Harold Jensen v. Minister of National Revenue, [1984] CTC 2097

Rip, TCJ:—This is an appeal from notices of reassessment of the appellant’s 1976 and 1977 taxation years. At issue is the value of shares owned by the appellant in Jensen Steel Limited on December 31, 1971, which were sold by the appellant in 1976.

At all relevant times the appellant was the president and sole shareholder of Jensen Steel Limited (hereinafter referred to as the “Company”); he owned 1,300 preference shares and 2,001 common shares in the capital stock of the Company. Of the proceeds of disposition of the shares in 1976, all but $45,000 was received in the year of sale; the $45,000 balance of purchase price was received in 1977.

The appellant is of the view that the shares of the Company had a value of $200,000 on December 31, 1971 (“Valuation Day”). The respondent has computed the gain on the sale of the shares on the basis that their value on Valuation Day was $105,046.

Prior to 1971 the company was in the steel fabrication business in Bowman- ville, Ontario, purchasing its supplies from wholesalers. At all relevant times the company was owned and operated out of premises owned by the appellant; the company paid the appellant an annual rental equal to annual mortgage and tax payments.

Sometime near the end of 1970 the appellant decided that in order for the company to be less dependent on its suppliers and to reduce the cost of supplies, it should expand its business by adding the business of warehousing steel. In this way the company would buy its steel directly from a mill at a reduced price; it would then use the steel in its fabrication business and also sell steel to other fabricators. The new business had a risk in that the company had to buy more of the product on an annual basis and also had to buy a monthly quota of steel from the mill, whether or not it required the steel.

The main witness for the appellant was Mr Keith Noble, CA; the appellant’s accountant and the company’s auditor during 1975 and up to and including October 31, 1976, the date Mr Jensen sold his shares. Mr Noble testified he took over the audit assignment of the company in 1975 from a Mr Wade, who became ill. Mr Wade was the company’s auditor in 1971. Mr Noble has been in public practice as an accountant for the past 19 years; he has been carrying on practice in his own name since 1974. Previously he was with a national firm of chartered accountants. His practice is devoted to small businesses although he does have at ‘least one client with an annual sales volume of $15,000,000. He services seven clients in the steel fabrication business with annual sales of up to $9,000,000. He does not represent himself as a business valuator, although he does do valuations for his clients.

Mr Noble determined the value of the company’s shares on Valuation Day to be $200,000. He acknowledged that because of the sale of the company he did not have access to Company records for 1971 and earlier years when he started working on the valuation in January 1977 for the preparation of the Appellant’s 1976 income tax returns. Nevertheless he used several approaches in arriving at his conclusion.

Mr Noble reviewed the financial reports of what he called “the chief competitors of Jensen Steel who are public companies”, such as Canron Inc. and Dominion Bridge, for comparison of data to the Company. He discovered the net market value of assets of the public companies was in excess of their book value shown in the financial statements. The Appellant had no records that could be used to appraise the company’s equipment and other assets owned as of Valuation Day. An inventory of the company’s equipment, including office furniture, as of September 7, 1976, prepared in contemplation of the sale, was submitted in evidence; the equipment on hand on Valuation Day which was still owned at the time was identified. In Mr Noble’s view, because of inflation, the value of equipment acquired prior to 1971 and owned by the company on Valuation Day had increased through the late 1960s and early 1970s. The value of such equipment on Valuation Day should therefore, in his view, approximate their costs on the books of the company rather than their depreciated value. In any event, the company was depreciating this equipment at 20 per cent per annum whereas the public companies were depreciating similar equipment at 10 per cent per annum.

In reviewing the components which made up the price paid for the shares of the company in 1976, Mr Noble determined the agreed value of the equipment, as determined by the purchaser and seller, was 87.9 per cent of the capital cost of the equipment. Therefore, to determine the value of the equipment in 1971, Mr Noble “took the equipment on hand in 1971 and the value it would have been worth in 1976 and added it up, ignoring disposals in the interim, and found that the total value of the equipment was $115,001 in 1976”. However since the net book value of the equipment on December 31, 1971, was only $45,000, and its cost on the balance sheet as of that date was $133,791, Mr Noble took 87.9 per cent of $133,791 to arrive at the market value of the equipment on Valuation Day, to wit, $117,602, some $72,602 above book value. Thus he concluded the company’s net equity as of Valuation Day should be increased by $72,602 from $104,890 to $176,800, and the value of the shares should be adjusted accordingly.

Mr Noble then determined the value of the shares by capitalizing earnings. The company had a net loss for tax purposes in 1971 of $1,148. The reason for this loss, according to Mr Noble and Mr Jensen, was due to “start-up” costs of the steel warehousing business in order to establish a customer base and mill contacts. Mr Noble, therefore, asked himself what would have been the profit of the company on a sales volume of $651,000, the actual sales for 1971: he concluded the profit would have been $65,000 based on the company’s past expe- rience. In order to be “conservative” he arbitrarily reduced this amount first to $50,000 and later on in a subsequent valuation to $45,000; he termed these profits “potential profit”. He then obtained the average income of the company for the years 1967 to 1971 inclusive, using the “potential profit” for 1971, and capitalized the average earnings by a factor of seven to arrive at a value for Valuation Day of $219,856.

Thus, in Mr Noble’s view, Mr Jensen’s shares on Valuation Day were worth $200,000.

Mr Noble admitted in cross-examination that in determining the “potential profit” of the Company he did not provide for a market rental between the company and Mr Jensen, nor did he make any adjustment for Salary paid to Mr Jensen.

Under cross-examination, Mr Jensen acknowledged that in 1971 he did not know how long it would take to build up the warehouse business. He knew there was a risk in starting a new business but he “didn’t worry about risk”.

Ms Carol Hock, employed as a project development officer with the respondent, testified as an expert witness on behalf of the respondent. Ms Hock joined Revenue Canada in 1969 and graduated as a certified general accountant in 1974. She has taken business valuation courses with Revenue Canada. She is an associate member of the Canadian Association of Business Valuators and has instructed in business valuation at the Canadian Association of Business Valuators’ course at the University of Toronto since 1976. While she worked as a business valuator at Revenue Canada she prepared over 400 business valuations. Her qualifications to give expert evidence were not challenged by the appellant.

Ms Hock prepared the valuation on which the respondent relies. In preparing the valuation she prepared an economic review of the Canadian economy in 1971 as well as a review of the steel industry and the Company itself for that year. Ms Hock valued the company on the asset apporoach and the earnings approach. In preparing the valuation of the company on the asset approach she had the assistance of the respondent’s appraisers. She relied on the respondent’s appraisers for information as to the value of the equipment and was informed, and did believe, that the value of the equipment on Valuation Day was at its book value. She also included in her valuation a list of certain assets of the company that had been sold in 1969 which shows that the sale price of assets that had been sold did not approach their historic cost.

Ms Hock also testified that in her view a new warehousing business of the nature undertaken by the Appellant would have losses for two to three years. She stated that there is high risk in warehousing which would cause a drain on capital and any investor would have to be aware of this. The company was also in a very competitive industry.

Ms Hock said the company could not be valued on an earnings approach since there was a deficiency; similarly, if a fair salary had been paid to Mr Jensen, the company’s cash flow as at December 31, 1971, would be in a negative position. Therefore, in her view, the only valuation approach is book value. She reviewed various literature on the subject and based on her experience in valuing other companies, including between 12 and 20 other steel companies, she determined that assets are generally the basis of valuing a company such as Jensen Steel Limited.

Ms Hock determined the adjusted book value of the company’s assets to be $84,353. She arrived at the value by using the company’s recorded book values and deducting good will at book value as well as tax costs of distributing retained earnings to shareholders. On a value in use basis approach to valuation, that is, the possibility of value enhancement for the synergistic effect of the company’s business, irregardless of profitability, Ms Hock determined the total value of the company’s assembled operation to be $125,324.

On a liquidation value Ms Hock found the shareholder of the company would realize only $28,298.

Therefore using her finding of the book value of the company at Valuation Day to be $104,891, and the adjusted book value to be mid point between the adjusted book value of $84,353 and the total value of the company’s assembled operation of $125,324, that is $104,839, she determined the valuation of the company as at Valuation Day to be $104,891*. [1]

Mr Noble, who also acted as the appellant’s agent at trial, asked that the appeal be allowed since the respondent in valuing the shares undervalued the assets and earnings of the company for 1971 and the respondent did not make any adjustments to income for 1971 which, he said, because of circumstances, did not reflect a true profit picture of the company.

I cannot accept the appellant’s argument. It may in fact be true that the value of certain equipment owned by the appellant in 1971 had a value in excess of its book value. But a business such as that carried on by the company has at least some obsolete equipment which has little or no value; the business would be acquiring modern equipment if it wished to remain competitive. There was no evidence which could lead me to reasonably conclude that the equipment on hand at the end of 1971 had a value different from that reflected in its balance sheet, after providing for depreciation. No evidence adduced by the appellant was sufficiently strong to rebut the value of the equipment adopted by the respondent.

In so far as fixing an artificial income level for the company’s 1971 fiscal year is concerned, the appellant did not satisfy me that this is a method of valuation that has been accepted by the courts or is recognized by professional valuators. Even if one was to accept this approach, the calculations prepared by Mr Noble would have to reflect a fair market rent and competitive salary to be paid to the company’s chief executive officer on an arm’s length basis.

In the circumstances, I must accept Ms Hock’s valuation of the shares of the company as at Valuation Day. The appellant has not shown the respondent erred in its valuation.

The appellant also appealed on two subsidiary issues, one which was abandoned at trial. The other issue concerned the appellant’s view that if he was unsuccessful in this appeal, interest on any unpaid tax should commence as of the date of the notice of reassessment of the additional tax. His authority is O J Rath v The Queen, [1982] CTC 207; 82 DTC 6175. In my view Rath is authority that prior to 1983 there was no statutory provision imposing an obligation on the taxpayer to pay interest for the use of a tax refund pending the Minister’s reassessment; the appellant’s appeal on this issue must also fail.

The appeal, therefore, will be dismissed.

Appeal dismissed.