Drouin v. The Queen

Drouin v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2013-10-17
Neutral citation
2013 TCC 139
File numbers
2011-5(IT)G
Judges and Taxing Officers
Paul Bédard
Subjects
Income Tax Act
Decision Content
Docket: 2011-5(IT)G
BETWEEN:
ANDRÉ DROUIN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
[OFFICIAL ENGLISH TRANSLATION]
____________________________________________________________________
Appeal heard on January 23, 24, 25, 26, 27, 30 and 31;
February 1, 2, 6, 7, 8, 9, 13, 27, 28 and 29;
March 1, 5 (teleconference), 13, 14,
15, 16, 19, 21 and 23;
April 3; and May 8, 9 and 10, 2012,
at Montréal, Quebec
Before: The Honourable Justice Paul Bédard
Appearances:
Counsel for the appellant:
Guy Du Pont
Michael H. Lubetsky
Jack J. Fattal
Counsel for the respondent:
Michel Lamarre
Alain Gareau
Vlad Zolia
Sara Jahanbakhsh
____________________________________________________________________
JUDGMENT
The appeal from the reassessment made under the Income Tax Act for the 2008 taxation year, notice of which is dated August 27, 2009, is allowed, with costs, and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
Signed at Ottawa, Canada, this 3rd day of May 2013.
"Paul Bédard"
Bédard J.
Translation certified true
on this 9th day of October 2013.
François Brunet, Revisor
Citation: 2013 TCC 139
Date: 20130503
Docket: 2011-5(IT)G
BETWEEN:
ANDRÉ DROUIN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
[OFFICIAL ENGLISH TRANSLATION]
REASONS FOR JUDGMENT
Bédard J.
[1] This is an appeal from a reassessment, notice of which is dated August 27, 2009, for the 2008 taxation year (the reassessment), whereby the Canada Revenue Agency (the CRA) denied $85,875.33 in deductions that the appellant had claimed as capital cost allowance, eligible capital property and interest in respect of the purchase of a franchise authorizing him to market computer software.
Background
[2] Prospector Networks International Inc. (PIN) was a company based in Barbados. The appellant submits that PIN carried on a business that developed software for business markets in North America and elsewhere (“the software”).
[3] The software consists of the following:
(i) Solutions Prospector: a software package designed to help salespeople identify prospective clients;
(ii) Mail it Safe: software designed to secure and track e-mail to help lawyers, health care professionals, public agencies and others who regularly send and receive confidential information;
(iii) CashOnTime: a software package designed to help financial officers and collection agents track accounts receivable and payments.
[4] PIN granted licences (in 2003 and 2004) and franchises (from 2005 to 2008) that, according to the appellant, allowed the licensees and franchisees (collectively, “the franchisees”) to use and market the software and any products derived from the software.
[5] According to the appellant, PIN also offered to market the software on the franchisees' behalf under contracts of mandate with PIN's subsidiaries and associated businesses.
[6] The appellant is a software engineer.
[7] In 2007, the appellant bought a franchise and signed an agency agreement with a subsidiary of PIN. Under the terms of this mandate, the subsidiary undertook to operate the appellant's franchise. I should immediately note that the respondent submits that this agency agreement is a sham. The appellant bought the franchise on the advice of his financial planner.
[8] The purchase price of the franchise in 2007 was $200,000: $10,000 for the franchise rights and $190,000 for the Solutions Prospector and Mail it Safe software. The appellant gave the franchisor a five-year full recourse promissory note bearing interest at a rate of 7.5% per annum. The respondent submits that this promissory note is a sham.
[9] The contracts signed in 2007 (i.e., the franchise agreement and the agency agreement) were replaced with new contracts in 2008. The cost of the franchise was raised by $30,000 in 2008. When he bought his franchise in 2008, the appellant gave the franchisor a ten-year full recourse promissory note bearing interest at the rate of 4% per annum. The respondent submits that the 2008 agency agreement and promissory note, too, are shams.
[10] Any dealings that the appellant had with PIN, the agent or any of PIN's affiliated companies were at arm's length.
[11] The respondent's position: The CRA's position is that the appellant bought the franchise solely for the purpose of obtaining tax deductions. This position is based on the following arguments.
(A) Argument I – There was no business
[12] First, the CRA submits that the deductions were not made for the purpose of gaining or producing income, because at no time during the relevant period did the appellant intend to carry on a business or in fact carry on a business, nor for that matter did Network Prospector or MarketX Services Inc. intend to carry on a business or in fact carry on a business on behalf of the appellant. See the Reply to the Notice of Appeal (the Reply) at subparagraph 26(l). See also the Reply at paragraphs 28, 29 and 36 to 38. See also the Reply at subparagraphs 25(o), (p) and (r), where the CRA alleges that the appellant never intended to draw income from his business.
(B) Argument II – The sham
[13] Second, the CRA submits that the full recourse promissory note and the agency agreement constituted [translation] "shams" (see the Reply at subparagraphs 26(l), (m), (p), (x), (y), (z), (aa) and (bb) and at paragraphs 32 and 34).
(C) Argument III – The unreasonable price
[14] Finally, the CRA submits that the [translation] "fair market value of the franchise and the rights attached to it was nil" (see the Reply, subparagraph 25(s)). The CRA further submits that [translation] "the fair market value of a franchise of Prospector International Networks Inc. was very low, if not nil" (see the Reply, subparagraph 26(cc)).
Issue
[15] The issue in this case is the following: Was the appellant carrying on a business in the year 2008? This issue also raises the following questions:
(a) Did the full recourse promissory note and the agency and management agreement constitute shams?
(b) Did the appellant pay a reasonable price for his franchise?
Procedural history
[16] On December 21, 2010, the appellant filed in this Court an appeal against the reassessment; the CRA filed its Reply on March 14, 2011.
[17] After two case management conferences held on May 19 and September 6, 2011, the Court set a tight, expedited schedule requiring the parties to disclose a considerable volume of documents and to hold examinations for discovery.
[18] On September 14, 2011, the Court rendered a confidentiality order in respect of the exhibits filed by the appellant (see Drouin v. The Queen, 2011 TCC 425, 2012 DTC 1020).
[19] On October 21, 2011, the CRA filed a [translation] "Motion to Amend the Reply to the Notice of Appeal" alleging that the appellant's franchise was a [translation] "tax shelter" and that the software that he marketed constituted [translation] "computer tax shelter property", such that the deductions claimed by the appellant were prohibited under the applicable provisions. On November 10, 2011, the Court dismissed the motion (see Drouin c. The Queen, 2011 CCI 519, 2012 DTC 1012).
[20] The hearing lasted a total of 30 days, from January 23, 2012, to May 10, 2012. The appellant filed approximately 785 exhibits, totalling around 13,000 pages. The respondent filed 161 exhibits.
[21] During the hearing, the Court rendered a decision dismissing inter alia an objection by the appellant to the testimonies of five other franchisees and two financial planners whom the CRA wanted to call as similar fact witnesses:
[translation]
[44] It is appropriate to reproduce paragraphs 22 to 24 of the written submissions of the respondent, which read as follows:
[translation]
22. The respondent submits that the testimonies of the franchisees and the financial planners are entirely relevant according to the criteria of the Supreme Court because these people were involved in transactions identical to those involving the appellant and thus will give evidence that may increase the likelihood that the contracts signed by the appellant and the promissory note allegedly given to him are in fact shams.
23. The testimonies of the franchisees and the financial planners will also increase the likelihood that representations were made to the Prospector franchise buyers to the effect that buying a franchise would give them a tax benefit in excess of the amount paid by them.
24. The testimonies of the franchisees and the financial planners will also increase the likelihood that no businesses were actually carried on through Prospector franchises.
(Drouin c. La Reine, 2012 CCI 94 [not translated], para. 44)
[22] In that same judgment, the Court also ruled on the qualifications of the expert witnesses that each of the parties planned to call after a motion on February 9 and 13, 2012. The Court thus accepted Jean‑François Ouellet (Mr. Ouellet) as an expert in management and in innovation marketing. However, the Court refused to accept Denys Goulet as an expert in appraisal, deeming his report to be of no probative value because his opinion was inextricably based on the opinions of an unidentified person who had not been presented to the Court as an expert.
Proceedings
[23] At the trial, the appellant presented an overview of the history of PIN from its beginnings to the present day through the testimonies of Thomas L. Jones (Mr. Jones), Michel Vincent (Mr. Vincent), Claude Duhamel (Mr. Duhamel), Paul‑André Mathieu (Mr. Mathieu) and Stéphane Teasdale (Mr. Teasdale).
[24] The testimonies of Mr. Jones and Mr. Duhamel reveal that PIN is the successor to Stratsite Inc. (Stratsite), an information technology company founded in 1998 by two young entrepreneurs, Mr. Jones and Carl Phoenix (Mr. Phoenix). Stratsite was initially involved in providing Web site development, PowerPoint presentation and electronic communications services for companies in the financial sector. Stratsite's clients included Valeurs mobilières Internat, a brokerage firm where Mr. Duhamel worked as a stockbroker. Mr. Duhamel had clients who wanted to invest in new high-tech companies. Being satisfied with Stratsite's work, he decided to approach Mr. Jones and Mr. Phoenix to learn more about their future projects. One of the projects that Mr. Jones and Mr. Phoenix discussed with him was C‑Local, an electronic data bank, similar to the Yellow Pages, that incorporated advanced search engines. However, this project required considerable financing. Mr. Duhamel managed to raise several million dollars in financing from various investors, which allowed Stratsite to go forward with the development of C‑Local.
[25] Near the end of 2000 and in early 2001, when the technology bubble burst, C‑Local's Web site was online and accessible to the general public, but the product was not being marketed. The financing needed to roll out C‑Local was impossible to come by, and an initial public offering had to be cancelled. The company was soon short of funds and had to reduce its staff considerably.
Solutions Prospector
[26] In spite of everything, Stratsite managed to finalize the tracking and notification system it had been working on. In 2002, Stratsite decided to breathe new life into the company by focusing on this tracking system. Building on their Web site design know-how, their database and the tracking system, Mr. Jones and his associate created a new computer program: Solutions Prospector. This software was designed to allow users to send an e-mail to a select list of recipients, inviting them to visit a Web site. The software would then track what action the recipients took, if any, after receiving the invitation.
[27] Mr. Duhamel testified that when he was seeking funds for Stratsite, he was referred to Andrew Murray (Mr. Murray), a businessman residing in Barbados who knew people with access to capital around the world. According to Mr. Duhamel, Mr. Murray had expressed an interest in Stratsite and had joined with him in preparing the financing plan and the following business plan with him. Canaventure, a company owned by Mr. Murray and incorporated in the British Virgin Islands, would ask Stratsite to develop Solutions Prospector on its behalf. Canaventure, which would hold the intellectual property rights for the software to be developed, would sell investors marketing licences for the products developed by Stratsite, and the licensees would in turn ask Stratsite to market the software on their behalf. The money paid to Canaventure would be given to Stratsite to finance the software's development.
[28] Licences were initially priced at $75,000 each. To maintain a stable cash flow for Canaventure and Stratsite, the licences had to be paid partly in cash and partly by means of a limited recourse promissory note. Mr. Duhamel explained that structuring the licences in this way had the added advantage of significantly reducing their risks by allowing them to claim a capital cost allowance on their licences while still receiving royalties.
[29] In 2002, only a handful of licences were sold. In 2003, the initial price of $75,000 was increased to $100,000, and the initial 30% down payment had to be paid in instalments over two years. The balance, paid by a limited recourse promissory note, was due 10 years later. Interest was paid out of the income earned. According to Mr. Duhamel, they sold approximately 140 licences in 2003 and 250 in 2004, under the same terms.
[30] In 2003, Canaventure began using the business name Prospector International and then officially changed its corporate name to PIN. On August 1, 2003, PIN incorporated Prospector Network Inc. (Network) to take over Stratsite's activities, and Stratsite was wound up. Mr. Duhamel explained that from then on, Network played two distinct roles: first, developing software for PIN; and second, marketing this software for the licensees. According to Mr. Duhamel, a third company, Prospector USA, wholly owned by Network, was incorporated in the United States to facilitate marketing efforts in that country.
[31] Development of Solutions Prospector was completed in November 2003. The company's business activities also began to pick up in 2003. For example, Network tried to do business with resellers of modified products, that is, businesses that were already selling information technology products and could distribute Solutions Prospector through their own networks. The attempt failed: Mr. Duhamel and Mr. Jones explained that the resellers refused to distribute Solutions Prospector because it was still unproven on the market. Network opened offices in Miami and Montréal to try to sell the software. A business plan identifying target markets was drawn up, and numerous presentations, personalized proposals and competitive analyses of competing products were done. Network made efforts to identify clients, efforts which included using Solutions Prospector. A few paying or prospective clients were using Solutions Prospector. Twelve of them were designated as [translation] "strategic accounts", that is, well-known businesses that, if encouraged to use Solutions Prospector, could foster market uptake and thus increase sales. Network offered these businesses free or discounted user rights. In addition, to target more niche clients, Network launched two derivative programs based on Solutions Prospector: "Prospector Finance" and "Prospector Trade Show". Licensees were informed of new releases and upcoming projects through updates.
[32] Despite all this, Network's efforts did not translate into sales. Mr. Jones and Mr. Duhamel attribute these disappointing results to the laborious nature of designing and developing microsites that meet high standards of professionalism. Clients also expected Network to provide the databases, which are very expensive, while Prospector's business model assumed that clients would provide their own lists.
Mail it Safe
[33] In April 2005, new software was announced. Prospect Mail, later renamed Mail it Safe, is described as a productivity and security tool. Basically, it allows senders to know when their messages have been read, how long the messages were looked at, and whether the attachments were downloaded. It also gives senders' messages added security by using encrypted networks on the Mail it Safe central server and by offering additional options, such as password protection. Initially, Mail it Safe could only be used via the Web as a module of Solutions Prospector, but it was later adapted to make it compatible with Outlook, and eventually with Lotus and BlackBerry, which increased the client base. Mail it Safe is offered either under a perpetual licence or through the purchase of a limited-time right known as "SaaS" (software as a service). Mr. Vincent described the difference between the two arrangements in the following terms (see Examination of Mr. Vincent, Transcript, January 25, 2012, Question 340):
[translation]
Generally, an SaaS solution is hosted. That means that the hardware isn't at the client's offices but is taken care of by the solution provider. So, for example, with Mail it Safe, the clients who are in SaaS mode use the solution via a server hosted by us, actually, by our partner, who has the specialized infrastructure. As to why we offer two modes, it's because it leaves us—it's a question of business flexibility. There are businesses that don't want to do what in industry jargon is called "capex", capital expenditures, and that prefer to have an operating expense in the budget. Because under their internal procurement approval procedures, it's easier to justify incurring an operational expense than a capital expense. In other businesses, it's the opposite. So we give ourselves the flexibility to align with the clients' interests.
What's more, there are businesses where technology is almost like a religion. There are some that think one thing is the best in the world and another thing is worthless, while others say the opposite. Everyone has their own beliefs. So there are businesses that say there's no way we can have the information from the applications we use be hosted outside our infrastructure. So these companies object to the SaaS mode because they can't accept having their data stored elsewhere. Other business will tell you the opposite. They don't want anything to do with managing that in house because they don't have the resources in place.
[34] In 2005 and 2006, Network devoted considerable effort and money to marketing Mail it Safe. Marketing consultants were hired to develop Mail it Safe's market image. Specific sectors were identified: legal services, financial services and health services. Network also decided to close the Miami office and open offices with sales teams in New York, Chicago, Los Angeles and Boston. It hired additional staff through the Montréal office. A “virtual office” was set up in London for about six months, and there were plans to open an office in Paris, according to Mr. Duhamel. There were also discussions with a Mexican associate, according to Mr. Duhamel.
[35] A significant amount of documentation was prepared for prospective clients: presentations, brochures, guides, user manuals, webinars and technical documents. Network created a Web site for Mail it Safe. It did strategic planning and trained in-house salespeople using reports, presentations and analytical documents. It also attended a number of trade fairs, including the LegalTech Trade Show in New York, and took part in various events attended by its target clientele. It also conducted a survey of selected members of its clientele to better understand clients' perceptions of the software.
[36] Network also entered into agreements with certain organizations, including the Greater Montréal Real Estate Board, the Corporation de services du Barreau du Québec and the New York County Bar Association. It donated 250 user licences to the Blythedale Children's Hospital, where the software was used. There were negotiations with Pitney Bowes and the Massachusetts Vietnam Veteran Association towards entering into a business agreement. Network also made IBM its technical associate, meaning that IBM took care of the security reports for Mail it Safe. Moreover, like Microsoft and BlackBerry, IBM allowed its logo to be used for advertising purposes.
[37] Network also tried to find resellers that could sell Mail it Safe to their clients. According to Mr. Duhamel, this solution could have led to sales but would have had the added advantage of raising the product's profile with a view to a possible acquisition by a major company. According to Mr. Duhamel, there were talks with Cablevision, Openface, Reach Everywhere, Merrill and BBDO, but nothing came of them.
[38] In 2005, Revenu Québec, which viewed the licensing system more as an investment than a business, threatened to disallow the capital cost allowances claimed. In response, Network and PIN offered the licensees the opportunity to convert the licences into franchises. According to Mr. Duhamel, approximately 40 licensees, or 20% of them, refused to convert their licences. Two hundred new franchises were sold in 2005. In addition, Mr. Duhamel explained that a special agreement, consisting primarily of a partial interest holiday, was concluded with 14 franchisees who had already invested in another of its business projects that had not turned out well.
[39] Mr. Duhamel explained that under the terms of the 2005 franchise agreements, the franchisees acquired [translation] "an operating franchise" giving them [translation] "the non-exclusive right to distribute, within the territory and to authorized clients, . . . Solutions Prospector and MISTM software for a term of 25 years beginning January 15, 2005". Under the contract, each of the franchisees was assigned a specific territory and had access to a data bank on the businesses located in that territory (see also the Solution Prospector and Mail it Safe franchise agreement between Prospector International Network Inc. and Annie Fortin dated December 30, 2005, Exhibit A‑55 (1‑97), Volume 27, page 10893, at page 10897, paragraphs 2.1 and 3).
[40] Another clause in that contract stipulated that if 75% of the franchisees agreed at a special meeting to sell their franchises to a third party, a franchisee could be required to sell its franchise, on condition that the sale be made under the same terms as for all the franchises.
[41] In response to a question from the franchisees regarding the number of franchises that PIN intended to grant, Mr. Duhamel answered that PIN had capped the number of franchisees at 1,500 and had divided the United States into 1,500 territories accordingly, by postal code. According to Mr. Duhamel, each territory was supposed to have between 10,000 and 20,000 potential clients entered in the Dun & Bradstreet data bank for businesses and professionals. According to Mr. Duhamel, the franchisees were told several times how the territories were divided up.
[42] Furthermore, the price of a franchise was raised to $160,000 (including $10,000 in franchise fees to take into account the launch of Mail it Safe), with an interest rate of 7% per annum. The term of the promissory note was four years.
[43] New franchises were sold in 2006 under similar terms.
[44] According to Mr. Duhamel, the money from the franchisees was used for development and marketing. Moreover, the evidence showed that Network was in regular contact with franchisees, usually by e-mail, but sometimes by regular mail. Most often, these contacts took the form of updates. There were also annual and special meetings, well attended by franchisees, during which presentations on the business situation and development were given. A [translation] "franchisees' manual" with periodic updates was sent to franchisees by mail and e-mail. A [translation] "VIP night" was organized to mark the launch of Mail it Safe, an intranet site was made available to franchisees, and franchisees were invited to refer people they knew to Network.
The 2006 appraisal by Wise, Blackman
[45] Mr. Duhamel explained that well after the technology bubble had burst, some financial groups renewed their interest in Mail it Safe and started negotiations. According to Mr. Duhamel, Mr. Murray considered the possibility of taking the company public. Mr. Duhamel also explained that it had become important to have a valuation of the company done (see Examination of Mr. Duhamel regarding the announcement to franchisees that the company might be taken public, Transcript, February 2, 2012, Questions 519‑531; Update (in a bundle), Exhibit A‑23.1.16.5, Volume 18, page 7852, at pages 7862-7865,) (announcement to franchisees that the company might be taken public).
[46] In addition, according to Mr. Duhamel, the franchisees started asking whether the franchisor and the agent had the financial capacity to continue developing and marketing the products (Examination of Mr. Duhamel, Transcript, February 2, 2012, Questions 293, 299 and 302.)
[47] To answer these questions, PIN hired renowned appraiser Richard M. Wise, FCA, FCBV, FASA, MCBA, of the firm Wise, Blackman LLP, which merged with MNP LLP on June 1, 2011 (Examination of Mr. Duhamel, Transcript, February 6, 2012, Question 88; Valuation of the business of Prospector International Network Inc. as at Sept. 30, 2006, by Wise, Blackman LLP, Exhibit A‑21.1, Volume 16, page 6939).
[48] In its report (the 2006 valuation), Wise Blackman concluded as follows:
[TRANSLATION]
In our opinion, according to the information and documents that we have reviewed and the explanations that were given to us, and subject to the assumptions and restrictions herein, the fair market value of the business on or about the valuation date was from $147,000,000 to $164,000,000 (rounded).
[49] The franchisees were notified of the conclusions of the 2006 valuation (Mail it Safe 2006 Overview and Forecast for 2007, Exhibit A-22.1.27, Volume 17, page 7298, at page 7301; PIN – Update – July 2009, Exhibit A‑22.1.36, Volume 17, page 7419, at page 7421).
[50] Despite all efforts, sales of Mail it Safe were weak. Mr. Jones and Mr. Duhamel attributed the failure of Mail it Safe to the managers of potential client's information technology departments, who failed to understand the added value of the tracking function and tended to take a lot of time to ensure that Mail it Safe was compliant with their own networks, such that sales became a very long process. Mr. Ouellet, whom I recognized as an expert, explained that the market had a poor awareness of the problem of the lack of security in electronic communications and was therefore less inclined to invest substantial amounts of money in security (Examination of Mr. Ouellet, Transcript, March 1, 2012, Question 47). Furthermore, according to Mr. Jones and Mr. Duhamel, given the disputes with the tax authorities, Network had to devote more resources to legal fees and liaison activities with franchisees. Finally, according to Mr. Jones, and especially according to Mr. Duhamel, the tax dispute negated the benefits of the partnerships that Network had entered into.
[51] Mr. Duhamel and Mr. Jones testified that Network took a number of steps to deal with these disappointing sales, including creating a [translation] "strategic sales committee", conducting surveys and seeking new partnerships. It also changed its human resources policy and required its salespeople to prepare reports when they lost potential sales. The price of Mail it Safe was changed, and new brochures and presentations were developed. In reaction to comments from certain clients, Network added a [translation] "secure Reply" function to Mail it Safe.
[52] Mr. Duhamel stated that in 2007, since results were still minimal, Network changed its business plan. He testified that Network decided to close its offices in the United States and focus its efforts on Quebec, a territory that had not been assigned to franchisees, in order to create a virtual storefront that could then be used to gain sales in the United States. Network was able to recruit two key employees: Mohammed Yacoub (Mr. Yacoub), the former president of a company with 1,200 employees and a turnover of $120 million; and Michel Lamontagne, a member of the ethics board of the Autorité des marchés financiers (AMF) and chairman of the board of the Régie de l'assurance maladie du Québec. Mr. Yacoub commissioned market studies targeting larger businesses. Intensive negotiations were held with IBM's Montréal office with a view to turning a technical partnership into a reseller partnership and to encouraging the use and adoption of Mail it Safe. IBM took steps in this direction with Royal Bank, Bombardier and Desjardins. Network also entered into an agreement with the Ordre des conseillers en ressources humaines et en relations industrielles du Québec and continued to create new software.
[53] According to Mr. Duhamel, in 2007, Network nevertheless continued its sales efforts in the United States, but from its Montréal office.
[54] Network made several sales in Quebec in 2007.
[55] Mr. Duhamel explained that in August 2007, Mr. Yacoub offered to take over the development and marketing business. According to Mr. Duhamel, Mr. Yacoub, however, wanted to operate that business through a separate company because he wanted to steer clear of trouble with the tax authorities. MIS International (MIS) was created for this purpose in December 2007. Mr. Yacoub and Mr. Lamontagne became chief executive officer and chairman of the board of MIS, respectively. PIN, which held 70% of the company's shares, tasked him with developing products and creating a virtual storefront for the franchisees (Examination of Mr. Duhamel, Transcript, February 29, 2012, Questions 575 and 577).
[56] According to Mr. Duhamel, the franchisees were informed of the planned creation of MIS at the annual general meeting in November 2007.
[57] To develop the software, MIS took charge of the technology team and the software's intellectual property. The relationship between MIS and PIN was governed by a series of contracts, some of which were filed in evidence (Exhibits A‑132, A‑133, A‑134 and A‑135). Under the terms of these contracts, PIN transferred the intellectual property to MIS for a royalty equal to 12% of the sales. The contracts also included clauses to ensure that PIN would be able to meet its obligations to the franchisees (see clause 2.1 of the contract entitled "Intellectual Property Licence Agreement", Exhibit A-134).
[58] The following emerged from the credible testimony of Mr. Vincent. In fall 2007, Mr. Vincent was appointed vice-president of sales of MIS and was instructed [translation] "to design and rethink the marketing strategy for the Mail it Safe solution". He came up with a new business strategy and restructured the sales team. In addition to capitalizing on its existing partnerships, MIS established new technology partnerships with Microsoft, the seller of Outlook, and RIM, the seller of BlackBerry. Mr. Vincent also implemented a [translation] "government strategy" aimed at having the product adopted by public and parapublic agencies that often deal with confidential data and communications. Significant resources were also devoted to training staff and preparing presentations. Some client prospecting was done by telephone. Mr. Vincent's efforts bore fruit, and Mail it Safe started to acquire some prestigious clients, including Revenu Québec. The proceeds from these sales were not shared with the franchisees, whose territories did not include Canada, but were used, according to Mr. Duhamel, to develop a virtual storefront for the international marketing of Mail it Safe in the franchisees' territories.
[59] Although MIS focused most of its efforts on Quebec and made most of its sales there, there were also some meetings and presentations in the United States, Toronto and abroad, even though no offices had been opened there. The contracts between PIN and MIS were amended in 2009 to make it clear that MIS's marketing rights were limited to Canada.
[60] The following also emerged from Mr. Duhamel's testimony. In late 2007, further discussions were held with Revenu Québec, this time regarding the promissory notes. Revenu Québec rejected the capital cost allowance claimed for the franchises acquired with limited recourse promissory notes. To rectify this problem, PIN proposed to the franchisees that the notes be converted into full recourse promissory notes. This meant that franchisees would promise to pay the amounts due upon maturity and would no longer be able to simply give back their franchises. The franchisees' initial reaction to this proposal was mixed, but in the end, after the meeting on November 27, 2007, about two thirds of the franchisees acquired new franchises with full recourse promissory notes.
[61] The main features of the 2007 contract are similar to those of the 2005 and 2006 contracts, with the exception of some significant differences regarding the price and the payment terms: the promissory note became a full recourse promissory note, the interest rate was reduced to 7.5%, and the term was extended to five years. Mr. Duhamel stated that the amount of the principal was raised to $200,000 to account for the improvements made to Mail it Safe and for the new partnerships.
[62] Mr. Duhamel explained that the territories were precisely defined: each franchisee would be given 20,000 businesses selected from the database according to a unique combination of postal codes and SICs (Standard Industrial Classification numbers). Mr. Duhamel also explained that territories in Florida and France, as well as Zurich, were expressly excluded from the assigned territories because they had been sold by PIN in 2005 and 2006. Canada was not expressly excluded, but as Mr. Duhamel stated, it was clear that Canada was reserved for the virtual storefront. According to Mr. Duhamel, approximately 1,100 new franchises were sold in 2007, including those assigned to new franchisees (such as the appellant) and those assigned to franchisees as a replacement for others.
[63] Mr. Teasdale, a lawyer who specializes in franchise law, explained that PIN hired him in 2008 to analyze the contracts and propose changes that would, on the one hand, better [translation] "reflect the business and operational reality" and, on the other hand, put the contract [translation] "on the cutting edge of what is being done in contracting in many industries". The 2008 version of the contract, prepared by Mr. Teasdale, included numerous changes and clarifications:
(1) the preamble was changed considerably;
(2) an express definition of [translation] "franchised business" was added (section 1.1.3);
(3) a manual was expressly provided for (section 1.1.4);
(4) a 10-year time limit was added to the renewal terms, as 10 years was considered to be [translation] "pretty much the industry standard";
(5) clarifications were added to explain how the exclusive lists work, and to provide for [translation] "a mechanism whereby if a franchisee sold to a client on someone else's list, compensation would have to be paid" (section 6.2);
(6) [translation] "additional services provided by Prospector, the franchisor" were spelled out (section 9);
(7) clarifications regarding the level of personal participation required of a franchisee were added (section 10);
(8) financing terms were largely moved into an appendix, since the financing terms can vary and it is [translation] "easier to deal with an appendix than to deal with a contract each time" (section 12 and appendix);
(9) the franchisee's right to his or her own agent was expressly confirmed, subject to the franchisor's approval (section 13);
(10) model clauses were added, as were an arbitration clause and a clause stating that the applicable law would be Quebec law (sections 16-17).
(Examination of Mr. Teasdale, Transcript, January 26, 2012, Questions 408, 409, 413 and 414; Prospector World E & T Network International franchise agreement (comparative version), Exhibit A‑36, Volume 26, page 10179.)
Furthermore, the franchise price was increased to $230,000, the interest rate on the promissory note was reduced to 4%, and the term was extended to 10 years. As suggested by Mr. Teasdale, who felt the expression "Prospector" was confusing, the expression [translation] "Prospector World franchisee" was replaced with [translation] "E&T Network International franchisee" ("E&T" stands for "Encryption and Tracking").
[64] According to Mr. Duhamel, the list of possible exclusive clients for each franchisee was reduced to 10,000 more carefully selected businesses. Self-employed workers were removed from the list, for example. Also, Canada was expressly excluded from the definition of the franchisees' [translation] "territory".
[65] As regards the mandate, MarketX Services Inc. (MarketX) became the agent. According to Mr. Duhamel, the law firm Fraser Milner Casgrain recommended that the agent should be a company other than Network, so as to maintain [translation] "a certain distance between the franchisor and the agent" (see court reporter's notes, March 21, 2012, paras. 79 to 81). The evidence showed that MarketX was never incorporated. It was not until March 2009 that Mr. Bernier (who had bought Prospector) realized that MarketX had not yet been created. I also note that under a resolution dated March 25, 2009, filed in evidence as Exhibit A‑80, PIN assumed all of the rights and obligations of MarketX. It also emerged from Mr. Duhamel's testimony that he learned that MarketX did not exist around the same time that Mr. Bernier did. The evidence on this point shows that the appellant did not find out that MarketX did not exist until April 30, 2009 (that is, at the meeting of franchisees). The appellant explained that at the time, he had assumed that Network was still his agent under the 2007 agency agreement because MarketX was supposed to replace Network. The appellant also testified that Network had been his agent until March 26, 2010, when the franchisees' association replaced Network.
[66] I reiterate that in the 2008 contracts, as compared against the 2007 contracts, the franchise purchase price was increased to $230,000, the interest rate of the promissory note was reduced from 7.5% to 4%, and the term was extended from 5 years to 10 years. Mr. Duhamel explained that the term was extended in response to pressure from the franchisees and their financial advisers, who were unhappy with the sales of Mail it Safe (Examination of Mr. Duhamel, Transcript, February 6, 2012, Questions 220, 222, 231, 244, 253, 283 and 285). Finally, the combined effect of the 2008 agency agreement and the 2008 franchise agreement increased the royalties payable to franchisees from 6% in 2007 to 12%.
[67] The following also emerged from Mr. Vincent's testimony. Although MIS succeeded in selling Mail it Safe to credible clients, sales revenues were never as high as hoped because the sales cycle was longer than expected and clients were not prepared to spend considerable sums of money to make electronic communications more secure because they could not measure the benefits in dollar terms. Mr. Vincent stated the following about Mail it Safe and its potential: [translation] "We have a good thing in Mail it Safe, but it's not clear that it can be turned into a viable business" (Examination of Mr. Vincent, Transcript, January 26, 2012, Questions 39 to 41).
CashOnTime
[68] The decision was, therefore, made in 2008 to develop a new business solution that was based on the tracking technology but [translation] "would allow us to quantify