Connor v. The Queen, 78 DTC 6497, [1978] CTC 669, aff'd 79 DTC 5256, [1979] CTC 365 (FCA)

Mahoney, J:—The issue is the fair market value on Valuation Day, December 31, 1971, of ten shares of a private company, Halifax Parking Limited, hereafter “HPL’’. Those shares represented 10% of HPL’s outstanding shares. They were treasury shares acquired by the plaintiff for $1 each after HPL’s incorporation early in 1970. They were sold by the plaintiff in 1974 for $2,000 each. The plaintiff says they were worth $4,796 each on Valuation Day; the defendant’s figure is $1. The onus is on the plaintiff to prove that the denfendant’s figure is wrong and that his, or some other figure, is correct.

The plaintiff was one of a group of ten persons, all dealing at arm’s length with each other, who, in 1963, caused Halifax Developments Ltd, hereafter “HDL”, to be incorporated. Each was allotted 10% of the stock and each advanced HDL $25,000. Their purpose was to formulate a plan for submission to municipal authorities for the development of a 17.5 acre site in downtown Halifax, now known as Scotia Square. The proposal was developed, submitted to the City of Halifax and accepted by it in preference to two others. Temporary financing was arranged and construction began.

It was envisaged that Scotia Square would comprise a complex focused on a structure containing two levels of retail shops, designated the upper and lower malls, and above them, 1600 parking stalls on five levels. A hotel, two office towers and an apartment building were to be part of the same complex. A trade mart building with display areas and offices and three additional highrise apartments, separate from the central complex, but part of the development, were proposed. It was, and is, no small undertaking.

HDL, originally incorporated as a private company, was converted to a public company and a public issue of securities was made in December, 1968. Thereafter the equity, consisting of convertible debentures, shares and options on shares, was owned about 20% by the public and 80%, apparently equally among them, by the ten promoters.

The development proceeded in stages. Leases were signed and premises opened and, by late 1969, HDL was ready to replace the interim bank financing of the portion that included the malls and parking structure with a mortgage. The lease of the parking structure at an eventual $367,000 minimum rent annually was the largest single lease in the premises then to be mortgaged. The convenant of the lessee, a national parking lot operator, was not acceptable to the mortgagee. It was suggested to those negotiating for HDL that the operation of the parking at Scotia Square could and should be very profitable and that the promoters should consider taking it over themselves. The mortgage company was prepared to accept a lease if the rent were severally guaranteed by the promoters personally.

Projections were made. They are not in evidence and have, it seems, been both misplaced and forgotten. In the result, HDL negotiated surrender of the outstanding lease effective January 31, 1970 for a consideration of $1 and a management contract with HPL. Nine of the ten promoters of HDL each took 10% of HPL. The remaining 10% was taken by HDL’s development manager. Each of the ten loaned HPL $5000. The loans were evidenced by interest free promissory notes although it was contemplated that interest would be paid when the loans were repaid. It was, at 10% per annum. At all material times, the ten promoters were all of the directors of HDL and the nine together with the manager were all the directors of HPL.

As of February 1, 1970, HDL leased the five levels of parking to HPL for a contingent term which, in the event, ascertained before valuation day, was to expire May 31, 1981. There was no renewal option. Rent payable was $5,000 per month from February 1 to May 31, 1970; $25,000 per month from June 1, 1970 until the occurrence that was to initiate the ten year term, and thereafter $367,000 per year plus 20% of the amount by which HPL’s total annual revenue in the year exceeded $367,000. HPL was responsible for payment of business taxes, utilities and non- structural repairs and maintenance. There was no provision for municipal tax escalation. Notwithstanding that HDL and HPL did not deal at arm’s length, the lease is said to have been on the same financial terms as that replaced.

For its first fiscal year, ended January 31, 1971, HPL had parking revenues of over $272,000 ($82,000 monthly and $190,000 hourly rentals); for the year ended January 31, 1972, total parking revenue increased 35% to $368,000 ($116,000 monthly and $252,000 hourly), while expenses increased 34% from $338,000 to $454,000 whereof rent comprised $220,000 and $322,000 respectively. No provision was made for interest on the shareholders’ loans. As at valuation day the deficit was $133,963.

As at December 31, 1971, feeling and cooperation among the promoters remained good.:900 of the 1600 parking stalls had been turned over and the remaining 700 were expected to be delivered progressively over the ensuing 18 months. A rent reduction of $68,000 over a 24 month period commencing June 1, 1971, was allowed to compensate for the delay in delivery of full parking capacity. The management contract had been terminated and HPL was, at the time, itself managing its entire business.

As to the rest of Scotia Square, the status follows:

1. The 250,000 square foot trade mart, with 60,000 square feet of office and display area and 190, 000 square feet of warehousing was complete.

2. Of the office buildings, the 200,000 square foot Duke Tower and the 180,000 square foot Barrington Tower were both complete.

3. Of the apartments, the 194 Scotia Tower was complete and the 114 unit MacKeen Tower was under construction. Both are separate from the central structure.

4. A lease for the 312 room, eight storey hotel had been concluded but construction had not begun.

5. Construction had not begun on the third separate apartment nor on the apartment in the central structure.

6. The 350,000 square foot upper and lower malls were complete. There were some vacancies, however, the 110,000 square foot department store and 750 seat theatre were among the 100 plus retail premises open for business.

Additional large. office buildings were expected to be built in the immediate vicinity and, in fact, two were later. HDL expected to continue its development and, in fact, did. The hotel was built, the apartment in the central structure was replaced by a third office tower and the third, separate, apartment is just now under way. It is, I think, fair to say that the expectations for development in and about Scotia Square entertained on valuation day have been proved reasonable by later events.

As to competitive parking, the trade mart and separate apartments provided additional parking at Scotia Square. A large parking structure nearby was, it appears, already fully utilized. There was a considerable amount of public parking ‘available on the waterfront; however, given its vertical as well as horizontal separation from Scotia Square, I can- not regard it as being seriously competitive with that provided in Scotia Square for users of Scotia Square. It would have been particularly inconvenient for shoppers. The evidence is that even the 900 stalls available at valuation day had not theretofore been fully utilized. The plaintiff’s evidence is that the underutilization was mainly due to the reluctance of customers, particularly women, to put up with the inconvenience of the ongoing construction, not to overcapacity.

On December 21, 1971, the directors of HDL, apparently perceiving a potential incongruity in their positions as directors of a public company, on the one hand, and as shareholders of one of its very important tenants, on the other, resolved that HDL offer to purchase the outstanding shares of HPL for $1 each and the notes at face value with interest at 9% per annum. The minutes do not record that the resolution was unanimously adopted. The plaintiff was present at the meeting but has no recollection of the resolution nor of the offer being made. It was unanimously resolved that, when purchased, the shares be deposited as security against any call on the HPL shareholders under their guarantees. It seems the offer, if transmitted, was not accepted by any of the HPL shareholders. I do not regard this as probative of the share’s fair market value.

These minutes also allude to the underwriting of a rights issue by four of the promoters. The plaintiff was not among them. In March, 1972, HDL issued the rights. Although the plaintiff must have known of the underwriting and the size of the issue, he says he was surprised when two of the original promoters, as a result of it, acquired control of HDL. In this they were successful in fighting off one of the other promoters who had, surreptitiously it seems, tried to gain control. In the process those two acquired the HPL shares of a third promoter. The 30 shares were sold to HDL for $1 each with the result that HDL then owned 30% of HPL, the manager 10% and six promoters, formerly equal partners in HDL’s controlling group, but now. minority shareholders there, owned 60%. The goodwill and cooperation which had prevailed on Valuation Day vanished.

On August 3, 1972, HDL’s board of directors again met, with the plaintiff present, and passed another resolution authorizing purchase of the HPL shares and notes on the same terms as before. This is the first offer the plaintiff remembers. The plaintiff opposed the resolution but, when it was passed, he tendered his shares in response to the offer feeling, he says, an obligation to abide by the majority decision. He was the only one to tender his shares and they were returned to him.

The seven agreed to take some advantage of their joint position in HPL and, some time after agreeing in principle to act in concert, their joint position was formalized. By an agreement made as of March 27, 1973, each gave the others a right of first refusal on his HPL shares. Within a matter of days, two of the seven attempted to sell their shares without observing the terms of the buy-sell agreement. The decision of the Supreme Court of Nova Scotia, rendered April 29, 1974, is in evidence as part of Exhibit 14A. The action was brought against the two by three of the remaining five, including the plaintiff, and the 20 shares were ordered to be transferred to the three. An appeal was taken, HDL sought to be joined as a party appellant but the application was refused. The plaintiff, however, still a director of HDL, says he considered himself in an embarrassing position. Rather than have the action go further, the plaintiff sold his shares in HPL to HDL for $2,000 each and, as well, his /3 interest in the 20 shares under the judgment, for $7,000. Apparently, his two fellow plaintiffs also sold their shares and rights under the judgment, the two who had not sued sold their shares and the two who had been sued carried out their intention to sell with the result that HPL became a wholly owned subsidiary of HDL in 1974. I have no evidence as to what the others, except the plaintiff and one of those who had sought to evade the buy-sell agreement, were paid. That person was paid $10 per HPL share at about the same time the plaintiff was paid $2,000. He reported a valuation day value of $1 per share. The notes were repaid with interest at 10% per annum. The mortgage company did not release the personal guarantees which remained outstanding. The arrangement, if any, as to any indemnity agreement in respect of the ongoing guarantees is not in evidence.

The plaintiff called P Roger Oldfield, W Grant Thompson and Harvey L Doane to give expert evidence. Oldfield is an executive of a company that operates and manages parking accommodation throughout Canada. He became familiar with Scotia Square parking in mid-1973 when his company took over its management. In early 1974, he was requested by the plaintiff to project HPL’s operating results for the balance of its lease term. He did not know the purpose of the projection. Oldfield had no knowledge of HPL prior to valuation day.

Based on actual results for HPL’s fiscal year ended January 31, 1974, and the first quarter of fiscal 1974-75, Oldfield made the following projection. While, in my view, nothing turns on it there is an arithmetic error in Oldfield’s 1973 calculation; revenue of $575,145 less expense of $119,000 yields a contribution of $456,145, not $467,145.

On the revenue side, Oldfield anticipated a rate revision every second year. The large increase in monthly revenue in 1975 anticipated completion of the third office tower which, on Valuation Day, was still to be an apartment building. The substantial increases in hourly and daily revenue for 1975 and 1976 depended largely on occupancy and use of that tower. An assumed 15% increase in hourly and daily revenue throughout also hinged on completion and occupation of nearby retail and commercial buildings then mooted and the assumption that they would not be adequately served by on-site parking.

The audited financial statements do not break revenue into categories as did Oldfield; however, they do indicate that his estimates were optimistic. HPL changed its fiscal year end to December 31 in 1974 so the actual revenue is for 11 months rather than a full year.

On the expense side, Oldfield considered only direct operating expenses and took no account of rent, management fees, depreciation, interest and the like. His expense estimate is of no assistance to the Court.

W Grant Thompson is a chartered accountant of over 25 years experience and was, from its inception through 1975, a partner in HPL’s auditors. I have no reason to doubt his professional and practical qualifications to form the opinion he has given. He was asked, in 1974, to establish a fair market value for the HPL shares as at Valuation Day. He based his forecast on HPL’s actual results through the year ended January 31, 1974, discussions with Oldfield and the plaintiff as to current operations and future outlook and Oldfield’s revenue projection. He based his expense forecast on past experience. Oldfield’s revenue forecast was reduced by Thompson who applied a somewhat lower inflation factor than had Oldfield. Thompson considered that, since HPL was still in its formative stages on Valuation Day, had experienced a limited period of operation under its lease and the nonarm’s length relationship with its landlord, the logical method of valuation was one based on return on investment. He further considered that, in the nature of its business, HPL’s revenues and expenditures over the balance of lease term were capable of reasonably accurate projection and that, therefor, the future earnings method was the proper approach to determining the value of an HPL share to a potential investor on Valuation Day.

I do not intend to review the calculations by which Thompson reached the conclusion that an after-tax return on investment of 8.44% would be appropriate. I merely note, at this point, that he made no reduction in his determination of fair market value for a minority shareholding in a private company since he assumed that any purchaser, on Valuation Day, who would offer fair market value would, of necessity, be found among the existing shareholders whom he considered, at Valuation Day, to have constituted a controlling group rather than several minorities. That said, his determination of the appropriate return and earnings multiple was not disputed in evidence and must be accepted if his premises are accepted.

His opinion, dated October 9, 1974, led to the following estimated future earnings as at Valuation Day. The figures are for fiscal years ending January 31 in each year so that Oldfield’s 1973 figure is to be compared to Thompson’s 1974 figure and so on. Thompson’s 1973 and 1974 figures are actual results. His 1972 figures are 1/12 of actual results for the fiscal year ended January 31, 1972 which calculation

With an estimated $8,472 per share available for distribution, assuming a 40% personal tax rate, distribution of half the available amount as dividends and the balance as a capital gain, Thompson concluded that a purchaser, expecting an 8.44% return on his investment would, on Valuation Day, have paid $4,796 per share. That is the plaintiff’s valuation day figure.

While there is no basis for rejecting Thompson’s 8.44%, it is based on the investor wanting an after-tax return 1 /2 times that available on high grade long term bonds on Valuation Day. I question that the return paid in the manner he projects for HPL’s distribution is comparable to the annual or semi-annual interest payment one receives on government and high grade corporate bonds. Payment of half the return would, it appears, be deferred until HPL was wound up after termination of its business with expiration of the lease. It would be some years after Valuation Day before any payments on account of the other half could be made because of the opening deficit.

The third expert called by the plaintiff is Harvey L Doane, a chartered accountant since 1957 and, since 1973, a member of The Canadian Association of Business Valuators. I agree with his basic thesis that, to the extent earnings are a factor in the determination of the value of a given investment at a given time, it is the prospect of future earnings that is critical, not the history of past earnings. The latter are of value as an index of future earnings, of course, but, given the stage of HPL’s evolution at valuation day, historic earnings are of no practical significance. Doane had recourse to Thompson’s valuation and other documents, interviewed the plaintiff and the present Executive Vice-President of HDL, the lessor, with which HPL has recently been merged.

He took two different approaches to the valuation: the discounted cash flow method and the maintainable earnings approach. As to the former, he says it is particularly appropriate where, as here, a reasonably reliable cash flow forecast can be made. He accepts the figures in the Thompson report as far as they go, assumes that the lease would be extended for another 5 years, projects $170,000 after-tax profit for each of those years, and calculates the present value of those earnings at valuation day to an investor expecting a 12% return before personal income tax. That, after deduction of the opening deficit, leads to a value of $5,853 per share from which Doane deducts 20% for the investment being akin to a closed-end investment fund and a further 10% for a minority interest with a resulting value of $4,214 per share.

I do not intend to deal further with the Oldfield to Thompson to Doane succession of estimates. The over-optimism at each stage appears to compound itself and Doane’s assumption of a five year lease extension is utterly unwarranted.

In the maintainable earnings approach, which Doane preferred, he normalized HPL’s earnings for its fiscal year ended January 31, 1972 by calculating the gross revenue that would have been received had all 1600 stalls been available and utilized to the same extent that the 900 had, in fact, been utilized. In the result, he projected income of $654,597 and, as additional expenses, 20% of the increase in revenue for rent, 6% thereof for management fee and a $34,000, or 50%, payroll increase over actual as well as a number of small upward adjustments in other expense items totalling, in all, $112,960. The adjusted revenue less the adjusted expense, led to a pre-tax profit of $91,755 in contrast to the $81,671 loss actually incurred that year. The net, after-tax, profit worked out to $58,377 and, after applying a 8.33 factor to allow for the expected 12% return and 10% minority discount, he arrived at a $4,377 per share value. There is no explanation as to why the 20% closed-end investment trust analogy was not considered appropriate to HPL when the shares were being valued on this basis as it was when the discounted cash flow method was employed.

This approach assumes an immediate, rather than progressive, delivery of the stalls, and leads to an overstatement of revenue in early Stages that, in my view, is fairly offset by its assumption that revenues, once normalized, would not increase in later stages. However, Doane’s failure to adjust for the actual rent payable over the term is highly misleading. He based his calculation on the rent of $32,064 that was actually paid during the year ended January 31, 1972, and added to it 20% of the increased revenue, or 20% of $286,386, when, had all the Stalls been available, the rent would have been $367,000 plus 20% of the difference between that and $654,597, ie 20% of $287,597. In other words, Doane projected the rent for normalized earnings purposes at $322,064 plus $57,277, a total of $379,341 when, on those earnings, it would certainly have been $367,000 plus $57,519, or $424,519. The result is to overstate normalized earnings by $45,178. Another omission from Doane’s normalized earnings calculation is the interest on the shareholders’ loans. It was always intended that it be paid but, as the applicable interest rate had not been determined, no interest was accrued prior to repayment of the loans in 1974.

The defendant’s expert witness, Mitchel A Smith had the most impressive credentials of all the experts and, regrettably, his evidence in chief is the least helpful of all which, in this instance, is saying something. He concluded that the HPL shares were valueless on Valuation Day and assigned them the nominal value of $1 each. He arrived at that result upon concluding that, as at Valuation Day, (1) there was no economic value to the HPL lease; (2) the prospects of future profits, given the existing deficit, could not reasonably have induced a prudent arm’s length investor to invest in HPL and (3) the HPL common shares would, at best, be a speculative investment. Having reached those conclusions, Smith did not attempt a valuation of the HPL shares. He felt he had insufficient information, not purely retrospective, to permit a responsible valuation.

I accept Smith’s definition of fair market value: “the highest price available in an open and unrestricted market between informed, prudent parties acting at arm’s length and under no compulsion to act, expressed in terms of money or money’s worth’’. When one comes to value the shares of a private company, the “open and unrestricted market” must be assumed. That notional market ought not be limited to the other shareholders; it should be assumed that strangers would be willing to take a position in the company at the right price and that the other shareholders would be willing to have him or meet his price. The applicable legislation* [1] provides no alternative to the “fair market value” approach where no “open and unrestricted market”, in fact, exists. The evidence established beyond doubt that on valuation day, the prospects for HPL were such that an informed, prudent, arm’s length investor would not have rejected, out of hand, the opportunity to acquire 10% of its shares and would not reasonably have expected to acquire it for a nominal price. Whatever degree or speculativeness he attributed to the investment, he would seriously have assessed the value of those shares.

Smith testified that the maintainable earnings approach taken by Doane is probably the most appropriate approach in most cases. That is particularly so where there is a long history lending credibility to the prediction of future earnings. Smith rejected the approach here, consistent with his view that HPL’s future was highly speculative as at valuation day..

It seems to me that, as at Valuation Day, HPL’s future was unusually predictable notwithstanding its brief past. Its business future was subject to a fixed termination date and its major expense item was fixed throughout that future.

In normalizing HPL’s earnings for the fiscal year ended January 31, 1972, to take into account the availability of all 1600 stalls rather than the 900 actually available, Doane projected an accupancy rate of 56.5%, the same as actually experienced during the year. That is a reasonable assumption. It led to normalized revenues of $654,597, an increase of $286,386 over actual. He estimated additional expenses of $112,900 with a resultant estimated pre-tax profit of $91,755 as against the actual loss of $81,671. I have already indicated two areas where he overlooked predictable expenses, his understatement of the rent by $45,178 and his failure to include interest on the shareholders’ loans in the principal amount of $50,000. At the time, 9% per annum was being mooted, an additional $4,500 annual expense. Otherwise his expense estimate appears reasonable.

The reasonableness of projected earnings may be measured against the yardstick of actual results without arriving at those projections by application of hindsight. HPL’s audited financial statements for its fiscal years ended January 31, 1973 and 1974 and December 31, 1974 (11 months), 1975, 1976 and 1977 are in evidence. Revenues were well under the projection in 1972 and 1973 but substantially exceeded it after 1974. The profit has been highly disappointing when compared to the projection. That said, there are numerous items that support the plaintiff's thesis that, since HPL became a subsidiary of HDL in 1974, substantial outlays have been made that would not have been made had the original relationship continued. For example, capital expenditures identified as “modifications and improvements to the interior of the parkade” were not the sort of outlay for which HPL was liable under the lease. Likewise, there was a remarkable investment in equipment and leasehold improvements. It ran to over $100,000 in 1975. Depreciation and amortization for the year ended December 31,1974, totalled $13,330. The next year, they totalled $42,220 and, in 1976, $54,471. Those differences, without regard to the extraordinary increases in salaries and wages, ($84,590 in 1974 (11 months); $127,402 in 1975 and $161,425 in 1976), much of which the plaintiff says ought to have been born by HDL, are sufficient to convert the normalized profit to a loss. The subsequent results, in the circumstances, do not lead to the conclusion that, subject to the corrections I have indicated, Doane’s calculation of normalized earnings was unreasonable.

Of HPL’s future earnings, $133,963 would not be available for return on investment; it would be required to cover the valuation day deficit. That is particularly significant in the case of HPL whose business future was finite. No prudent investor, on Valuation Day, would have assumed that HPL would be in any business other than the one it was in, or that it would be in that business after May 31, 1981, nine years and five months hence.

Taking account of the omission of predictable rent and interest expenses and of the average annual amount ($14,226) required to offset the opening deficit over HPL’s remaining business life, normalized pretax profit would have been $27,851 and its after-tax profit $20,888. It would therefor have appeared that almost $200,000, or $2,000 per share, would be available for distribution to HPL’s shareholders, in one form or another within ten years, allowing time for winding up its affairs after termination of the lease.

The 12% expected return, viewed as of Valuation Day, appears reasonable and, by Doane’s calculation would result in a value of $1,667 per share. That calculation, however, seems predicated on two erroneous assumptions. It appears to assume that a share in HPL would have an ongoing value and that the return would be realized by payments more or less evenly distributed over the balance of the lease term. A prudent investor, looking at HPL as of Valuation Day, would assume no ongoing value and he would know that his return would not be evenly distributed but rather paid out during the latter portion of the term. With that in mind, he would certainly want not only a 12% return but a realization of his capital outlay and he would do a calculation taking account of the deferral. He would also apply a discount in respect of both the locked in and minority interest characteristics of the particular investment.

It appears it would have taken over four years’ pre-tax earnings to eliminate the opening deficit and that, therefor, no distribution to the shareholders would have been possible for four years after Valuation Day. With his expected 12% return, the prospective purchase would consider that, after four years, he would have about $157 invested for each $100 he had originally paid. It also appears that, in the fifth and following years, HPL could have paid amounts equal to the investor’s current return expectations and, in addition, annually increasing amounts which he could regard as being on account of his capital investment. If he went through that sort of calculation, the prudent investor might well conclude that, for every $100 he was willing to pay for a share, he required a distribution in the order of $230. He would then consider the closed end and minority aspects of the investment. As to them, Doane’s evidence that discounts of 20% and 10%, respectively, are appropriate stands alone and must be accepted. Taking all of the foregoing into account, I find that the fair market value of a share in HPL, as at valuation day, was $625.

Success is divided. Both parties took, and maintained throughout, extreme positions which were entirely dissociated from reality. While the defendant ought to have recognized that the HPL shares had some significant fair market value on December 31, 1971, the plaintiff, an experienced businessman, ought to have recognized that the value did not remotely approach that claimed by him. There were, of course, experts for hire willing to support those extreme positions. This is an appropriate case for the parties to bear their own costs.