53(1) and 52(2) of the new Act.
4.2 The parties cited a long, line of authority and referred to many articles on legal theory.
The Board, for its part, referred to Georges-Henri Couture v MNR, [1978] CTC 2687; 78 DTC 1511 and Raymond Ducharme v MNR, [1978] CTC 2562; 78 DTC 1414. Although these judgments cite the same legal theory and case law, they differ in their conclusions because the main facts were different. In these judgments, the Board summarized sixteen of the leading judgments handed down in Canada on goodwill in the last twenty years.
In Ducharme, the Board disallowed a large portion of the goodwill because it was personal (and so not permanent, which contravenes one of the basic principles of an intangible asset, namely, that it must be permanent, stable and durable). Further, basing itself on the case law and articles on legal theory, the Board allowed transferable business goodwill because of the organization then existing (made up of two specialists, excluding the appellant and two secretaries) of a firm of management consultants, and also because of contracts then current.
These conclusion were based on, inter alia, Donald L Neuls v MNR, [1975] CTC 2215; 75 DTC 170, and Jack Richard Thomas v MNR, 75 DTC 37.
It relied on the basic components of general business goodwill as set forth in the articles on legal theory and case law: length of time the business has been in operation; past profits; the competence of employees; good relations between the business and its clients; a competent, experienced team of managers; current contracts, and so on.
The evidence entered in the case at bar reveals an impressive number of points that are solid proof of general business goodwill, such as the following:
(a) the firm has been operating since 1956;
(b) it has a stable organization with three architects, three draftsmen and one secretary;
(c) it has a well-established repeat clientele owing to the serious, professional manner in which work is performed;
(d) the firm had $388,000 worth of contracts that had been signed, but not yet begun or not completed.
When we consider that, at bottom, goodwill is based on earning Capacity, it is clear from the few points mentioned above that such a capacity existed.
4.3 Might all or part of the earning capacity in the case at bar be considered personal goodwill? The respondent advanced a number of arguments in his pleading.
4.3.1 In the course of the hearing it was established that a large percentage of the clientele were obtained either through the partners’ or even the employees’ personal contacts, or through the mailing of prospectuses on the partners’ qualifications.
Was this not a sign of personal goodwill and an absence of permanence?
Even though personal contact could have accounted for a large part of the clientele, it was nevertheless established that almost as large a part of the clientele were persons who had had work done in the past. In the Board’s view if, at the outset of a career, personal contact is almost the sole means of attracting clientele, this is no longer so after a number of years of practice. The quality of the work done and the resultant good reputation assume more importance. Someone will not ordinarily give a professional work to perform if the latter is incompetent, even though he is a friend or acquaintance.
There is no business that has not at some time or another needed personal. contact, courtesy and human relations either to obtain or retain clientele. Some institutions make their employees’ courtesy a key feature of their advertising. This does not mean, however, that the earning capacity resulting from all these personal relations is personal goodwill.
4.3.2 Are not the facts that, in the contract with the client, the rights of the parties are not transferable, that the contract expires with the death of the professional or professionals party to the contract, or if they are given a suspension, and that a professional can only undertake work specified in the agreement, indicative of personal goodwill?
In the contract entered in evidence in court, the partnership of Roux, Morin, Langlois et Associés was the contracting party, and not the appellant or one of his partners in particular. Further, as a general rule, even though the contract is concluded with a partnership, the latter does not have the right to transfer its rights to someone else. If a partnership is selected for its competence and organization, it obviously cannot substitute a new organization for itself unless the other party is informed.
The Board does not therefore see these as arguments in favour of personal goodwill.
4.3.3 Is there also not something transitory, impermanent and nondurable in the fact that some of the clientele are located in the vicinity of the partners’ office?
The Board does not concur with this opinion. Such a thing is normal. Besides, there is also evidence that the partnership had contracts in Sept-Iles even before an office opened there.
4.3.4 Counsel for the respondent cited Lucien Fl Le Daire v MNR, [1977] CTC 2539; 77 DTC 391, which concerned an architect who incorporated his architectural firm in 1969, setting goodwill at $28,000. According to Delmer E Taylor, CA, the Member who dismissed the appeal, the financial records were incorrect, and there was no qualified Staff nor sizable current contracts. No one, apart from the appellant through a corporation, would have been interested in buying this business. This case cannot apply to that at bar where the organization, qualified staff and current contracts could attract a third party and are hence transferable.
4.4 It now remains to establish the value of the goodwill.
The appellant substantiated his valuation by three different valuation methods: gross fees, net profits and current contracts. The respondent did not call witnesses.
4.4.1 Gross Fees Method
Taken once, the average gross fees for the last six years of the partnership are $155,000. The respondent did not challenge the absolute figure, although he did dispute that it represented goodwill.
This gross fees method was used in W E Butler et al v MNR, [1967] CTC 7, 67 DTC 5019, which cited an article that appeared in the November 1959 issue of Canadian Chartered Accountant, written by Mr Clem L King, FCA:
“The valuation may be computed as a percentage of gross fees.
Amounts reputed to have been paid in Canada in the last number of years have ranged from under 75% of one year’s gross fees to 125% of one year’s gross fees paid in one amount or in a few cases over a period of years. In the United States, prices paid are reputed to have ranged from 45% to 200% on one year’s gross fees.”
In the same case, Gibson J cited an article that appeared in the October 1975 issue of the Journal of Accountancy, which was written by Mr Richard C Rea, CPA:
“It is generally believed by small practitioners and small firms that their practice is worth one year’s gross fees.”
4.4.2 Net Income Method
Using the average net income for the last three years, 1970, 1971 and 1972 (after a reasonable salary was paid to the three partner architects), the appellant’s witness Mr Michel Guertin, CA, arrived at a figure of $53,000, which, after a 50% tax provision, leaves $26,500.
A net income after salary ($53,000) may be capitalized with factors of three or four in professional firms, according to Messrs George Ovens and Donald I Beach in their book, Business and Securities Valuation, page 138. According to Mr Clem L King, cited by Gibson, J in Butler, the average net income may be capitalized one to three times.
According to Messrs Ovens and Beach, the average net income after salary and taxes ($26,500 in the case at bar) may be capitalized six to eight times.
Both calculations (either before or after taxes) give a minimum figure of $159,000.
4.4.3 Current Contracts Method
It was explained, using the books with $388,000 worth of orders (contracts signed before December 31, 1972, but not begun or not completed) that an architect who took two years to complete these contracts would realize net profits of $183,000:
| — gross fees | $388,000 |
| — operating costs (40 per cent) | 155,000 |
| — net profits before architect’s salary | $233,000 |
| — architect’s salary for two years | 50,000 |
| — net profits | $183,000 |
Hence this figure of $183,000 only represents current contracts, and does not take into account other intangible assets existing in the partnership.
The respondent did not call expert witnesses to contradict these facts.
The Board concludes that $155,000 is a reasonable estimate of the goodwill existing in the partnership of Roux, Morin, Langlois et Associés at December 31, 1972.
5. Conclusion
The appeal is allowed and the whole is referred back to the respondent for reassessment in accordance with the above reasons for judgment.
Appeal allowed.