Valuations for Income Tax Purposes

This article is from the quarterly Canadian Overview, a newsletter produced by the Canadian member firms of Moore Stephens North America. These articles are meant to pursue our mission of being the best partner in your success by keeping you aware of the latest business news.

Valuations for Income Tax Purposes – What Does the Canada Revenue Agency (“CRA”) think?

Tax planning and corporate restructuring have become an integral part of the services provided by professional advisors to their clients. A key component of any plan is establishing the fair market value (“FMV”) as the valuation represents the first step towards assessing the tax consequences of any transaction.

Given the increased level of complexity in many tax plans, “cutting corners” by not obtaining independent valuation advise may lead to unintended consequences such as income tax penalties or failure to achieve the desired after tax results.

In practice, a Chartered Business Valuator (“CBV”) may be engaged to assist you in the following tax related situations:

• Estate Freezes where the FMV of various classes of shares may need to be determined;
• Corporate Reorganizations where business assets and related debt are being transferred from one entity to another;
• Death of a shareholder where FMV of assets is required for the Terminal Tax Return;
• Emigration, where under certain circumstances a taxpayer is deemed to dispose of their worldwide assets at FMV;
• Defending a FMV previously filed in a tax return under audit by CRA.

So what is CRA’s position on valuation?

Information Circular 89-3 (“IC 89-3”), Policy Statement on Business Equity Valuations, outlines the general valuation principles and policies adopted by CRA in the valuation of securities and intangible property of closely held corporations for income tax purposes.

There are no formal requirements in IC 89-3 for a valuation by a CBV, however this should not be taken as a recommendation to apply a “do-it-yourself” approach to valuation, as IC 89-3 requires:

• The standard of value to be used is FMV;
• All relevant factors of the entity being valued must be considered;
• The approach to valuation must be justified;
• Factors used in determining the valuation multiple applied must be disclosed;
• Reasonable Judgement and Objectivity must be used.

In addition to IC 89-3, IT Folio S4-F3-CI provides CRA’s policy on Price Adjustment Clauses which states:

• FMV must be determined by a fair and reasonable method;
• FMV does not have to be determined by a valuation expert, BUT it is not sufficient to rely upon a generally accepted valuation method;
• It is necessary to perform a complete examination of all relevant facts and valuation methodology must be properly applied.

Finally, there are provisions in the Income Tax Act to apply gross negligence penalties to third parties (preparers) making, or participating in the making of, false statements or omissions in matters of valuation where there is a substantial difference between the FMV as filed and the FMV attributed by CRA. These penalties can be substantial depending on the circumstances.

In light of the above, best practice dictates engaging a CBV or at least having a CBV review a non-valuation practitioner’s valuation to avoid potential pitfalls including a challenge of your FMV by CRA.

A CBV will apply the proper application of generally accepted valuation methods and use their experience and professional judgement essential in any situation where there could be doubt about the value of a private corporation.

If in doubt, consider consulting a CBV for guidance.

Contributed by Michael Frost and Andrew Dey from Mowbrey Gil. This piece was produced as a part of the quarterly Canadian Overview, a newsletter produced by the Canadian member firms of Moore Stephens North America.