342583 B.C. Ltd. v. R., [1999] 3 CTC 2279, 99 DTC 1102

Bell T.C.J.:

Issue:

This is an appeal from an assessment imposing liability upon the Appellant under subsection 160(1) of the Income Tax Act (“Act”) in the amount of $163,409.91 in respect of a transfer on June 4, 1992 of property, being a house and surrounding land, from Kurt Freiburghaus (“F”) to the Appellant. The Minister of National Revenue (“Minister”) made the assessment on the assumption, inter alia, that at the time of the transfer no consideration was given by the Appellant for the property.

Facts:

The parties filed an Agreement Statement of Facts. That Agreement sets forth that F was, under the Act, not dealing at arm’s length with the Appellant. The property, on June 4, 1992, the date of transfer to the Appellant, had a fair market value of $280,000 and was subject to a mortgage in the amount of $85,000.

The Appellant paid F by issuing to him 195,000 Second Preferred Shares (“Shares”) having a par value of $1.00 each. The rights and restrictions attaching to those shares were as follows:

(a) non-voting;

(b) entitled, when declared by all directors, to cumulative dividends of 10% per annum for five years from issue and thereafter to non-cumu- lative dividends at the same rate, in each case on the redemption amount (i.e. $1.00) per share plus unpaid cumulative dividends and declared but unpaid non-cumulative dividends;

(c) redeemable at the option of the Appellant for the redemption amount;

(d) retractable at the option of the holder after five years for the redemption amount; and

(e) entitled on winding up to the redemption amount in priority to all other classes of shares (other than First Preferred Shares none of which were at any material time outstanding).

By virtue of the provisions of section 21 of the Property Law Act, the Appellant became responsible for the mortgage against the property. The Appellant made the mortgage payments for its fiscal years ending August 1, 1992 through 1997. The Appellant agreed to rent the property to F for an amount which included mortgage payments, cost of upkeep, property taxes and insurance.

On June 4, 1992 F had a tax liability of not less than $163,409.91.

The Appellant’s sole witness was Mr. W.A. McMann (“McMann”), Vice-President at PricewaterhouseCoopers and a business valuator. He was qualified as an expert witness and gave his opinion about the valuation of the Shares. The letter of enclosure with his appraisal report reads in part as follows:

You have requested that I provide you with my opinion of the fair market value, as at June 4, 1992, of 195,000 Second Preferred Shares of 342583 B.C. Ltd. which were issued on that date to Mr. Kurt Freiburghaus as consideration for the transfer by him to 342583 B.C. Ltd. of property located at 1036 West 17 Street, North Vancouver, B.C.

His written report stated that the 195,000 Shares, as at June 4, 1992, had a fair market value of $174,000.

The report said that:

...fair market value is defined as the “highest price available in an open and unrestricted market between a fully informed, knowledgeable and prudent vendor and purchaser, acting at arm’s length and under no compulsion to transact, expressed in terms of money or money’s worth.”

Mr. McMann said that the key points for a business valuator to consider in that definition include an assumption of a notional sale at the highest price available with the parties being assumed to have full knowledge. He also stated that hindsight and retrospective evidence were not to be considered and that he had to put himself back at the June 4, 1992 date and assume no knowledge after that date.

He said that the redemption amount of $195,000, increased by the cumulative 10% dividend on that amount annually for five years, would be $292,500. He did not anticipate an annual receipt of $19,500 but, rather, a deferral of the cumulative dividends until redemption in five years. He understood no formal lease or rental arrangement existed and therefore the purchaser would look to a capital appreciation to yield the amount of $292,500. He stated that any principal payments on the mortgage to be made in those five years would enhance the net equity position of the company in the property and that the property had a rental value from which rent, mortgage and property tax could be paid.

He set forth, as at June, 1992 some key interest rates and rates of return including 7.5% as bank prime interest rate, five year mortgage rate of 9.9% and five year Guaranteed Investment Certificates rates of 774 to 8%. He also listed, for at least 14 years, a summary of B.C. municipal assessments of a $282,000 home in 1992 and British Columbia Real Estate Board statistics. The former showed annual compound growth of 10.1% for the period 1987- 1992, 8.6% for the period 1982-1987 and 9.4% for the period 1982-1992. For the latter, the annual compound growth was 14.2% for the 1987-1992 period, 4.4% for the 1982-1987 period and 9.2% for the 1982-1992 period.

He noted that the annual rate of return compounded required for $195,000 in five years, to yield $292,500, was 8.45%. He stated that using the B.C. Assessment Values and the Real Estate Board market values and two separate five year periods that return was exceeded three times in the four tests. He said that it was also exceeded in both tests in the ten year period. He said further that the B.C. Economical and Statistical Review set forth the following:

Housing starts totalled 40,621 units in 1992, up 27% from 1991. The large increase was due to the high level of in-migration, lower mortgage rates and increasing consumer confidence.

He further said that the valuation question may be stated as:

What is the highest price available for the potential receipt five years hence of a maximum $292,500 as the redemption proceeds of retractable preferred shares where the value of a parcel of real estate can be looked to as the underlying asset to fund the redemption proceeds.

He stated that in his opinion, based upon all the foregoing factors, the fair market value of the subject shares on June 4, 1992 was $174,000. He said he had arrived at that conclusion by discounting the total potential receipt of $292,500 five years hence at 11%. He further said that he chose that discount rate to reflect a risk premium above then current yields of 7.25% to 8.275% as outlined in his report. In short, he was saying that he would not put up more than $174,000 to obtain the sum of $292,500 at the end of the five year period. He said further that he was indifferent as to whether that figure was arrived at for the vendor or the purchaser. In looking at the previously stated yields of 7.25% to 8.5% he chose 11% for an added risk factor. Taking the amount of 8% from those figures, he added three percentage points which effectively was an increase of 37.5%. Finally, he said that he was comfortable with what he described as an objective approach resulting from his experience and that behind these facts was a house in North Vancouver.

Upon cross-examination McMann, agreed that the Appellant could replace the property asset and that a purchaser of the Shares would have no control over the company assets except the retraction privilege in five years. He agreed that the Appellant could sell the house and buy something else but referred to the fiduciary obligation of the directors stating that they would have to be careful in their actions. He stated that if the Appellant borrowed money on a property it would have to invest it and implied that inappropriate behaviour in that regard could spark a lawsuit. He said that in 1992 he looked at the history in order to make a projection about the future. He also agreed that there could be a drop in market value after 1992 but said that in the history of values that he used there was a drop and that he had looked at a ten year period overall and that his 11 % factor took a potential drop into account. He said further that there could be no more land made in North and West Vancouver and that “even today” he believes real estate values will increase. He stated that immigration and interest rates were other factors driving the market value. With respect to the question as to what consideration he gave to money being tied up for five years, he replied that it was a risk and yield rate. He selected the 11 % rate because a demand for redemption couldn’t be made for five years. He also said that the fixing of that rate took into account that the Appellant was a private company. He stated that it was not logical to assume that the company would pay an annual dividend because it did not have to.

Respondent’s counsel then presented one Frank Pollock (“Pollock”) and attempted to qualify him as an expert witness. The Court did not accept him as such. He had received a Bachelor of Commerce degree from the University of British Columbia in 1973, worked one year with a chartered accountancy firm and had been with Revenue Canada since 1977. He said that he took in-house valuation courses and six courses in relation to Chartered Business Valuation sponsored by the University of Toronto. He also said that he took that examination two times and was successful in neither. All of his valuations had been done for Revenue Canada. He also said this was his first appearance in court.

The Respondent asked no questions of Pollock and presented no other evidence.

Appellant’s Argument:

Appellant’s counsel submitted that, as a matter of law, the value of the consideration received by F from the Appellant was $195,000. He said that pursuant to section 42 of the British Columbia Company Act no shares with par value may be allotted or issued except at a price or consideration at least equal to the product of the number of shares multiplied by $1. He said that upon subscribing for the shares F became obliged to pay the Appellant the sum of $195,000 in cash or property. He referred to sections 42, 43 and 55 of the British Columbia Company Act as support. Subsection 42(1) provides that no shares with par value may be allotted or issued except at a price or for a consideration at least equal to the product of the number of shares allotted or issued multiplied by their par value. Section 43 provides, inter alia, that no share may be issued until it is fully paid and that a share is not fully paid until the issuing company has received the full consideration for it in cash, property or services. Section 55 provides that the liability of a member for a share is limited in the case of a share with par value to the amount unpaid on it and that a member is not personally liable for more than the amount actually agreed to be paid for a share.

He then submitted that F was obliged to pay $195,000 to the Appellant on June 4, 1992 and that this obligation was discharged by the transfer of the property which had a fair market value of $195,000. He proceeded to submit that the consideration received by F was the receipt of 195,000 Shares with a par value of $1 each and a discharge of his liability to pay for those shares in cash.

He referred to Osborne v. Steel Barrel Co., [1942] 1 All E.R. 634 (Eng. C.A.). In that case a company starting business acquired stock [1] for £10,000 cash and fully paid shares of a par value of £30,000 issued to the owner of the stock. The Crown contended that the shares cost the company nothing and that the value of the stock should be entered in their books at £10,000. The Court rejected that contention. At page 637 and 638, the Court said:

It was strenuously argued on behalf of the Crown that, if a company acquires stock in consideration of the issue of fully-paid shares to the vendor, that stock must, for the purpose of ascertaining the company’s profits, be treated as having been acquired for nothing, with the result that, when it comes to be sold, the Revenue is entitled to treat the whole of the purchase price obtained on the sale as a profit. This is a remarkable contention, and it would require conclusive authority before we could accept it.... The argument really rests on a misconcep- tion as to what happens when a company issues shares credited as fully paid for a consideration other than cash. The primary liability of an allottee of shares is to pay for them in cash; but, when shares are allotted credited as fully paid, this primary liability is satisfied by a consideration other than cash passing from the allottee. A company, therefore, when, in pursuance of such a transaction, it agrees to credit the shares as fully paid, is giving up what it would otherwise have had - namely, the right to call on the allottee for payment of the par value in cash.... Accordingly, when fully-paid shares are properly issued for a consideration other than cash, the consideration moving from the company must be at the least equal to the par value of the shares and must be based on an honest estimate by the directors of the value of the assets acquired.

Appellant’s counsel then referred to Tuxedo Holding Co. v. Minister of National Revenue (1959), 59 D.T.C. 1102 (Can. Ex. Ct.), a decision of the Exchequer Court of Canada. In that case Mr. Justice Cameron applied the Steel Barrel principle at page 1108:

In my opinion, the consideration paid by the appellant for the 905 lots was the par value of the shares issued and nothing more. What it gave up was the right to call upon the allottees of the shares for payment of the par value of each share. The sum of $200,000.00, therefore, correctly represents ... such lots to the appellant.

Further, in Marina Quebec Inc. v. Minister of National Revenue (1990), 92 D.T.C. 1392 (T.C.C.) the foregoing two cases were cited. At page 1440 Judge Tremblay said, after quoting Lord Greene in Steel Barrel Co. with approval said:

Since the facts of this case are similar to those in the three decisions cited above, the value of the preferred shares issued during the 1979 taxation year of Robitaille (1978) will be equal to the real value of the inventory property acquired.

Appellant’s counsel concluded his argument by submitting that because this principle of value and par value shares has been recognized in the Canadian courts since at least 1959, Parliament must have been aware of that principle when it enacted section 160 of the Income Tax Act. He stated further that this principle is of fundamental importance in order to bring certainty to commercial transactions in which shares are issued for property. His conclusion 1s, therefore, that the fair market value of the 195,000 Second Preferred Shares was their par value, namely $195,000.

Alternatively, counsel submitted that the value was $174,000 on June 4, 1992. The only evidence before the Court as to value is that of McMann. Having studied his valuation report and having reviewed his frank responses to questions on cross-examination and having regard to his overall analysis and presentation, I am impressed with his credibility and his work. Therefore, I find his appraisal figure of $174,000 acceptable.

I do not accept the Appellant’s submission that the value of the consideration received by F from the Appellant was $195,000. The purpose of the Osborne case was to determine the cost of inventory paid by the Company. It issued shares of a given par value because it received property having a value of that amount. The question of the value of shares received by the transfer of property was not under examination. The same result arises in the Tuxedo case. Mr. Justice Cameron’s words are repeated:

The sum of $200,000.00, therefore, correctly represents the cost of such lots to the appellant.

(italics added)

I have just described the first result of a share subscription transaction, i.e., the cost to the Company of property for which it issues shares. The second result of that transaction is the fair market value of the shares received by the transferor of property. In order to determine same, one must look at, inter alia, the conditions attached to the shares. In this case, F had no contractual right to receive the amount of $195,000 until five years after the shares were issued. McMann determined that the cumulative dividends, the passage of time and the assets of the Company did not support a valuation of $195,000. As stated above, I accept his evidence. It is highly improbable that a party at arm’s length with the Appellant would transfer assets to it on the terms and conditions extant in this situation.

Subsection 160(1) provides, in part:

(1) Where a person has ... transferred property ... to ... a person with whom the person was not dealing at arm’s length ... the transferee and transferor are jointly and severally liable to pay under this Act an amount equal to the lesser of

(i) the amount ... by which the fair market value of the property at that time exceeds the fair market value of the consideration given for the property, and

(11) the total of all amounts each of which is an amount that the transferor is liable to pay under this Act in or in respect of the taxation year in which the property was transferred or any preceding taxation year.

The lesser of those two amounts is $21,000 ($195,000 - $174,000). The appeal is allowed to the extent that the Appellant is, under the above provision, liable for this amount only.

Appeal allowed in part.