The Galway Family Trust v. Minister of National Revenue, [1990] 2 CTC 2486, 90 DTC 1913

Mogan, T.C.J.:—The appellant is a trust of which the trustee is Frank H. Galway and the beneficiary is his son Geoffrey Galway. At all material times, the appellant was the sole shareholder of Kentway Transportation Ltd. ("Kentway") which carried on business in Ontario as a school bus operator. In June 1972, the issued shares of Langdon's Coach Lines Co. Ltd. ("Langdon's"), another Ontario school bus operator, were owned 50 per cent by Frank H. Galway (the trustee of the appellant) and 50 per cent by Bimont Holdings Ltd. ("Bimont"). At the end of June 1972, Kentway purchased 50 per cent of the issued Langdon's shares from Bimont in an arm's length transaction.

In September 1974, Kentway purchased the remaining 50 per cent of the issued shares of Langdon's from Frank H. Galway for a price of $285,000 and paid the following amounts as part of the purchase price:

The respondent concluded that the fair market value of 50 per cent of the issued shares of Langdon's in September 1974 was an amount not greater than $105,000 and that the appellant desired to confer a benefit of $180,000 on Frank

H. Galway being the amount by which the purchase price ($285,000) exceeded the respondent's estimate of fair market value. Accordingly, the respondent issued notices of assessment to the appellant for its 1976,1977 and 1978 taxation years adding the above amounts to the appellant's reported income and relying on subsections 15(1) and 56(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the 'Act").

The issues in this appeal are to determine the fair market value of 50 per cent of the issued shares of Langdon's in September 1974 and to determine whether subsections 15(1) and 56(2) can support the assessments under appeal.

The agreement between Kentway and Frank H. Galway provided that the purchase price for 50 per cent of the Langdon's shares was to be the fair market value of those shares determined either by mutual agreement or by the auditors of Langdon's. The purchase price could easily have been determined by mutual agreement because Frank H. Galway was both the vendor and the sole trustee of the appellant purchaser. Mr. Galway was the first witness to testify for the appellant but he could not recall how the purchase price was determined. There is no evidence that the purchase price was, in fact, determined by the auditors of Langdon's. The parties are in agreement that the purchase price was $285,000 and, at the hearing, each side called expert evidence to prove the fair market value of the issued shares of Langdon's as at September 1, 1974.

Lloyd Gerald Wait, a witness for the appellant, was a senior officer of "Travelways" from 1970 to 1977 when it became the largest school bus operator in Ontario. During that seven-year span, he participated in the purchase of many school bus operations across Ontario. Mr. Wait explained that the consolidation of school boards in the 1960s resulted in more school bussing as small schools were closed and local students were bussed to larger schools with more facilities. There was much activity in the purchase of school bus operations as the local farmer or gas station operator with one or two buses would sell to the larger operator with more capital when it was time to replace a bus. In York Region, for example, there were 18 school bus operators in 1960 but, by the early 1970s, there were only four of which Travelways and Langdon's were two.

Mr. Wait stated that the value of a school bus operation was usually based on earnings. He would start with the financial statements and, make adjustments if the operator were a private corporation like Langdon's. The critical, indicators were rolling stock (number and age of buses), school contracts and operating costs. If the operator owned a fixed asset like a garage with repair facilities, it would be appraised independently. As a rule of thumb, 50 per cent of contract revenue was regarded as goodwill and gross profit should be in the range of 25 per cent of contract revenue.

Mr. Wait was shown the financial statements of Langdon's at August 31, 1974, very close to the valuation date. He observed that for gross revenue of $1,053,000, the vehicle leasing costs of $580,000 were disproportionately high. He would have replaced the high leasing costs with a purchased fleet of buses resulting in depreciation, financing and wages in the aggregate estimated amount of $399,000 based on an 8-year write-off. He also thought that the gross profit of $46,000 (4.4 per cent) was too low and could have been increased by $181,000 (17.2 per cent) with a purchased fleet. If Travelways had purchased Langdon's, some administrative costs could have been reduced. Mr. Wait would not have purchased the Langdon's bus business in 1974 if the vehicle lease arrangement had stayed in place.

When Kentway purchased the remaining 50 per cent of the issued shares of Langdon's in September 1974, Langdon's had many good school bus contracts but leased all of its vehicles from Kentway on the basis that Kentway provided the buses and drivers but Langdon's paid the costs of fuel, repairs, insurance and licences. It was the lessor's costs of buses and drivers which Mr. Wait said he would replace with depreciation, financing and wages to save $181,000.

Mr. Perry Phillips testified as an expert witness on behalf of the appellant concerning the fair market value of the issued shares of Langdon's as at September 1, 1974. He is a member of the Canadian Association of Business Valuators with approximately ten years' experience in business valuations. Mr. Phillips stated that because school bus contracts are negotiated in the spring for the following school year, the school bus business has a stability which does not exist in many other businesses. In his view, if costs can be estimated closely, then profit should be stable and permit easier valuation. He relied on statistics provided by the York Region Board of Education to show that in the period 1970-1975, school enrolment was stable; the number of schools was decreasing and transportation budgets were increasing. He therefore concluded that more students were being carried by bus.

Mr. Phillips used capitalization of earnings as the appropriate method to value the shares of Langdon's as at September 1, 1974. He started with the audited financial statements of Langdon's for the year ended August 31,1974 and the reported earnings for 1973 and 1972. He noted that the transfer of all buses to Kentway in 1968 caused material inter-company charges to appear on Langdon's profit and loss statement. After reviewing the Langdon's and Kentway financial statements for 1969-1974 and adjusting for inter-company charges, he concluded that a reasonable gross profit would be in the range of 22 per cent to 27 per cent. He therefore adjusted the direct operating expenses to reflect a gross profit of 23 per cent. On a weighted average basis for 1972,1973 and 1974, he determined that future maintainable earnings would be $103,000 per annum.

In Mr. Phillips’ opinion, the appropriate capitalization rate would have been in the range of 17 per cent to 20 per cent. Applying those rates to his estimated maintainable earnings, he computed a fair market value of Langdon's shares in the range of $618,000 ($103,000 x 6) to $515,000 ($103,000 x 5) and he chose the midpoint of $567,000. If the fair market value of all issued shares of Langdon's was $567,000 at September 1,1974, then the fair market value of 50 per cent of those shares was $283,500 being close to the purchase price of $285,000. Therefore, Mr. Phillips’ expert opinion supported the actual purchase price paid by Kentway to Frank H. Galway.

Mr. Murray Game testified as an expert witness on behalf of the respondent concerning the fair market value of the shares of Langdon's. He is a member of the Canadian Association of Business Valuators with approximately ten years' experience in business valuations. He (like Mr. Phillips) used capitalization of earnings as the appropriate method to value the shares. Unlike Mr. Phillips, Mr. Game did not adjust the inter-company charges between Langdon's and Kentway. Instead, Mr. Game reduced the salaries and employees benefits from $75,000 to $40,000 because of their non-arm's length nature; and he reduced the administrative expenses recovered from an affiliate from $80,000 to $49,000 based on the revised management salaries.

After making the above adjustments, Mr. Game determined that the net after-tax earnings of Langdon's at August 31, 1974 should have been $22,000. Using a capitalization rate of 20 per cent, he multiplied these earnings by five to obtain a fair market value of $110,000 for all issued Langdon's shares. After deducting $2,000 for preferred shares, he concluded that the fair market value of all common shares of Langdon's was $108,000 or $54,000 for 50 per cent of those shares.

There is, of course, a significant difference between the fair market value of the Langdon's common shares as determined by Mr. Phillips ($567,000) and Mr. Game ($108,000). The difference is a direct result of the way they treated the vehicle leasing agreement between Langdon's and Kentway. Mr. Phillips recognized that the leasing agreement was too onerous for Langdon's because it sent too much revenue to Kentway; and he adjusted the payments under that agreement by $217,000 so that Langdon's could earn a gross profit in the range of 22 per cent to 27 per cent even though Langdon's actual gross profit was 4.4 per cent at August 31, 1974. The term of the seven-page vehicle lease agreement was from September 1, 1971 to August 30, 1976 and there was evidence that lease payments of $580,000 per year were paid by Langdon's to Kentway in 1974, 1975 and 1976.

Mr. Game did not make any adjustment for the vehicle leasing agreement because he regarded it as a binding contract in force at the valuation date. He showed in a schedule (Exhibit R-2) that the adjustment of $217,000 which Mr. Phillips used to give Langdon's a higher gross profit in 1974 would, if deducted from Kentway revenue, cause Kentway to suffer a loss. And if there were expenses tied to that $217,000 which Kentway could have saved, then those expenses should have been transferred to Langdon's and would have reduced its adjusted gross profit. The adjusted gross' profit in Langdon's which Mr. Phillips achieved by reducing direct operating costs by $217,000 must be coupled with a resulting loss in Kentway. Both of those results are in conflict with the situation which really existed in 1974.

Mr. Game also showed in another schedule that the combined operations of Langdon's and Kentway produced a gross profit of only 15.86 per cent which is significantly below Mr. Phillips’ target of 23 per cent for Langdon's alone. I am satisfied that Mr. Game’s method of determining the fair market value of Langdon's shares is more reasonable than Mr. Phillips’ because Mr. Game adjusted only management salaries and employee benefits which are usually established each year on an informal basis whereas Mr. Phillips adjusted payments under a five-year lease agreement which was reduced to writing and signed in 1972. Also, Mr. Phillips’ adjustment to payments under the vehicle leasing agreement would have had a significant impact on Kentway (an affiliated company) which was not adequately explored in evidence.

My only reservation on Mr. Game's valuation is the fact that the vehicle leasing agreement expired in 1976 and, if it was unduly onerous to Langdon's, it could be renegotiated at that time. When issuing the assessments under appeal, the respondent assumed that the fair market value of the issued common shares of Langdon's at September 1, 1974 was not greater than $210,000; and the fair market value of the 50 per cent sold by Frank H. Galway to Kentway was not greater than $105,000. In Mr. Game's opinion, the fair market value of the issued common shares of Langdon's at September 10, 1974, was $108,000. Even if Mr. Game’s value were increased by 94 per cent to $210,000 because he may have overlooked the fact that the vehicle leasing agreement could be renegotiated in 1976, such increase in value would not exceed the Minister's assumed value.

In my view, Mr. Game's valuation should be increased by as much as 50 per cent to $162,000 because Langdon's had many school bus contracts and should have been able to earn a better profit after 1976 with a better vehicle lease agreement. As I have just stated, however, increasing Mr. Game's appraised value from $108,000 to $162,000 does not bring the fair market value of the issued common shares of Langdon's up to the value of $210,000 assumed by the respondent for assessment purposes. Therefore, I would not grant the appellant any relief with respect to the fair market value of the issued shares of Langdon's in September 1974.

Before leaving the valuation issue, I should note that in June 1972 Kentway purchased 50 per cent of the Langdon's shares from Bimont for $50,000 in an arm's length transaction. Mr. Phillips thought that the 1972 sale was not an indication of value for 50 per cent of Langdon's shares in 1974 because part of the consideration in 1972 was the release of substantial bank guarantees. Also, there was some evidence that the 1972 vendor was insolvent and it could have been a distress sale. Even accepting those limitations, there should have been more evidence to show how the cash value of 50 per cent of Langdon's shares could increase from $50,000 to $285,000 in two years. The financial information in evidence does not indicate that such an increase was warranted when the purchase price in 1974 was paid over four years.

There is a second issue as to whether subsections 15(1) and 56(2) can support the assessments under appeal.

15.(1) Where in a taxation year

(a) a payment has been made by a corporation to a shareholder otherwise than pursuant to a bona fide business transaction,

(b) funds of property of a corporation have been appropriated in any manner whatever to, or for the benefit of, a shareholder, or

(c) a benefit or advantage has been conferred on a shareholder by a corporation,

otherwise than

(d) . . .

(e) . . . , or

(f) . . .

the amount or value thereof shall, except to the extent that it is deemed to be a dividend by section 84, be included in computing the income of the shareholder for the year.

56.(2) A payment or transfer of property made pursuant to the direction, of or with the concurrence of a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to him.

In a nutshell, the appellant argues that if the fair market value in September 1974 was less than $285,000, there may have been a benefit conferred on Frank

H. Galway but such benefit was not intended. That argument would be valid if the purchase price were the result of a bona fide attempt to determine fair market value; and if the fair market value as determined by this Court were not significantly below the purchase price. Mr. Galway testified that he could not recall how the purchase price was established. This is surprising because the evidence was that in the period 1972-1974 he made all the important decisions within the Galway group of companies. In evidence, Mr. Galway would say “1 bought" and "I sold” when he was referring to purchases and sales by companies within the Galway group.

I have concluded that there was no bona fide attempt by the auditors of Langdon's to determine the fair market value of the Langdon's shares at September 1, 1974 because such attempt would have been documented and the appellant did not produce any documents as evidence of such attempt. And even if it could be said that the purchase price of $285,000 was the result of a bona fide attempt to determine fair market value, that price is $204,000 higher than the fair market value which I have just determined for 50 per cent of the Langdon's shares, being $81,000 (one half of $162,000). In other words, the actual purchase price for 50 per cent of the shares was $204,000 (252 per cent) higher than the fair market value of 50 per cent of the shares as determined in this appeal.

I also conclude that the purchase price of $285,000 was determined by Frank H. Galway (as vendor and as sole trustee of the trust which owned all the shares of the purchaser) without adequate regard to the question of whether it was fair market value. If Frank H. Galway had owned shares directly in Kentway, I would have held that in September 1974 Kentway conferred a benefit or advantage on Frank H. Galway within the meaning of paragraph 15(1)(c) of the Income Tax Act when it paid $285,000 to him for 50 per cent of the Langdon's shares. In the circumstances of this appeal, when the actual purchase price of $285,000 was 252 per cent higher than the fair market value of $81,000, I think that the appellant did desire to confer a benefit on Frank H. Galway within the meaning of subsection 56(2). The appeal herein is dismissed.

Appeal dismissed.