Tax Planning and Fair Market Value

As a small business owner, you are well aware that proper tax planning and corporate structuring are essential for increasing your wealth and protecting the assets you have built up over many years of hard work. After carefully planning your financial, legal and personal affairs, and with so much at stake, would you put your plans at risk by not taking the necessary steps to ensure success? Many business owners do just that, by failing to value their assets approriately prior to implementing their plans. Cutting corners on your tax plan by not obtaining a valuation of your assets is like buying a new car and neglecting to top up the engine oil. The plan might work well for a while, but there is a significant risk that it will come to a rather abrupt and unpleasant end. 

The term "fair market value" (FMV) is used well over 1,000 times in the Income Tax Act (the Act), a number that indicates some importance. The Department of Finance has stated its interest in valuation because it is essential to the administration of the Act. FMV is defined in case law as:

 "the highest price, expressed in terms of money or money's worth, obtainable in an open and unrestricted market, between knowledgeable, informed and prudent parties acting at arm's length, neither party being under any compulsion to transact."

Essentially, this definition means that a transaction at FMV represents a transaction between unrelated parties working for their own interests. Transactions occurring between persons who are related to each other usually are not considered to be at FMV because it is not clear whether the parties are working in their own self interest or if they are working in concert to achieve some other desired result. Consider a parent seeking to gift an asset to a child. Except in specific circumstances, the Act requires gifts to be transferred at FMV or significant penalties and interest charges may result. Not having exposed the asset to a market place to see what price an unrelated party would pay, it would be prudent for the parent to have the asset valued to reduce the risk of reassessment by the Canada Revenue Agency (CRA). 

Many tax plans involve a number of related-party share transactions that meet certain shareholder objectives but do not change the beneficial interest in the underlying property. For example, an owner/manager may want to "freeze" his/her interest in a business to ensure future growth accrues to other family members. The "freeze" transaction does not change the owner's beneficial interest in the underlying property on the date of the freeze, but does direct future growth to other persons who will now own the common shares. Many of these transactions are considered "rollover" transactions in that they are elected or deemed to occur at the original cost of the asset and, therefore, no income tax is triggered at the transaction date. 

So now you might ask: if there is no change in the beneficial interest in the underlying property and the transaction is going to be a tax-free rollover at cost, why do I need a valuation at all? The answer is that the Act requires these transactions to occur at FMV. While the transaction may be a tax-free rollover at your cost, the consideration you receive must equal the FMV of the asset(s) you transfer. Otherwise, there is a risk that an unintended benefit will accrue to another person who is a party in the transaction. For example, imagine that an owner freezes his value in a company with a tax-free rollover at $500,000 and allows his/her children to acquire ownership in the company at a nominal amount. If the CRA subsequently reassesses the value of the owner's company at $1,000,000, there would be a $500,000 transfer of value to the children. Needless to say, this situation would give rise to some nasty tax consequences that might include double taxation of the $500,000 transferred value.

One tool that many professional advisors use to mitigate the risk of reassessment by the CRA is the Purchase Price Adjustment clause (PPA). A PPA is designed to adjust the value of a transaction should the CRA or another competent authority determine a different value. In the above situation, it would allow the value of the transaction to be adjusted from $500,000 to $1,000,000 and side-step any adverse tax consequences. The catch is that the CRA will only accept a PPA under certain conditions, one of which is "the parties.....arrive at the [FMV] for the purposes of the agreement by a fair and reasonable method."

In the case of Guilder News Co. (1963) Ltd. et al v. MNR, the taxpayers included PPA clauses in their 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 shareholder was 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 CRA did not recognize the PPA because the parties had not reasonably and in good faith attempted to transact at FMV. The court concluded that the PPA was a sham and that the shareholders never intended to transact at FMV and, therefore, the CRA was justified in not recognizing the PPA. 

The shareholders in Guilder had made no reasonable attempt to determine the FMV of the shares transferred, but rather transacted using a price of convenience that met their reorganization objectives. Whether a valuation error is intentional or unintentional is irrelevant when you are audited by the CRA. Engaging a Chartered Business Valuator to provide an independent opinion of FMV establishes that the shareholders acted in good faith and arrived at FMV using a fair and reasonable method. An independent valuation protects the PPA clauses included in your tax planning, supports the tax plan you intended to implement, and avoids the penalizing implications that may come with a reassessment of value. Supporting the values inherent in your tax planning transactions protects your assets and keeps the plan running smoothly, even under the scrutiny of the CRA. 

Dave Clarke, CA, CBV, is a Principal with the Ottawa office of Collins Barrow.