Hamlyn, J.T.C.C.:—This is in the matter of Majean Investment Co., appellant, and Her Majesty the Queen, respondent.
This is an appeal with respect to the appellant's income tax reassessment for the 1987 taxation year. The appellant is a body corporate carrying on business at 72 MacLaren Street in the City of Ottawa, Province of Ontario.
On or about January 2, 1987, the appellant sold its 50 per cent share of the ownership of M. McGrath Canada Ltd., hereinafter to be called McGrath Canada, for the sum of $175,000. In reassessing the appellant for the 1987 taxation year, the Minister of National Revenue included additional capital gains to the income of the appellant in the amount of $250,000, and disallowed a claimed deduction for small business in the amount of $20,917.
The appeal on the deduction for small business disallowance was abandoned at the outset of the trial.
Facts
Mr. Matthew J. McGrath and his wife, Mrs. Jean McGrath, were the sole shareholders of the appellant Majean Investment Co. At all material times the appellant owned 50 per cent of the shares in McGrath Canada, and Mr. Matthew McGrath personally owned the other 50 per cent of the shares in the company.
During the 1987 taxation year the appellant disposed of itsshares in McGrath Canada in a non-arm's length transaction for proceeds of disposition in the amount of $175,000.
The appellant’s shares in the company were acquired by Kevin McGrath and Mary Jean McGrath, the children of Mr. Matthew McGrath and Mrs. Jean McGrath.
Significant evidence from the testimony of Matthew McGrath
Mr. McGrath, the chief executive officer and chief operating officer and president of McGrath Canada, testified at length about his involvement with the appellant holding company and the related, interconnected and associated companies involved in the debt collection business of McGrath Canada. He also testified as to the events leading to the sale of McGrath Canada.
Clearly Mr. McGrath was the operating and directing mind behind McGrath Canada. The interrelated and connecting companies, many incorporated by Mr. McGrath, were there to serve McGrath Canada. Those companies, through membership in industry associations or affiliations with ex juris corporations, or incorporations, to achieve residential status, all served to enhance the debt collection business of McGrath Canada. In particular, one company McGrath Quebec Ltée was a corporation formed to achieve Quebec residency but in reality all the business was conducted at the headquarters in Ontario of McGrath Canada.
Through these associations, affiliations or residency acquisitions the client base was built. Behind the development of this base was the personality of Matt McGrath. These associations, membership affiliations, and corporations created a business network of cooperation and protected territories that allowed the business to significantly prosper. Profits from these other related and inter-connected corporations were channelled to McGrath Canada by way of management fees.
Mr. McGrath, in testimony, was direct and adamant in his view that the trade territories were restricted and protected in large measure by virtue of his own personal presence and the membership in the trade associations. In particular, one association, "A.C.B.C.", (Associated Credit Bureaus of Canada), the membership was, by bylaw, non-transferable. He, (Mr. McGrath), however stated the unwritten rule of A.C.B.C. was structured to protect families, and the transfers to family members of a particular member could take place without objection if the lobbying and politics of the proposed transfer was handled properly. Beyond that, the rule (the bylaw) was strictly enforced to third arm's length parties. This A.C.B.C. relationship was the source of over 30 per cent of the business income of McGrath Canada.
Mr. McGrath further emphasized that the federal government collection business that came through this connection was periodically up for tender, and that business could easily be lost in the contract-tender process.
All this evidence was presented to support the appellant’s position at the time of the sale that a third party arm's length purchaser would have no guarantee on transfer of the same business level, and to some degree certain business could not be transferred because of contractual (i.e., bylaw) prohibition.
Mr. McGrath also stated the purchase and sale was handled through a longstanding experienced company auditor, Mr. Parrot, who, after deliberation, arrived at the purchase price and then presented it to the parties for their consideration. He further stated it took some deliberation and the passage of time before the agreement was agreed to and finalized.
The agreement was an in-escrow agreement that gave the vendor (i.e., in reality, Mr. McGrath) considerable latitude over a long period of time to nullify the sale. Moreover, the shares were in the hands of the trustee and not directly in the hands of the purchaser.
The appellant's position from the pleadings
The appellant states that the valuation of the company at $175,000, shown in the appellant’s tax return, is the correct valuation. The appellant further states that the company does not own any fixed assets such as land and buildings. Therefore, it is submitted that the true market value of the company sold would oe very close to its book value.
The appellant further submits that the valuation of the company should be similar to those of major financial institutions. A comparison of the sale prices of common shares in three Canadian banks reveals that the median sale price of the shares was 102.28 of book value at an average of 6.13 times the weighted adjusted average of earnings. The appellant further concludes the value placed on the company by Revenue Canada would be 15.07 times earnings.
The respondent's position from the pleadings
At all material times the fair market value of the shares in the company disposed of by the appellant was $425,000. The adjusted cost base of the shares in the company disposed of by the appellant was $154,814. The appellant realized a capital gain in the amount $270,185.50 in disposing of its shares in the company.
Issue
The fundamental issue to be decided is: what was the fair market value of the shares in the company at the time of the disposition.
The appellant's expert opinion as to valuation.
The appellant’s expert submitted the starting point to determine fair market value is to establish the maintainable after-tax earnings of the company. Once the net after-tax earnings have been calculated for the five years preceding the sale, the average earnings and the weighted average earnings would be determined. The average or weighted averaged earnings would have to be adjusted to account for the potential loss of business following a sale resulting in maintainable earnings between $64,000 and $72,000 per annum.
He further stated that a prudent investor would expect a rate of return on the purchase of McGrath Canada sufficiently high to compensate for the risks involved in the investment. The starting point for determining a reasonable rate of return, the witness submitted, is to look at the rate of return available on similar investments. The 1988 financial reports for three major chartered banks (Royal Bank, Bank of Montreal and Scotiabank) show that their average share price is equal to 6.13 times the earnings. This translates into an average return on investment of 16.3 per cent.
As all of the income generated by M. McGrath Quebec Ltée is transferred to McGrath Canada, it is this witness's opinion that the book value of M. McGrath Quebec Ltée should not be added to the capitalization value of McGrath Canada to obtain a reasonable purchase price for the companies.
The book value of the company represents the underlying value of the assets of the company which are used to generate its income was also the position of this witness. The book value of McGrath Canada Ltd. and McGrath Quebec Ltd. he found to be $337,329. The witness concluded the valuation using the capitalization method where he utilized a capitalization rate of 20 per cent and considering the book value of the two companies combined, was the fair market value of M. McGrath Canada Ltd. was $360,000 as at January 2, 1987.
The expert opinion of the respondent was presented as follows: The opinion commenced with a definition of fair market value. Fair market value is defined as the highest price available in an open unrestricted market between informed and prudent parties acting at arm's length and under no compulsion to act, expressed in terms of money or money's worth.
The respondent's expert considered also the capitalization of earnings approach. Under this approach he adjusted the historical earnings to reflect the maintainable after-tax earnings of the business and established a capitalization rate to reflect the rate of return an investor would expect for an equity investment in McGrath Canada.
Maintainable earnings
He established the maintainable after-tax earnings were between $80,000 and $90,000 per annum. In terms of a capitalization rate, he stated: a prudent investor would expect a rate of return in the order of 12 per cent to 14 per cent for an equity investment in McGrath Canada.
The rate of return will depend on the degree of risk associated with the expected maintainable earnings of the business. In order to assess the degree of risk, the following factors must be considered: general economic and market conditions prevailing, industry and market comparisons, financial condition of the business under review, and the qualitative assessment of the operations of the business.
He summarized by finding the range of maintainable earnings at $80,000 to $90,000; and indicated to him, on analysis a fair market value of the company: between $752,937 and $729,127.
The witness also referred to a rule of thumb. A rule of thumb is a common criteria used within a specific industry which is applied to gauge an element of business value. He further went to state, there is a rule of thumb that stipulates an established collection agency with a reasonable rate of growth pattern should be worth between 70 and 100 per cent of its average annual gross commission revenue. Under this rule-of-thumb approach, he established the value of the company to be between $850,000 and $950,000.
Summary
He concluded that 10,000 common shares of M. McGrath Canada Ltd. as of January 2, 1987, would be between $700,000 to $800,000.
General comments on the opinion evidence
Specifically, most of the sub-issues, including a reasonable expected level of revenue, the economic forecasts, the appropriate discount rates and the market rate of managerial services, as well as the question of whether McGrath Quebec was in reality McGrath Canada, have been addressed in varying degrees by the respective valuations.
Generally, the application of technical approaches adopted by experts is useful and dependent upon factors and assumptions which are entirely a matter of judgment. The end result is merely an opinion, not a precise solution arrived at by precise methods using constant factors. The value of property on a certain date is inextricably bound to be valuator's prophecy of the future.
Accordingly, the more accurate of two expert opinions will be the one that attempts to reflect all factors that affect the value and the value is no less real at that time, if later the prophecy turns out to be false than when it comes true.
The expert for the respondent, Mr. Racicot, in calculating maintainable earnings, adjusted the cash flow to reflect general uncertainty. However, particular uncertainties known at the time of the valuation were not reflected in the forecast cash flow. There was a failure to consider the possible loss of income that could result from the loss of membership in “A.C.B.C.”, as well as the effect of the renewal of the federal government collection contract.
Mr. Racicot was also unaware of the precise duties of Mr. McGrath and Mrs. McGrath, and, therefore, selected an inappropriate economic salary.
Generally, Mr. Racicot the expert for the respondent, in his analysis lacked sufficient information or refused to apply new information relating to the specific aspects of this company to properly determine maintainable earnings. The discount rate used to capitalize maintainable earnings is a synthesis, of inter alia the inherent risk in maintaining the projected cash flow, prevailing economic factors, risk-free rates of return ana the security of investment.
Mr. Racicot did not adjust his valuation to reflect the risk, (that is the lack of security of the investment and the inability of the vendor to transfer all the business).
The expert for the appellant also based his value upon a capitalization approach. In arriving at a fair market value, he did not place a value in the acquisition of a controlling interest. McGrath Canada was for sale, and a controlling position in a privately held business accords certain rights and privileges to the owner in which there exists value. Among these are the ability to draw salary and receive emoluments in excess of what would usually be paid for management services rendered.
When selecting a discount rate to capitalize earnings, Mr. Parrot drew upon information which would not have been available to him as of the date of valuation, namely the 1987-88 bank statements from Royal Bank, Bank of Montreal and Scotia Bank, however, he did state his long-standing review of those statistics left him with the conclusion they were stable and reliable.
Finally, Mr. Parrot expressed the opinion that McGrath Canada was worth $350,000 upon which the sale price proceeded.
Subsequently, he was requested to prepare a report of the fair market value of McGrath Canada. I do not believe there was a conscious effort to make the figures correspond, but I must recognize that there may be some aspect of a self-ful prophecy operating.
Mr. Parrot and Mr. Racicot were both credible witnesses. In the end, Mr. Racicot's approach to valuation was technically proper and in accordance with the methods and techniques generally accepted in the profession, however, arriving at an opinion on the value, he did not accumulate sufficient data or information relating specifically to this company. He was also unwilling to recognize new variations, as presented, that would significantly affect his valuation. Mr. Parrot, on the other hand, has been associated with McGrath Canada for 40 years as their auditor and, as such, had an intimate knowledge of the company and its operations and he expressed himself clearly, such that his evidence showed a depth of analysis, not only on facts but on experience that was founded in his many years of private chartered accountancy practice, including other business valuations and opinions tendered in other clients’ tax matters.
As a result, the degree of reliance I place in the report of the expert for the respondent is minimal; fundamentals were there but the ability to accept and assimilate new information was absent.
Expert opinion evaluation
The business of evaluation is an art and not an exact science. Judge Brulé of this Court has stated in Ample Investments Ltd. v. M.N.R., [1990] 2 C.T.C. 2217, 90 D.T.C. 1748, at page 2220 (D.T.C. 1750):
In trying to account for the differences in valuations in addition to explanations given or omitted one must consider the source of the valuations.
In The Modern Law of Evidence by Adrian Keane, 1985 edition, he said of opinion evidence at page 337:
The danger is particularly acute in the case of opinions expressed by expert witnesses of whom it has been said, not without some sarcasm, “it is often quite surprising to see with what facility and to what extent, their views can be made to correspond with the wishes or the interests of the parties who call them".
Judge Brulé goes on to say that the Court process is not merely choosing one opinion over another wherein he states at page 2220 (D.T.C. 1750):
In situations such as this, it is comforting to follow the comments made by Mr. Justice Walsh, in Edna J. Bibby v. The Queen, [1983] C.T.C. 121, 83 D.T.C. 5148, at page 131 (D.T.C. 5157):
While it has frequently been held that a Court should not, after considering all the expert and other evidence, merely adopt a figure somewhere between the figure sought by the contending parties, it has also been held that the Court may, when it does not find the evidence of any expert completely satisfying or conclusive, nor any comparable especially apt, form its own opinion of valuation, provided this is always based on the careful consideration of all the conflicting evidence. The figure so arrived at need not be that suggested by any expert or contended for by the parties.
During the hearing of this appeal, I encouraged the parties to attempt to resolve the dispute by indicating litigation of this type is seldom an all-or-nothing proposition. However, now, after all the evidence is in, I do not find myself faced with this dilemma of finding a compromise.
The expert evidence, for the stated reasons, was somewhat weak on the respondent's side. On the other hand, the appellant's expert, albeit an in-house opinion, was sound and full of many years of business experience and particular knowledge of this business. I am, therefore, not left in the position of finding that both opinions, being so diverse from one another, or defective that both opinions are wrong.
I accept the opinion of Mr. Parrot, the appellant’s expert witness, as being closest to best assist the Court in its deliberation. This evidence indicates the value of all the shares at disposition was $360,000.
Conclusion
On balance, I conclude the valuation arrived at in the agreement of purchase and sale was reasonable.
Decision
The appeal is allowed, and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that $350,000 was the fair market value of all the shares of M. McGrath Canada Ltd. as of January 2, 1987.
Costs
The appellant being successful is entitled to its costs. In argument prior to this judgment I asked for submissions as to costs. For its part, the appellant expressed frustrations in attempting to bring the matter to Court, specifically the appellant experienced difficulty in the rigidity of the respondent's expert witness. The appellant asked for costs on a solicitor/client basis, with full remuneration for consultations between the counsel and the appellant's expert witness.
I cannot come to that conclusion. I do not accept that the frustrations expressed by the appellant's counsel although real are out of the ordinary in the varied course of normal litigation. Costs to the appellant are awarded on a party- and-party basis.
Thank you.
Appeal allowed.
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