On July 18th, our Canadian Department of Finance released their paper, Tax Planning Using Private Corporations, wherein it introduced a series of proposed tax reforms that will significantly, and negatively, impact the operation of small businesses in Canada, the growth of entrepreneurship in Canada, and the Canadian middle class; the backbone of our economy. One of the proposed reforms target multiplication of the Lifetime Capital Gains Exemption (LCGE) by persons under the age of 18, family trusts and adult children and spouses not involved in the operation of the family business. This is a major change and could translate into lost tax savings in the range of $83,000 to $223,000 per person depending on the marginal tax rate of the family member able to utilize the exemption. Since the proposed changes will make it difficult for family members to access this exemption, Finance has included a special election in the draft legislation to allow individuals 18 or over to utilize their LCGE in 2018 for shares that qualify as qualified small business corporation (“QSBC”) shares.
Planning will need to be undertaken to ensure the shares qualify as QSBC shares. This is necessary as the shares must meet specific criteria for 12 months and the relieving provisions are only available until December 31, 2018. Therefore, planning must start now and be implemented by December 31, 2017 at the very latest. Furthermore, the active business must be valued as part of the election which will determine the extent of the capital gain that can be sheltered from tax. As a result, many taxpayer’s may be enticed to overstate the value of the business in order to maximize the full exemption amount. To combat this, Finance will deny a portion of the exemption where the fair market value of the shares is overstated by 10% or more.
From a pure valuation perspective, we foresee certain issues with Finance determining that a valuation error is greater than 10%. Firstly, the valuation of an operating company (i.e. an active business) for a tax election is prepared on a notional basis. This means that the valuation simulates the value that the owner might receive on an actual sale of the company. To accommodate optimistic and conservative views of the company’s value, the notional valuation conclusion is shown as a range of values. This value range can typically be plus or minus 10% of the midpoint of the value range. Does this mean that Finance would determine than a valuation error of greater than 10% occurred if the elected value is higher than the low end of the range of values?
Secondly, if the valuation is examined and challenged by Finance, how would a valuation error be determined? The active company’s current value is based on an assessment of future earnings and the risk of attaining these earnings. As a result, certain assumptions are made in the valuation model. Even a small change in an assumption can result in a large change to the valuation conclusion due to the application of the earnings multiplier. The use of professional judgment is paramount in the reasonableness of assumptions underlying the valuation conclusion. However, one can easily see that it doesn’t take much to assess a 10% valuation error.
Thirdly, the value of a company can change over time due to changing economic conditions, risk factors, etc. One of the basic valuation principles is that hindsight not be applied in preparing notional valuations. If a company’s value were to decline after the election due to economic conditions, will Finance use hindsight to challenge the valuation conclusion at the time of the election.
Although the draft legislation has only been proposed at this time, it is unlikely the Federal Government will abandon the proposed changes in this area. With Fall already upon us, there is not much time to undergo planning to utilize the election. It is imperative that your tax and financial situation be analyzed as soon as possible to determine if any planning can be undertaken in order to benefit from the election in 2018.
Our valuation experts can assist in reviewing your current financial situation to ensure that: (a) the benefits of these relieving provisions can be utilized where possible, and (b) that the valuation conclusion is supportable to minimize the risk of a valuation error penalty.
By: Douglas Craig CPA, CA, CBV and Joe Figliomeni CPA, CA
The information in this article is of a general nature and is in summary form and may not include all the details noted in the consultation paper. Contact one of our tax and valuation professionals to discuss these matters in the context of your situation before acting upon such information.