THE ROLE OF VALUATIONS IN TAX PLANNING

Transcription

1 THE ROLE OF VALUATIONS IN TAX PLANNING Manu Kakkar, CPA, CA, MTax, TEP Manu Kakkar CPA Inc. London Marissa Halil, LLB, BCL Manu Kakkar CPA Inc. Montreal Christine Larkin, CPA, CA, CBV Gilbert & Larkin LLP Bracebridge 2015 Ontario Tax Conference

2 The Role of Valuations in Tax Planning By: Manu Kakkar, CPA, CA, MTax, TEP 1 Marissa Halil, LLB BCL 2, and Christine Larkin CPA, CA, CBV 3 Introduction Valuation is the systematic act or process for determining the fair market value of a transaction or an asset. Fair market value is defined as the highest price available in an open and unrestricted market between informed, prudent parties acting at arm s length and under no compulsion to act, expressed in terms of cash. 4 In many circumstances valuation will drive the tax plan, as the valuation represents the first step towards assessing the tax consequences of any transaction. 5 The role of valuations is heightened where there is no publicly traded market such as with private corporation shares. The purpose of this paper is to highlight the role that valuations play in several typical tax planning scenarios. 6 Before discussing the impact of valuation on tax planning, the first part of the paper will discuss selected issues to consider before undertaking a valuation (such as who may perform a valuation, when one should hire a professional valuator, what supporting documentation is required for a valuation, and what types of valuations reports exist). The second part of this paper will discuss the valuation issues arising in estate freezes (particularly in the situation of a freeze low sell high ), and the valuation of particular share attributes often used in an owner manager context, such as the entitlement to discretionary dividends or voting control. Finally, price adjustment clauses shall be discussed. 1 Of Manu Kakkar CPA Inc., London. 2 Of Manu Kakkar CPA Inc., Montreal. 3 Of Gilbert and Larkin LLP, Bracebridge. 4 The Valuation of Business Interests by Ian R. Campbell and Howard E, Johnson, Glossary of Defined Terms, page xx. 5 It is perhaps trite to say that a tax plan which involves the transfer of property with inherent gains will differ significantly from a transaction in which no value changes hands. 6 The thrust of this paper is tax and not valuations oriented. For more information on detailed concepts of valuations please refer to the most current versions of Canada Valuation Service, Student edition by Ian R. Campbell published by Carswell, and The Valuation of Business Interests by Ian R. Campbell and Howard E. Johnson for the CICA 1

3 The final part of the paper will discuss the valuation of different divisions within a company, which is often done as part of an unrelated party butterfly under paragraph 55(3) (b) of the Act 7. A. Issues to Consider Before Performing a Valuation The decision to hire a professional valuator is a discretionary one. Indeed, at no time is a professional valuation required either under the Canada Revenue Agency s ( CRA ) administrative policy or under relevant professional legislation. According to CRA, anyone can perform a valuation (a valuation expert is not required). However, when performing a valuation, reliance upon generally accepted valuation methods is not enough the valuation method must be properly applied. 8 As most laypersons cannot be expected to know generally accepted valuation methods, much less how to properly apply them, a professional valuator plays an important role in any situation where there is any doubt about value usually the case in the owner-manager context of private corporations with thinly traded shares. Similarly, CPA Ontario does not specifically prohibit Ontario CPAs from preparing valuation reports as part of a tax plan. However, since CPAs are required by their Rules of Professional Conduct (the CPA Rules ) to keep informed of, and to comply with, developments in professional standards in all functions in which they practice or are relied upon, 9 any CPA that completes a valuation for tax planning must arguably be expected to know and follow the CICBV Practice Standards. 10 Thus, although not strictly prohibited by any professional statute or CRA, a do-ityourself ( DIY ) approach to valuation is risky. Common mistakes arising in DIY valuations include: applying unreasonable multiples given industry or company risks, such as applying the same multiple to a mom and pop grocery store as you would to a public company department store chain Income Tax Act, RSC 1985, c.1 (5th Supp.), as amended and proposed to be amended, and including the regulations promulgated thereunder (the Act ). Unless otherwise stated, statutory references in this memo are to the Act. No assurance can be given that proposed amendments to the Act will be enacted in the form proposed or at all. 8 Income Tax Folio S4-F3-C1 Price Adjustment Clauses 9 Ontario s Rule of Professional Conduct The CICBV standards require providing a written report for any written communication containing a conclusion as to the value of shares, assets or an interest in a business, prepared by a Valuator acting independently including all of the minimum components of such reports as listed in the CICBV Standard No Since multiples are the inverse of assessed risk, one must consider the likelihood of continued profits of the small stand-alone grocery store (with limited customers) to the likelihood of a chain of stores ability to continue to be profitable. The risk rate of a business will be built from the following variables: the risk-free rate of return, the risk premium over the risk-free rate for large public companies, additional risk for private companies and the size of the company and risk factors specific to a business less an expected inflation rate. 2

4 not considering different risk rates for different company divisions such as assuming the same risk in manufacturing mature products as there is in the R&D division with no proven product sales history. not normalizing the earnings or cash-flows prior to applying a multiple to capitalize operations. For example, not adding back an owner/manager s large bonus in a certain year paid solely because the owner wanted to purchase a new house. 12 counting operational capital asset values twice by not understanding that the working capital and tangible assets used to produce the maintainable earnings are already factored in to the capitalized earnings and should not be added to the capitalized value for a total share value. not adding redundant assets to operational values when determining total share value of a company which, unlike operational assets, have not had their value included in the capitalized earnings value; valuing a highly profitable operating company using the Adjusted Net Book value approach, as it gives no consideration for intangible assets including goodwill. 13 (The adjusted net asset method is generally appropriate for companies that are going-concerns and which are expected to generate a reasonable rate of return on the underlying assets, but are not expected to have any significant level of goodwill) and using hindsight for a historical valuation date (since all valuations are at a historical point in time, and no future information could be known at that point in time that would affect the decision to purchase a business or the price to be paid for it). Involving a professional valuator will avoid the above pitfalls, and will mean the fair market values used in a transaction are less susceptible to CRA attack. Furthermore, as discussed later, involving a professional valuator will help establish the bonafides of a price adjustment clause. Thus, it is a best practice to either engage a professional valuator or have one review a practitioner s valuation. 14 In practice, a professional valuator may be called upon in the following situations: 12 Earnings must be normalized before capitalizing to determine what an arm s length party would report as revenues and expenses to earn the highest profit attainable for the business. 13 The adjusted net asset method (also referred to as the adjusted net book value method) expresses the value of a company as the fair market value of the assets, net of liabilities. Some level of corporate and personal taxes may be reflected depending on the individual circumstances. 14 A lack of adherence to the CICBV standard could also increase the practitioner s professional liability with CPA Ontario. 3

5 An estate freeze where the present fair market value of shares is to be determined and segregated from future growth shares; Butterfly or other tax related transactions where business assets, including intangible assets, and related debt are being moved from one corporation to another; To assist in defending a value under audit by CRA; Shareholder disputes and buy-outs; Family law for the determination of net family property; or Determining value prior to listing a business for sale. Independence Rules Chartered Business Valuators ( CBVs ) must act independently and objectively in carrying out their valuations. 15 The CPA Rules specifies when firms cannot provide valuation together with assurance services, 16 and also when firms cannot provide tax advisory services together with assurance services. As with all other prohibitions, the emphasis is on a firm not providing assurance on its own work. For example, a firm may complete a valuation for tax purposes and concurrently provide assurance services to the same client, if the valuation will not materially affect the financial statements (and assurance work thereon). However, a firm may not complete a valuation involving a significant degree of subjectivity if the valuation relates to material amounts on the financial statements that are subject to audit or review by the same firm. Similarly, a firm cannot provide tax advisory services to an assurance client where the effectiveness of the advice depends on a particular accounting treatment or will have a material effect on the financial statements. 17 Required Supporting Documentation To ensure proper documentation and support of a value conclusion, anyone valuing a business for tax purposes should follow Practice Standard 110 of the Canadian Institute of Chartered Business Valuators ( CICBV ), and keep supporting 15 CICBV Practice Standard Specifically, CPA Ontario s Rule of Professional Conduct lists prohibitions to conducting assurance engagements. Paragraph 204.4(25) outlines circumstances when a firm cannot provide both valuation and assurance services, and paragraph 204.4(34) outlines the circumstances when a firm cannot provide both tax planning or advisory services and concurrent assurance services. 17 Professional judgment is required when determining whether a change in share structure and new share issuances with high redemption values reportable on the financial statements is solely a tax entry or requires a material disclosure under Canadian generally accepted accounting principles. 4

6 documents in an organized file. 18 Supporting documentation should include source documents, correspondence and interviews directly with the client. Where the valuator is involved on a valuation for a third party client through the recommendation of another practitioner, responses relating to the fact finding should come not just from the referring practitioner but also from the third party client. Furthermore, as the jurisprudence (discussed below) shows, a valuator s independence is key. 19 A statement within the valuation report that the valuator acted independently and objectively may not suffice if there is any perception of an independence issue. Independence should be documented in the file: for example, best practice would have the engagement performed by a valuator who has never met the client, or worked in the same office as the client s assurance partner. Finally, engagement letters, representation letters and retainer letters should be kept in the file as evidence of independence, thereby treating an existing firm client requiring valuation services exactly the same as a one-time service referred client. Professional valuators must go one step further to ensure there are no perceived or actual independence issues. Types of Valuation Reports The CICBV recognizes three different types of Valuation Reports with certain shared and unique standards for each report. The Comprehensive Valuation Report, which provides the highest assurance, is generally only used for public company offering documents and will not be discussed in this tax related paper. All reports are distinguished by the scope of review, disclosure provided, and level of assurance provided in the conclusion. One of the following reports are the reports one would expect prepared by a CBV for tax purposes: Calculation Valuation Report a Calculation Valuation Report contains a conclusion as to the value of shares, assets or an interest in a business that is based on minimal review and analysis and little or no corroboration of relevant information, and generally set out in a brief Valuation Report; or, Estimate Valuation Report an Estimate Valuation Report contains a conclusion as to the value of shares, assets or an interest in a business that is 18 CICBV Practice Standard 120 provides the file documentation standards and recommendations for valuation reports and Practice Standard 130 provides the File documentation standards and recommendations. These standards are not in a checklist form but many CBV firms will have taken these standards and formatted them as a checklist that includes both the minimum standards and the additional recommendations. 19 In Garron Family Trust v. R TCC 450, Justice Woods questioned the credibility and independence of the taxpayer s valuator, whose firm also provided the taxpayer with audit services and tax advice. The valuator s significant business relationship with the taxpayers partly led the Tax Court to favor the valuation of the opposing side. 5

7 based on a limited review, analysis and corroboration of relevant information, and generally set out in a detailed Valuation Report. There are very few minimum standards and recommendations that differ for these two types of engagements and CBVs in Canada have very differing opinions as to when you would use one report over another. Unlike in the Canadian accounting profession with Notice to Reader engagements, one can complete as much work and analysis as the CBV considers necessary to come to their conclusion and still consider their report to be a Calculation Valuation Report. Some CBVs and their clients, request a higher level of review, such as an Estimate Valuation Report, if they believe there is a likelihood of a challenge on the valuation conclusion. This could be the case, for example, in a tax re-organization that does not allow room for valuation error, where litigation is a possibility, or perhaps where a higher level of perceived credibility and lack of bias will help negotiations on a sale or buy-out. It is interesting to note that only Estimate and Comprehensive Valuation Reports have a minimum standard to document the valuation approach and techniques selected in the file, along with the reasoning for the selection. Also, the standard is met if this information is included in the report itself rather than in supporting papers. 20 However, one should expect that all CBV practitioners would have their approach stated and rationalized in every report. An internally prepared valuation calculation is acceptable to CRA if the CICBV Practice Standards have been followed and the approach and methodology used in the valuation is appropriate for the business being valued. If a taxpayer cannot provide such a calculation to support a value being audited, CRA may infer that no reasonable effort was made to transact at fair market value and may not invoke a price adjustment clause on the share or debt. With an incorrect valuation conclusion, and the price adjustment clause set aside, an expected tax deferred transaction could become immediately taxable in its entirety. In conclusion, one does not need to be a CBV to perform a valuation for a tax reorganization however it is a best practice to either engage a professional valuator or have one review a practitioner s valuation in many situations. B. Estate Freezes: In an estate freeze, the fair market value of the company at a particular date is frozen (capped, limited) and conferred, via the issuance of fixed value freeze shares, to the freezor. Furthermore, new shareholders (eg. children) are introduced (acquiring nil value common shares, usually through a discretionary family trust) in order to benefit from any future growth in the company. When advising clients to restructure capital with a freeze, one should always keep in mind 20 CICBV Standard 130, 5E 6

8 the company s growth potential. If a company has reached its peak value (for example, a restaurant operating at maximum capacity), one would consider not implementing an estate freeze structure to save the client unnecessary costs. To achieve their purpose, freeze shares must have a fixed value. Fairly recently 21, CRA has re-iterated what it considers to be the essential attributes of freeze shares: redeemable at the option of the holder at a redemption price equal to the fair market value of the common shares exchanged, plus any declared and unpaid dividends; no dividend can be paid on other classes of shares for an amount that would reduce the fair market value of the preferred shares below their redemption price, or that would result in the corporation not having the necessary net assets for the redemption of the preferred shares; they must have, at least, voting rights on any matter involving a modification to the attributes attached to them (these voting rights can be provided by the relevant corporate law or the articles of incorporation); 22 absolute priority on all other classes of shares in the event of the distribution of the assets of the corporation on a winding-up or a dissolution of the corporation or any other distribution of its assets, up to the redemption price, plus any declared and unpaid dividends; absolute priority on all the other classes of shares with respect to the redemption of the shares, and the corporation cannot acquire shares of others classes before the redemption of all the preferred shares; no restriction with respect to the transfer of the preferred shares (other than the restrictions required, if applicable, by the relevant corporate law in order to qualify as a private corporation); and contain a price adjustment clause for the redemption price of the preferred shares which is applicable when the redemption price agreed to by the parties is not equal to the fair market value of the common shares exchanged, and also containing other appropriate adjustments when the shares have already been redeemed at the time of an adjustment of the redemption price. 21 Technical Interpretation C6 22 In TI 4M09660, CRA has stated that to protect the value of the freeze shares it is not necessary that the freeze shares be voting. Rather, the freeze shares should have at least have voting rights on any matter involving a change to their preference or rights attaching to them. 7

9 The involvement of an independent valuator is particularly important in an estate freeze, as the general bias of owners-managers may (arguably) be to under-freeze their shares in order to minimize their taxes on death. Yet, all owner-managers will wish to maximize proceeds on a share sale to an arm s length third party. Consider the following example: Example 1: Freeze Low, Sell High 1. Mr. Y implements an estate freeze at $800,000 of his engineering firm and takes back voting freeze shares. 2. The engineering firm carries on business in Toronto. 3. A family trust with 4 immediate family members(spouse and 3 children) as beneficiaries subscribe for non-voting growth shares months pass and the engineering firm s shares are sold for $4 million. 5. $800,000 is allocated to each of the 5 family members and the entire capital gain is tax exempt, as each taxpayer claims the capital gains exemption on their portion. Figure 1 Proceeds to be allocated equally among spouse and 3 kids Mr. X $800,000 Freeze shares Family Trust $3.2 million Common shares Engineering Firm 8

10 Question: Is this purchase price allocation reasonable from a valuation and tax perspective? Valuation Perspective- How You Would Justify a Freeze Low Sell High? Although not often discussed in this context, the Tax Court level decision of Garron Family Trust v. R., 23 provides an interesting example of this exact fact pattern (a freeze low then sell high ). In that case, an estate freeze was carried out, whereby the owners of the common shares of a corporation, PMPL, exchanged their common shares for fixed-value preference shares. Newly issued common shares were then issued for nominal consideration to holding companies which were held by Barbados trusts. The Minister s first line of attack (ultimately successful) was that the trusts were resident in Canada, and thus taxable on the capital gain from the share sale. The interesting valuation issue arose in Garron as an obiter point. As one of many alternative arguments, the Minister posited that subsection 75(2) would apply to tax the capital gains in the hands of the individual Canadian resident freezors. Indeed, according to the Minister, the freeze value of the common shares was understated at $50,000,000 since the trusts sold the shares shortly thereafter to an arm s length party for more than ten times that amount --$532,000,000. The Minister s valuator determined that at the time of the freeze, the value of the common shares was $102,000,000. It is interesting that the Minister did not argue that the freeze value was $532,000,000. Rather, the Minster s valuator explained that at the time of the freeze, the fact that PMPL was on the cusp of a meteoric rise was not entirely foreseeable. The Court ultimately did not peg a specific value to the freeze shares, but concluded they were substantially greater in value than $50,000,000 at the time of the freeze. The Court noted that at the time of the freeze, PMPL was in the process of launching two new business products for General Motors. The launch was marred by a pricing dispute with General Motors, was some months away, and was generally not riskfree. However, the Court rejected the taxpayer s position that a potential purchaser would not ascribe any value to the profit potential of the new launches TCC 450 9

11 What lessons can be inferred from this obiter discussion on valuation in Garron? Perhaps if the taxpayers in Garron had involved a truly independent valuator 24, and the freeze shares were valued at $100,000,000 instead of $50,000,000 at the time of the freeze, the Minister s line of attack under subsection 75(2) would have been avoided. The good news from Garron is that there may be situations where a freeze low/sell high situation is justified. In Garron, the new product launches were marred by disputes and thus not free of risk. Even the Minister conceded that at that time of the freeze, the fact that PMPL was on the cusp of a meteoric rise was not foreseeable. In what other situations would one be able to justify an unforeseeable increase in fair market value? As explained below, one would have to argue there was a material change in the company in the intervening time period between the freeze and the sale. To justify that the engineering company in example 1 has actually grown 500% in two years a valuator, in a defending role, would explain not only all the reasons for the meteoric rise in value, but also the timing of the factors and prove those factors weren t in place or could not have been foreseen when the initial valuation and freeze took place. As was noted in Garron above, hindsight is not permissible in a valuation approach and a business must be valued at an historical point in time with the facts available at that date any growth factors considered in the report must have been foreseeable. Some examples of supporting factors may include the following: new long-term contracts the engineering company wins a major contract with a developer for the drawings for of all residential units for several subdivisions until all lots are sold and built; new sales territory new crew managers become available and are hired that allow the engineering company to expand and draft in several communities at the same time; buying power with the growth from new contracts and expansion better pricing on materials were negotiated that increased profit margins on every job; the acquisition of competitors an aging competitor approaches the engineering company to purchase the competitor upon his retirement 24 Justice Woods questioned the credibility and independence of the taxpayer s valuator, whose firm also provided the taxpayer with audit services and tax advice. The valuator s significant business relationship with the taxpayers partly led the Tax Court to favor the valuation of the opposing side. 10

12 thereby increasing the number of sites completed each year, leaving less competition on bids and higher synergistic profits per site as the existing administrative staff had capacity to take on the paperwork of additional sites; insolvency of a competitor not only will the engineering company have less competition on bids, but may very well pick up the existing unfinished jobs of the competitor that went bankrupt mid development; and situations where the company is a take-over target by a synergistic purchaser the engineering company has grown large enough on its own given the above factors to become a threat to other large competitors that will buy the engineering company for its workforce, contracts and synergies. On the other hand, it would be very difficult to justify a large increase in value over any time period if the business was in a mature stage with little growth from year to year or declining in sales and profits. There may be some justification of a change in the capitalization multiples but as the capitalization rates are the inverse of the risk on earning continued profits, the rates will only change as fast as risk-free rates change, other risk factors change, and overall economic changes occur in the industry and geographic region of the business. Taxation Perspective If the Freeze Shares are Undervalued 25 If CRA does not agree with the valuation arguments to justify the freeze low, sell high and in the absence of a valid price adjustment clause, CRA may take the position that the freeze shares were undervalued at the time of the freeze. When freeze shares are undervalued, a number of provisions may apply, in particular subsection 75(2), 51(2), 86(2) and 85(1)(e.2) to name a few. 26 Where a freezor is a trustee and beneficiary of a trust, and the freeze shares are undervalued, the common shares will have more than nominal value, yet the trust will have subscribed for shares for nominal consideration. In CRA s view, the freezor has arguably transferred property (the value of the common shares) to the trust, and subsection 75(2) may apply, as the growth shares may revert back to the 25 Although this shall not be discussed in the paper, where freeze shares are overvalued, the freezor is receiving shares that have more value than the common shares that were exchanged. In this scenario, the excess amount may be included in the income of the freezor under subsection 15(1) of the Act. Alternatively, section 69 may apply 26 Others include sections 74.1, 74.2, 74.3 and A detailed discussion of all these attribution rules is outside the scope of this paper. The attribution rules are generally triggered where an individual transfers property (directly or directly by any means whatever) for the benefit a spouse or minor child. In TI I7, CRA states that a shift in value resulting from an undervaluation of exchanged common shares is a transfer of share rights attributable to existing equity from the former holders of common shares to the new common shareholders. 11

13 freezor as trustee or beneficiary. 27 Thus, any income or gains on the common shares would attribute to the freezor and be taxed in his or her hands. If the freeze shares are undervalued, then subsections 51(2) and 86(2) may apply. Indeed, these subsections apply where the fair market value of the old shares exchanged is greater than the fair market value of the new (freeze) shares received. However, subsections 51(2) and 86(2) apply only where it is reasonable to regard the excess (the gift portion ) as a benefit the taxpayer desired to have conferred on a person related to the taxpayer. If the bona fide intention of the taxpayer is to transact at fair market value, then arguably, the intention is not to confer a benefit on any person related to the taxpayer, and the application of these subsections is precluded. The effect of subsections 51(2) and 86(2) are similar. Under both these subsections, the taxpayer is deemed to dispose of the old shares at the lesser of (i) their cost plus the gift portion and (ii) their fair market value. 28 Moreover, in both these subsections, the capital loss on the disposition of the old shares is deemed to be nil. 29 The application of subsection 86(2) where the freeze shares are undervalued shall be illustrated by the following example 30 : Example 2: Undervalued Freeze Shares 1. The freezor owns common shares of Opco with a fair market value of $ The common shares are erroneously valued at $ Thus the freezor exchanges his common shares for freeze shares with fair market value of $ The adjusted cost base of the original common shares is $ The freezor s family trust subscribes for common shares at a nominal subscription price. 6. The taxpayer s intention is to confer a benefit on family members In this case, the gift portion is $100. Under subsection and 86(2), the taxpayer will be deemed to dispose of the old common shares at the lesser of their cost plus the gift portion ($150), and their fair market value ($200). The lesser amount is $150. Since the adjusted cost base of the common shares is $50, a gain results of $ TI I7 28 See paragraphs 51(2)(d) and 81(2)(c) 29 Paragraphs 51(2)(e) and 81(2)(d) 30 Subsection 51(2) will produce the same tax consequences as subsection 86(2) in this example. 31 The same gain would be triggered under subsection 51(2) 12

14 Under paragraph 86(2) (e), the adjusted cost base of the new shares is the amount by which the adjusted cost base of the old shares ($50) exceeds the lesser of (i) the fair market value of any boot receivable on the exchange plus the gift portion ($100) and (ii) the fair market value of the old shares immediately before the disposition ($100). Thus, the adjusted cost base of the new shares under paragraph 86(2)(e) would be $ The taxed gift portion of $100 is not recuperated on the adjusted cost base of the new shares, and thus represents double taxation. If the freeze was effected under section 85, and the fair market value of the new freeze shares is in excess of the old common shares, then a capital gain might result in the amount of the excess. As above, paragraph 85(1)(e.2) applies where the taxpayer desires to confer a benefit on a person related to the taxpayer. If the bona fide intention of the parties is to transact at fair market value, then arguably, the intention of the parties is not to confer a benefit on any such persons. C. Valuation of Different Shares Commonly Used in an Owner/Manager Context Discretionary Dividend Shares (no value) Discretionary dividend shares allow a corporation to declare dividends on a class of shares to the exclusion of the other classes. Moreover, discretionary dividend shares are designed to have nil or nominal value, as they are not participating, but are redeemable and retractable for the consideration for which they were issued. Historically, when held by individuals, discretionary dividend shares have been used for income splitting. Where held by a corporate shareholder, discretionary dividend shares have been used in purification techniques for the purpose of obtaining the capital gains exemption. Proposed changes to subsection 55(2) of the Act may very well put an end to nominal value discretionary dividend shares in the inter-corporate context. Proposed subsection 55(2) introduces a new purpose test whereby subsection 55(2) is triggered (inter alia) if one of the purposes of the dividend is to effect a significant reduction in the fair market value of any share. Problematically, under proposed 55(2.5) (introduced as part of the July 31, 2015 proposals) a significant reduction is to be determined as if the fair market value of the share immediately before the dividend is increased by the amount, if any, by which the fair market value of the dividend received exceeds the fair market value of the share on which the dividend is paid. When a dividend is paid on a discretionary dividend share with 32 Under subsection 51(2), the adjusted cost base of the new freeze shares shall be deemed to be the lesser of (i) the cost of the old shares ($50) and (ii) the fair market value of the freeze shares plus any denied loss ($100). Thus, the cost of the new shares under subsection 51(2) shall be $50. 13

15 nominal value, the dividend will almost always exceed the value of the share, and accordingly, there will an addition to the fair market value of the share prior to the dividend. After the dividend payment, the fixed value preferred share will revert back to its nominal fixed value. Accordingly, a significant reduction in the fair market value of the share may have occurred. Example 3: Discretionary Dividend Shares in an inter-corporate context A $2,000 dividend is paid on discretionary dividend share with a fixed value of $10. Proposed subsection 55(2.5) requires that the excess of the dividend over the fair market value of the share ($1,990) be added to the fair market value of the share immediately before the dividend payment. Once the dividend is paid, the deeming rule under subsection 55(2.5) ceases to be operative, and the share would revert back to its fair market value of $10. As the fair market value of the shares therefore decreases from $2,000 to $10 as a result of a dividend payment, this would presumably constitute a significant reduction in the fair market value of the share. To avoid this problem, in an inter-corporate context, discretionary dividend shares should be designed to have value. 33 The alternative would be to argue that the purpose of the dividend payment was not to create a significant reduction in the fair market value of the share. However, as some tax commentators have pointed out, this may be difficult to do, in light of the fact that a reduction in fair market value of a share is a natural and logical consequence of a dividend payment If the value shares happen to lack the required discretionary dividend entitlement, they may be exchanged for shares under section 86 or 51 with the necessary attributes. 34 STEP Canada Tax Technical Committee letter to Finance dated September 30,

16 Example 4: Discretionary Dividend Shares for Income Splitting 1. Dr. X owns 100% of the issued 50 full voting and participating common shares of a dental professional corporation ( DPC ) practicing dentistry in Ontario. 2. Mrs. X, the spouse of Dr. X owns 100% of the issued 50 non-voting nonparticipating discretionary dividend class of shares of the DPC. 3. The redemption amount, adjusted cost base ( ACB ) and paid-up capital ( PUC ) of these discretionary dividend shares is nominal. 4. Both Dr. X and Mrs. X have held their respective shares for 24 months 35. The DPC meets the 50% test 36 and the 90% test 37 for the qualified small business corporation share capital gains exemption tests Dr. and Mrs. X do not have an cumulative net investment loss 39 ( CNIL ) balance nor have claimed an allowable business investment loss 40 ( ABIL ). 6. Dr. and Mrs. X are Canadian and Ontarian residents for income tax purposes. 7. Dr. and Mrs. X are not US citizens, were not born in the US, are not green card holders nor were both of their parents born in the US. 8. Dr. X and Mrs. X each sell their entire respective shareholdings for $1.6 million to an arm s length purchaser. The allocation of the purchase price is allocated between the non arm s length parties as follows: $800,000 to Dr. X s participating shares $800,000 to Mrs. X s discretionary dividend shares 35 Paragraph 110.6(1) qualified small business corporation share 36 Ibid. 37 Ibid. 38 For a more detailed article on the capital gains exemption, please refer to Manu Kakkar, CA, and Nancy Yan, CA, "Practical Considerations in Claiming an ABIL or the Capital Gains Exemption," 2012 Ontario Tax Conference, (Toronto: Canadian Tax Foundation, 2012), 5: Defined in subsection 110.6(1) 40 Defined at paragraph 38(c) 15

17 Figure 2 Dr. X Mrs. X 50 voting participating shares ( voting common shares ) 50 non-voting non participating shares ( discretionary dividend shares ) DPC Question: Is this purchase price allocation reasonable from a valuation and taxation perspective? Valuation Perspective Justifying the Allocation of More Value to the Discretionary Dividend Shares Example 4 outlines a situation where Dr. X has complete control over the company, both from an operating stand point to meet the rules of his professional association, and from a voting control standpoint. At any time, unless outlined differently in the share attributes, Dr. X could vote to redeem Mrs. X s shares at a nominal value. This is why having an equal partition of the sales proceeds between Dr. and Mrs. X seems far-fetched from a valuation perspective. Unless extraordinary circumstances dictate otherwise, one would generally attribute value to the non-voting discretionary dividend preferred shares at the greater of their paid-up capital and their redemption value. The following theoretical arguments could be used to support an increased but not equal split of proceeds as between husband and wife, Dr. X and Mrs. X: Look at was whether or not the DPC was purchased, or built from the ground up. If Dr. X purchased the common shares at fair market value, say of $500,000, and has continued to operate the practice with the same or 16

18 growing profits, it may be expected that the first $500,000 in value to be attributable to his shares and then look at the subsequent increase in value to be shared. If the initial practice was built rather than purchased, if Mrs. X owned the shares as long as Dr. X and if she paid as much for her shares as Dr. X paid, one could argue pro rata growth to each class of share based on length of ownership. One could argue that the dividend stream on Mrs. X s shares would continue and present value future expected dividends to determine a value on those specific shares. If Mrs. X truly was a partner and full time participant in the practice, say with the office manager title, it could be argued that there had always been an expectation of equal entitlement and the different share classes were solely in place to meet the professional association guidelines. In all cases, there would need to be strong reasons to attribute more than the redemption value to shares that are by their very nature non participating in growth. CRA considered the value of a discretionary dividend share in TI E5 (in French). In that letter, it was contemplated that discretionary dividend shares would be used to purify a corporation of its cash on an annual basis. CRA stated that the value of the discretionary dividend shares would be greater than their redemption amount, as it appeared that the shareholder had the right to receive dividends annually on the basis of a pre-established policy. Incidentally, the letter does not specify whether the pre-established policy in question was a written policy or merely reflective of the taxpayer s intention. Taxation Perspective- Discretionary Dividend Shares In example 4 above, could CRA use section 68 to try to reallocate proceeds from the wife to the husband? Paragraph 68(a) applies where an amount is receivable in part for the consideration of the disposition of property of a taxpayer. Paragraph 68(a) allows CRA to reallocate reasonable proceeds to the disposition of such property regardless of legal form. In this case, in order to reallocate the proceeds of disposition from the share sale as between husband and wife, paragraph 68(a) would have to apply to re-allocate proceeds as between taxpayers. However, paragraph 68(a) has not been interpreted in this manner by the courts. Rather, paragraphs 68(a) and 68(b) have been interpreted to apply to reallocate proceeds as between different kinds of property or services sold by a single taxpayer Except for paragraph 68(c), which specifically contemplates re-allocating proceeds between different taxpayers when an amount is received or receivable in respect of a restrictive convenant 17

19 This finding was confirmed in Robert Glegg Investment Inc. v. R., 42 where it was considered that paragraph 68(a) could not reallocate proceeds as between shares and a non-compete where the non-compete had been granted by a different vendor who was not a party to the share sale. Of course, paragraph 68(c) was later added to allow for a reallocation of proceeds from a restrictive covenant as between different taxpayers. Nonetheless, Robert Glegg arguably still provides an accurate interpretation of paragraphs 68(a) and (b), as these have not been since amended. Furthermore, arm s length bargaining specifically in respect of the purchase price allocation between purchaser and vendor will create a presumption in favor of the taxpayer that the allocation should stand. 43 Furthermore, in order for the attribution rules under sections 74.1 and 74.2 to apply, there must be a transfer (directly or indirectly by any means whatever) by husband for the benefit of the spouse. In this case, there is no such transfer, (narrowly construed) as the husband does not divest himself of any shares in favor of the wife. 44 It is accordingly not clear how CRA would use those rules to attack the purchase price allocation. If CRA disagrees that the fair market value of Mrs. X s discretionary dividend shares is $800,000, then subsection 56(2) is the most likely risk. 45 The share sale proceeds may be reallocated to the husband under subsection 56(2) if the intention of the husband was to benefit the wife. 46 However, the involvement of an independent valuator would arguably mitigate if not negate the gifting intention and thus preclude the application of subsection 56(2) CarswellNat 62 affirmed at 2008 CarswellNat 4148 (FCA) 43 The Queen v. Golden [1986] 1 SCR 209; aff'g. Golden v. The Queen, 80 DTC 6378 (FCTD); rev'g. 83 DTC 5138 (FCA). Robbins v. MNR, 78 DTC 1669 (TRB). For a more recent case on section 68 see TransAlta Corporation c. Canada, 2012 FCA 20; rev'g. (in part) 2010 TCC In Fasken Estate v MNR, [1948] C.T.C. 265 (Exch), the meaning of the word transfer was discussed as follows: The word transfer is not a term of art and has not a technical meaning. It is not necessary to a transfer of property from a husband to his wife that it should be made in any particular form or that it should be made directly. All that is required is that the husband should so deal with the property as to divest himself of it and vest it in his wife, that is to say, pass the property from himself to her. The means by which he accomplishes this result, whether direct or circuitous, may properly be called a transfer. 45 The Queen v. Neuman [1998] 3 CTC 177 establishes there are four preconditions in order for subsection 56(2) to apply: 1. there must be an actual payment or transfer of property by one person to another, other than the taxpayer, 2. the payment or transfer be made pursuant to the direction of or with the concurrence of the taxpayer, 3. the payment or transfer be for the benefit of either the taxpayer or some other person the taxpayer wished to have it conferred upon, and 4. the payment or transfer would have been included in computing the taxpayer's income if it had been received by the taxpayer instead of the other person. 46 See for example Hasiuk [2008] 3 C.T.C 2262; aff d [2009] 2 C.T.C. 7 (FCA) 18

20 Thin Voting Shares Thin voting shares are non-participating and voting, and allow the freezor to retain control of a corporation after a freeze. Since the shares are non-participating, it is assumed that the shares have nominal value. According to CRA, it will not attribute value to th in voting shares where the freezor, as part of the estate freeze, keeps controlling non-participating preference shares in order to protect his economic interest in the corporation. 47 CRA requires that thin voting shares be voted in a manner to protect the value of the freeze shares, but not to run the corporation in conflict with the common shareholders. Moreover, the owners of the thin voting shares must act in a manner consistent with the assumption that no value attaches to the voting rights. Otherwise, CRA might assess value to a thin voting share. 48 By their very nature, thin voting shares exist solely to control the company without any dividends or growth to the shareholder. These shares are usually issued to ensure the management and profitability is maintained over a transition period or during the buy-out of a shareholder over time. Since the share attributes exclude future income or growth, the present value of all the earnings of these shares (and their fair market value) would be nil. To attribute any value to these thin-voting shares one would require an argument that by controlling this particular company s management decisions, profits will be made elsewhere by the shareholder for an overall increase in wealth. For example, a shareholder with voting control via thin voting shares could require that the company acquire all its widgets from a sister company owned by the same shareholder rather than a competitor, which would result in increased profits for the sister company and its shareholder. It should be noted that thin voting shares are not as effective as they once were to avoid an acquisition of control (loss restriction event) and the resulting consequences, for example, under subsections 111(4) and 111(5) of the Act. 49 Indeed, subsection 256.1(3) (introduced by the 2013 Budget) will trigger an acquisition of control of a corporation at a particular time if: Immediately before the particular time, the shares held by a person or group does not exceed 75% of the fair market value of all the shares Immediately after the particular time, the shares held by a person or group exceeds 75% of the fair market value of all the shares. Thus, a shareholder who previously owned 74% of the fair market value of all shares, and who later acquires an additional 2% of the shares, to hold 76% of the 47 TI C6 48 John F. Oakey, "Estate Planning - Hot Topics," 2011 Atlantic Provinces Tax Conference, (Halifax: Canadian Tax Foundation, 2011), 3B:

21 total fair market value of the company will have triggered an acquisition of control of the corporation. The resulting consequences under subsections 111(4) and (5) of the Act will include a deemed year-end, 50 the inability to carry forward (and back) net capital losses to periods after (before) the acquisition of control, and the inability to carry forward (and back) non-capital losses to the period before (or after) the acquisition of control, unless the same business is carried on by the taxpayer with a reasonable expectation of profit. In light of what appears to be a major paradigm shift in the acquisition of control rules in the Act, involving an independent valuator seems more important than ever. Indeed, one must be very careful not to unwittingly cause a shareholder to cross a 75% fair market value threshold. Example 5: Valuation of Various Share Attributes 1. Dr. X has 50 common voting, participating and discretionary dividend entitlement shares of the DPC. 2. Mrs. X has 50 common non-voting participating discretionary dividend entitlement shares of the DPC. 3. Both of Dr. X s major children have discretionary dividend, non-voting nonparticipating preference shares. 4. Both Dr. X and Mrs. X have held their respective shares for 24 months 51. The DPC meets the 50% test 52 and the 90% test 53 for the qualified small business corporation share capital gains exemption tests. 5. Dr. X and Mrs. X do not have an cumulative net investment loss 54 ( CNIL ) balance nor have claimed an allowable business investment loss 55 ( ABIL ). 6. Dr. and Mrs. X are Canadian and Ontarian residents for income tax purposes. 7. Dr. and Mrs. X are not US citizens, were not born in the US, are not green card holders nor were both of their parents born in the US. 8. Dr. X and Mrs. X sell all of their interests of the DPC to an arm s length purchaser. 50 Subsection 249(4) 51 Paragraph 110.6(1) qualified small business corporation share 52 ibid 53 ibid. 54 Defined in subsection 110.6(1) 55 Defined at paragraph 38(c) 20

22 9. Dr. X and Mrs. X each sell their entire respective shareholdings for $1.6 million to an arm s length purchaser. The allocation of the purchase price is allocated between the arm s length parties as follows: $880,000 to Dr. X s voting participating shares $720,000 to Mrs. X s non voting participating shares Figure 3 Dr. X Mrs. X 50 voting participating shares ( voting common shares ) 50 non-voting participating shares ( non-voting common shares ) DPC Question: Is this purchase price allocation reasonable from a valuation and taxation perspective? Valuation Perspective Example 5 also outlines a situation where Dr. X has complete control over the company, both from an operating stand point to meet the rules of his professional association, and from a voting control standpoint. At any time, unless outlined differently in the share attributes, Dr. X could vote to redeem Mrs. X s shares at a nominal value. However, the share structure was purposely set to provide growth to both the voting and non-voting common shares and that was the intention of the shareholders from inception. Additionally, the major children have non-voting, nongrowth shares as the intent is not to share the growth of the retained earnings with the children. The shareholders have purposely distinguished between growth shares and those that may, at the voting shareholder s discretion, only receive 21