Terry v. The Queen, 85 DTC 5179, [1985] 1 CTC 135 (FCTD)

Collier, J:—The plaintiff, in 1967, was the owner of certain corporate shares. Between October 13 and October 17 of that year, he transferred to two sons, by way of gift, 798 of the shares. The Minister of National Revenue reassessed the plaintiff for gift tax on their value. The Minister’s valuation was $490,000. The plaintiffs position is the shares had only nominal or no value.

The dispute as to value is the issue before the court.

The plaintiff and other witnesses gave evidence at trial. The plaintiff has since died. Some agreed facts, were, as well, part of the evidence.

Potter Distilleries Ltd (“Potter”) was, originally, a small British Columbia distillery. It had been incorporated in 1958. Its shares were privately held by one E Potter and another.

The plaintiff was a British Columbia businessman. In 1962 he bought into the company. He and E Potter became the sole shareholders. Prior to June 1964, Potter bought liquor from an Alberta distillery, then sold products under its own label (Potter). That arrangement terminated.

An agreement was then entered into with Melchers Distilleries Limited (“Melchers”). Potter and Melchers agreed to incorporate a BC company, Marier Holdings Ltd (“Mar-Ter”). That was done on August 27, 1964. Another company, Potter Holdings Ltd (“Holdings”), was incorporated on August 27, 1964. Mar-Ter became the owner of all the issued shares of Potter. Mar-Ter then issued shares to Melchers and Holdings on a basis.

A distillery was to be constructed by Potter. Construction began in 1966. In that year, the plaintiff acquired E Potter’s shares in Potter Holdings. The distillery was completed by November 1967, at a cost of about $1,000,000.

In 1966 Melchers endeavoured to increase its ownership in Mar-Ter. The plaintiff turned down an offer that was made. He felt he and his companies would suffer a loss on the proposal. In 1967, Melchers decided to get out of the arrangement. They had advanced slightly over $300,000 in respect of the building of the distillery. They held a 15-year mortgage for $300,000. Some negotiations took place. Melchers, finally in 1967, sold their interest in Mar-Ter to Potter Holdings for $1. The mortgagee was eventually paid.

I go back a little in time.

In 1966 the plaintiffs advisers approached a number of underwriters, including Pemberton Securities Ltd, in respect of a public underwriting. No one was interested to the point of coming to an arrangement.

Again in 1967, after it became apparent Melchers were going to withdraw, Potter went to underwriters with a view to a public subscription. Certain transactions were carried out increasing the issued capital of Potter. Potter was then converted into a public company. A prospectus, dated October 27, 1967, was issued. An underwriter, S H Lennard & Co Ltd, became involved.

A total of 325,000 shares, at $4 per share, was to be offered. The underwriter was on a “best efforts” basis, and commission. The sale did not go particularly well. The underwriter endeavoured to sell 200,000. The plaintiff, the controlling shareholder through Holdings, and certain other companies he owned, decided to take the balance of 125,000. Eventually, about 170,000 shares were sold, by the underwriter, to the public.

At the material times in 1967, the situation, on the evidence, was this. Potter had been essentially a bottling company, selling purchased liquor under its own name, and bottling for others. The venture with Melchers was to create a distillery operation in which Potter (through Holdings) would have a 7; interest and Melchers a /3 interest. The Melcher-Potter arrangement, as recounted, terminated. Potter, at that stage, was left with people inexperienced in distillery operation and marketing. Several years of aging of whiskey, before it could be sold, was necessary. All sales and earnings were mere future projections. There was no past earnings record to support them.

Against that background, the value of the shares in issue must be determined.

I turn to the precise description, and holdings, of those shares. They are Class A, participating but non-voting, shares of Potter Holdings Ltd.

The authorized capital of Holdings was $10,000, divided into 9,000 preference shares, 900 Class A shares and 100 Class B shares. The Class A shares could not vote. They were entitled to dividends. The opposite applied to the Class B shares.

Prior to 1967, the shares were held as follows:

No preference shares had been issued.

The plaintiff acquired the 193 A shares held by E Potter. The 102 shares held by Stokes were also acquired. Stokes had been an officer of Potter. Difficulties had arisen between him and the plaintiff. A settlement was reached. As part of the settlement, Stokes turned over all his Holdings shares.

The plaintiff then had 798 Class A shares.

At the material times, he made, as earlier recounted, gifts to his two sons. On completion of the transfers, the share holdings were as follows:

Prior to Potter becoming a public company, Holdings held 316,500 of its issued shares. Stokes held the remaining 8,500.

I turn now to the question of value.

The parties agreed that fair market value is the test. The two expert chartered accountants, one on each side, were in substantial accord on the meaning of “fair market value”. I need not set out their definitions. They are the classic versions.

Both experts were well qualified.

Mr Beach, for the plaintiff, concluded the 798 shares had only a nominal value. Mr Marshall, for the defendant, arrived at a figure of $626,430, or $785 per share.

Both Beach and Marshall endeavoured, first, to calculate the value of Potter’s shares, Holdings substantial asset. On this point, Beach said:

31. It is impossible to place any value on the Potter Distilleries shares on either an earnings or tangible net asset basis because there was no history of earnings and no net tangible assets. The only value of the shares was a speculative one in respect of possible future earnings. This was some distance in the future because Canadian whiskey, which the distillery was to produce, was required by law to be aged three to four years before it could be sold.

Marshall rejected past earnings as a guide. For practical purposes, there had been no earnings of any consequence. He relied, however, on future earnings projections. These calculations came from Potter, in respect of the proposed public share offering. He estimated maintainable average earnings, per year, for the ensuing five years to be approximately $334,000. Applying a price — earnings factor of 6, he arrived at a valuation of approximately $2,004,000 for Potter, or $3.083 per share. From there, he went on to estimate Holdings’ worth on the basis of adjusted value of net assets, that is, adjusted to fair market value. He arrived at a net of $706,500. He attributed all of that value to the 900 Class A shares.

Marshall conceded his opinion was a qualified one. He had not visited the distillery premises, nor looked at the records of the two companies. He had no discussions with management or employees

. . . to obtain first-hand knowledge of circumstances that existed at the valuation date. Our report has been prepared solely on the basis of the information provided and we have relied thereon without having undertaken any procedures to verify its accuracy of reasonableness. The material on which we have relied is set out in Exhibit I to this memorandum and the data on corporate history and shareholdings has been reconstructed therefrom.

As to the projected future earnings, he said this:

Attached as Exhibit VII is a summary of the projected income statements of the company for the fiscal years ending August 31, 1968 to August 31, 1972 as extracted from the report on the company included in Exhibit VIII and adjusted only to reflect normal income taxes on earnings. We understand that these projections were prepared by the company for use in arranging the public issue of shares. We have not been able nor have we attempted to assess the basis of compilation of this information or its reasonableness but have accepted and relied thereon for purposes of determining the value of the company.

He felt the projections were optimistic. Because he “. . . did not have access to the details supporting the projections to adjust them directly . . .”, he compensated by reducing his price-earnings multiplier.

All of the above lessens considerably the weight to be given to Marshall’s conclusions. In fairness, however, he had been instructed by the defendant’s advisers not to make inquiries or investigations; to arrive at his conclusions in isolation, confining himself to the materials provided to him. He frankly said, if he had been acting for a prospective purchaser of the shares, he would have tried to establish the basis for the future earnings projections.

Beach, on the other hand, had access to all information he wanted, as well as discussions with management. He felt the projections of future earnings were quite speculative. This was a fledgling venture with inexperienced management. The plaintiff said “we were pretty green” in October 1967. Both the plaintiff, and the witness Goode, testified the projected earnings were largely based on the hope of making bulk whiskey sales in the United States. But, according to Goode, no surveys had been made of the United States market. In October of 1967, Terry began to worry about the United States prospects.

I accept the approach taken, and the evidence given, by Beach.

He pointed to: the Melchers transaction; when that company withdrew, it put no value on its /3 interest in Potter; approaches to other underwriters attracted no interest; an issue of 200,000 shares in September 1967, to capitalize corporate debt, was at $1 per share.

As with Beach, I give little weight to other indicia, said by the defendant to indicate a value of something more than nominal, or $1, value per share. Those matters were:

(a) in respect of the interim financing of the new plant by Holdings, Holdings was given an option to purchase Potter shares; 200,000 were bought at $1 per share (referred to above); a further 25,000 were obtained in October 1967 at $4 per share; no further options were ever exercised. The real purpose of the two options taken up was, as earlier stated, to capitalize the existing debt already committed to the new distillery. This latter subscription was a relatively small one, and, probably for business appearance purposes, fitted in with the proposed public sale price of $4 per share.

(b) As part of the settlement with Stokes, 2500 Potter shares held by him were exchanged for a promissory note for $10,000 in favour of the plaintiff. Stokes also turned over his A shares. There was obviously bad feeling between Stokes and the plaintiff. A settlement was reached, following which, Stokes’ relationship with the companies terminated. Many factors enter into settlements. The so-called $4 per share value in the Stokes matter cannot, in my opinion, be any reliable guide as to the fair market value of the Potter shares at the material times.

(c) The sale to the public at $4 per share. I agree with Beach. This was a speculative venture and a somewhat speculative offering. As of October 16, 1967, Potter had not technically gone public. In any event, the underwriter had difficulty with sales, a large block was eventually taken by the Terry companies; the members of the public who did buy were not, apparently, experienced investors; they were more likely small speculators. A small investment at $4 per share does not, as Beach said, mean someone would pay that price for the company.

The evidence convinces me a value of $1 per Potter share, as estimated by Beach, is realistic.

The next step is to establish a value, if any, for the A shares.

Once more, I adopt Beach’s views.

Normally, voting shares (here, the B shares) have some premium. Votes control management and operations. Here, the hypothetical purchaser in the market place is only looking at the A shares. If he bought at all, he would not be buying control. I agree with Beach: The Class A and Class B, as a package, might have had some value to a hypothetical purchaser. But the Class A shares alone held, in my opinion, no interest to an outsider, and had no value in a potential purchaser’s eyes.

The Minister’s reassessment is varied to delete the inclusion of $490,000 in the plaintiffs taxable income for 1967.

The parties agreed, at the outset, the penalties levied were, in any event, to be vacated.

The plaintiff is entitled to costs.