Thursday, June 26, 2014

Supporting Valuations in Tax and Estate Planning

30% to 40% of business owners are planning to transfer their business internally to another shareholder, management, employees or family member. [1]  One option for those planning to transfer the business to the next generation over time is through an estate freeze.

In an estate freeze the business owner’s common shares are exchanged for preferred shares of equal value to the common shares.  New common shares are then issued by the company to the next generation family members.  This allows the business owner to “freeze” his/her unrealized gain in the corporation on a tax-deferred basis, with any future growth in value of the company accruing to the children.  As a result, the business owner can estimate and plan for the future tax liability, perhaps with life insurance.

Under an estate freeze the fair market value of the common shares must be established.  According to the CRA, the fair market value must be determined “by a fair and reasonable method”. [2]  If not, CRA will likely challenge the validity of the transaction alleging that a benefit had been received by a shareholder who acquired property from a corporation at less than fair market value.

In the event of a potential dispute with the CRA, price adjustment clauses (PACs) are sometimes used to retroactively adjust the fair market value to avoid the “conferral of benefit” problem.  Unfortunately, a PAC may not help if a fair and reasonable valuation attempt was not initially conducted.  

In Guilder News Co. (1963) Ltd. et. al. v. M.N.R., 73 DTC 5048 (FCA), the Court rejected the PAC as a basis for adjusting the price and eliminating the benefit on the grounds that the parties had not reasonably attempted in good faith to transact at fair market value.  Other recent case law involving PACs include St. Michael Trust Corp. v. Canada (2010 FCA 309, affirming Garron, 2009 TCC 450) and Krauss v. Canada (2010 FCA 284, affirming 2009 TCC 597).  Potential implications of not having a fair and reasonable valuation to the business owner include additional taxes, interest and penalties.

An independent valuation prepared by a qualified business valuator can provide a fair and reasonable basis for the fair market value used in an estate freeze, essentially acting as insurance for potential disputes with the CRA.  Inadequate fair market value assessments can give rise to unfortunate tax consequences as well as costly and time-consuming litigation, not only with the CRA but also with the advisors. 

Other tax and estate planning mechanisms involving the transfer of assets or shares to a related party could include business incorporations, corporate restructuring, share reorganizations or family trusts.  In order to take advantage of tax deferrals, these transfers typically must occur at fair market value.  You will be well served and protected by involving and retaining an independent business valuator to assist you with the fair market value determinations.

If you are considering an internal transfer, contact us at or to assist with your business valuation needs.

1.  Sources: 2007 RBC Study - Quantitative Study of the Business Succession Market in Canada and CICA/RBC Business Monitor (Q1 2010).
2.  Source: CRA’s Interpretation Bulletin IT-169.

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