Taylor Estate v. MNR, 90 DTC 1777, [1990] 2 CTC 2304 (TCC)

Couture, C.J.T.C. [Translation]:—The appellant argues that an assessment issued by the respondent for the 1981 taxation year dated December 12,1983 is not valid. In this assessment the respondent established a taxable capital gain arising from the deemed disposition of 500 ordinary shares in Les Entreprises Harry Taylor Ltée (the company) following Harry Taylor's death on October 4, 1981.

In the appellant's tax return for the taxation year under appeal these shares were valued as follows on the date immediately preceding his death:

The respondent, on the other hand, valued them on the same dates as follows:

The appellant filed a notice of objection to this assessment and, when the assessment was confirmed by the respondent, filed a notice of appeal.

The first witness for the appellant was the son of the deceased, who gave a brief history of the company. Harry Taylor had worked for 17 years for a company involved in mining and industrial machinery work, but he abandoned this employment to set up his own operation in this kind of business in Noranda and in 1966 he incorporated a company by the name of Harry Taylor Mining Machinery Installation Inc., which purchased the assets and liabilities of his business.

At first this company specialized in installing and maintaining mining and industrial machinery. According to the witness, Harry Taylor was regarded as an expert in operations of this kind and there was great demand for his expertise in this area of industry. Furthermore, his company was the only one providing such services in the region. It had up to 100 employees and his operations extended as far afield as the mining centres of northern Ontario since, at that time, there were no restrictions on the mobility of manpower between the two provinces. It provided specialized services and had several technicians trained and qualified in operations of this kind.

In 1971 the company purchased its first crane. In the following years other cranes were purchased so that as of April 30, 1981 the company had 15 cranes of various capacities among its assets.

In its balance sheet for the fiscal year ending April 30, 1970 we find "Moveable Equipment" costing $42,854 and under the item "Trucks and Cars" a cost of $57,509 for a total of $100,363 with a book value after a reserve for depreciation of $36,139. As of April 30, 1981 the cost of these assets in the balance sheet was $1,254,284 for a book value as of that date after a reserve for depreciation of $712,284. These purchases necessarily took the company's operations in a new direction in that the leasing of manpower was replaced to a large extent by the leasing of heavy machinery in 1971 and subsequent years.

Two expert witnesses testified at the hearing as well as filing valuation reports, the first in the appellant's favour and the second in the respondent's favour.

It is agreed that valuation is not a science, that is, a discipline governed by rigid and dogmatic principles, but rather an art the activities of which involve formulating an opinion as to the commercial value of a property, which is expressed as its fair market value of whatever kind on a date determined by either an established or a notional free market. Authors specializing in this discipline have proposed certain methods that may be applied in such determinations and factors that should be taken into consideration in producing a valuation. However, these authors do not suggest or propose absolute principles that must be followed and accepted blindly. Each valuation must be prepared in light of factors and characteristics unique to the property being valued. If a method or criteria suggested by the authors appear to produce results in a particular situation that do not seem in accordance with economic reality, it is necessary to seek and apply those that will produce acceptable results in the circumstances. On the other hand, the valuation of shares in a private company, especially in the case of a deemed disposition, the task involved is much more complex since it is necessary to determine a notional value for the shares since normally there is no market for such shares. In some areas, such as real estate, the procedure of finding a parity between the property that is being valued and the value of similar properties sold previously normally gives realistic results. However, the application of this method requires that the economic, political or other conditions existing at the time of the sale of the properties used for comparison purposes be similar to those existing when the subject property is valued.

An essential characteristic of a valuer is that he must set aside any factor that may influence his objectivity in his work and thus impair his conclusions or make them suspect. The general principle is that the expert must support his conclusions and explain what they are based upon. In R. v. Turner (Terence), [1975] 1 Q.B. 834, at 840, Lawton, L.J. made the following comments concerning the opinions of expert witnesses:

It is not for this Court to instruct psychiatrists how to draft their reports, but those who call psychiatrists as witnesses should remember that the facts upon which they base their opinions must be proved by admissible evidence.

[Emphasis added.]

These comments apply not only to psychiatrists but also to all other expert witnesses.

At page 383 of The Modern Law of Evidence by Adrian Keane, LL.B., we find the following comments:

The facts upon which an expert's opinion is based must be proved by admissible evidence. In other words, if an expert relies on the existence or non-existence of some fact basic to the issue on which he expresses an opinion, that fact must be proved.

He continues at page 386:

What weight, if any, should be attached to the opinion evidence of an expert is a matter entirely for the tribunal of fact. The duty of an expert, it has been said, is to furnish the judge or jury with the necessary scientific criteria for listing the accuracy of their conclusions, so as to enable the judge or jury to form their own independent judgment by the application of these criteria to the facts proved in evidence. [1]

In explaining his choice of a valuation method, the appellant's expert witness told us in his narrative report:

When it seems that the "company" is capable of generating a satisfactory return, we recommend that the valuation be based on the capitalization of profits. Thus, in order to assess the value of the company on this basis, the sustainable profits must be calculated and capitalized using an appropriate multiplier, which will guarantee the investor a reasonable rate of profitability despite the inherent risks.

To establish the amount of the sustainable profits, he used the net pre-tax profits shown in the financial statements, which were corrected in accordance with accepted commercial practice. Tax was then calculated at the rates in effect on the valuation dates. He added that the choice of a rate of capitalization must reflect a number of economic factors that will enable the investor to obtain an acceptable return on his investment, despite the degree of risk. The following factors were taken into consideration:

(a) general economic situation;

(b) market and geographic location of business;

(c) economic conditions in the region;

(d) financial situation of the business;

(e) competition;

(f) success of business and ability of directors;

(g) return on similar investments;

(h) management of the company; and

(i) continuity in management of the company.

The company's sustainable profit was established at $36,900 as of December 31, 1971 and $85,345 as of October 3, 1981.

In light of the factors listed above he selected a capitalization rate of 10 per cent as of December 31,1971 and 28.6 per cent as of October 3,1981. These capitalization factors are therefore equivalent to a multiplier of 10 times the company's sustainable profits as of December 31, 1971 and 3.5 times as of October 3, 1981.

In his testimony he explained the reasons that led him to apply these factors.

He said that as of December 31,1971 the interest on Canada Savings Bonds was 6.56 per cent while the prime rate was 6 per cent. In selecting a rate of return of 10 per cent for an investor who might have been interested in purchasing the business, he gave him a risk premium of 3.44 per cent over Canada Savings Bonds and 4 per cent over the prime rate, which he felt was conservative. In percentage terms this was 34.4 per cent in 1971 and 40 per cent in 1981.

The next stage was to establish the business's sustainable profits and these could be obtained from the company's operations since it started up, namely, in 1966. According to the witness, it was necessary to determine what the company could earn on average after tax in subsequent years. Some adjustments were made to the figures shown in the company's financial statements for the years in question in that they were reduced by part of the salary paid to Mr. Taylor and his children, which was considered to be excessive, and other minor sums to obtain a net standardized profit, which was, in the witness's opinion, required by the valuation techniques.

The company's income for its financial years from 1967 to 1973 was, according to the financial statements:

The witness explained that, in order to establish its sustainable profit he stopped at the 1971 and 1972 fiscal years because he felt that they represented a normal period. The 1970 year seemed abnormal and the preceding fiscal years did not provide a standard because the company was just beginning its operations.

After the adjustments to the directors' salaries for 1971 and 1972, a reduction of $16,650 and $25,087 respectively, after-tax profits rose to $54,810 and $1,131 respectively. The general average for the two years was $27,970 but, since the company's income showed substantial fluctuations from year to year, he preferred to apply a weighted average to obtain a reasonable sustainable profit for subsequent years.

According to the formula used by the witness, the sustainable profit was calculated as follows:

By applying the multiplier of 10 after rounding off the figure of $36,917 to $36,900, he assessed the fair market value of the business as of December 31, 1971 at $369,000.

The next task was to establish the sustainable profit as of October 3, 1981, the day before the death on which the deceased was deemed under the Act to have disposed of his shares in the company. The witness explained that he used essentially the same valuation technique for 1981 as for 1971.

The data he considered related to operations for the years 1977 to 1981. Gross income in the financial statements was:

As he did with respect to 1971 he standardized the profits by deducting the salaries and bonuses of $104,746 paid to Mr. Taylor and his children for 1977, of $11,332 for 1978, $10,397 for 1979, $20,920 for 1980 and $165,971 for 1981, which he considered to be excessive, and a number of other minor corrections to obtain a realistic return.

Following these adjustments, profits increased to:

The major correction was that made to directors' salaries for 1981 in the amount of $165,971. These salaries consisted of a basic salary as well as a bonus. After the corrections the total earnings of the principal employees of the company were:

According to the witness’ report, the rate of return on Canada Savings Bonds as of October 3, 1981 was 17.66 per cent and the prime rate was 21.25 per cent. (These figures agreed with those of the respondent's valuer.)

The witness applied a 28.6 per cent rate of return for the business in 1981, which involved a risk factor of 10.94 per cent over Canada Savings Bonds and 7.35 per cent over prime rate. This gave him a multiplier of 3.5 for sustainable after-tax profit.

To establish sustainable profit for 1981, the witness chose the general average of net standardized profits, unlike what he selected for 1971, and this gave him a general average of $85,345, multiplied by 3.5, which gave a value for the business in 1981 of $298,707, rounded to $300,000 for valuation purposes.

The reason he gave in his testimony for selecting the general average rather than the weighted average was that he had established this weighted average at $77,089 for a value of $269,811 for the business and he felt that the higher figure would be more acceptable to the senior officers of the respondent.

I must mention that, in making a valuation, a valuer may not, in the witness’ view, take factors into consideration that are not relevant to the real value of the property he is required to value.

To support and justify his theory of the fair market value of the shares as of October 3, 1981 based on the return or sustainable profit of the business method, the witness explained that he also proceeded to determine the breakup value of the business. However, no admissible evidence was filed to establish that the market value of the company's assets was correct. The witness merely said that:

the market value of the moveable and immoveable property had been determined on the basis of information provided by persons in the firm and then determined also what was buildings and what was land on the basis of the municipal assessment.

A statement of this kind is not admissible evidence and for this reason I cannot assign any probative value to this feature of the report. An expert is permitted to complete his valuation on the basis of a valuation prepared by another expert when among the property to be valued by him is property that he does not have the requisite skill to value. Moreover, for a valuation prepared by a second expert to be admitted as evidence, the qualifications of the second expert must be clearly established to the satisfaction of the Court and also the author of the report be at least accessible to the other party so that it may examine or cross-examine him in order to determine whether his expert opinion is correct. Absent testimony from the author, the Court cannot assign any probative value to this valuation.

Two valuation reports were filed by the expert witness of the respondent, the first establishing a value for the company's shares as of December 31, 1987 and the second as of October 4, 1981.

In the preliminary comments in the report dated December 31, 1971 we find the following:

Approach to the Valuation

Since there is no generally recognized mathematical or standard formula for valuing a business, each case must be considered in light of the particular circumstances and particular facts existing as of the valuation date.

On the one hand, we must recognize that, in a valuation of a business with limited ownership, two (2) methods are commonly recognized: value of the assets and value of the return.

Asset value is used when:

(a) it is impossible to contemplate the business in an on-going situation and it is necessary to consider winding it up

or

(b) the very nature of the business is such that the possible purchaser would be interested in purchasing it for the tangible assets (i.e. vacant lots, investment portfolio etc.).

The return method is used where the return obtained on the capital invested is sufficiently high to persuade a possible purchaser to purchase the business's ability to generate adequate income. This value is the result of the rate of return required by the investor in light of certain risk factors inherent in the business to be valued.

In another paragraph entitled "Economic" the author states:

[Translation]

Economic

Competition was non-existent as of the valuation date but this situation entailed an inherent risk because, if the business proved to be profitable, competitors would not hesitate to invade the market given the low investment required.

The company was greatly influenced by the situation in mining markets and at that time the mining industry was going through a difficult period. The drop in production recorded at that time was the result primarily of the closure of three (3) molybdenum (silver mixed with lead) mines between 1969 and 1972, a number of copper-zinc mines and especially gold mines.

The main customers were as follows:

— Noranda Mines Limited	Noranda	40% of sales
— Falconbridge Copper	Lac Dufault	20% of sales
— Domtar Inc.	Quevillon	10% of sales

Finally, we find at page 5 in the paragraph entitled "Correlations":

[Translation]

After taking into consideration the approaches and methods applicable in the circumstances and on the basis of our analysis of the facts, we believe that a value based on yield is most representative (see Appendix A).

The after-tax profit used for capitalization purposes was $20,000, which represents sustainable future profits.

The 12.5% capitalization rate (multiple of 8) was chosen for the following reasons:

(1) External factors

Existing and anticipated economic conditions as of the valuation date;

Prime rate of 6%;

Rates offered on other types of investment:

— Long term
Provincial bonds	7.75%
Canada Savings Bonds	6.56%
Mortgages	9.10%;
— Medium and long term;
Canada Savings Bonds	4.75%

Trends in the money market over the last few years

The choice of a capitalization rate of 12.5 per cent when the prime rate was 6 per cent shows a risk premium of 6.5 per cent or 6 per cent in relation to the yield on Canada Savings Bonds.

On the basis of these data the expert concluded that the value of the business as of December 31, 1971 was $160,000.

The calculation used to obtain this figure is shown in Appendix A-1 of the report as follows:

[Translation]

Les Entreprises Harry Taylor Ltée

Typical Profit

as of December 31, 1971

	1972	1971	1970	1969	1968
Pre-tax profit, from financial
statements	($23,078) $ 56,057 ($20,507) $ 33,211 $ 29,446
Adjustments
Directors’ salaries (note 1)	25,000	16,650	5,000	15,000
Interest on loans to directors
(note 2)	(530) (1,060) (620) (1,320) (2,190)
Bad debts (note 3)			(11,000)	22,000
Adjusted pre-tax profit	$ 1,392 $71,647 ($27,127) $ 68,891 $ 27,256
Simple average (note 4)				$ 28,412
Income tax: 27%					7,671
Typical profit				$ 20,741
Rounded Off				$ 20,000

In his assessment of the situation as of October 3, 1981 the respondent's expert stated by way of preamble that the company was developing in a sector that was increasingly competitive and he gave the names of seven companies that had invaded this market at that time in competition with the appellant. He added:

[Translation]

Prices of base metals, especially copper and gold, declined and forecasts were not encouraging. This situation will have the effect of reducing production, closing certain mines and a halt to expenditures on capital investments by mining companies.

[Emphasis added.]

Following his calculations he concluded that the sustainable future profits of the appellant as of October 3,1981 were $120,000. The capitalization rate he chose was 22.2 per cent for a multiple of 4.5 times the profits in question or a value of $540,000 for the business.

His capitalization rate was related to the mortgage rate, which was, in his opinion, 20.54 per cent as of October 4, 1981. Since a capitalization rate of 22.2 per cent was used, the risk premium applied was 1.66 per cent.

To obtain a figure of $120,000 for sustainable future profit, he "standardized the profits" reported by the company, as both experts called it, and this involved adding to these profits the portion of salaries and bonuses paid to certain employees that was considered excessive. For the years from 1977 to 1980 inclusive both experts were in agreement as to the amounts. These were salaries paid to the members of the Taylor family.

For 1981, however, the respondent's expert added $225,971 to the income of the appellant, whose expert had added $165,971. The difference, namely, $60,000 was deducted arbitrarily from the total salaries paid to the employees who were not related to the Taylor family, but no explanation was given as to how this reduction was distributed among the employees and no supporting evidence of the validity of such a reduction was adduced.

On cross-examination he explained that, in his view, the percentage increase in salaries between 1980 and 1981 was too high and, according to the average suggested by an expert in salaries, was 15 per cent while he felt that an increase of 32 per cent was reasonable, which effectively reduced the total salaries by $60,000 and increased the company's income for 1981 by a corresponding amount. I believe that, in estimating reasonable total salaries, the respondent's expert confused his role as a valuer with that of an auditor.

When an auditor (assessor) prepares an assessment, he is allowed to refuse arbitrarily as a deduction in computing a taxpayer's income an expense or portion thereof that seems excessive to him and it is the taxpayer's task to prove first that he actually incurred the expenditures and later justify the amount thereof.

In the valuation procedure a valuer is not allowed to act arbitrarily in changing the data under study by presuming facts without proving their existence. In other words, it is not the task of an expert witness to express an opinion on a fact situation unless admissible evidence showing that it is not in accordance with reality has been adduced in advance. In a decision of the Supreme Court of Canada, William Hamilton Co. v. Victoria Lumber and Manufacturing Co., 26 S.C.R. 96 at 109, the Honourable Sedgewick, J. stated the following:

What are the facts which these experts really know upon which they based their opinion? They do not tell us. Now in the absence of evidence and explanation of this kind, the statement by them of their opinion is not proof, and in my view no judgment can be based upon it. It is more conjecture, or suggestion, or guess work, probably true, probably not, upon which no verdict could safely rest.

To conclude that the appellant's wage bill was too high because the amount exceeded a figure suggested by a so-called expert, whose qualifications were not identified in evidence, is, in my judgment, a purely gratuitous statement by the respondent's expert. A claim of this kind without supporting evidence cannot be accepted seriously as one of the factors determining the value of the business. This purported excessive surplus had, after all, been paid to the company's regular employees.

The percentage increase in the wage bill from one year to another seems to have impressed the expert for the respondent, although, on the other hand, the increase in the appellant's gross income between 1980 and 1981 of $1,268,502, namely 77 per cent was not mentioned.

Turnover of $2,901,323 in 1981 made this the company's most profitable year since it began operating and it seems to me that such results must at the very least have required a greater number of employees or the possibility of overtime. Whatever the reason may be, given the company's results for 1981, the increase in the wage bill in the absence of evidence to the contrary seems reasonable in the circumstances and the Court cannot take this factor into account in assessing the respondent's valuation because it was arbitrary and not based on any evidence that might have justified it.

The expert then submitted what he felt was the net tangible worth of the company's assets. He determined from the company's financial statements as of April 30, 1981 that their book value was $551,006. He added to this figure what he felt was an excess value of lands and buildings to take their market value into account at a sum of $199,055.

We find the following comments in an explanatory note: "The fair market value of the lands and buildings was determined by our real estate valuation service. The valuation report on these buildings is attached to this report."

Moreover, the appellant's evidence confirmed that the respondent's real estate expert had relied on the municipal assessment of the buildings for 1983 as the basis of his valuation rather than that for 1981, which was $184,950, whereas, according to the appellant's documentary evidence, the municipal assessment of the buildings was $74,500 in 1981.

He subsequently added the taxes carried back and deducted the depreciation, that is, the difference between the book value of these assets and their presumed market value.

We find the following remarks in notes attached to this report concerning the mobile equipment and rolling stock: "We used the values submitted by the corporation."

To conclude, a final note states: "We assumed that all the assets and liabilities other than those we adjusted in calculating the break-up value had a market value equal to their book value.” [Emphasis added.]

In preparing a valuation to be used as evidence in court, a valuer may not accept figures that he did not check or take facts for granted over the correctness of which he has no control. Expert testimony must be the product of the expert's personal opinion based on established facts the existence of which is proved, and not on conjectures or information he receives from third persons. It is for the Court, and for the Court alone, to rule whether a witness may be admitted as an expert for the purposes of a trial and subsequently to admit or reject his opinions. My comments concerning the admissibility of the evidence presented by the appellant's expert concerning the value of the company's moveable and immoveable property also apply to this part of the respondent's evidence.

To come, finally, to the sustainable profit in 1981, the witness submitted the following figures in the form of a table:

Two fundamental errors emerge from this exercise.

The first relates to the 18.75 per cent rate of tax paid. The witness maintained that for the 1981 taxation year the tax rate on company profit had been considerably reduced by the Province of Quebec [3] and subsequently the effective rate of federal and provincial tax was about 18.75 per cent. With respect to this claim the appellant's expert witness admitted that, in fact, the provincial rate had been reduced but the province had also considerably increased the tax on paid-up capital of companies and the employer's contribution to the health insurance plan. [4] The expert continued that the effect of these increases was additional tax payable by the appellant. The impact of the tax increase on capital and the contribution to the health insurance plan had resulted in additional expenditures for the company in an amount of $24,100 in 1981 and, according to him, these increases should be taken into account for the preceding years if a realistic sustainable profit for this period was to be obtained.

He himself applied a tax rate of 27.75 per cent to the company's profits of $200,000 and under and a rate of 50.8 per cent on those exceeding $200,000 on the ground that the difference between 27.75 per cent and 18.75 per cent took into account the additional tax resulting from the above-mentioned increases. He admitted that this difference was possibly not very precise but, no matter what the discrepancy was, it was immaterial for the purposes of his valuation. I shall not spend time considering whether the rate of 27.75 per cent chosen by the appellant's expert witness was correct but merely accept the validity of his arguments that the increases in the rates of tax on companies’ paid-up capital and contributions to the health insurance plan should be taken into consideration in determining the company's net profits for the year and subsequently sustainable profit.

The second error was to apply the combined uniform tax rate of 18.75 per cent to the average profits for the period since this had the result that the company's profits for 1977 and 1981, which, in his view, were $239,555 and $436,458 respectively, were its net after-tax profit, which was reflected in the calculation of the sustainable profit. What should have been done in the circumstances was to deduct the company's actual tax before establishing the simple average.

For purposes of deciding this appeal, I do not intend to spend time considering whether the expert testimony in the circumstances should have been established on the basis of five years of operations rather than two or determining whether the simple average or the weighted average would have been preferable in establishing the company's sustainable profit. I shall limit myself to the valuations as a whole and I conclude that the valuation prepared by the appellant's expert witness is much more realistic than that of the respondent's expert.

In addition to my observations on the valuation techniques of the respondent's expert witness, I have found it difficult to accept the validity of the reasoning on which he relied in reaching his conclusions as to the values of the company on the two valuation dates. In fact, there seems to be a contradiction between his assessment of the situation in 1971, from which his conclusions emerge concerning the value of the shares as of that date, and that which existed in 1981.

In 1971 when the company had operated for only six years and did not have any competition in the area in which it carried on business, economic conditions were relatively stable, interest rates were at a minimum and it had already made considerable profits, he determined a sustainable profit of $20,000, which was much lower than the profits it had made in some fiscal years in the period. It seems to me that this experience in earlier years offered a potential for the years to come that was much higher than $20,000, the figure suggested by the respondent's expert witness, given the profits made during the period.

—. On the other hand, for 1981 he relied in his report on a series of facts and conditions that did not show that the company's operations were flourishing. He stressed the fact that the company was facing strong competition and that economic conditions were not encouraging for the coming years but failed to mention that interest rates were at their highest. Despite all this adversity he arrived at a sustainable yield of $120,000, a sum that the company had achieved only twice in a period of sixteen years of operations, namely, in 1977 and 1981. It is known that for 1981, according to the evidence of the deceased's son, a substantial increase in the price of gold at the time had led to additional maintenance and other work for the mining companies in the area. No information was provided for 1977 concerning the cause of the increase in income and profits, but it is clear that it was an aberration from past experience.

The reasoning in both these cases is illogical and makes the valuation for 1981 suspect, at the very least.

I do not find that the data submitted by the respondent's expert witness are incorrect but much more precise evidence would have been required to persuade me that they are valid.

Nor do I express an opinion on the correctness of the data of the appellant's expert witness, but I could not find any fundamental errors in their presentation that might seriously have distorted the results of his valuation and the opinions he expressed.

Given the evidence that was adduced at the hearing, which was not as complete as it might have been, I have no alternative but to accept the appellant's valuation, which seemed to me to be more realistic in the circumstances.

For these reasons the appeal is allowed and the assessment referred back to the respondent for reconsideration and reassessment in accordance with the reasons for judgment. The appellant is entitled to party and party costs.

Appeal allowed.