Glenex Industries Inc. v. R., 97 D.T.C. 291, [1997] 3 C.T.C. 2217

Hamlyn T.C.J.:

1 This appeal is with respect to the Appellant's 1988 and 1989 taxation years. The Appellant, a publicly traded company, has formerly been known by such names as Portcomm Communications Corporation Limited (“Portcomm”), Hal Roach Studios Corp., and HRS Industries Inc.

2 On January 25, 1971, the Appellant incorporated Hal Roach Studios Inc. (“New HRS”), which issued 100 common shares (the “New HRS Shares”) to the Appellant for a subscription price of $147,543 (Cdn).[FN1: <p>At valuation day the U.S. and Canadian dollars were relatively equal. For the purposes of this litigation, unless otherwise stated, anything in relation to on or about valuation day will be in Canadian dollars.</p>] .

3 On or about January 25, 1971, the Appellant settled a legal action against Hal Roach Studios, Inc. (“Old HRS”), an arm's length company. The legal action involved, among other things, alleged infringement of the Appellant's license to produce video cassettes of movies from the Hal Roach Film Library (the “Library”) maintained by Old HRS. The Library included the rights to more than 1,000 films produced by the Hal Roach Studios, including a large collection of “Laurel and Hardy” features and the rights to certain television series.

4 Pursuant to the settlement, New HRS acquired certain rights from Old HRS for an aggregate amount of $250,762.73 (U.S.), which was allocated as follows:

5 The Appellant also acquired certain accounts receivable of Old HRS at their adjusted face value and agreed to assume certain employment contract obligations of Old HRS, but no value was allocated to the settlement.

6 On November 19, 1971 and December 3, 1971, all ownership rights with regards to the Library throughout the Eastern Hemisphere (an area which includes the entire inhabited world except for the Americas) were sold and assigned to two arm's length parties for a total of $200,000 (U.S.).

7 During the ten years immediately following its acquisition of the Library, New HRS did not invest any significant effort, time or capital in the exploitation of the Library's market potential. Licenses in respect of certain items in the Library were granted on an irregular basis during this period. The copyrights in respect of certain films in the Library lapsed during this period causing such films to enter into the public domain.

8 From December 1981 through March 31, 1984, New HRS reorganized its share capital through such means as stock splits, new initial public offerings and warrants, leaving 55% of the equity of New HRS in the hands of the Appellant.

9 During its 1988 and 1989 taxation years, the Appellant sold the New HRS Shares and received gross aggregate proceeds of disposition in the amounts of $8,438,220 (Cdn) (1988: 900,000 New HRS Shares were sold) and $11,907,755 (Cdn) (1989: the remaining 1,165,000 New HRS Shares were sold). The Appellant incurred selling costs on these transactions in the amounts of $32,824 (Cdn) (1988) and $48,353 (Cdn) (1989). In its income tax returns, the Appellant reported its adjusted cost base for its disposition of the New HRS Shares during the respective taxation years as $653,753 (Cdn) (1988) and $846,247 (Cdn) (1989). The Appellant further reported its net proceeds of disposition for the respective taxation years as $8,405,396 (Cdn) (1988) and $11,859,402 (Cdn) (1989). The Appellant therefore reported capital gains of $7,751,643 (Cdn) (1988) and $11,013,155 (Cdn) (1989), and taxable capital gains of $3,875,821 (Cdn) (1988) and $6,883,222 (Cdn) (1989). With regards to the 1989 taxation year, the Appellant also disposed other shares of New HRS acquired after December 31, 1971.

10 The Minister reassessed the Appellant in respect of its 1988 and 1989 taxation years, changing the adjusted cost base of the shares sold by the Appellant in those years to $64,304 (Cdn) (1988) and $83,239 (Cdn) (1989). The net proceeds of disposition on the sale of the shares as reported in the Appellant's 1988 and 1989 returns are not disputed. The Minister therefore reassessed taxable capital gains to the Appellant on the sale of the New HRS Shares of $4,170,545 (Cdn) (1988) and $7,360,102 (Cdn) (1989).

Issue

11 The issue is: what is the aggregate fair market value of the New HRS Shares in question as at December 31, 1971 for the purposes of determining the aggregate adjusted cost base of the shares disposed of by the Appellant in its 1988 and 1989 taxation years and the resulting capital gains? The fair market value of the New HRS Shares was attributable primarily to the fair market value of the Library as at December 31, 1971. The focus of this litigation is to determine that value.

The Evidence

12 The Appellant called three witnesses: Mr. Robert Boyle, the Vice-President and Chief Financial Officer of the Appellant, and two evaluation experts, Mr. Walter Senior and Mr. Scott Davidson.

13 The Respondent called one witness, an evaluation expert — Mr. Glenn Bowman.

Mr. Boyle

14 Mr. Boyle stated that while the Library was acquired pursuant to a settlement agreement arrived at as a result of litigation, no value was allocated as to the settlement of the litigation at that time.

15 Further, the only meaningful asset acquired under the settlement was the Library.

16 In November 1971, ownership of all of the film and television productions of the Library and the copyrights therein throughout the Eastern Hemisphere (the world except for North, Central, and South America) were sold to arm's length parties for aggregate proceeds of $200,000.

17 Mr. Boyle stated that little significant activity was conducted with regards to New HRS until late 1981.

18 During this period the Appellant searched the world to seek film parts of the Library that had been lost or destroyed.

19 In 1981, in preparation of a prospectus, an appraisal of the Library was obtained from one Max Youngstein. One of the expert witnesses who was a film industry executive, Mr. Senior, confirmed Mr. Youngstein's film industry knowledge stature in the film industry. Mr. Youngstein found the film library had a value of $7 million in October 1981.

20 In 1988 and 1989, the Appellant sold its shares of New HRS for $20.3 million.

21 Mr. Boyle, after several discussions with persons in the film industry, determined the adjusted cost base for the shares of New HRS and the Library as being $1,500,000 (Cdn).

22 Mr. Boyle stated that the one individual from the Appellant corporation who did have knowledge of the specific transactions in 1971 was Mr. Earl Glick. However, Mr. Glick is now in poor health and as a consequence was not available to the Court. Further, Mr. Boyle did not or was not able to obtain any court documents relating to the settlement of the litigation.

23 In his evidence, Mr. Boyle took the Court through three volumes of documents relating to the matters in issue (these documents included litigation papers, financial statements, purchase agreements, bills of sale, prospectuses, etc.).

The Expert Witnesses for the Appellant

Mr. Senior

24 Mr. Senior was qualified as an expert film valuator with over thirty years of experience distributing and exhibiting films in the international market. In the presentation of his report he stated:

In the course of my work experience I have consistently, explicitly and implicitly, been called upon to value films and film libraries in all major markets of the world. With respect to the Library..., I was personally familiar with material components of that Library at December 31, 1971 and prior thereto. While not one of the major motion picture libraries, the Library was significant and well known within the film and television industry at that time.

25 He stated that, at the relevant time, the value attributed to non-North American film rights represented a relatively small percentage of their total value; thus, the sale of the non-North American rights to the Library for $200,000 (U.S.) suggests a value of $1.8 million to $2 million (U.S.) for the retained rights. The approximately $150,000 allocated to the Library in the settlement is clearly not reflective of its fair market value. Further doubt is cast upon the reliability of the settlement value as an indicator of fair market value by the fact that the 50% interest in the Hans Christian Andersen film was given a value of $80,000, suggesting that its full value was $160,000; surely, this one film cannot have a value which is greater than the whole of the Library, which comprises over one thousand films of significance.

26 Mr. Senior did not fully clarify his methodology in reaching his conclusion. It is clear his opinion was based on his many years of experience and his instinctive conclusion of the value.

Mr. Davidson

27 Mr. Davidson was qualified as a business valuation expert. His background is that of a principal in a business valuation firm and as a Chartered Accountant and a Chartered Business Valuator. His evidence indicated that a discounted cash flow method was generally considered to be the most appropriate means for determining the fair market value of a film library, but it was considered inappropriate under the circumstances. The lack of certain particulars, including financial details and contractual arrangements, overly limited the discounted cash flow approach, thus a comparable transaction approach was used.

28 The comparable transaction method: At the time in question, the domestic rights values of films were heavily weighted relative to foreign rights values. An article in Screen Digest, a trade publication, was cited which estimates North American rights values during that period as 10 times that of the rest of the world. The Western/Eastern rights value ratio of the Library should be higher than the appropriate Domestic/Foreign rights value ratio because the Eastern rights sold in 1971 did not include the rights to all foreign markets, and New HRS was to share in net revenues from Eastern video rights that it sold. Thus, a ratio between 7.5 and 10 results in a fair market value between $1.5 million and $2 million for the Library.

29 The capital appreciation method: A 15% rate of return was arrived at by comparing the $1.5 million to $2 million V-Day value to the $7 million valuation by Mr. Youngstein in 1981. This was considered to be reasonable and conservative in light of available interest rates at the time and the 16% annual rate of growth implied by the sale of the New HRS Shares in 1988 and 1989 for $23.7 million.

30 The discounted cash flow method: This technique begins with projected future cash flows for a selected period; adds a terminal value which is estimated based on a capitalization of the cash flows in the last year of projection; and discounts the sum to arrive at the present value at the valuation date. In selecting the terminal value multiples and discount rates, anticipated distribution growth opportunities available on expiration of older existing contracts, discussion with industry participants and relevant risk and return standards were considered. The figure which was arrived at under this method is $0.7 million to $1.2 million. This was likely due to the apparently limited financial resources available to New HRS at V-Day, which resulted in an inability to exploit the Library to its fullest potential; given that fair market value is the highest available market price, this method is considered to produce a low estimate of V-Day fair market value which, nonetheless, is supportive of the conclusion reached under the comparable transaction approach.

The Expert Witness for the Respondent

Mr. Bowman

31 Mr. Bowman was qualified as an expert in the field of business valuation and was presented as a rebuttal witness to the evidence of the Appellant's expert opinions.

32 Mr. Bowman's position was that the best indication of value could be derived from the discounted cash flow approach, which represents the net present value of an asset as equal to its potential to generate future cash flows. Notwithstanding his concerns about methodology under this approach pertaining to Mr. Davidson's report and its use of hindsight in making calculations (particularly the use of actual reported results in the discounted cash flow analysis rather than mere projections), Mr. Bowman maintained that this is the most objective indicator of the Library's value at V-Day. Given the lack of meaningful historical data which might be used to determine the Library's value, the maximum value that could be ascribed to the Library is approximately $1,100,000.

33 He did agree on cross-examination that he did not have the material that was before Mr. Davidson and that his rebuttal was based solely on a survey of the Appellant's expert reports.

34 Although both the Davidson report and the Senior report adopt similar value conclusions based on comparative criteria, Davidson's calculations are based upon unsubstantiated assumptions regarding the Domestic/Foreign values ratio at V-Day. Also, although industry experts support the relative ratio included in the Senior report calculations, there is no empirical evidence to support the value conclusions in the Davidson report.

35 The Davidson report used a discounted cash flow approach which arrived at a figure that was considerably lower than the comparable transaction value it adopted. The discounted cash flow calculation employed by Davidson was of dubious reliability due to the inherent difficulties of accurately projecting future cash flows and in estimating the residual cash flows at the end of the cash flow period.

Jurisprudence

Valuation

36 In Ample Investments Ltd. v. Minister of National Revenue (1990), 90 D.T.C. 1748 (T.C.C.)(T.C.C.), Judge Brulé raised the difficulties posed when different valuation methods are used to appraise property, at page 1749:

In order to arrive at an estimate of market value, such as at V-Day, the appraiser may use one or more of three appraisal methods, namely: (1) the comparative or market data approach; (2) the income investment or economic approach; and (3) the cost, or contractor's approach.

In trying to account for the differences in valuations in addition to explanations given or omitted one must consider the source of the valuations.

37 He concluded by adopting the comments of Mr. Justice Walsh in Bibby v. R. (1983), 83 D.T.C. 5148 (Fed. T.D.), at page 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.

38 Thus, the Court may arrive at an opinion of value which differs from the values submitted by the parties as long as their evidence has been considered.

Appraisers

39 In Riendeau c. R. (1995), 96 D.T.C. 1442 (T.C.C.), Judge Archambault addressed the difficulties faced by courts in looking to the reports of appraisers, at page 1445:

To determine the fair market value for February 1989 and December 1971, the appraisers essentially adopted the same technique of comparables. Cattanach, J., in Salt v. The Queen[84 D.T.C. 6395, at page 6401], clearly described the problems that face the courts when using that method:

The efficacy of that method depends on comparing the sales of like properties identified as the “comparables”.

The weakness in the method, which, is the best devised, is that it is virtually impossible to find an exact comparable. In my experience it has happened but once and the event was characterized as an “appraiser's dream”. That the matter came to trial was because of the rival appraiser's complete misunderstanding of an arm's length transaction.

But there must be similarity in the conditions regarding the properties to be compared, the location, proximity, size, topography, likeness in use or potential use, zoning and the sales should be recent and under like conditions.

Because ideal comparables cannot be found requires the making of adjustments and the making of adjustments introduces a subjective factor as contrasted with objectivity and this is only explanation of the divergence in evaluations by different appraisers.

Thus the more adjustments which must be injected to achieve comparability the less reliable is the resultant estimate.

In my view, that last statement cannot be universally applied. In some circumstances, failure to make certain adjustments could vitiate an appraisal's probative value. Furthermore, it is this subjective aspect of appraisal work that, in Donald L. Neuls v. Minister of National Revenue[75 D.T.C. 170, at page 172], led Chairman Flanigan of the Tax Review Board to describe appraising as an “imprecise science almost verging on guesswork”.

It is thus in this context that the Court must choose which of the appraisals better represents the fair market value of the parcels of land in February 1989 and at December 30, 1971.

40 If a valuator's evidence is to be accepted as reliable, it must be demonstrated that the evidence is based upon an accepted or acceptable valuation methodology, that the facts on which the opinion is based have been gathered from objective sources wherever possible, and that pertinent factors have been taken into account. Where a judge suspects the accuracy or reliability of an appraiser's findings, those findings will be weighed accordingly.[FN2: <p>See<em>Whent v. R.</em>(1996), 96 D.T.C. 1594 (T.C.C.), in which Judge Mogan voiced concerns regarding the reliability of the Appellants' experts after questioning their valuation methods and noting that they failed to take into account certain pertinent considerations and some conflicts of interest.</p>] . Also, where the expert's independence or objectivity is suspect, lesser weight will be accorded to that evidence.[FN3: <p>See<em>Frith v. Minister of National Revenue</em>(1991), 91 D.T.C. 1160 (T.C.C.)at page 1169 (T.C.C., per Mogan J.). Chief Judge Couture reviewed the basic principles in this regard in<em>Taylor (Succession de) c. Ministre du Revenue national</em>(1990), 90 D.T.C. 1777 (T.C.C.), and concluded at page 1779:<blockquote><p>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.</p></blockquote></p>] . The weight of that evidence will also be affected by the manner in which the expert uses his experience and judgement.[FN4: <p>See<em>Gulliver's Travels Motor Hotel Ltd. v. Minister of National Revenue</em>(1993), 93 D.T.C. 183 (T.C.C.), where Judge Mogan stated at page 186:<blockquote><p>If a summary like Schedule “A” had been included in Mr. Dowling's report, he would have shown in an explicit manner how he used his experience and judgment, as an expert, to adjust the raw factual information from the sales data. It is the manner in which the expert witness uses his experience and judgment which lends greater or lesser weight to his opinion as evidence. I am inclined to attach less weight to Mr. Dowling's opinion because he has not adequately explained his adjustments.</p></blockquote></p>]

Analysis

41 The real issue for analysis is the fair market value of the Library as at December 31, 1971.

42 Fair market value is defined as the “highest price available in an open and unrestricted market between informed and prudent parties, acting at arm's length and under no compulsion to act, expressed in terms of cash.”[FN5: <p>Canada Valuation Service, November 1996, CVS 117.</p>]

43 I conclude that the value of the asset (the Library) stated on the Appellant's balance sheet for 1971 was not the fair market value of the Library on the 31st of December 1971.

44 The opinion evidence in this case focused primarily on two approaches to valuation: the comparable transaction method, which uses the actual transaction of a sale in another market with the use of multiples to determine the fair market value of the asset in the market in question; and the discounted cash flow method where a projected future cash flow is discounted by a percentage to reflect risk to achieve that cash flow and that value becomes the fair market value.

45 The facts relied upon by the expert witnesses were seriously constrained for several reasons, including the limited operation of the Appellant for the seventies, the insufficiency of information surrounding the legal settlement involving amongst other things the Library and the absence of the one individual who could have shed light on the legal settlement transaction and other relevant matters concerning the Appellant's activities (as stated that individual is now disabled preventing his participation in this proceeding).

46 Within these constraints the difficult task of the expert valuators was to place themselves into the shoes of a third party buyer and determine fair market value as at valuation day.

47 Mr. Senior followed the comparable transaction approach. His valuation was based on a combination of experience and instinct. He spoke of variables affecting film libraries, including the types of films (i.e. shorts, features, action, animation, children's). He also spoke of known technological advances. He did speak of the ‘travel’ ability of a library, that is, the appeal of a film in one geographical market as opposed to another. He also spoke of differences between markets, with stars and producers in one market being paramount and directors being paramount in another market. From this evidence he concluded the “Americas” market was the equivalent minimum ratio value of ten times the rest of the world market at the time of valuation in question. It was not made clear precisely how he arrived at this ratio.

48 His valuation was that the fair market value of the Library, excluding Eastern Rights, as at December 31, 1971 at $1.5 - $2 million.

49 The methodology of Mr. Senior was not clear and not all relevant matters were considered by Mr. Senior in his valuation; in particular, the examination of Mr. Senior revealed that he was not aware of contractual arrangements within the Library at the time of the valuation that in effect constrained the commercial availability of some film properties at valuation day.

50 Mr. Davidson reviewed the valuation approaches of comparable transactions, capital appreciation and discounted cash flows. He reviewed the Senior report, a Revenue Canada report (not presented in evidence in this hearing) and the Youngstein report. While he felt the discounted cash flow approach was otherwise the most appropriate method of valuation, because of the fact limitations in this case he opted for the comparable transaction method. He concluded that a Western-Eastern rights value ratio at valuation day was 7.5-10 times the Eastern rights sale proceeds of $200,000, yielding a fair market value of $1.5 - $2 million for the retained rights.

51 The difficulty in the comparable transaction method employed by Mr. Davidson also results from the use of the value ratio of Western rights and Eastern rights. Mr. Davidson did consult others and did rely to some degree on a Screen Digest estimate of North American rights' values being ten times the rest of the world. Mr. Davidson did not test this finding through independent research nor did he develop precisely how the ratio was arrived at. Without further support, I must conclude that this ‘rule of thumb’ ratio is too simplistic, given the variables identified by both Mr. Senior and Mr. Davidson.

52 The discounted cash flow approach was stated to be the best approach by Mr. Bowman (called by the Respondent). Towards this end, he presented two rebuttal reports to the opinions of Senior and Davidson. The first report was corrected by the second wherein Mr. Bowman deemed he had made an error and recalculated the discounted cash flow.

53 It is somewhat surprising with this upward correction that Mr. Bowman did not believe his conclusion that the maximum value of $1,100,000 should be changed.

Conclusion

54 I conclude that, given this particular fact situation, both methods of valuation are problematic and I have a sense of a lack of satisfaction given the discussed deficiencies of the evidence. While some strength lies with the comparable transaction approach with the multiple ratio of Western to Eastern rights, I am not satisfied that the precise multiples have been clearly established on the evidence. I am of the view that the valuators' opinions on this point are not conclusive. Moreover, I find the discounted cash flow valuation is not a realistic approach given the operational circumstances of the Appellant in the seventies. On balance, in view of all the evidence presented to the Court and weighing the approaches to valuation, I conclude that the fair market value of the Library on the 31st of December 1971 was $1.3 million.

Decision

55 The appeals are allowed and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the fair market value of the Library was $1.3 million on the 31st of December 1971, and the Library being the primary asset of the Appellant, the aggregate fair market value of the shares in question shall be adjusted accordingly.

56 The Appellant is entitled to its costs.