Many tax planning initiatives involve transactions in which assets are exchanged. Many of these exchange transactions are intended to occur on a rollover basis, such that they do not trigger immediate income tax consequences. Generally, the Income Tax Act requires transactions to occur at fair market value (FMV). Accordingly, when transactions occur between related parties, the FMV must be estimated.
Since professional judgment is always involved in estimating the FMV of an asset, it is possible that a Canada Revenue Agency (CRA) valuator might draw a different conclusion of value than the parties to the transaction. In addition, since the CRA may review the transaction several years after the transaction date, it would have the benefit of seeing how events have unfolded since the date of the transaction, which might affect the CRA's perception of the FMV of the asset.
To mitigate the risk of negative income tax consequences resulting from the CRA reassessing the FMV of an asset, purchase price adjustment clauses (PPAs) are usually included in the asset transfer or exchange agreements. Essentially, should the CRA reassess the FMV of the assets transferred, the PPA will revise the transaction retroactively to ensure that an immediate income tax liability does not result from the reassessment of FMV.
The inclusion of a PPA in the asset transfer or exchange agreement is not a guarantee that income tax consequences will not arise should the CRA reassess the FMV. CRA Interpretation Bulletin 169 (IT-169) states that the CRA will only honour a PPA if the share agreement reflects a bona fide intention of the parties to transfer the asset at FMV arrived at by a fair and reasonable method. IT-169 goes on to state that whether the method used to determine FMV is fair and reasonable will depend on the circumstances of each case. In other words, should the CRA decide that the method of determining fair market value is not fair and reasonable, it likely will conclude that the parties did not intend to transact at FMV. The result will be significant income tax consequences.
In the case of Guilder News Co. (1963) Ltd. et al v. MNR, the shareholder taxpayers included PPA clauses in their corporate reorganization agreements to mitigate the risk of a valuation adjustment by the CRA (then called Revenue Canada). The CRA reassessed the shareholders on the transactions on the basis that the FMV of the assets sold was greater than the price stipulated in the agreement. The shareholders were assessed a benefit for the excess FMV over the price stipulated in the agreement, an assessment that would have resulted in double taxation of the excess FMV. The Court concluded that the PPA was a sham, agreeing with the CRA's position that the shareholders never intended reasonably and in good faith to transact at FMV. Thus the CRA was justified in not recognizing the PPA.
Even where the parties to a transaction determine FMV by some methodology, IT-169 states that the CRA will determine whether that methodology is fair and reasonable. If the CRA disagrees with the methodology, the parties' actual intentions are irrelevant.
Valuation is an art. There is, necessarily, a degree of subjectivity. However, a valuation by a qualified Chartered Business Valuator should be sufficient to demonstrate a taxpayer's intention to transact at fair market value, and should help to support the validity of a PPA.
Contact your Collins Barrow advisor for more information.
Dave Clarke, CA, CBV, is a Partner in the Ottawa office of Collins Barrow.
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