Lakehouse Enterprises Ltd, Lakehouse Holdings LTD v. Minister of National Revenue, [1983] CTC 2431, 83 DTC 388

Guy Tremblay:—These appeals were heard on common evidence in Vancouver, British Columbia, on August 9 and 10, 1982.

1. The Point at Issue

The point at issue is the V-Day value of pieces of land located at Duncan, BC. They were sold for $825,000 on August 31, 1976. The appellants’ contention is that the V-Day value was $419,000 because of the theory of the special purchaser.

The respondent contends that the V-Day value of the said property is $250,000. There is also another point concerning the recapture of capital cost allowance.

2. The Burden of Proof

2.01 The burden is on the appellants to show that the respondent’s assessments are incorrect. This burden of proof results especially from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. The Facts

3.01 The appellants are companies duly incorporated under the laws of British Columbia.

3.02 On August 31, 1976, the appellants sold the following property to the Royal Bank of Canada, located at Duncan, BC, for $825,000 including the buildings:

(a) lots 12 and 13 owned by Lakehouse Enterprises Ltd;

(b) lots 1,10 and the remainder of 14 owned by Lakehouse Holdings Ltd.

3.03 On December 31, 1971, Lakehouse Enterprises Ltd only owned lot 13. It had been purchased in 1968. Lot 12 was acquired in November 1972 for $51,963 including land and buildings. In 1974, on the said lot 12, a building of 1,120 square feet was built as an extension of the existing buildings.

3.04 On December 31, 1971, Lakehouse Holdings Ltd owned only lots 1 and

14. They had been purchased respectively in 1955 and 1957. Lot 10 was purchased in November 1973 for $27,500.

3.05 Lakehouse Holdings Ltd and the Royal Bank of Canada had entered into a 15-year lease commencing July 15, 1969 with option to renew for two 10-year terms. The annual rental was $23,000 with monthly payments of $1,916.97 payable in advance.

3.06 After the evidence given by different witnesses, especially the appraisers, (5 appraisal reports were filed) the parties agreed that the normal price of the subject property (lots 1, 13 and 14) was $250,000 on December 31, 1971.

3.07 The appellant, however, contended during the evidence that in the instant case, a special price was involved because of the application of the theory of a special purchaser, the Royal Bank of Canada. The special price for the V-Day value was $419,000.

3.07.1 The appellant’s appraiser, Mr Keenleyside, contended that a bank, as a purchaser of this class, was ready to pay 70% more than a normal investor or user for the subject property. This figure is based on five purchases made from 1963 to 1973 by the following types of purchasers: bank, company, motel, shopping centre and gas station, located in the districts of Victoria, Burnaby and Port Coquitlam. Applying the rate of 1.70% to the figure of $246,500, at which he arrived for the normal price in his report, he concluded that $419,000 was the value on December 31, 1971 (1.70% X $246,500).

3.07.2 The appellant’s appraiser, Mr Keenleyside, confined the figure of 1.70% above in showing that the Royal Bank of Canada paid, in 1976, $820,562 ($825,000 - $4,438 of equipment) for the subject property (lots 1, 10, 12, 13, 14 and buildings) which had a normal value of $462,000. This gives a rate of 1.77%. If one considers that after the purchase, the Royal Bank of Canada sold lot 10 for $44,000 and demolished the buildings on lots 12 and 13 which had a value of $59,332 in 1976, this means that the Royal Bank of Canada paid in fact $776,562 ($820,562 - $44,000). This is 1.8578 times its value to a normal investor who would have paid $418,000 ($462,000

- $44,000).

3.07.3 The main reasons given in the report by Mr Keenleyside (Exhibit A-2) to base his conclusions are cited:

Summary and Final Conclusions

The question of definition of market value is the major issue in cases where there is a property of special utility to a particular purchaser.

To analyze this situation a longer more detailed definition of market value is considered. This one is from the American Institute of Real Estate Appraisers Terminology Hand book, 4th Edition.

“Market Value — The highest price in terms of money which a property will bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus.

Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions thereby:

1. buyer and seller are typically motivated.

2. both parties are well informed or well advised, and each acting in what he considers his own best interest.

3. A reasonable time is allowed for exposure in the open market.

4. payment is made in cash or its equivalent.

5. financing, if any, is on terms generally available in in the community at the specified date and typical for the property type in its locale.

6. the price represents a normal consideration for the property sold unaffected by special financing amounts and/or terms, services, fees, costs, or credit incurred in the transaction.

Numerous definitions of Market Value have been devised over the years by professional organizations, government bodies, courts, etcetera.

The Supreme Courts of most states have handed down definitions of Market Value for use in the state courts. These definitions are subject to frequent change.

Persons performing appraisal services which may be subject to litigation are cautioned to seek the exact definition of Market Value in the jurisdiction in which the services are being performed.

It, in general, says the same thing as the one shown earlier.

To me, item 2, in the explanation is all important.

“2. both parties are well informed or well advised, and each acting in what he considers his own best interest.”

The vendor knew what he wanted for the property considering his future plans for the four lots.

The purchaser, I would accept as being well informed. I understand they had it appraised. They didn't have to buy it. They could have moved to the Mall when it was built and subleased their space for the rest of the lease. It seems to me another bank, a credit union or trust company would have picked it up.

The other question is, did the same motivations exist in 1971 as they did in 1976?

The Royal Bank moved to this site in 1955 in 2,520 sq ft. In 1973 the bank required further expansion and was suggesting about 8,000 sq ft as their requirement. In 1971 they had been on this site for 16 years. In 1976 — 21 years.

In 1971, the neighbourhood was moving and taking all things into consideration, it seems to me that all of the ingredients that motivated them in 1976 were present in 1971 and that they would have acted in a similar manner.

In conclusion, the following table sets out my views.

	1971 Value	1976 Value
Lot 14	$343,400	$486,744
Lot 13	75,650	131,904
Lot 12	—	157,914
Lot 10	—	44,000
		$820,562

3.08 The basic figures of this computation were, in fact, confirmed by the respondent’s witness, Mr Innes James Mitchell, leasing officer of the Royal Bank of Canada who has been employed with the said bank for twenty-nine years. According to that witness, in 1976 the appraisal by a firm of independent appraisers in the Duncan area, Whitham & Company, showed that the subject property had a fair market value of $460,000 ($414,000 for the land). The bank paid $825,000.

3.09 The respondent’s appraiser did not deny the existence of the theory of the special purchasers, but said it was not applicable in the present case in 1971. The Royal Bank of Canada indeed in 1971 had no special interest in purchasing the property. This fact was confirmed by Mr Mitchell of the Royal Bank of Canada. The latter, however, said that in 1971, the Royal Bank of Canada could foresee an expansion in the future, but the bank was not interested in buying the property in 1971. The bank had 28 employees, and still had room for 5 or 6 more. In fact, they were overcrowded in 1976 when the number of employees reached 36.

3.10 Mr Mitchell, however, admitted that the rent the bank paid in 1971 was considerably “more than the going rate for property in Duncan at that time” and that “this particular location was a special value to the Bank”. In fact, the bank paid $5.65 per square foot.

3.11 Pursuant to the appraisal of Mr Jones, (Exhibit R-4 at page 26) one of the respondent’s appraisers, the normal rental rate in the area in 1971 was $3.80 per square foot.

3.12 Mr Jones, on the income approach, used the capitalization rate of 9% in computing the V-Day value and 5% for the 1976 value. At the rate of 9%, the 1976 value would be $390,000. The property was sold for $825,000. Mr Jones admitted in cross-examination that the application of the 5% rate in 1971 would give a V-Day value of about $460,000.

3.13 Mr Pyne, a town planner and urbanist of the City of Duncan, confirmed the testimony of Mr Keenleyside, the appellant’s appraiser, by saying that in 1971 the establishment in Duncan was there, the basic development had really all taken place and that Duncan had already established its pattern of growth.

3.14 Also, there was a problem concerning the recapture of depreciation and the parties did not give evidence on this point, following an agreement to the effect that first they would wait for the decision to be given by the Board on the V-Day value. After that decision if no settlement was reached between the parties concerning the recapture, they would come back before the Board.

4. Law — Cases at Law — Analysis

4.01 Law

The main provisions involved in the present case are sections 3, 38, 39, 40 and 53 of the Income Tax Act and sections 20 and 26 of the Income Tax Application Rules. They shall be quoted in the Analysis, if necessary.

4.02 Cases at Law and Doctrine

The counsel for both parties referred to the following cases at law and doctrine:

A. Cases at Law

1. William Earl Laycock v The Queen, [1978] CTC 471; 78 DTC 6349;

2. Wilfred Riendeau v MNR, [1982] CTC 2433; 82 DTC 1412;

3. Demco Management Ltd v MNR, [1982] CTC 2283; 82 DTC 1248;

4. Dr Lloyd Miller v MNR, [1978] CTC 2924; 78 DTC 1666;

5. Bay Centre Apartments Ltd v MNR, [1981] CTC 2521; 81 DTC 489;

6. Henry and G wen ni th Appell v MNR, [1981] CTC 2232; 81 DTC 206;

7. Les Meubles de Maskinongé Inc et al v MNR, [1979] CTC 2028; 79 DTC 66;

8. Dubbel Wear Holdings Ltd v MNR, [1981] CTC 2348; 81 DTC 351;

9. Fambau Limited v MNR, [1982] CTC 2228; 82 DTC 1027;

10. Estate of A M Collings Henderson v MNR, [1973] CTC 636; 73 DTC 5471;

11. The Queen v National System of Baking of Alberta Limited, [1978] CTC 30; 78 DTC 6018; [1980] CTC 237; 80 DTC 6178;

12. Stanley M Smith et al v MNR, [1980] CTC 2208; 80 DTC 1185;

13. Untermeyer v A-G BC, [1929] 1 DLR 315;

B. Doctrine

14. J G Vicq, Farm Property Valuation in the Prairie Provinces, an article in the “Canadian Tax Journal’’, Vol 25, No 6 — November/December 1977;

15. Richard M Wise, Valuation and the Income Tax Act, an article in the “Canadian Tax Journal”, Vol 29, No 5 — September/October 1981;

16. lan R Campbell, Canada Valuation Service, pages 4-11 to 4-35;

17. Robert W Winstead, Real Estate Appraisal Desk Book, “Techniques in Selecting Capitalization Rates”, Prentice-Hall, Inc, Englewood Cliffs, NJ 1968;

18. Introduction to Real Estate Appraising, Published by the Appraisal Institute of Canada, 1977 edition revised 1980, “The Comparative Method” at pages 12-20 and 12-21;

19. Alfred A Ring, The Valuation of Real Estate, Second Edition — 1970, Prentice-Hall, Inc, Englewood Cliffs, New Jersey, “Determining the Rate of Capitalization” at pages 238 to 243;

20. Ian R Campbell, Business Valuation: Some Current Thoughts, an article in the “Canadian Tax Journal”, Vol 23, No 4, pages 373 ss.

4.03 Analysis

4.03.1 The first point is whether the Royal Bank of Canada was a special purchaser in the instant case. lan R Campbell defines “special purchasers” in his article in the Canadian Tax Journal (referred to above in para 4.02(20):

Special purchasers may be defined as those who, for one or more reasons, are williing to pay a higher price for a given asset than are other purchasers.

In a similar manner, special purchasers of businesses generally pay higher prices than do more ordinary purchasers; however, their motivations are related to economics as opposed to sentiment. The premiums paid by such purchasers stem from their ability to realize greater earnings through combination of the acquired and their own operation than the two businesses could generate separately and/or to the reduced risk experienced by such a purchaser following acquisition (operating and/or financial “synergies”). In general terms, the following may be cited as major factors potentially influencing the level of operating and financial synergies to be realized on a post acquisition basis and thus influencing the quantum of a special purchaser premium:

(a) the ability to horizontally integrate the purchasing and acquired companies; that is, the ability to consolidate the managements, sales, and production functions of two like entities. For example, the purchase of one steel company by another steel company;

(b) a reduction in the dispersion of cash flows ie, anticyclical diversification. For example, the purchase of a company producing snowmobiles by a company producing boats and motors;

(c) a reduction of input and output risk as a result of obtaining secured inputs and/or a locked-in market for outputs ie, vertical integration. For example, the purchase of a rubber plantation by a tire manufacturer; and,

(d) a reduction in the cost of financing operations; that is, a reduction in the purchaser’s cost of capital. For example, the purchase of a company with a substantial tax loss carry forward which can be utilized by the acquiring entity in lieu of likely more costly forms of financing in the future.

Numerous cases illustrating the existence of special purchasers could be cited. For example, when recently assessing a possible acquisition candidate a prospective purchaser found, much to his surprise, that the candidate, which was currently generating approximately $15,000 in after-tax income per year, could, if acquired by the prospective purchaser, generate $75,000 per year on the same sales vol- urne. This resulted from the fact that the purchasers and vendors businesses were almost exactly aligned, and with the exception of sales commissions, all indirect expenses of the vendor could be eliminated by the purchaser following acquisition. At the same time,however, the prospective purchaser also realized that there were several other possible purchasers who could similarly realize substantial operating synergies. Accordingly, the prospective purchaser hastily offered the vendor 7 times current earnings or $105,000. Without realizing the concept of, or the possible existence of, special purchasers, the vendor accepted the offer. In effect, the transaction was consummated at 1.4 times post-acquisition earnings.

Although such extreme cases may be rare, at least two conclusions can be drawn from this example. First, only when comparable transactions are recognized as such through first hand knowledge (by being party to, or an advisor to parties to such transactions) is it appropriate to treat such transactions as comparables in determining fair market value in the notional marketplace? An outsider looking at the final transaction might reason that the purchaser paid 7 times after-tax earnings for the acquired business when, in effect, the purchaser paid only 1.4 times post-acquisition earnings. Second, anyone who proposes to sell a business in the open market should carefully review the marketplace for possible special purchasers and attempt to determine the quantum of those synergistic benefits that such purchasers might derive. In the above-cited example, had the vendor recognized the special purchaser concept and realized its applicability in the sale of his company, it is probable that he could have induced a bidding situation between special purchasers and garnered a substantially higher price than was in fact realized.

4.03.2 The application of this principle can be applied in different ways.

The courts have already applied the principle of the special purchaser in the Laycock, (Supra), case where Mr Justice Smith (FCTD) accepted that a piece of land of 119 acres had a value of $135 per acre in 1971 as ordinary farmland, as contended by the Minister but, however, increased this value by 50% to take into account the fact that the taxpayer’s land was a logical site if C Ltd should decide to expand. In fact, C Ltd in 1971 offered $400 per acre for 40 acres only. In 1973, the whole piece of land of 159 acres was acquired by C Ltd for $300 per acre. Mr Justice Smith then decided that the V-Day value was $400 per acre, for the first 40 acres, and $202.50 for the remaining 119 acres as explained above.

In Les Meubles de Maskinongé Inc et al, (supra), the Tax Review Board accepted in part the Minister’s thesis based on the theory of the special purchaser. The value of the shares of the said company was fixed at $195,000 despite the fact that the said company was in bankruptcy when the shares were bought by Les Associés Houde Inc for $1. Some of the reasons for applying the theory of the special purchaser were that the purchaser, Les Associes Houde Inc, was in the same kind of business as Les Meubles de Maskinongé Inc, the latter had 200 qualified employees and still had an important list of clients. Moreover, the buildings and equipment had a good value. The amount of $225,000 paid to Dr Bernèche, the former main shareholder of Les meubles de Maskinongé inc as special consultant ($15,000 for 15 years) was considered by the Tax Review Board in part as salary ($30,000) and in part as payment of the shares ($195,000).

4.03.3 In the instant case, the preponderance of the evidence is to the effect that in 1976 the Royal Bank of Canada was a special purchaser. The testimony of the appellant’s appraiser is that the normal value of the property was $462,000, but $820,562 was paid (para 3.07.2). The said normal value was confirmed by the respondent’s witness, Mr Mitchell, employee of the purchaser for 29 years, who said that the Royal Bank of Canada, before purchasing the property, paid an independent appraiser to value it. The valuation was $460,000 (para 3.08).

4.03.4 Did the same special value exist in 1971?

The uncontradicted adduced evidence and the facts described in paragraphs 3.07.1, 3.07.3, 3.09 and 3.10 convinced the Board of the existence of the special value in 1971. Moreover, some conclusions of Mr Jones, one of the respondent’s appraisers, confirmed the appellant’s thesis (see paras 3.11 and 3.12).

4.03.5 Is it correct to compute the special value by taking the rate of 1.70% of the normal value? The preponderance of evidence is to the effect that the Board must accept 1.70% and the figure of $419,000 as the spécial value at V-Day.

4.03.6 Concerning the recapture of depreciation, the Board will wait for the agreement of the parties (para 3.14).

5. Conclusion

The appeal is allowed in part and the matter referred back to the respondent for reassessment in accordance with the above reasons for judgment.

Appeal allowed.