Fair market value is a term used hundreds of times in the Income Tax Act (ITA). In simple terms, the fair market value (FMV) of a company is determined by the underlying tangible and intangible value of its assets and business.
The FMV of a particular share or class of shares is determined by the characteristics of the shares such as voting rights, dividend entitlement, redemption or retraction value, and entitlement on dissolution.
At a high level, there are two main methods for valuing a company: net present value of future earnings, and liquidation.
Net present value
The net present value (NPV) of future earnings begins with the average of recent EBITDA (earnings before interest, taxes, depreciation and amortization) adjusted for unusual or excessive items (i.e., normalized earnings), which is then multiplied by a capitalization factor that takes into account the risk-adjusted discount rate. The discount rate reflects the investor’s perceived investment risk.
|Average normalized earnings (3 years)||$200,000|
|Mulitplied by:capitalization factor||5|
The capitalization factor of five represents an expected rate of return of 20%. In this case, the investor will pay $1 million to obtain before-tax earnings of $200,000. The NPV approach is commonly used for valuing a going concern.
Alternatively, when the prospect is low for continuing a business, the liquidation approach is commonly used. It values each asset owned by the company and deducts the liabilities owed. For example:
|Value of all assets||$600,000|
|Less: taxes arising from sale of assets||$ 50,000|
|Less: debts of the company||$200,000|
The process used to arrive at a value will be unique to each situation. The definition of fair market value for tax purposes, developed through case law, is:
“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.”
Of particular importance when looking at FMV in a tax context is the issue of arm’s length and non-arm’s length. CRA accepts that arm’s length parties deal at FMV, but when non-arm’s length (NAL) parties are involved, the rules are far more rigid. The NAL rules would apply when families undertake business transactions, such as the sale of a business or asset, to a closely related family member.
The FMV used in NAL situations is carefully scrutinized, so strong documentation and independent valuation will help to eliminate tax surprises. For example, a transaction price agreed to by a parent and child may appear fair and equitable to the two parties, but the ITA deems that NAL parties must deal at FMV.
If CRA re-assesses the FMV as higher than the amount agreed to by the parent and child, the selling parent will be taxed at the reassessed FMV while the purchasing child’s adjusted cost base remains at the original transaction price. For instance:
|CRA’s reassessed FMV:||$150|
|Parent taxed on:||$150 in proceeds (higher than what parent actually received)|
|Child’s ACB:||$100 (in future, when the child sells, her gain will be calculated on $100, not $150)|
Alternatively, if the FMV is reassessed as less than the original amount, the vendor pays tax on the higher amount, while the purchaser’s adjusted cost base goes down to the real FMV. For instance:
|CRA’s reassessed FMV:||$50|
|Parent taxed on:||$100 in proceeds (amount agreed upon)|
|Child’s ACB:||$50 (in future, when the child sells, her gain will be calculated on $50, not $100)|
To prevent adverse tax consequences, NAL parties can put a price adjustment clause (PAC) into their buy-sell agreement. A PAC is a clause that provides a mechanism to adjust the FMV of the property should the CRA or courts of law disagree with the original valuation.
But, for a PAC to work as intended, the parties must address specific conditions set out by the CRA, including:
- It must be a bona fide transaction.
- The method for determining the original FMV must have been reasonable, given the specific circumstances, and reflect a good-faith effort.
- The shortfall or excess on the adjusted price must be refunded or paid between the parties or adjusted as a legal liability.
Why do a valuation?
Shareholders of private corporations may need to value a corporation for many reasons. The following are some of the most common.
A taxpayer is deemed to have disposed of all capital assets at death, which triggers the realization of any accrued capital gain. Corporate shares, rights or other assets require valuation specifically at time of death to accurately measure the taxpayer’s income-tax liability. If there is a tax-free rollover of capital assets to the taxpayer’s surviving spouse, that would defer the need for valuation.
As important as income taxes are, valuation is also used in the distribution of a testator’s assets to beneficiaries. Sometimes one beneficiary will receive a specific asset, such as the family business, cottage or artwork, and it could be important that other beneficiaries receive something of similar value.
Valuation is used when a shareholder undertakes a corporate reorganization, such as interposing a holding company or restructuring current shareholdings. Taking the time to establish true FMV, and ensuring a price adjustment clause is part of the agreements, will go a long way to ensuring the taxpayer avoids unnecessary tax penalties.
Divorce settlements rely heavily on values when dividing assets. Shareholders of privately held companies do not have the benefit of easily establishing FMV through the open market, so valuations become critical to a fair and equitable divorce settlement. In addition, the value of assets brought into the marriage, including shares of a privately held business, may be a factor in the settlement.
Business owners need to plan their exit; otherwise, the transition is left to chance. An exit strategy could involve an outright sale of the business, introducing a business partner, or passing the business on to the next generation. Valuation will be important to aid in negotiating the sale of the business, determining income tax implications (see more on tax issues with selling your book at advisor.ca/carroll) and ensuring fairness among family members.
A side benefit of the valuation process for private corporations is that you often identify unique features that contribute significantly to a firm’s value. Examples include trademarks, market restrictions, or secret formulas. Knowing these features can help business owners who might want to focus on increasing the firm’s value in advance of a business transaction.
Who can help?
Chartered Business Valuators are educated in valuation principles and offer experience to assist business owners in arriving at the true FMV, which is particularly important in non-arm’s length transactions. Arm’s-length transactions are more likely to arrive at FMV through the process of negotiations, although both parties may retain a valuator to assist in the negotiating process.
by James W. Kraft, CPA, CA, MTax, CFP, TEP, and Deborah Kraft, MTax, LLM, TEP, CFP. Deborah is faculty and director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo. James is vice-president, Head of Business Advisory & Succession, BMO Nesbitt Burns.