Packer Floor Covering Ltd. v. The Queen, 82 DTC 6027, [1981] CTC 506 (FCTD)

Dubé, J:—The issue to be resolved is whether the sum of $100,000 paid to the plaintiff by Kraus Carpet Mills Limited (“Kraus”) pursuant to an out of court settlement is income from the taxpayer’s business for the 1976 taxation year as held by the Minister of National Revenue, or a capital receipt as claimed by the plaintiff.

The plaintiff (“Packer”) became the exclusive distributor in the Province of Quebec for carpets sold under the trade name and mark “Kraus”, manufactured in Waterloo, Ontario, and remained so from 1959 until March 26, 1974 when it was notified by letter from Kraus of the termination of the relationship between the two firms.

There ensued an action launched by Packer in the Quebec Superior Court. In its statement of claim, Packer sought damages for loss of profits on sales, inventory, carrying charges, samples and overhead, for a total claim of $1,602,000. It was alleged that the cancellation of the long standing agreement was unjustified, arbitrary and disastrous to Packer’s business, and that the plaintiff was entiled to at least one year’s notice of termination (it had been given three months’ notice only).

In its plea, Kraus asserted that Packer failed to comply with its commitment to purchase products from Kraus for “a minimum amount of $1,750,000 in the year 1969 and at a yearly increase thereafter of 15%”. It referred to a market survey prepared by Currie Lehman & Associates Limited reporting that Packer had not shown sales comparable to the growth of the Canadian market in general and confirming that plaintiff’s “market share declined from 6.3% to 5.1% in the period between 1970 and 1973”.

In its answer to plea, Packer stated that “the installation of Kraus’s needle punch production equipment did not provide Plaintiff with the type of carpeting required for the Quebec market and that, moreover, Defendant’s shipping problems caused Plaintiff loss of contracts and retail sales”.

The declaration of settlement out of court recognized that Kraus had the right to terminate the distributorship arrangement at any time and had terminated it upon three months’ notice. The governing paragraphs of the one- page settlement bear reproduction:

3. Whereas Packer recognizes Kraus’ right to terminate the agreement at any time upon giving adequate notice but contends that the period of notice given by Kraus is inadequate.

4. Whereas Kraus recognizes that termination of the arrangement materially affects Packer’s profit making apparatus.

5. Whereas Kraus desires to resolve the matter with Packer by mutual agreement.

THEREFORE:

Kraus hereby offers to pay Packer $100,000.00. This payment is not in respect of cancellation of the agreement but is solely in recognition of the facts that Packer contends that 12 months notice should have been given instead of 3 months notice.

It is also useful to reproduce at this stage a statement of sales and profits of the plaintiff company filed at the outset of the hearing of this action. It will be noted that while Packer was the exclusive distributor of Kraus in Quebec, it did sell carpets procured from other manufacturers and also related products such as floor undercoverings, glue, and other accessories not produced by Kraus, for instance, for the year 1973, that is the full year preceding the discontinuation of the dealership, Packer’s total sales amount to $5,666,000, while sales of Kraus products amounted to $3,111,000.

I will return to the statement of sales after a review of the jurisprudence in the matter. First, the English authorities and then the more recent Canadian cases.

In Glenboig Union Fireclay Co Ltd v CIR (1922), 12 TC 427, the House of Lords held that an amount received for compensation in respect of fireclay left unworked was not a profit earned in the course of the Company’s trade, but was a Capital receipt, being a payment made for the “sterilisation of a capital asset”. Lord Wrenbury said at 465 that the sum “was the price paid for sterilising the asset from which otherwise profit might have been obtained”. In Van Den Berghs Limited v Clark (1934), 19 TC 390 two companies bound themselves to work in a friendly alliance and one cancelled the agreement some years later. The House of Lords held that the payment of £450,000 was for the cancellation of the appellant company’s future rights under the agreements, which constituted the capital asset of the company and was accordingly a capital receipt. Lord Macmillan found (at 431) that “the cancelled agreements related to the whole structure of the appellants’ profit-making apparatus”.

Three years later, in 1938, in Kelsall Parsons & Co v CIR (1938), 21 TC 608 the appellants entered into several agency agreements on a commission basis for the sale in Scotland of the products of various manufacturers. One of the agreements was terminated in consideration of the sum of £1,500. The Court of Session held that the sum was a taxable profit. The Lord President (Normand) said at 619:

. . . That was a contract incidental to the normal course of the Appellants’ business. Their business, indeed, was to obtain as many contracts of this kind as they could. . . . The Appellants’ business is entirely different from the business carried on by someone who, under contract, acts exclusively as agent for a single principal.

In 1945, that same court held in Barr, Crombie & Co Ltd v CIR (1945), 26 TC 406, that the sum paid as compensation for the loss of a shipping management agency was fundamental to the appellant company, therefore a capital payment. The Lord President (Normand) said at 412:

. .. where you have a payment for the loss of the contract upon which the whole trade of the Company has been built, .. . and where in consequence of the loss the Company’s structure and character are greatly affected, the payment seems to me to be beyond doubt a capital payment.

In Wiseburgh v Domville (Inspector of Taxes), [1956] 1 All ER 754, the Court of Appeal held that the sum of £4,000 paid in settlement of an action expressed to be in damage for breach of agreement was properly assessed to tax as being profits. The taxpayer had two agencies, one was terminated by the principals without due notice. It was found by the court that the loss of the agency was one of the incidents of the taxpayer’s business, did not partially destroy that business, and thus was not the loss of an enduring capital asset. In his writ the taxpayer had asked for damages for breach of contract and also for an account of commission due and unpaid in respect of past work. Lord Evershed, MR, said at 757:

. . . I can well conceive that the taxpayer would have had a strong case for saying that damages would not be taxable, in so far as they were claimed because his goodwill as a sales agent had been impaired.

But he concluded that:

. . . On the face of it, it is impossible for the court to infer that this £4,000 or any part of it represented damages for the loss of the taxpayer’s goodwill. I think the form of the damages really make that impossible.

In CIR v Fleming & Co (Machinery), Ltd, (1951) 31 TC 57, the Court of Session held in 1951 that the sum of £5,320 received by the company as compensation for the loss of one agency out of eight was for loss of profits and not for loss of a profit earning asset. Lord Russell then formulated this general principle at 63:

. . . When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient’s profit-making apparatus, involving the serious dislocation of the normal commercial organisation and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilisation of a capital asset and is therefore a Capital and not a revenue receipt.

Lord Russell’s rule was followed by the Canadian Courts. In Parsons- Steiner Limited v MNR, [1962] CTC 231; 62 DTC 1148, Thurlow J of the Exchequer Court (now Chief Justice of the Federal Court) reviews some of the English cases. Parsons-Steiner had been the sole agent in Canada, since 1933, for Doulton & Co Ltd. The agency was for one year, and thereafter until terminated on three months’ notice. In 1954 Doulton discontinued the agency and in 1956 paid the sum of $100,000 in compensation. The learned judge held that the payment was a capital receipt. He said at 244: [1154]:

On the whole therefore having regard to the importance of the Doulton agency in the appellant’s business the length of time the relationship had subsisted, the extent to which the appellant’s business was affected by its loss both in decreased sales and by reason of its inability to replace it with anything equivalent. . .. The payment received in respect of its loss was accordingly a capital receipt.

In 1973 the Federal Court heard the case of MNR v Import Motors Limited, [1973] CTC 719; 73 DTC 5530. The taxpayer, after having operated a Volkswagen distributorship franchise in Newfoundland for several years, was informed that Volkswagen Canada Limited would take over as wholesaler. The taxpayer agreed to a payment of $100,000, purportedly calculated in past sales, but described as “additional distributor discount”. Urie J, (now of the Appeal Division) held that notwithstanding the form of the transaction, its business substance was the cancellation of the distributorship agreement: thus, the compensation for the loss of a substantial portion of the business was a capital asset which would never be recovered. In Courrier M H Inc v Her Majesty the Queen, [1976] CTC 567; 76 DTC 6331, the Postmaster General of Canada cancelled two contracts for the transportation of mail awarded to the taxpayer only two months previously. Compensation in the amount of $293,015 was given to the taxpayer, based on an estimate of expected proceeds for three months. I held that the compensation represented an amount received for the sterilisation of a capital asset, thus not taxable.

The taxpayer in Pepsi-Cola Canada Ltd and Her Majesty the Queen, [1978] CTC 801; 78 DTC 6546, held an agreement with Schweppes and was paid $100,000 on its termination. The plaintiff alleged that the payment was for “goodwill”, but the trial judge looked at a document signed by Schweppes to the effect that the payment was in full satisfaction for “all costs, expenses and loss of income incurred or to be incurred” and held the payment to be income. The Federal Court of Appeal reversed that decision and held that the only reasonable inference to be drawn from the evidence of the only witness at the trial, an officer of the appellant, was that the terms of the receipt prepared by Schweppes did not contain the terms of the termination agreement: the amount was a capital payment for goodwill. The court noted that for the purpose of effecting the transfer of its established goodwill the appellant provided Schweppes with a list of its customers, and notified them by letter of the changeover.

I now return to the case at bar, and first to the statement of sales reproduced earlier. It appears from the document that the volume of sale of Kraus carpets represents barely more than 50% of the total sales of the taxpayer for the years 1969 to 1973 it is below 50% for 1974, the termination year. Kraus carpet sales plummeted down to 2.5% the following year. However, other sales nearly fill the gap during that period and gradually increase in the course of the following years, with the result that the gross profit remains substantially the same between 1972 and 1979.

The statement also indicates that in 1976 the Omega line comes on stream. The following year, Omega sales reach approximately the volume previously held by Kraus sales. Omega is but another name for carpets manufactured by Kraus; after the settlement of 1976, Kraus had resumed its relationship with Packer and supplied it with Omega carpets. It now appears from a samples’ salesbook filed at the hearing that “Tapis Kraus & Cie.” (Packer under another name) is presently the distributor of Kraus carpets for the Province of Quebec.

The doucments filed at the hearing disclose that Packer was not succeeding as well as Kraus expected. In 1973 and 1974, the relationship between the two companies was rapidly deteriorating. Packer was not meeting its purchase commitments. There were reasons. The type of carpet manufactured by Kraus was less in demand in the Province of Quebec than elsewhere in Canada; apparently the Quebec clientele preferred nylon, or “shaggy dog” carpets, not produced by Kraus. Moreover, the Government of the Province of Quebec was favouring carpets produced in that province for provincial buildings. Kraus continued to apply the pressure. Several letters prior to the fateful message of March 26, 1974 impart an increasing degree of exasperation on the part of Kraus. The letter of March 26 is the logical culmination to previous admonitions.

The discontinuation of the agreement did not therefore bring Packer to a halt. It did not “sterilise its capital asset”. The plaintiff proceeded with its expansion plans and moved to a new and more expensive warehouse. Those new expenditures partly explain the decrease in the net profit of the taxpayer. The statement shows that the gross profit remains steady, around 20% throughout the years, whereas the net profit drops to 5.1% in 1974, 1.1% in 1975 and -1.0% in 1976. The year 1974 was the year of termination with Kraus, but also the year of expansion. Admittedly, the introduction of new lines of carpets from new suppliers was costly and caused severe problems to Packer. But I cannot find that the discontinuation of the Kraus line (specially where it is later replaced by a similar Omega line) “materially crippled the whole structure of the profit-making apparatus” of the plaintiff: the apparatus clearly continued to produce about the same volume of sale and the same gross profit throughout those years.

The declaration of settlement does boast a few judicially magic words, such as the “termination of the arrangement materially affects Packer’s profit making apparatus”. The document was prepared by attorneys for both parties and it is not unreasonable to assume that the words were put in, at the request of Packer’s attorneys, to enlighten future readers. The conclusion of that document, however, is to the effect that the sum of $100,000 is paid in compensation for the short notice. The mere use of magic words will not, of course, create instant paralysis, or materially cripple an apparatus, or sterilise a capital asset. It is still for the court to pronounce the final diagnosis.

In the Kelsall Parsons case, the Lord President (Normand) described the sum paid (at 620) as “really and substantially a surrogatum for one year’s profits”, as there was one more year remaining to the agreement. In the Fleming case, Lord Russell said (at 64) that the payment for the loss of that agency — terminable at will — was no more than “a surrogatum for the loss of future profits”. Lord Keith added (at 65) that since the agency was at will “it is difficult to see how it could be given any goodwill value and there is no suggestion that it had any goodwill value in the company’s books”. He concluded: “Compensation in lieu of notice would in my opinion quite clearly be a revenue receipt”.

In the Wiseburgh case, the termination of the agency without notice led to a consent order. Lord Evershed, MR concluded at 757) that “on the face of it, it is impossible for the court to infer that this £4,000 or any part of it represented damages for the loss of the taxpayer’s goodwill. I think the form of the pleadings and the amount of the damages really make that impossible”. Another pronouncement of Lord Evershed, MR (at 758) applies equally well to the instant matter:

. . . The business has suffered something perhaps of a disaster by reason of this quarrel with a valuable customer. But, beyond that, it seems to me it is not right to say that the taxpayer had his undertaking as a sales agent partially destroyed or taken away.

In the Parsons case, where it was held that the sum of $100,000 was paid for goodwill and for a capital asset of an enduring nature, the product was “a line of figurines which alone accounted for a considerable portion of the business and which was unique in the trade”. And the taxpayer accommodated Doulton by introducing Doulton’s staff to the customers and by transferring two of its seventeen employees to Doulton on the termination of the agency. In the Pepsi-Cola case as well, the taxpayer delivered its list of clients to Schweppes and notified them to buy their products directly from Kraus. To the contrary, Packer went all out to establish other lines.

It will also be recalled that the plaintiff's statement of claim in the Quebec Superior Court claimed for loss of profit resulting from the short three months’ notice. Nowhere is there to be found a claim for goodwill. Along with Lord Evershed in the Wiseburgh case, “on the face of the pleadings’, I would find it “impossible to infer” that the payment was for goodwill.

The sole witness at the trial, the Vice President of Packer, very honestly pointed out that the name Packer was not important. The name sold and publicized was “Kraus”, not Packer. There could therefore be no goodwill attached to the name Packer. Again, the declaration of settlement recites that the payment “is solely in recognition of the fact that Packer contends that 12 months’ notice should have been given instead of 3 months notice’. As Lord Keith said in the Fleming case, “Compensation in lieu of notice would in my opinion quite clearly be a revenue receipt”.

Under the circumstances, the appeal is dismissed with costs.* [3]