Valuation and Family-Business Share Structures – Some Musings

[1] This became a matter of national attention after an article appeared in the July edition of Canadian Tax Highlights.
 

[2] In fact, fairly recently, there have been at least three major presentations covering this issue: “Valuation – Allocation of Value”, Vern Blair, 2007 BCC p.9:1; “Valuation and Tax Issues”, D. Jeffery Harder, 2004 BCC p.20:1; and “Valuation Issues Relating to Shares of Private Corporations”, Richard Wise, 2004 CR p.13:1.  It is not surprising that two out of three papers were penned by British Columbia practitioners.  Much of the initiative for control premiums seems to be coming from that neck of the woods.
 

[3] As many readers will be aware, at least one leading publication suggests that the control premium issue should be resolved by Re Mann Estate ([1972] 5 W.W.R. 23(B.C.S.C.), aff’d. [1974] 2 WWR 574 (S.C.C.)), but goes on to discuss ways in which the “cautious tax planner” may minimize the issue.  For further comments on shareholder remedies and Re Mann Estate, see note 14 and note 3 to “CRA Statement on Control Premium”, also in this newsletter.
 

[4] The “special value” of such shares in respect of non-voting participating shareholders may also be relevant.  In this respect, a hypothetical speculator could acquire the thin voting shares, with a view to "flipping" them to the non-voting, participating shareholders, thereby providing them with the "key to the vault".  Alternatively, these non-voting shareholders could, themselves, attempt to negotiate directly with the controlling shareholder.
 

[5] Perhaps 15% would be a high number.
 

[6] See, for example, Interpretation Bulletin IT-64R4, paragraph 23(b). Note also that the liquidation value of a corporation’s assets may be less than the retraction amount due to deferred tax exposure.
 

[7] I submit that it would be disingenuous for the CRA to disagree with this position (assuming that that is possible for the CRA to be disingenuous).  In paragraph 23 of Interpretation Bulletin IT-64R4, it is stated that de facto control depends on each factual situation and that a “substantial” investment in retractable preferred shares could be indicative of de facto control.

Consider also the effect of a standard non-impairment clause – that dividends or other distributions cannot occur if they would impair the ability to redeem the freeze shares.  As the redemption amount will often reflect goodwill at the time of the freeze, freezor might assert that there must be an increase in the value of goodwill or other assets before distributions could be made to other shareholders.
 

[8] A counter-argument to the effective control of retractable shares could be based on the enforceability of the retraction rights.  The directors of the corporation might resist retraction on various grounds.  Recent cases in which the rights of such shareholders have cropped-up include Itak International Corp. v. CPI Plastics Group Limited and Peter Clark,  2006 CanLII 22117 (ON S.C.);  and Heesh v. Baker [2008] NSWSC 711.  These cases indicate that retractable shares should not be treated as equivalent to debt.  Retraction might be resisted on the grounds of corporate solvency test.  In Itak, where the corporation’s Articles envisioned a corporation not being permitted to redeem by virtue of insolvency or other provisions of applicable law “or otherwise”, the failure to redeem the retractable preferred shares was nonetheless oppressive to the preferred shareholders in spite of arguments based on the business judgment rule, because, in the particular circumstances, the business judgment of the directors lacked the touchstone of an informed reasoned judgment.
 

[9] In non-start-up situations, careful consideration should be given to the attributes of such shares, in order to support a nominal value.
 

[10] Mr. Dennis Turnbull, in various presentations; see Harder, op cit., p. 20:3.  One of the basic issues pertaining to control premiums relates to the “family control” concept – that is, the premise is that family members will act together to maximize their mutual wealth, including in respect of the sale of shares of a family business, so that minority discounts should not apply to particular members.  However, the CRA has indicated  that family control does not apply to allocations between classes of shares – so that the CRA is open to take the position that virtually no value is attributable to non-voting exclusionary dividend shares.
 

[11] 72 DTC 6187, FCTD
 

[12] However, an opposite conclusion was reached in Shepp v. The Queen, 99 DTC 510 (TCC).  For a discussion of Shepp and other cases in which control premiums and the family control concept have been in issue, see Harder, op. cit., p. 20:9.

A recent case in which somewhat similar concepts are involved is Laflamme v. The Queen, 2008 TCC 255, in which a family trust held growth shares, but father held shares with conversion rights to these shares sufficient to flood out the family trust’s holdings to a nominal amount.  The court ignored the conversion rights in determining the fair market value of the growth shares, noting that the exercise would be inconsistent with father’s estate planning objectives, the rights were not in fact exercised, and that a buyer of the growth shares would have insisted on a waiver of the rights, which father would have willingly given.
 

[13] As I mentioned last month, there are indications that, in the Vancouver area, the CRA may also be taking a particularly aggressive stand in respect of an actual tax file involving exclusionary dividend shares.  However, it may be too early to tell how serious the CRA is.
 

[14] Of course, one issue as to the value of non-voting exclusionary dividend shares is the argument that minority shareholder remedies may apply if the voting shareholder attempted to strip the company, particularly in view of Re Mann Estate (supra, note 3), and other cases.  In the context of exclusionary dividend shares at least, I am skeptical as whether minority shareholder remedies should dramatically affect valuation (presumably this would be the CRA’s view as well).  It has also been pointed out that the more recent McClurg and Neuman cases (91 DTC 5001; 98 DTC 6297; S.C.C.) suggest that a holder of non-voting shares cannot claim pro rata value for minority interest based on having legitimate expectations of dividends because of being in a position to apply for an oppression remedy (see “Valuations and Price-Adjustment Clause”, R. Wise, 98 CR p.33:11).  One CRA valuator has asserted that where non-voting shareholders have paid a nominal amount for their shares, and the rationale for the exclusionary dividend share structure is tax-motivated, the non-voting shareholder would not have a “reasonable expectation” (per the oppression remedy) of receiving substantial dividends.  However, oppression cases themselves indicate that, although the fact a shareholder may have acquired his or her shares as a gift could be relevant to the determination of the “reasonable expectations” of the shareholder, it does not deprive that shareholder of the protection of the oppression remedy or the duties owed to shareholders generally by directors; expectations are not static and may change over time.  While Mann Estate and other cases may show that the possibility of oppression actions should be taken into account in determining the valuation of shares, the valuators I have spoken with seem to agree that the oppression remedy may have limited scope in respect of sustaining a dramatically higher valuation in this context, because of the trouble and expense of bringing these to court, and the fact that the outcome on this type of situation is questionable.  There appears little in the way of guidance offered by existing Canadian (non-tax) case law on exclusionary dividend share situations; it may be the case that the protection afforded to holders of non-voting exclusionary dividend shares would be largely fact driven.  However, because of the importance of the oppression remedy in the United States, and the fact that Canadian courts often look to US jurisprudence, it may be that the oppression remedy could become a greater factor in the future.

What about the rights of non-voting shares to participate pari passu on a winding-up of the corporation?  Again, similar reasoning may apply.  Until a wind-up, the voting shareholder would have the ability to strip the company.  A non-voting shareholder can go to court for a winding-up order under the OBCA on the grounds that there is oppressive conduct or that a winding-up would be “just and equitable”; however, query whether this prospect would be of material value to a “willing buyer”.
 

[15] For readers who are interested in additional information on valuation issues, including those discussed in this article, I recommend www.wiseblackman.com/english/articles.htm.