Tax experts play a critical role in educating clients about the need for obtaining independent business valuations.
Company owners who don’t bother with a valuation argue that they’re too small for Revenue Canada to pay attention to or think they know better than anyone else what their business is worth. But they are setting themselves up for potential risk, including reassessments, litigation costs, and the possible interest and penalties if the transfer values used are not defensible.
Valuations are recommended for a wide range of tax-related situations, including tax-free transfers of assets, estate freezes, corporate reorganizations, family succession planning, management buyouts, exercise of rights under shareholder agreements, death and terminal returns, probate and U.S. estate tax, emigration, gifts, tax treaty issues and the incorporation of a professional practice.
Andrew Shalit, chartered accountant and tax partner with Segal LLP, says, taxpayers need to make those moves “at an appropriate value at the appropriate time—when this value is supportable by an independent valuation.”
As soon as you have the valuation results, the clock is ticking. Material changes in a company’s worth can happen quickly – you win or lose a major client, a principal of the business dies, or there’s an unpredicted loss of key management or relationships.
Hindsight, or use of facts that became known after the valuation date, is not permitted when determining fair market value. A valuation report will set out the facts and circumstances that were known (or reasonably foreseeable) at the valuation date, which helps defend the number you’re using in the event it’s challenged in the future.
Shalit remarked that Revenue Canada has been quite clear they’re looking to see independent opinions from chartered business valuators (CBVs) when tax transactions are performed. At a presentation at the 2010 Atlantic Provinces Tax Conference of the Canadian Tax Foundation, participants were told one Tax Service Office was specifically warning tax professionals to expect to be asked to provide support for the valuation amounts.
As well, if tax practitioners expected to rely on a price adjustment clause to avoid penalties and interest in the event the original transfer amounts were replaced with Revenue Canada’s values following a challenge, the “reasonable effort” test would be considered be met if the work was prepared by a CBV. Lastly, the audience was cautioned that informal, back of the envelope, calculations would no longer suffice and that engaging a CBV was a useful, proactive measure.
In Shalit’s practice, an independent valuation is most commonly recommended in estate freezes, planning for elderly clients, and succession planning. In a freeze, the business owner exchanges their existing (old) common shares for preferred shares having a redemption value equal to the fair market value of the common shares. New common shares to which future growth of the business accrues are then issued to the intended recipient (e.g. children, a trust, employees, etc.)
Many re-freezes and thaws occur in periods of economic downturn, with new common shares being issued to different shareholders, sometimes including those who originally froze their common shares.
A freeze can be advantageous for elderly shareholders, as the preferred shares can be redeemed over time, typically at a lower tax rate than would be payable if taxes were paid in a lump at death. If enough other assets exist to generate capital gains (such as gains from a portfolio of securities), the corporation could use its capital dividend account to redeem the preference shares, resulting in the shareholder paying no tax on the redemption of the preferred shares.
In family business succession planning situations, an independent valuation helps to remove some of the emotion from the discussions. Ideally, the founders would get a valuation done proactively to help them assess how to distribute their wealth. If only some of the children will receive shares, knowing the overall business value will help the owner allocate other assets to make the desired distributions to each child.
What reasons do business owners give for not having an independent valuation performed? We’ve both had interesting responses. I can’t improve on Shalit’s advice, whether it relates to obtaining an independent valuation or getting expert tax advice: “Don’t be penny-wise and pound-foolish”.
This article was originally published on capitalmagazine.ca.