When to Value a Company – Part 5: Reorganizing share capital to achieve tax planning objectives

There are many stages throughout a company’s life cycle where a business valuation might be helpful, or even required by law. These include the following situations, among others:

  1. Raising capital to fund your new venture
  2. Expanding the business with equity capital 
  3. Attracting and retaining talent by issuing shares or options to key employees 
  4. Buying out a shareholder to settle a dispute about how the company ought to be run 
  5. Reorganizing share capital to achieve tax planning objectives 
  6. Determining the value of family assets in a divorce proceeding 
  7. To assist with planning your exit strategy for retirement 
  8. To evaluate an unsolicited offer to purchase your business 
  9. Purchasing a business at its true value

This article is the fifth part in a series of articles that will describe common circumstances that give rise to the need for some sort of valuation.

In these articles, we convey some of the key valuation issues that should be considered in each situation.

In part one of our series on when to value a company, we discussed raising capital to fund a new venture, and how venture capitalists value investment opportunities.

In part two of our series on the subject of when a valuation is required, we discussed raising equity capital to expand your business after it becomes profitable.

In part three of our series, we discussed issuing stock options to attract top talent.

In part four of our series, we described some best practices to consider when valuing a company in the context of a shareholder dispute.

In this fifth installment, we discuss how a valuation is used to support a proposed reorganization of share capital that is being undertaken to achieve a tax planning objective.

Tax Reorganizations

Let’s face it, nobody wants to pay a nickel more of income tax than they absolutely must! Canadian tax rules are complex, onerous, and expensive if you don’t seek out ways to minimize your tax bill. This reality has spawned an entire industry of professionals dedicated to helping clients reduce their tax exposure.

There’s a wide variety of tax planning opportunities available, and we’re certainly not going to describe all of them in this short article.  However, one of the most common tax planning opportunities arises in the context of transferring ownership of a family-owned business to the children.  If the parents were to just give their shares to the children as a gift, the Canada Revenue Agency (CRA) would consider this transaction to be a “deemed sale” at fair market value, even though no money changed hands. This could trigger a large capital gain for tax purposes, leaving parents with a significant tax liability without any sale proceeds to pay the tax.

To achieve the same objective without triggering immediate income taxes, the parents could exchange their common shares for fixed value redeemable preferred shares. Then, the children would subscribe for new common shares that could be issued for a nominal price (since the entire current value of the company is reflected in the preferred shares issued to the parents). This is known as an “estate freeze” since the parents’ equity value has been “frozen” in the new preferred shares. The parents would only pay taxes when the company redeems their preferred shares at the fixed redemption price.

Why is a Valuation Necessary?

It is very important to set the redemption price assigned to the preferred shares equal to the fair market value of the common shares given up in exchange.  This is because:

  • If the redemption price is set above the FMV of the common shares, the children may be less motivated to build company value, since a lot of it will just be paid out to their parents upon redeeming their shares.
  • If the redemption price is set below FMV, the CRA may view this as a tax avoidance scheme, and there will be hell to pay, so to speak. For example, they will recalculate the taxes payable as if the redemption price was set at the higher amount that they ‘deem to be FMV’.  But they may disallow you to reset the actual redemption price that you will need to receive additional cash (upon redemption) necessary to pay the higher tax liability – not a good outcome for the parents who have just retired!

To minimize the risk of this outcome, clients will often include a ‘price adjustment clause’ (PAC) in the share exchange agreement.  This would allow the redemption price of the preferred shares to be reset to the amount deemed (by the CRA) to be FMV.

However, the CRA will only recognize the PAC if a ‘bona fide attempt’ was made to establish the FMV of the common shares at the date of the reorganization. Many clients opt to have an independent valuation report prepared by a professional valuator. This will usually be sufficient to meet the ‘bona fide attempt’ requirement. Other clients who are skilled in business valuation may prepare their own internal valuation, and perhaps have their advisors review it for completeness.

a bunch of wrenches and other tools in a box
Supporting your Estate Planning Objectives

Case Study

The client: the founders and owners of an auto service center chain in the Lower Mainland who are preparing to retire. The founders want to pass the business on to their four children.

The background

The founders worked for several decades to build a successful and profitable business with a significant portfolio of real estate assets. The founders want to retire and pass the business onto their children and freeze the value of their estate at its fair value on the date of the transaction closing.

The requirement

A valuation of the common shares is needed to estimate the value of the redeemable preferred shares formed by the founders. In a tax-free share capital reorganization, the children would be able to purchase new common shares at nominal prices. The founders would like to redeem preferred shares gradually, based on their cash flow requirements, while minimizing income taxes.

Smythe’s role

Smythe was retained to provide a valuation of the common shares for the purpose of estimating the preferred share values. Our advisors used the capitalized cash flow method to value the shares of the operating businesses and adjusted net asset method to value the shares of the real estate holding companies. The valuation report needed to be objective and accurate to avoid challenges by the CRA.

The outcome

The engagement was successful in reorganizing the Company’s ownership structure, allowing the founders to exchange their common shares for redeemable preferred shares of equivalent value. The tax-free reorganization of the share capital allowed the children to be subscribed for new common shares at a nominal price, and Smythe’s valuation report was not challenged by the CRA.

Types of Valuation Reports available

In a previous blog article, we discussed the three types of valuation reports that are available under the current reporting standards set by the Chartered Business Valuator’s Institute (CBV Institute). In most cases, clients choose either: (1) a Calculation Valuation Report, or (2) an Estimate Valuation Report.

Calculation Valuation Report

This type of report contains “a conclusion as to the value of shares, assets or an interest in a business that is based on minimal review and analysis, and little or no corroboration of relevant information, and generally set out in a brief report.”

Some clients choose this option because it is less costly to produce, while still providing the protection that comes with complying with the CRA’s rules regarding a ‘bona fide attempt’ to establish FMV. In this situation, the valuation report is viewed as an ‘insurance policy’ to guard against some harsh tax penalties.

Estimate Valuation Report

This type of report contains “a conclusion as to the value of shares, assets or an interest in a business that is based on limited review, analysis and corroboration of relevant information, and generally set out in a less detailed report.”

Some clients choose this option because they are more concerned about getting the most accurate valuation possible. This is especially true if there’s multiple children in the family, and they’re all receiving different types of assets held in the estate (i.e., real estate vs. family businesses, vs liquid investments or other assets). So, the valuation report is viewed as providing two elements: protection from tax risks and a methodology to ensure a fair allocation of wealth to their children.

Many clients have also reported an unexpected benefit from opting for the more detailed Estimate Valuation Report. Since this type of report involves a deeper analysis of the business, it can reveal some very useful insights such as:

  • Key valuation drivers that managers need to be kept “top of mind”
  • Risk factors and threats that need to be carefully managed
  • Strengths that should be guarded and opportunities that should be pursued

For example, one client noted in a recent testimonial:

“I found your valuation process to be insightful, thorough and interactive throughout. At the end, I felt that I understood considerably more about some important aspects of my company and its business than I did at the start of the process.”

The value of these additional learnings could be especially important to the next generation of managers taking over the business from mom and dad.

If you would like to discuss how we can help you meet your tax compliance objectives, while adding additional value in the process, please contact one of our valuators.