Elliott v. The Queen, docket 97-3498-IT-I (Informal Procedure)

Date: 19990902

Docket: 97-3498-IT-I

BETWEEN:

TERRY E. ELLIOTT,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Margeson, J.T.C.C.

[1] This appeal is from an assessment for the 1992 taxation year with respect to the valuation of goodwill of the Appellant's accounting practice, which she estimated at $125,000.00, when transferring the assets to a Corporation on January 12, 1992. The Corporation recorded the goodwill on the balance sheet in the amount of $125,000.00 and included this amount as an eligible capital expenditure. The Appellant obtained an advisory report prepared by Robert J. Landry and Associates valuing the goodwill in the range of $74,000.00 to $87,000.00. The Minister calculated that the fair market value of the goodwill transferred from the Appellant to the Corporation was not more than $32,000.00 and assessed the Appellant as having realised a taxable capital gain of $24,000.00.

Issues

[2] The only issue to be decided is the fair market value of the goodwill of the accounting practice transferred to the Corporation by the Appellant on January 12th, 1992.

Facts

[3] Robert John Landry testified that he was a certified general accountant and was a chartered business evaluator. He had practiced in this area since 1969 and was qualified as such in 1987. His report was marked Exhibit A-1 and was admitted by consent subject to the qualification that it was considered to be an advisory report only and on the understanding that it did not consider some factors which might be relevant in the giving of an opinion. In his report he looked at theories as to how goodwill is to be valued in an accounting practice. He analyzed the earnings of the operation and considered that the determination of goodwill value based on the rule of thumb method is acceptable for an accounting practice. He worked primarily with the definition of fair market value as set out in paragraph 4 of his report.

[4] What he was considering was the individual goodwill of the accounting practice which was commercially transferable. His position was that it does survive even if it was created or generated by the individual.

[5] He admitted that he did not go so far in his advisory report as he would have if he had been giving a final report and that this report was restricted by time and the amount of money that was spent on it. He did not provide variances in the report to show some differences which might exist down the road. In his report he attempted to show that goodwill was transferable and that high goodwill values are used in the market place. Insofar as he was concerned a key element to his evaluation involved the empirical (rule of thumb) method of evaluation. It was his position that this method had been approved by Archambault, T.C.C.J., in 1860 - 3043 Québec Inc. v. The Queen, 94 DTC 1685. This method was a key element of his report.

[6] In considering the history of this accounting practice he considered the fact that there was no other practice existing in that area. This accounting practice preferred the type of business provided by farming, ranching and small businesses. Billings increased by an average of 33% per year during the two years ending June 30th, 1991, going from $103,260.00 to $123,925.00. He asked the Appellant what she believed that the practice could achieve in the way of annual billings and she said that it could achieve the amount of $250,000.00 in annual billings. This accounting practice experienced a stable, high retention rate and this suggested a very good capability of a future sale to another client. He used an overall retention rate of 105.6%.

[7] The excess earnings method provided the best evidence as to where the business stood at the date of transfer of the asset. He also considered the cost of running the business due to the need for renumeration of an owner of $37,000.00 per year. Based upon this method he concluded that the value of the goodwill was between a high of $61,411.00 and a low of $49,129.00.

[8] He would like to make some adjustments if there were a professional corporation in place since the tax rate would be lower and if the buyer had an established practice the overhead would be lower.

[9] He introduced Exhibit A-2, schedule F(A), in which he took into account the reasonable remuneration of an owner which he set at $37,000.00 per year based upon salary paid the accountants in Alberta doing this kind of work. In Exhibit A-2 he calculated income tax on excess earnings at 19% rather than 39% as in schedule F, Exhibit A-1. Consequently, he valued good will between $52,397.00 and $65, 918.00 rather than $61,411.00 to $49,129.00 shown in schedule F of Exhibit A-1.

[10] It was his position that a person who is in an existing practice could make savings by buying this practice and if there were more than one they might pay significantly more than the figure as shown in schedule F(A) in Exhibit A-2.

[11] Schedule G produced a calculation of goodwill value based on the rule of thumb method. In this calculation he looked at the billings achieved up to December 31st, 1991 and came up with a low goodwill value of $73,257.00 and a high goodwill value of $107,354.00 based on the Guthrie / Bonnatyne formula.

[12] He considered valuations based upon the ICABC goodwill surveys and admitted that different interpretations could be placed upon schedule G depending upon the factors he looked at. In his calculation, on the basis of the ICABC goodwill surveys he considered all clients at the 70% retention factor which he believed took care of the clients that might not be retained. He came up with an evaluation of $86,762.00 based upon the 70% retention factor and a low of $74,367.00 based upon the 60% retention factor. He also considered the actual retention rates of this practice. He then deducted 10% for those that had been retained by the Appellant specifically. Using this method he concluded that the low value was $86,415.00 and the high value was $98,810.00.

[13] He also considered the future earnings method set out in schedule H of Exhibit A-1. In schedule H he calculated the position of the practice at the valuation date and tried to find out what might happen in the future. In schedule 1 his calculations of the goodwill value were based on discounted future cash flows. He did admit that he used the Appellant's statement that billings could reach $250,000.00 annually in the future. He said that based upon the discount of future cash flows method the figures were all over the place. Further the excess earnings calculations did not support the other calculations but he believed that the rule of thumb method could be used based upon the ICABC studies.

[14] He did not consider special purchasers. On page 16 of his report he concluded that the valuation of the goodwill on the date in question based upon the different methods was as follows: (1) excess earnings method. - low, $49,100.00, high, $61,400.00.

(2) Rule of thumb method -schedule F (A) - Exhibit A-2 - low $65,900.00, high $82,400.00.

(3) Githrie / Bonnatyne method, - low $73,300.00, high, $107,300.00

(4) ICABC surveys - low $74,400.00 - high $86,800.00.

(5) Actual retention rates method - low, $86,400.00, high, $98,800.00.

(6) Future billings method - low, $83,600.00 - high $92,100.00.

(7) Discounted future cash flows method - low, $117,600.00, high, $147,500.00.

[15] It was his position that the most appropriate method of calculating value was considered to be the rule of thumb calculations based on the ICABC surveys.

[16] He was referred to the Respondent`s report and he said that he had reviewed it. As far as he was concerned there were no great differences between his report and this report based upon theory but it had more to do with quantum. They both agreed that the rule of thumb method was appropriate. They both had a problem explaining the result by the excess earnings method. Further, he used figures as of December 1991 as the client base and the Respondent's report was based upon June of 1991. He said that there was a big difference in the client base. He believed that there was similarity in theory between his report and that of the Respondent. The difference was in the weight assigned to the different elements.

[17] He reviewed three other offers for the purchase of other practices and one sale in reaching his conclusion.

[18] In cross-examination he agreed that the other purchases were not in the same place but were in other parts of Alberta. The first and third offers he reviewed were in small communities. There were other variables that differentiated these areas from the area in question but there were also different retention rates.

[19] He agreed that Exhibit A-1 was an advisory report only and that it might lack an in-depth study and a consideration of more detailed factors. However, he had adhered to theories and it was not sloppy work. He did not use the date of June 1991 because he decided that the most reliable period was the six months closest to the valuation date. This was December 1991.

[20] He admitted that the excess earnings approach was still the preferred method but Revenue Canada has accepted the rule of thumb approach as well. The accounting profession was accepting the rule of thumb approach based on hard facts.

[21] If he had relied on the excess of earnings approach his appraisal would have been lower. The low would have been $49,000.00 and the high would have been $61,400.00 as set out in schedule F.

[22] As a result of a question from the Court he said that the figure of $250,000.00 did not affect his calculation in the rule of thumb approach as he took the factors from other areas. To the extent that he used it, it would have been in schedule I. He admitted that time and money was a factor and that if he was to give an opinion he would have gone into the factors in greater depth.

[23] The Appellant testified that the area in which she practised was a unique community. Her clients came from the Oil and Gas industry, from farming, from ranching and from tourism. They went through a growth period in the service sector. The area required a lot of accounting services.

[24] She increased her staff from one and one half to three and doubled her computer equipment. Her office was "jammed-packed and she had to turn people away". There was a lack of better office space available. She was concerned about the quality of the product that she was delivering but she expected to gross $140,000.00 by the end of December 1992. She considered the twelve months period ending December 31st, 1992 which was the first year of the incorporation and she used the figure of $134,872.00.

[25] As of December 31st, 1993 she used the figure of $142,350.00. It was her position that she would not have to increase staff to increase her fees. Her fees were going up and there was more room for an increase in the fees. She believed that it was a special community at that time. There was a lack of accounting service available which added to the value of her business. She had investigated buying other businesses and they were going from 80% to 110% of gross income under the rule of thumb method.

[26] In cross-examination she was asked what basis there was for the figure of $250,000.00 as possible earning potential. She said that she had barely scratched the surface of the service industry in that area. The potential was there and realistic. It was a "ball park" figure but it was determined in accordence with her past and based upon her aggressively marketing her services which she was prepared to do. There was no resident accounting practice there. There were two satellite firms there only. In 1992 it was the same. Some chartered accountants came in on a daily basis.

[27] Ronald M. Kavanaugh was a chartered accountant with a considerable professional educational background as well as considerable supplementary education. He had been a senior business and security evaluator for Revenue Canada taxation from 1992. He had considerable business and security evaluation experience. All of the above are set out in his curriculum vitae which was not disputed.

[28] He did an evaluation of the accounting practice in this case. His evaluation was prepared for the purpose of these court proceedings. An original evaluation had been done in 1996 by another party who left Revenue Canada and someone else had to take on the file. He produced Exhibit R-2 which was his evaluation. His qualifications were accepted and it was agreed that he could give opinion evidence in the field of his expertise.

[29] His general approach was to determine the commercial value of goodwill, based upon the fair market value approach, not on the open market approach. Therefore, substantial reliance must be given to the common law definition of fair market value which was defined in his report.

[30] He researched cases on personal goodwill but what is involved here is the commercial value of goodwill. He considered the excess earnings approach and the B.C. studies. He assigned a weight to each of the different approaches and he determined that a fair market value of goodwill of this business at the time of the transfer was between $21,000.00 and $32,000.00. In completing his calculations he considered the client base up to December 31st, 1991 and used the billings as of that date as the base.

[31] 67% of all of the audit business of the Appellant was accounted for by four clients. This work, he concluded, was retained on a contract bid basis from year to year which would result in a potential purchaser attributing additional risk to this earnings stream and accordingly discounting value for the risk. It was his position that a business that is heavily dependent on relatively few clients will be worth less because of a greater risk of losing a substantial revenue source all at once.

[32] 54% of the review engagement revenue was provided by six clients. He considered this to be a high risk earnings stream given the dependence on so few clients. Further 46% of the work was based upon 28 clients which was the industry standard.

[33] The two compilation engagement clients accounted for 37% of this type of revenue. He felt that this was a high ratio and that a successor would necessarily discount this earnings stream for the risk which he would incur.

[34] He determined that the personal tax return preparation client services was well diversified among 90 different clients. However, it was his position that these clients are generally very portable with respect to their personal tax preparation and can change practitioners essentially on a moment's notice but there was a high risk factor of losing this part of the practice as well.

[35] He took the position that special engagement revenue constitutes one time or perharps two times fee sources. A successor would not pay for this part of the client base although an incidental occurrence of such revenue could be expected to result in the future on an annual basis. Even in the presence of a continuity arrangements (which did not exist here) a loss on succession must necessarily occur.

[36] With respect to growth factors he took the position that a successor would not be willing to pay for growth expectations that would require his or her own efforts to generate it. Consequently, the fair market value should only recognise growth that would directly result from the asset in question; the client base up to the date of the sale.

[37] Even if growth potential was as much as $250,000.00 as indicated by the Appellant, that is not a factor to be considered in evaluation since the result would be obtained by the work of the purchaser and not by the transferor.

[38] Further, if there is a good possibility for growth in the business in the area there is little likelihood that someone else would pay for it since they could go in and open up their own business. If there is more competition then there might be more people willing to pay for clients which might be handed over to them by the vendor.

[39] In this case, what is being appraised is the commercial value of the goodwill transferred, not the net value of the asset, not the personal goodwill. In the case at bar the transferred goodwill is basically composed of the client list and possibly the organizational value of the existing business.

[40] The valuation should take place in a notional market and not the open market. He agreed that fair market value is the correct reference. The valuation must be with reference to informed purchasers. One must know how the sale was settled, how it could be reduced to cash value. Sometimes goodwill is paid on the basis of what the earnings are after the sale. If it is to be related to present value there must be an adjustment made to take into account the amount of income which might not come in after the sale.

[41] Further, one must take into account what is happening in the market place. This is open to different interpretations as can be seen in the B.C. surveys. The desire is to try and converge on a value for notional purposes (as here) as close to the market value as you can achieve. He had factored in the results of the market studies. He took the position that the only relevant source of goodwill is the transferable portion and not the personal portion i.e. personal attributes, experience, acumen of the vendor. Therefore, any earnings attributed to it have no value.

[42] In the case at bar the Appellant was working out of Sundry. She regarded herself as the key person in the business. She worked 50 to 65 hours per week. He admitted that personal goodwill does exist in accounting practices and the problem is how to quantify that element. Further, one must consider the loss rate on succession. Non-competition agreements are very common in accounting practices but he did not allot any weight to management continuity agreements or non-competition agreements in this case. If there were some in place then the buyer would have to pay extra for them. The rate of loss is factored into the three models that this witness used in making his report. The excess earnings method has to have significant weight and he assigned it 50%.

[43] In the model, one must take into account the absentee seller's position in the business and what she generated for the business while she was there. To take just a statistical figure and use that factor without making adjustment is not realistic. One must take into account some of the factors specifically related to the Appellant. Here he used $50,000.00 as the amount that the Appellant would have to go out and pay someone else to manage the business.

[44] He also considered the fact that the number of hours that the Appellant put into the business was during a building period which was significant and he took this account when making his calculation.

[45] With respect to income taxes it was his position that this had to be taken into account when considering the excess earnings model. The Appellant's accountant made an adjustment by reducing the ratio of income tax from 39% to 29% whereas this witness believed that 39% was the appropriate rate which should be used.

[46] It was his position that a valuator would base earnings not only on the corporate rate but also on anything coming out of a distribution of funds of the corporation. If one individual acquired it or if a small accounting firm acquired it there would be some tax benefits in effect so that the rate could be anywhere between 19 to 35% depending upon what the potential purchaser market was. If there were both a small firm or corporation in the market then the rate of 19 to 39% would be appropriate. To suggest that only 19% was applicable was not correct. Any buyer would have to pay tax when money came out. In this case it was more likely that an individual would buy it out rather than a firm of more than 2 or 3 persons. In the excess earnings model a rate of 30 to 39% would be appropriate, since anyone would take into account the tax implications.

[47] The difference between the excess earnings calculations of Mr. Landry and himself were in the capitalization rates. Mr. Landry used multipliers of four to five and he used multipliers of three to four. The capitalization rate he used was 25 to 33% based on the five to ten years period using the Bank of Canada bond rates which entailed no risk. The number of years of net earnings that a practitioner would pay to get this asset was two to three, whereas Mr. Landry used three to five. He considered risk factors that Mr. Landry's study did not. For a small practice of this size there would be fifteen to twenty per cent additional risk premium associated with this enterprise bearing in mind its client mix. Further, to use surveys properly in determining the model one must take into account various protective clauses where goodwill payments are based on the history of billings.

[48] He referred to sheet 1 schedule 2 and said that he picked out the various factors that were necessary to be considered in the calculation of the value and not on the calculation of the price. The type of discount should reflect the mix of clients and other associated risks. In schedule 3 of sheet 1 he calculated the value of the goodwill based on ajusted gross future billings as per the 1992 ICABC survey. It was his position that one would likely expect payment to take place over a four year period and the factor could be 71% of maintainable, billable fees taking into account other factors as well.

[49] Of the three models identified it was his view that the capitalization of excess earnings model was the most appropriate. Therefore, he assigned a 50% weighting to excess earnings and 50% to both other models combined. Based on the assigned weightings he concluded that the fair market value of the goodwill fell in the range of $21,000.00 to $32,000.00. He took the mid-point of these two calculations and arrived at a figure of $26,500.00 as the fair market value of the goodwill at the time of sale.

[50] The witness commented on the effects of using the billings date of June 31st, 1991 instead of December 31st, 1991 as Mr. Landry had done. He admitted that the figures that he employed were not as up to date as that of Mr. Landry but he said that the effect for a 6 months period would be very little and there would have to be evidence of very great changes in earnings for it to be of any great significance.

[51] In his calculations he did make reference to the client mix of December 31st, 1991 but the figures that he used were for June 31st, 1991. An increase of $23,000.00 over that period would make his calculations go up but he would not use work in progress as at the year end. Therefore, there was a difference of about $13,000.00 between the figures he used and the ones that Mr. Landry used. Using these figures he would come to a value range of $28,000.00 to $36,000.00 as opposed to $21,441.00 to $31,758.00.

[52] He did not take into account the special purchaser factor because there was no evidence of a special purchaser that was interested at a particular date or who would be interested. Therefore, special factors could not be recognized. No one in the evaluation industry would recognize buying the practice at three times the billings. The 39% tax rate was appropriate and he believed that the business would most likely be purchased by one person. There was considerable room for others to move into the area and there was a fair amount of accounting work available. He used a 12% discount rate regarding any amounts that might be reflected back to the vendor. Mr. Landry used only a 7% discount rate. However, a risk free rate of return is considered to be 8.5%. Therefore Mr. Landry used 1.5% less than the risk of free rate and this was inappropriate.

[53] In his interpretation of the ICABC studies he took into account the risk attached to the business whereas Mr. Landry did not make any adjustments with respect to the client base mix or the type of work done by the business. The loss rate on succession used by Mr. Landry was smaller than the one he used. He used 10% to 15% whereas Mr. Landry had used 5% to 10%. He said that it is necessary to consider the case law to date with respect to the different models and he had done so in detail.

[54] In cross-examination the witness said that he did not attend at Sunbury but received the list of clients and the information that the original evaluator had used and he also used Mr. Landry's schedule regarding the clients and the different kind of fees that they generated. There is much more risk associated with one large client than with a number of clients.

[55] He was questioned with respect to the method used to quantify the personal goodwill. He said that he characterized it for the loss of succession that a buyer would encounter on the sale. From his experience 10% to 15% was a reasonable rate that could be assigned to the personal goodwill if the owner left the practice. However, he did not analyse which clients would be lost, although there would be a loss on succession. He had never known anyone who had considered otherwise.

[56] Work in progress should not be included. Mr. Landry should have deducted it out of his calculations. The figure that he came up with was too high. It was not the same thing as a completed transaction. Therefore, the quantum assigned to it in terms of value was different. The amount of risk associated with it could also be higher. He considered it to be collectable but not receivable. It was a source of value but one should make sure that it is not double counted. Again he did not think that it would make much difference in the growth factor whether he used the six months ending June 31st, 1991 or the twelve months ending December 31st, 1991 as his base.

[57] He was asked why he did not include the figure in schedule B, the income statement, in his calculation period. He said, "perhaps it was an oversight". He was referred to page 14 of his report where he had considered that the key person in the business worked 60 to 72 hours per week at the valuation date. He said that these figures were referred to in the original report and he also used the May 29th, 1995 working paper which said that Ms. Elliott had indicated that she was working 60 to 72 hours per week. He reiterated that the modifier of three was reasonable in the multiple of gross billings model.

[58] He was questioned with respect to schedule no. 1 sheet 1 where he had used the absentee practitioner remuneration adjustment of -$50,000.00 to -$45,000.00. He said that this was based on statistics and taking into account the key manager status of the Appellant and other management factors.

Argument on behalf of the Respondent

[59] In argument counsel for the Respondent said that the main issue in this case is the valuation of the asset transferred, being the goodwill. There is a difference of opinion on this matter. There are two different types of reports. One report, presented on behalf of the Appellant is merely an advisory report, whereas the report submitted on behalf of the Respondent is an evaluation report by a competent evaluator. Mr. Landry himself at paragraph 1.5 of his report attested to the advisory nature of his report. He admitted that his type of report was not as detailed although it may not have been sloppy. There was also a difference in the use of the model by the two appraisers. Mr. Landry used the rule of thumb method as being the most appropriate but he admitted that the excess earnings method was the predominant one in the industry. He also agreed that the excess earnings method using the figures in Exhibit A-2 brings the parties closer to the proper percentage to be used in calculating income tax on excess earnings. Mr. Landry used 19% which was at the lower end of the range.

[60] The evaluation of Mr. Kavanaugh on behalf of the Respondent used a combination of all of the methods by applying a weighting value to each model. Therefore, even though he obtained a lower figure when using the excess earnings method this was not increased since he used a combination of all three methods.

[61] Counsel pointed out that in the reply at paragraph 10-I the fair market value of the goodwill transferred from the Appellant to the Corporation was indicated as being not more than $32,000.00. This was the upper range between $28,000.00 and $36,000.00 which would be obtained by use of the December 31st, 1991 data. However, does the revised range mean that the Appellant has shown that it was greater than $32,000.00, which is the mean and which is the figure used by the Minister in the presumption ?

[62] Counsel referred to the lack of competition that exists in the market place. It was her position that this was both a positive and a negative factor with respect to the evaluation period. Mr. Kavanaugh deducted for personal goodwill since the Appellant worked very hard at the business herself and when she left that goodwill would go with her. Mr. Kavanaugh's analysis is a reasonable one. If the Appellant left the business there would be considerable loss on her leaving. This was not considered by Mr. Landry in his report.

[63] Mr. Kavanaugh's discount rate of 12% took into account the risk free rate of 8.5%. It would be unreasonable to consider a discount rate for a professional practice to be less then the risk free rate. Mr. Landry used 7%. This was unreasonable.

[64] Mr. Landry said that he did not use the figure of $250,000.00 which was the projected possible earnings capacity of this business but the projection of that amount must have influenced Mr. Landry in the estimation of value of the practice so that the values determined by him were in the best possible light insofar as the business was concerned and to an unreasonable extent.

[65] As to the two opinions Mr. Kavanaugh's was more reasonable and should be accepted by the Court.

Argument on behalf of the Appellant

[66] The Appellant said that Mr. Kavanaugh stated that Mr. Landry factored synergies into his opinion but he did not. Those factors were not allowed to be introduced into the evidence in Court.

[67] Mr. Kavanaugh's report is erroneous. He used the wrong gross and net numbers. He used the wrong rating including the $50,000.00 management fee.

[68] The Appellant argued that Mr. Landry used three methods including the rule of thumb method. The calculations come in at 60% gross on the low range and 70% gross on the high range. It was her position that the market uses a method of calculation based upon gross earnings. Mr. Landry's report is to be preferred. The appeal should be allowed with costs.

Analysis and Decision

[69] In this case the Court is faced with two opinions which, although not necessarily completely contradictory one to the other, contained wide variations as to fair market value of "the goodwill" which is in issue in this case. According to the opinion of Mr. Elliott, who prepared the evaluation on behalf of the Appellant, the fair market value of the goodwill was within the range of $74,000.00 to $87,000.00 and he suggested the higher end of the range, or $87,000.00, as he had concluded that all calculations prepared to test the validity of the primary method produced value ranges higher than this range. On the other hand Mr. Kavanaugh, who prepared the evaluation on behalf of the Respondent had estimated the fair market value of the goodwill held by the Appellant in her practice as a self-employed accountant as of January 12th, 1992 within the range of $21,000.00 to $32,000.00 and took the mid-point as being the appropriate one and valued it at $26,500.00. This is indeed less than the amount referred to in the presumption to the reply where the Minister used the figure $32,000.00.

[70] Both of these appraisers appeared to be well trained, competent and capable. Both appeared to use methods of calculations which were in accordance with methods used in the market place, in accordance with studies completed on the matter and took into account the so called "rule of thumb" method. Under those circumstances one might question how two qualified appraisers could come up with such a wide diversion of opinion as to the fair market value of "the goodwill", at the appropriate time.

[71] However, when the Court considers all of the evidence produced and the arguments of counsel it becomes obvious that there are reasons for this great diversion of opinion. Some of the factors leading to this difference of opinion are more significant than others.

[72] On the basis of the evidence there can be no doubt that the opinion of Ronald M. Kavanaugh is more detailed and took into account some relevant factors which were obviously not considered by Mr. Landry in his report and that was admitted by Mr. Landry in his evidence.

[73] In the report of Mr. Landry at page 3, the limitations of his report are set out by him when he said, "based on the information available to me in the restricted scope of my review, the attached calculations indicate that the estimated fair market value goodwill is within the range of $74,000.00 / $87,000.00." Further, in his evidence in Court he confirmed that this was an advisory report only. He admitted that he did not consider some factors which might be considered in giving an opinion. Thus, he was not giving an opinion but filing an advisory report only. Further, he relied intrinsically on the rule of thumb method as being the best method available and in reality placed too high a reliance on this method.

[74] The Court is satisfied that this was not the best method for determining the fair market value of the goodwill in this case. The Court is satisfied that the rule of thumb method has its place, but the other methods should have been given more weight by Mr. Landry in his calculations. To that extent the methodology used by Mr. Kavanaugh in assigning appropriate weights to the different methods was more appropriate and more accurate.

[75] Further, the Court is satisfied that Mr. Landry placed some considerable weight on the information provided to him by the Appellant that the practice could generate as much as $250,000.00 of income if the Appellant had decided to put her efforts into the business. Yet the Appellant was putting 60 to 72 hours per week into the business according to the evidence given and it is difficult to see how she could have put many more hours into this business to generate any more income and indeed there was no evidence to substantiate this figure. At best, this figure was a relatively optimistic projection only and it should not have been given too much consideration. That is not to say that it should not be given any consideration, even though if one were to increase the amount of income, there would have to be greater effort put into the business then had heretofore existed But the Court is satisfied that the condition of the market place that existed at the time of sale was certainly a relevant consideration.

[76] Further, Mr. Landry indicated that he did not provide variances in the report to show differences down the road.

[77] The Court is satisfied that Mr. Landry placed too high a premium on the transferability of the goodwill that might have existed at the time of the transfer. The Court is satisfied that some of this goodwill could have been transferred but not all of it and not as much of it as this appraiser believed would be transferred.

[78] The Court is further satisfied that Mr. Landry was too generous in recognizing that in the market place someone would pay three times the annual billings as a basis for the evaluation and the Court agrees with the evidence given by Mr. Kavanaugh that no evaluator would be so generous.

[79] Further the Court is satisfied that Mr. Landry failed to consider properly the type of practice that existed and in particular the high risk of non retention clients due to the specific type of client which had been retained heretofore. According to the calculations of Mr. Kavanaugh the audit engagement revenue came from four clients, one of which accounted for 67% of this source of revenue. Further, this source of work was retained on a contract bid basis from year to year so that there was a great chance that it might not be continued on after a sale. The Court is satisfied that Mr. Landry did not adequately consider that a potential purchaser might attribute additional risk to this earning stream and consequently discount the value of the business. Further, 54% of the review engagement revenue was provided by 6 clients. These clients as well must be regarded as a high risk earnings stream which was not properly considered by Mr. Landry. Likewise, of the compilation engagement clients, two clients accounted for 37% of this type of revenue. Again this presented a high risk factor which was not properly considered by Mr. Landry in his calculations.

[80] The Court is satisfied that Mr. Landry failed to take properly into account, the reasonable salary that would have to be paid to someone else to manage the business in the absence of the Appellant who performed that function before the business was sold. The figure of $45,000.00 to $50,000.00 used by Mr. Kavanaugh in his report would not appear to be unreasonable and there was no evidence to indicate that it was. Further, the Court is satisfied that Mr. Landry's deductions with respect to income taxes in the excess earnings model was too low. He used 29% instead of 39% and the Court is satisfied that the rate of 39% would be more applicable under the particular factual situations that existed in the present case. The Court takes into account the possibility that it was more than likely that an individual would purchase this asset rather than a number of individuals or an existent corporation. The Court cannot find fault with Mr. Kavanaugh's calculations that in the excess earnings model an appropriate rate of 30 to 39% would be appropriate with respect to tax implications.

[81] The Court is also satisfied that Mr. Landry used an inappropriate discount rate of 7% which is 1.5% lower than the risk free rate of 8.5% according to the surveys. The Court is satisfied that the discount rate of 12% used by Mr. Kavanaugh is more appropriate.

[82] These are some of the shortcomings that are reflected in the preliminary report from Mr. Landry. However, that is not to suggest that there were not some shortcomings in the report of Mr. Kavanaugh as well, although these shortcomings were not as significant nor as numerous as those found in the report of Mr. Landry.

[83] As a result of the cross-examination and the argument on behalf of the Appellant, the Court is satisfied that these shortcomings are of some significance and do affect the ultimate evaluation of the goodwill in this case, which must be decided by this Court.

[84] The Court is satisfied that Mr. Kavanaugh was entitled to consider, in arriving at his ultimate evaluation, the type of practice that the Appellant conducted and the type of client that she served, the total billings that were reflective of each client and the percentage of the total billings which related to each type of engagement. However, the Court is satisfied that Mr. Kavanaugh attached too much risk to the retention rate of the audit engagement clients, the review engagement clients and the compilation engagement clients. It was his position that "one that is heavily dependent on relatively few clients, will be worth less because of the greater risk of losing a substantial revenue source all at once." The Court is satisfied that Mr. Kavanaugh overemphasized the risk attached to this portion of the Appellant's client base and accordingly discounted to too great an extent the value of this risk.

[85] Further, the Court is satisfied that Mr. Kavanaugh assigned too high a rate to the personal goodwill of the Appellant which would have been lost when she left the business. This, to some extent, affected this evaluation. He indicated himself in his evidence that he did not analyze which clients would be lost and that was a shortcoming of his report.

[86] Mr. Kavanaugh did not include work in progress in his calculations. It was his position that this work was not a completed transaction and therefore the quantum ascribed to it in terms of value could be different than the completed work. However, the Court can certainly see why possible purchasers would take into account the value of the work in progress as some kind of yard stick as to what the practice was doing and might very well ascribe to it some value. Consequently, Mr. Kavanaugh's treatment of this aspect of the business should be revisited.

[87] The Court is satisfied that Mr. Landry's approach in making use of the twelve months ending December 31st, 1991 was better than that used in the appraisal on behalf of the Respondent. The Respondent used the six months ending June 31st, 1991 and the Court is satisfied that in doing so the value ascribed to the goodwill as calculated by Mr. Kavanaugh was somewhat less than the fair market value at the appropriate time. Mr. Kavanaugh admitted in his evidence that he probably did not consider schedule B of Exhibit A-1, which were the income statements for the year end, December 31st, 1991 and this was probably an oversight. This would indicate that there was some significance to be attached to these figures and the Court is satisfied that a proper consideration of them would have led to a different valuation by the Respondent's appraiser. As a matter of fact in the cross-examination of this witness he agreed that the upper range would be $36,000.00. The range would be $28,000.00 to $36,000.00 as opposed to $21,441.00 to $31,758.00 as contained in the report.

[88] The Court is also satisfied that Mr. Kavanaugh in his report underplayed the significance of the established practice and the client base that had been built up. It is true that the evidence indicated that the market was wide open and that a person wishing to establish a business might very well open a new practice rather than purchase an existing one, but it is also reasonable to conclude that there would be other possible purchasers who would be motivated to purchase the existing business of the Appellant rather than to start from the beginning with an entirely new practice.

[89] Under these circumstances, considering all of the evidence and the shortcomings of both reports, the Court is satisfied that the Appellant has established on a balance of probabilities that the value of the goodwill at the relevant date was greater than the sum of $32,000.00 upon which the Minister made the assessment although it was not as great as that offered by the Appellant. The Court is satisfied that a reasonable evaluation of the goodwill of the practice as the time was $42,000.00

[90] The appeal is allowed and the matter is referred back to the Minister for reassessment and consideration based upon the Court's finding that the fair market value of the goodwill of the accounting practice at the time of the transfer was $42,000.00.

[91] Under the circumstances, there will be no costs.

Signed at Ottawa, Canada, this 2nd day of September 1999.

"T.E. Margeson"

J.T.C.C.